16 April 2013

13 minute read

Price fluctuation is part of a normal functioning market and allows supply and demand signals to be passed to producers. However, extreme fluctuations or volatility can have significant negative consequences. At producer level, excessive volatility makes financial planning and investment decisions more difficult. The completion of accurate cashflows is significantly more challenging when carrying out analysis of a potential dairy investment proposal. In addition, excessive price fluctuations may also lead those who are uncomfortable with constantly changing prices to decide against additional investment. This applies at producer level and processor level and could prevent the Industry as a whole from maximising its potential should it transpire.

During periods of very low output prices, only the most competitive of producers typically make positive margins from milk production. The deficit incurred during substantial downturns will require funding, most likely from either own resources or Bank finance.

End users who encounter substantial price volatility may consider switching from dairy ingredients to other ingredients. During periods of sustained price volatility, end users will consider investing in new processes that allow them to substitute other products that are less volatile for dairy ingredients e.g. butterfat with vegetable oil. Similarly, there are examples where food producers used other sugar-based products in place of lactose during sustained price peaks and changed their processes to facilitate this. There is no guarantee that these producers will switch back to the initial ingredient if it subsequently returns to more competitive pricing levels relative to the substitute ingredient. However, the movement of other commodities in tandem with dairy commodities does help reduce the risk of product substitution occurring.

Price Volatility – Financial Effect at Producer Level

A small change in milk price has a major financial effect for dairy producers. This is best illustrated by taking the example of a 500,000 litre dairy farmer in spring milk production. It is also assumed that the farmer in question has €300,000 of term borrowings over a 12-year term. A 2 cent/litre drop in milk price equates to a €10,000/ annum drop in revenue. Based on 2011 Teagasc Profit Monitor data this equates to:

• a 6% drop in milk price⁽ⁱ⁾
• a 13% drop in net margin⁽ⁱ⁾
• a 53% increase in total feed costs⁽ⁱ⁾
• a 85% increase in fertiliser costs⁽ⁱ⁾
• 116% of total Vet/AI costs⁽ⁱ⁾
• 122% of total contractor charges⁽ⁱ⁾
• a 30% increase in loan repayments⁽ⁱⁱ⁾

⁽ⁱ⁾ Based on 2011 Teagasc Dairy Profit Monitor – average producer excluding own labour charge and direct payment income.

⁽ⁱⁱ⁾ Loan interest rate of 5% assumed – used for illustrative purposes only and may not reflect current interest rates.

It is notable that the percentage drop in milk price has over twice the effect on net margin. Average milk price for 2012 is likely to be around 4 cent/litre lower than 2011 or levels double the above scenario. It is therefore very clear that changes in milk output price have by far the largest financial effect on milk producers.

Why is Price Volatility now More Evident?

For dairy producers in the EU, price volatility is a relatively new phenomenon. Prior to 2005 milk price was remarkably stable across the EU, as the European Commission (EC) managed the internal dairy markets, keeping prices stable through various market management mechanisms. However, these controls had significant marketaltering effects on international dairy markets. Prior to the last World Trade Organisation (WTO) agreement, the EC agreed to significantly reduce market support and allow internal EU milk markets to become more closely aligned with international dairy market movements. The effect has been dramatic, with massive price movements evident since this policy shift in 2005.

This increased volatility, internally in the EU, has not been solely as a result of dairy policy changes. The policy shift was quickly followed with a substantial increase in dairy prices in 2007-2008 followed by a collapse in 2009 – price movements that were extreme in historical terms. However, dairy markets internationally have always been volatile.

Figure 1 illustrates the level of volatility that has been evident over the past 20 years and shows that for sustained periods SMP (Skimmed Milk Powder) prices were at levels of greater than 10% above or below the trend price for the period. However, it is clear that there has been a marked increase in volatility since 2007.

There are a number of reasons why dairy prices are more volatile than before. Some of these reasons are as follows:

• Dairy (and other food) commodities are inelastic in terms of price demand. This means that a modest scarcity of product causes a major increase in prices and vice versa.
• Supply response in terms of increased production of dairy products is slow following a change in price. This is due to the nature of the production cycle in dairy farming which is prolonged when compared with other production cycles e.g. pigs.
• There is an increasing integration of global commodity markets with financial markets which is likely to have some effect in increasing speculation in food commodity markets.
• Increased globalisation of dairy commodity trade and increased price transparency e.g. Globaldairytrade auctions.

