One key strategy gaining momentum in the dairy sector is the adoption of milk-price hedging tools. This article explores the benefits of utilising these tools in New Zealand and why implementing a milk-price hedging policy can be a prudent move for dairy farmers.
Four reasons for considering milk-price hedging tools
- Protection against price volatility: One of the primary advantages of milk-price hedging tools is their ability to shield farmers from the inherent volatility in milk prices. The global dairy market is influenced by myriad factors, including weather conditions, geopolitical events and shifts in consumer demand. By employing hedging instruments, such as futures contracts or options, farmers can establish a fixed or minimum price for their milk, providing a degree of certainty in an unpredictable market.
- Risk mitigation for input costs: Dairy farming is a complex operation that involves various inputs such as feed, fertiliser and fuel. Fluctuations in the prices of these inputs can impact overall production costs. Implementing a milk-price hedging policy allows farmers to manage input cost risks by stabilising their revenue streams. With a more predictable income, they can better plan and allocate resources, ensuring the sustainability of their operations.
- Enhanced financial planning: Milk-price hedging tools empower farmers to create a more robust financial plan. By establishing a fixed price for a portion of their milk production, farmers gain a clearer understanding of their revenue potential. This clarity is invaluable when making strategic decisions, such as investments in technology, expansion, or debt management. A well-thought-out financial plan contributes to the long-term viability of the farming business.
- Improved borrowing capacity: Lenders often look for stability and predictability when assessing the creditworthiness of agricultural businesses. A milk-price hedging policy provides farmers with a more stable cash flow, enhancing their ability to secure loans and financing at favourable terms. This increased borrowing capacity can be instrumental in implementing growth strategies or navigating challenging periods.
Establishing a hedging policy for your business
Establishing a robust hedging policy is a crucial step in leveraging milk-price hedging tools effectively for a farming business. Any such policy should be a guide for yourself and any other decision-makers of the business on when and how much to hedge. These decisions are influenced by your purpose for wanting to use hedging tools and your appetite for risk.
- Risk assessment and objectives: Begin by conducting a thorough risk assessment for your farming business. Identify key risk factors such as market price volatility, input cost fluctuations and external variables like weather conditions. Once risks are identified, establish clear objectives for your hedging policy. Determine what you aim to achieve, whether stabilising revenue, creating certainty for budgeting or perhaps just looking to make gains when you see a potential opportunity.
- Define risk tolerance: Assess your farm's risk tolerance and understand how much volatility and uncertainty your operation can withstand. This involves considering your financial position, debt levels and overall business resilience. Your risk tolerance will guide the level of hedging you implement and the instruments you choose.
- Select appropriate hedging instruments: Explore the various milk-price hedging tools available in the market, such as futures contracts, options and fixed milk-price contracts. Each instrument has its own set of advantages and considerations. Futures contracts, for example, offer a fixed price for a future date, providing certainty but also locking in the price. Options provide more flexibility but come with a premium cost, more like an insurance policy. Evaluate these options based on your risk profile and financial goals.
- Determine hedging ratios: Establish the proportion of your milk production that you want to hedge. This involves deciding how much of your production you are comfortable locking in at a fixed price. Consider factors like production costs, market conditions, any other hedging you have in place (such as contracted feed and fertiliser or interest-rate hedging) and your risk tolerance when determining these ratios. It's often prudent to hedge a portion of your production to manage risk while leaving some exposure to benefit from potential market upswings.
- Implement a monitoring system: Once you've initiated hedging positions, implement a robust monitoring system to track the performance of your hedges against market movements. Regularly review your hedging strategy in light of evolving market conditions. Adjust your positions if needed to align with changing circumstances and to ensure your hedges remain in line with your business objectives.
- Stay informed and seek professional advice: Keep yourself informed about market trends, global economic factors and developments in the dairy industry. Consider seeking advice from financial professionals or agricultural economists with expertise in commodity markets. Their insights can help refine your hedging strategy and ensure it aligns with both short-term and long-term business goals.
