Hedging should not be the elephant in the room

It’s a muggy mid-July afternoon in Chicago and all is quiet on the dairy front for today. A quick glance at dairy product spot prices reveals that cheese powder and butter prices are all at — or within pennies — of their 2016 high price print.

Over the past six weeks, prices boomed northward amid growing — downright burdensome — inventory levels and largely bearish market sentiment. Dairy prices so far this year remind me of a quote by George Bernard Shaw who wrote, “If history repeats itself, and the unexpected always happens, how incapable Man must be of learning from experience.”

Maybe it’s time to review dairy price risk management.

On the surface, dairy price risk management sounds about as fun as sitting through a calculus class with an ingrown toenail. If that’s the case for you, simplify the concept down to the nuts and bolts to make it more interesting. Managing price risk is essentially attempting to shift part (or all) of your business from price taker to price maker. See, simple enough.

Let’s dial in a little deeper here. In my experience, dairy buyers wake up every morning wanting price certainty. But many dairy buyers also have many misconceptions about risk. They also have concerns about the cost of hedging and fears of loss on hedging transactions. Meanwhile, dairy hedging simply attempts to transform unacceptable price risks into an acceptable form.

Operational and financial risks

Break down your business into two risk categories: operational and financial. Operational risks are all those directly associated with the daily production of a clean, fresh and quality product. While problems from a failed refrigeration compressor to a lack of available trucks are serious, they’re fairly straightforward. The financial risks can be more ambiguous but just as critical.

To understand financial risks is to first accept that you have them. Be open to the idea that the dairy company that does not take responsibility for its financial risks is really betting that the markets will either remain static or move in its favor. Ironically, speculation is another main hurdle to hedging.

When it comes to markets, speculation is a dirty word. Many commercial hedgers do not hedge because they automatically believe they’re trying to “beat the market.” They believe that using futures or options introduces additional risk. In reality, the opposite is true. A properly constructed hedge lowers risk. Betting that the prices will arrive at or below some arbitrary budget level is really the gamble.

Hedging or speculating?

Those who understand and are comfortable with hedging as the opposite of speculating may still struggle with the costs associated with hedging. Admittedly, some hedging strategies do cost money. But consider the alternative. To accurately evaluate the costs of hedging, you have to consider them against the costs of not hedging. The cost of not hedging is the potential loss your company can suffer if market factors move against your interests.

Additionally, the failure to evaluate the performance of a hedge by the appropriate benchmark also prevents action. The key to properly evaluating the performance of all futures, options, swap or forward-contracting transactions lies in establishing appropriate goals at the outset.

If your company buys a million pounds of cheese per month and you price 50% of cheese forward at 10 cents below budget (after considering adjustments for any basis issues), then we need to be comfortable with those figures at the beginning and at the end. (Note: there are ways to make the hedge more flexible and profitable, but for the sake of this article, we have to be comfortable with the concept of setting a real budget). You need to be OK with the idea that you’re establishing a fixed price and profit margin, and removing volatility.

Although it’s valuable to get a sense of market tenor, many market participants fall into a trap of trying to construct hedges on the basis of their market outlook. As a dairy risk consultant, I spend a lot of time talking to buyers and sellers of dairy products about short- and long-term price direction based on supply and demand assumptions. But the best hedging decisions are made when you acknowledge that market movements are unpredictable. A hedge should always seek to minimize risk first. It should not represent a gamble on the direction of market prices.

Your well-designed hedge — one that considers the central aspects discussed above — reduces both risks and costs to your operation. Hedging stabilizes earnings, frees up resources and allows you to focus on basic competitive advantages of quality and quantity of your products.

Take some time this summer to review what risks you are comfortable with and which ones make you uncomfortable. Ask questions, make a plan, move your business forward with more certainty in what has increasingly become an uncertain commodity price world.