Taking the above factors into consideration, it is reasonable to assume that the current trend in price volatility in dairy markets is likely to continue into the future.

Why Farmers are Most Exposed

Farmers are more exposed than others in the dairy industry to the worst effects of price volatility for a number of reasons:

• Farmers are price takers rather than price makers and are unable to easily pass on input price increases. In addition, farmers are exposed to both input price and output price risks. Milk processors and end users can limit their risk by passing on input price increases – this option is not readily available to primary dairy producers. It should be noted though that the increased power of retailers is making it more difficult for processors to pass on input price increases also.
• Irish and EU milk producers have limited options to hedge their milk price to reduce the worst effects of volatility. Hedging is defined as making an investment to reduce the risk of adverse price movements. In practical terms, it would involve a dairy farmer fixing the price of his/her milk for a defined period of time in order to provide milk price stability.
• The Irish Dairy Industry is heavily export-dependent and is a seasonal producer of mainly commodity products. This makes the Irish dairy sector more exposed to volatility than other EU countries.

Which Farmers are most exposed to the effects of price volatility

Price volatility will not impact on all dairy farmers in a similar fashion. The potential impact will be very much down to the competitive position of the farmer in question. In addition, the type of farming system employed will also govern what type of hedging of milk price will be available to the producer.

Before any farmer makes a decision on hedging milk price, if that option is available, he/she must first establish their competitive position, as it will govern what effect price volatility will have on their business. The basis of this theory was put forward by Torsten Hemme, Chairman of the IFCN Dairy Network at the 2009 World Dairy Summit and is best explained by Figure 2:

The erratic line above represents a volatile milk price while the broken lines represent the cost of production of three different producers. These three different producers have been categorised into high cost, medium cost and low cost. So what effect does price volatility have on each of these producers?

High Cost Producer

Managing price risk and volatility is not the issue here, it is competitiveness. This producer will struggle to operate profitably with the exception of unusually high milk price periods and will eventually be forced to exit dairy farming unless he/she improves competitiveness. Price adequacy rather than price volatility is the issue in this case – the average milk price is not adequate to sustain the business at its current cost of production. The main objective for this farmer must be to reduce his/her cost of production and/or increase their average output price (most likely through improving milk solids) to a level which is sustainable in the medium-term.

Medium Cost Producer

This producer will benefit from risk management on milk price. Hedging of milk price will not improve their average milk price, (if anything it will slightly reduce it), but this producer will manage better financially with periods of very low milk price as in 2009. This producer is typically farming an efficient high-input system. Therefore, any price risk management strategy needs to incorporate management of input costs particularly given the recent volatility of input prices.

Low Cost Producer

This producer can cope with periods of very low milk price relatively comfortably. Therefore, hedging of milk price will not confer the benefits that it will to a medium-cost producer as milk price volatility does not have any significant long-term financial implications. Potentially, they may gain more from not hedging as a hedged milk price will be slightly lower on average in the medium-term than the unhedged market price. This low-cost producer is most likely in a low input grass-based production system.

How to Reduce Price Volatility Effects

The options to manage price risk available to Irish producers are currently limited. Some of the options available are as follows:

• As shown earlier in the paper, improving competitiveness is a very effective way of positioning your farm business to deal effectively with price volatility.
• Build a cash reserve during high margin periods – this reserve can then be used to fund any deficits incurred during periods of low milk price.
• Use bank finance to fund cash deficit periods. This option is available, but its effectiveness will be governed by how efficient the farm business is. For high-cost inefficient businesses, there will be substantial deficits to finance and it may take a substantial period of time before the deficit incurred is repaid, possibly not before another deficit period is encountered.
• Forward-purchase of inputs as well as adjusting capital spending (e.g. capital fertilisers (lime, P and K), re-seeding) are methods of managing cashflow in order to better prepare a farm business for a downturn.
• Income averaging can be used in order to reduce variances in tax liabilities incurred, thus helping to manage farm cashflow more successfully.