- Document and review: Formalise your hedging policy by documenting all aspects, including objectives, risk tolerance, hedging instruments and monitoring procedures. Regularly review and update the policy as market conditions and your business evolve. A dynamic and adaptable hedging policy is key to staying ahead of market dynamics.
By following these steps, a farming business can establish a well-defined and effective milk-price hedging policy. This not only helps in managing risk but also contributes to the overall financial resilience and sustainability of the operation in the volatile dairy market.
How we can help
Navigating a hedging strategy for the first time can be daunting, and the different products available can be somewhat overwhelming. They all carry different reporting and tax treatments, varying levels of complexity and levels of risk and cost. Here are a few ways that our Rural & Farming team at Baker Tilly Staples Rodway can provide some assistance throughout the process:
- Reporting on milk-price hedging contracts: We have developed a comprehensive yet simple solution to summarise your hedging positions to provide timely and clear information for your ongoing hedging decisions.
- Tax advice for different tools: Different milk-price hedging tools may have varying tax implications. We offer tailored tax advice to clients based on the specific instruments they use. For example, futures contracts and fixed milk-price contracts are treated differently for tax purposes. Providing guidance on the tax treatment of gains or losses from hedging activities ensures that clients optimise their tax positions and meet regulatory requirements.
- Education on available tools: As a farmer, you have a diverse range of milk-price hedging tools at your disposal. We can provide educational resources and one-on-one consultations to help you choose the tool that best suits your reasons for hedging. At the end of this article, you will see a summary of different instruments, and some pros and cons of those. This list is not exhaustive but provides some idea of the variety of hedging tools available.
- Market and industry information: Keeping informed about market and industry trends is crucial for effective hedging decision-making. We can provide regular updates on relevant market conditions, global economic factors, and shifts in the dairy industry that we see and hear of through our wide range of contacts. This information equips you with the insights needed to adjust your hedging strategies in response to changing circumstances, ensuring they remain agile in the dynamic dairy market.
- Customised hedging plans: Finally, we develop customised hedging plans tailored to our clients’ unique circumstances, through working closely together. This includes identifying the optimal mix of hedging instruments, determining hedging ratios, and establishing clear objectives to suit their reasons for hedging and their risk appetites. A personalised approach ensures that clients' hedging strategies align with their overall business strategy and financial objectives.
Products and descriptions
|Fonterra fixed milk price
|A contract direct with Fonterra to supply X kgMS for $X price per kgMS in a particular season.
|A hedge contract that commits a specified volume of milk at a fixed milk price for a specified season, that is linked to the Fonterra forecast (and then actual) Milk Price for that season. Requirement to pay margin on any mark-to-market gains and initial margin at specified rates.
|A hedging instrument that sets a floor (minimum milk price). It gives you the option of taking the cover when there is value in the hedge or forgo if the hedge is “out of the money” (i.e. when milk price is higher than the option).
Is a combination of a high and low milk price contract (put option and “call” option) providing a hedged “milk price band” with minimum and maximum milk prices. Pay a premium for the put option but receive a premium for the call option. Therefore, it is possible to have a “zero-cost collar” if you choose put and call prices with the same premiums to offset each other.
The minimum milk price (floor) is guaranteed, but if Milk Price is higher, you can choose not to exercise it. However, if milk price goes above the call option (ceiling) then you must pay the difference between the final milk price and your call option.
A hedge contract that commits a specified volume of milk at a fixed milk price for a specified season, that is linked to the Fonterra forecast (and then actual) milk price for that season. No initial or variation margin requirement so this is a simpler alternative to milk price futures with less attention to cashflow management required, however it has slightly higher sunk costs.
Max of 50% current season, 50% next season and 25% two years out. Requires at least $6mil net assets (with shareholder loan accounts deducted from assets).