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• Dairy producers now have a new tool that will allow them to manage their own price risk.
• Market volatility can be a real issue as Illinois dairy farmers learn to cope with free-trade markets. New pricing tools can help level the "ups and downs" and keep dairy operations financially sound.

As government reduces its role in milk pricing, dairy farmers will have an opportunity to learn how to manage milk price volatility for their own operations. Grain farmers have always had a marketing edge with futures contracts, options and forward cash contracts. Grain farmers learned how they could lock in certain levels of income to act as collateral for loans, or to improve cash flow. Dairy farmers now have that same opportunity with Basic Formula Price (BFP) milk contracts, and options contracts offered by the Chicago Mercantile Exchange (CME). The following are some common questions asked by dairy farmers about BFP milk contracts, and an example of how a contract can be used to lock in a profitable price.

How large of a dairy operation do I need to be to use BFP milk contracts?

You can be any size dairy. A dairy operation that averages 55 pounds of milk per day per cow would need to milk around 120 dairy cows in a month to match production to a CME BFP milk contract. As you will see later in this article, matching production to the contract is not as critical as one might expect for the reason that all contracts are cash market settled. In some months a CME BFP milk contract might represent 90 percent of your monthly production, and in other months, the contract might represent 120 percent of your monthly production. Word of caution: BFP milk contracts should be used to HEDGE a price. That means it is best to match production to a contract. When contracts and production are not well matched there is a speculative element in the portion of milk not covered by a contract.

What is a BFP Milk contract?

A contract is 200,000 pounds of milk, 3.5 percent butterfat (approximately 4 tank truckloads of milk)

In what months are contracts offered?

CME offers price quotes for all months so pricing a BFP milk contract is very convenient.

Do I have to do anything differently to deliver milk under contract?

No. All contracts are cash settled. You will deliver your milk through your usual channels. Because all contracts are cash settled, offsetting a position in BFP milk futures is not necessary. The contract will stop trading on the fourth day of the following month. The price used to offset a contract will be the BFP price announced the fifth of every month for the preceding month's final price. This is a very convenient feature of the BFP milk contract.

How often are prices quoted?

Prices are quoted every marketing day at CME under the title of "BFP Milk." Trading hours are 8:00 a.m. to 1:10 p.m. CST. Prices quoted are per hundredweight (cwt.) of milk. The minimum price fluctuation is one penny per cwt.

What part of the milk price is covered in the CME price quote?

CME quotes BFP. The BFP is the average price paid for manufacturing grade (Grade B) milk in Minnesota and Wisconsin in the base month, updated to the current month with a cheese-butter-nonfat dry milk product price formula. The BFP is the foundation for pricing Grade A milk used in three classes of dairy products.

Is there a "basis" to calculate? Or put another way, what is the difference between my actual cash price and the BFP price?

The difference between your actual cash price and BFP price is the Class I price (fluid milk) differential established for each Federal Milk Marketing Order and the $.30 Class II price differential for all Orders. Historical prices show that the blend price of Illinois milk price differentials range from a positive $1.80 to a positive $2.35. The reason for the price range can be found in the way prices are "blended" to pay dairy farmers. Each month there is some variation in the amount of milk used in fluid markets (Class I price, the highest) and manufactured milk markets (Class II and Class III prices). In months where more milk is utilized in fluid markets, the blend price paid to dairy farmers is higher. Your final milk price will also include butterfat differential, quality bonuses and premiums negotiated by dairy cooperatives for their members.

Do I have to use a broker?

Yes, for now. In the future, I expect dairy cooperatives to offer forward contracts to their producers thus eliminating the need for a broker. In turn, dairy cooperatives will shift their risk to BFP milk contracts. It will be another service offered to dairy cooperators.

What does it cost to trade a contract?

Most brokerage firms will charge $60.00 to turn (buy and sell) one contract ($.03 per cwt. of milk.) Most brokerage firms also require that a minimum amount of money be deposited into a trading account (usually $2,500.) This is the account where margin money will be maintained and where additions and subtractions will be made according to changes in the market.

Will there be margin calls?