Managing Price Volatility – Other Potential Options

There are other potential options available and in use in other countries to help farmers manage price volatility. Four of these options are examined in detail below:

Income Stabilisation Tool

This is a subsidised mutual insurance fund which producers would contribute to and avail of under a specific set of circumstances. An Income Stabilisation Tool proposal is currently included as part of the draft Pillar II CAP reform proposals. Under this proposal farmers would be able to access the fund under the following circumstances:

• Farm income drops by over 30% of previous 3-year average or Olympic average of previous 5 years.
• Compensation cannot exceed 70% of income loss.
• Maximum community funding of 65% of total cost of fund.

It is likely that a fund of this type would be cumbersome to operate from an administrative point of view. In addition, it remains to be seen whether the proposal makes the final CAP Reform agreement. The aspect of cofinancing may also make it unattractive to some states should it become available.

It should also be noted that income is defined as inclusive of any direct payments. Going forward, the EU still views the Single Farm Payment in its revised form as the primary tool to reduce the worst effects of market price volatility.

Hedging of Milk Price Using Futures Markets

Hedging of price is defined as making an investment to reduce the risk of adverse price movements. An example of this would be a dairy farmer availing of a futures contract to reduce the risk of a fall in milk price. Dairy futures markets are well-established in the US where some dairy farmers use them directly to hedge milk price. Where using futures markets to hedge output price, it is also strongly recommended to hedge the bulk of your inputs also. This reduces the risk of a negative movement in input prices eroding a farmer’s net margin.

Despite the availability of futures markets in the US for around 20 years, less than 5% of dairy farmers use them directly. This is explained by a number of reasons; only very large farmers can justify using them directly, they are complex and therefore need a high level of understanding to use them effectively and there can also be substantial financial deposits required to use them.

Futures markets in the EU are still at a very early stage and the lack of an independent auditable milk price index is a major drawback in their development. Futures markets are of major benefit to heavy end users of product who can use them to stabilise the price of their dairy inputs.

Hedging Using Forward Contracts

This is similar to hedging using futures markets. However, forward contracts are more flexible and are generally offered through a milk processor. A recent example of this would be the Glanbia Fixed Price Scheme. As with futures contracts it is important to hedge input prices in tandem. Forward contracts are used successfully in the US where milk processors offer them usually in conjunction with a commodities broker. The disadvantages of these are that you are tied to the milk processor for the duration of the contract and a farmer cannot exit should milk price increase substantially.

During the above 12-year period, the average hedged milk price was $13.84/cwt versus an average unhedged milk price of $14.15/cwt, a 2% difference in milk price. This illustrates the fact that you cannot beat the market, but you can make the ride less bumpy. Hedging of milk price gives producers some degree of certainty, avoids the peaks and troughs that those in unhedged positions experience and it results in a very similar milk price over a long-term period.

Even with the option of forward contracts, such as above, the use of this remains quite low in the US. In all, it is estimated that as little as 20% of US dairy producers use some form of price risk management.

Farm Savings Accounts

This is a designated savings or deposit account designed to encourage farmers to build a cash buffer fund during high margin periods for use during cash deficit periods. Their use is encouraged normally through a tax deferral incentive. Various eligibility criteria can be incorporated, including a maximum deposit per farmer and a maximum length of time before the tax deferral expires. In terms of tax planning they are quite similar to the existing income-averaging option; however they also encourage participants to build up a cash buffer. Their availability would also reduce solely tax-driven investment. Variants of these savings accounts are currently in use in Australia and Canada.

Conclusion

• Price volatility is a relatively new phenomenon for Irish and EU dairy farmers who were previously shielded from its worst effects. However, all indications are that the price volatility evident over the past 5 years, is likely to continue into the future.
• Dairy farmers, due to the nature of their business, are significantly exposed to the effects of price volatility. Those in high-cost production systems are even more exposed and need to look at improving competitiveness as their first priority in order to position their business to better cope with the effects of volatility going forward.
• Currently, the options to manage volatility are limited for Irish dairy farmers. Internationally, there are other potential options available, such as forward contracts and farm savings accounts, whose use could help substantially in managing future price volatility in Ireland.
• It is likely that price volatility, if not managed, will lead to reduced investment in the Irish dairy industry both at primary and processor level. It is therefore a major threat to the Irish dairy industry fully maximising the opportunity presented in a post-quota environment.

Further Reading You can view the full report by clicking here.

March 2013