Price hedging is key to survival for dairy processors and farmers

03-Sep-2012 - Last updated on 04-Sep-2012 at 16:18 GMT

Hedging is claimed to introduce certainty in an uncertain world

Milk processors and dairy farmers will need to make far greater use of price hedging tools if they are to survive in today’s increasingly volatile world, claims a leading dairy risk management analyst.

Price volatility is huge within dairy commodities, such as butter, skimmed milk powder (SMP) and cheese. But the sector makes little use of hedging as a means of managing costs, John Lancaster, an analyst with FCStone Commodity Risk Management told delegates at the Dairy UK conference yesterday (September 3).

It’s not about predicting highs and lows in the market price, said Lancaster: ”It’s all about locking in your margin and finding equal and opposite risk to create certainty.”

But there is little appetite within the European dairy sector for using such financial tools, Dr Joop Kleibeuker, secretary general of the European Dairy Association, told Foodmanufacture.co.uk. He doubted the situation was likely to change in the near future.

Another conference delegate also questioned whether there was sufficient “liquidity” in the market for hedging to work.

However, conference chairman Peter Dawson, Dairy UK’s policy director, said: “Price risk management is something that the dairy industry has to come to grips with.”

Price fluctuations

Hedging is widely used as a tool to manage price fluctuations in areas such as foreign exchange, equities and energy. And yet they have shown far lower price fluctuations than the dairy sector, said Lancaster.

Despite the fact that prices have fluctuated by as much as ±40% in the dairy sector since 2007, hedging of commodities such as butter and SMP has been relatively limited within Europe, he added.

“We have moved from a period of extreme stability – a ‘walled garden’ – to an incredibly volatile environment,” said Lancaster. “Would Gordon Gecko [the fictional hard-nosed trader depicted in the film ‘Wall Street’] trade milk? I don’t think he would.”

To make matters more difficult for dairy farmers, their animal feed prices have also exhibited extreme volatility for a number of years, added Lancaster.

Contrary to popular belief, the source of the volatility is not market speculation, said Lancaster, but imbalances between supply and demand compounded by policy decisions by governments which have relaxed controls on trade.

Ingredient substitution

Dairy ingredient volatility had led to substitution of, for example, butter with palm oil. Palm oil is a “very liquid market” and widely hedged, said Lancaster.

“Buyers prefer to do business with suppliers providing stable prices and volumes,” he noted. “Substitution became important in the decision made by many processors in what to use in new products.”

The fact that the US drought had led to an increase in the amount of wheat being hedged “gives a clue for the development of dairy markets” with “far more hedging”, he added. “It gives farmers a far greater level of financial stability – they miss the highs, but they also miss the lows. The farmer has a certainty as to the price he is going to get.”

By hedging between 40 and 60% of what they handle – enough to cover their fixed costs – farmers could benefit from some market exposure without being exposed to too much risk, he added. It would make it easier for them to raise finance from the banks, while ensuring processors milk supplies.