Your account is settled every day according to the price at market close. If the market moves up and you are in a short or sold position, you will have a margin call. If the market moves down and you are in a short or sold position, the gain will be posted to your account. Each penny move in the market translates into $20. You are required to maintain a certain percent of the total value of your contract in an account. Most firms require 6 to 15 percent of the total value of the contract in an account. These percentages can change especially if the market is very volatile.

The following example shows how an Illinois dairy farmer can use BFP milk futures to lock in a price.

Fred Farmer owns a dairy operation where he and a hired-man milk, on average, 125 Holstein cows daily. His rolling herd average is 18,000 pounds, 3.7 percent butterfat. Fred Farmer's breakeven price for milk is $12.00 per cwt. His breakeven includes fixed costs and variable expenses. In January 1999, Fred Farmer watches price quotes from CME on his farm data screen and sees that July BFP milk is trading for $12.50, with each month after that trading lower. Fred Farmer sees an opportunity to lock in a profit. He contacts his broker and places an order to sell one contract (200,000 lbs.) of milk for July production at $12.50 per cwt. The broker executes the order through his brokerage firm seated with the CME. Fred Farmer now has a BFP of $12.50 per cwt. for 200,000 pounds of milk locked in.

To calculate his anticipated price, Farmer adds an expected Class I and II differential of $1.80 per cwt., $.32 butterfat premium, and $.20 quality premium for a total of $14.82 per cwt. minus $.50 cwt. hauling for a final expected price of $14.32.

His total monthly production is around 221,000 lbs. so the $14.32 price can be applied to about 90 percent (200,000 lbs. of milk under BFP contract divided by his actual production of about 221,000 lbs. equals ninety percent) of his anticipated production.

In July if prices decline to $12.00 per cwt., Fred Farmer can do one of two things. He can offset his contract any time before the final trading day by instructing his broker to buy one contract of milk. In January he sold 200,000 pounds of July milk for $12.50 and in July he offset his contract by buying it back for $12.00 per cwt. His profit is $.50 per cwt. for 200,000 pound of milk. Fred Farmer improved his monthly cash flow by $1,000 less commission fees ($.50 X 2000 cwt. = $1,000) by using the futures market to lock in a profitable price.

The second thing Fred Farmer could do is "nothing." July BFP milk contracts would stop trading on the fourth day of the month following his contract month. For this example, on August 4^th Fred Farmer's contract would stop trading and be offset automatically by his brokerage firm with the announced price of the BFP on August 5^th. The results would roughly be the same (Table 1).

Table 1. Income Comparison With and Without July BFP Milk Contract For 221,000 Pounds of Milk Produced in July

*Combination of Blend Class Price Differentials, Butterfat Differential, and Quality Premium.

What would happen if BFP prices had gone higher to $13.00 per cwt.? Fred Farmer would still offset his contract as planned or let his contract automatically be offset by the brokerage firm. But instead of making a profit his brokerage account would be $1000 less. From the time price increased to the time the contract stopped trading or was offset, Fred Farmer had to face margin calls that totaled to $1000. In January he sold 200,000 pounds of milk for $12.50 and now he has to offset it at a higher price of $13.00 per cwt. (Table 2).

Table 2. Income Comparison With and Without July BFP Milk Contract For 221,000 Pounds of Milk Produced in July

*Combination of Blend Class Price Differentials, Butterfat Differential, and Quality Premium.

For this reason it was critical that Fred Farmer knew his breakeven price. Even though the market moved up when he anticipated a price decrease, the price he locked in was profitable for his operation. Using futures for a commodity rich in regulation and steeped in politics may take a little getting use to. However, the opportunity is there to learn to use a tool that moves the dairy industry one step closer to free market trade and provides more price control for individual dairy farms. Further information on this subject is available through your local dairy cooperative, brokerage firm, Chicago Mercantile Exchange or qualified Extension Educator. To locate a qualified broker, contact the CME by calling Errol Baxter (312) 930 8202. CME maintains a list of brokerage firms qualified to handle BFP milk contracts.

Web sites to visit www.cme.com/dairy or www.ams.usda.gov/dairy