(RM2-40.0)
9-01

Milk Futures, Options and Basis

Michael Haigh, Matthew Stockton, David Anderson and Robert Schwart[1]

Dairy producers confronted with uncertainty associated with the future price of milk have several methods of limiting that risk. Hedging with either futures or options contracts is one method of price risk management for producers. This publication replaces an earlier publication entitled: “Hedging Milk with BFP Futures and Options (RM2-35)”.  In 2000, the federal order program abolished the Basic Formula Price (BFP) and adopted a new formula pricing system for milk.  The BFP contract became the “Milk” contract.  This contract settles to the Class III price, which is similar to the BFP.  Since early 2001, milk futures and options are traded only on the Chicago Mercantile Exchange.

Price Risk

Uncertainty associated with the future cash price to be paid for a commodity is known as price risk.  No one knows the direction of future prices.  A dairy producer would want an increase in prices but a processor wants a decrease.   For both of these parties there is uncertainty associated with the future.  The milk futures and options market enables both parties to manage these unfavorable price changes known as price risk.

Milk Futures and Options

Currently, two futures and options contracts are currently traded on the CME (Chicago Mercantile Exchange). The “Milk” contract corresponds to the USDA Class III price, and the other is called the Class IV contract[2].  The standardized futures contracts are for delivery of 200,000 lbs. of Grade A milk testing 3.5 percent butterfat.    Futures contracts for both Class III and Class IV milk, trade every month, up to 18 months in advance. Futures and options prices are quoted in dollars per hundredweight (cwt).  For every one-cent change in a futures contract price the value of the futures contract changes $20.00.  One option contract equals one futures contract in size. 

At expiration, no milk is actually delivered or received; instead contract prices are forced to the corresponding announced Class III or Class IV price for that month.  A unique characteristic of the milk market is the announcing of prices for the previous month on or around the 5^th of the following month.  There is a spot market for milk other than Grade A and for some Grade A milk not associated with a regulated market.  However, for milk associated with a regulated market, prices are announced monthly. 

Hedging

Hedging is the process of laying off risk to some one willing to assume that risk.  Hedgers may use the futures market to lock in a price.  Product producers hedge to minimize the risk associated with a price decline, while product users try to minimize the risk associated with a price increase.  Producers selling milk hedge by selling futures contracts.  Those buying milk, buy futures contracts.  The cash and the futures prices move in the same direction.  If the producer loses because of a decline in the cash market, then he or she gains it back in the futures market.  The opposite is true for the milk buyer.

Margin Accounts

All participants that buy or sell futures contracts are required to maintain a margin account as long as a position is held in the futures market.    The margin account is a performance bond, and the initial margin requirement varies depending on the type of trader (speculator or hedger) and the contract.  Each contract is compared to the closing price at the end of each trading day.  A contract that is profitable will result in money being added to the margin account.   A hedger in a short position (sold a contract) has a profit if the price of the contract is above the closing futures price. The hedger can close out the position at a profit by buying a contract for the same month.  The profit is the difference between the price of the contract sold and the price of the purchased contract.  This difference is added to the margin account.  For example, imagine a November contract was sold for $13.27; the next day the market closes at $12.87.   The seller could buy the $12.87 contract and earn $.40/ hundredweight or $800 per contract. 

Money is subtracted from the margin account, if the contract position is unprofitable.  To maintain the contract the maintenance level must be maintained, and if the margin account falls below the maintenance level, the hedger will receive a margin call.  Figure 1 illustrates the changes in the margin account balance as the value of the contract changes.

Figure 1. Example Margin Account Activity

Basis

Basis is the defined as the difference between the cash price and the futures price. The simplicity of the formula does not reflect the complexity of its application.

The basis formula is:

Cash Price – Futures Price = Basis                                            (1)

If this basis calculation yields a negative number the market is ‘normal’, and if the calculation yields a positive number the market is ‘inverted’.

The basis formula can be rewritten as:

Basis + Futures Price = (Expected) Cash Price                         (2)

The basis can be determined using either a gross price or a “mailbox” price.  The mailbox price is the gross price minus hauling, promotion and marketing charges.   The mailbox price is sometimes called the net price.   Some cooperatives print the gross price on the check printout, while others print the net price.  Preliminary research suggests that either the net price or the gross price can be used to calculate the basis, with little adverse consequence[3].

Milk basis calculations also differ from basis calculations for other commodities such as livestock and grain, because milk price is not strictly based on grade or transportation.  Milk prices reflect season, market location quality differences, and milk use.  These designations and destination differences determine the pool price[4].  For example, a producer whose milk is associated with a market pool composed primarily of Class I (beverage) milk receives a higher price than a producer whose milk is primarily associated with a pool dominated by Class III (cheese) milk.  Their milk quality may be identical, but the end use of their milk determines their price.    Except for Grade B milk and some unregulated milk, prices are announced after the product has been delivered and used. These announced prices hold for a whole month.  There are no cash market prices quoted or published on a daily basis for Grade A milk.  Except for some spot market transactions, and some transactions involving Grade B milk or unregulated milk, milk prices are based on USDA formula prices.   

Tracking Basis

Tracking basis is a simple process because futures prices are cash settled to announced milk prices.  The process involves the dairy producer subtracting the price for the futures contract for which he or she wants to determine the basis from the pay price printed on the milk check.  Table 1 illustrates this process.  Suppose the producer wants to determine the basis for each month of the year 2000.  The January pay price for the dairy producer’s milk was $11.46.  The announced Class III price for January 2000 was $10.05.  This producer’s basis for January 2000 is $1.41.    This producer’s basis varies 38 percent over the year 2000.        

Table 1. Basis calculation for a central Texas dairy for 2000.

If the basis is to be of use to the producer he or she should determine it for each month over at least three years.  To estimate a monthly basis, the producer could average the basis for each month over several years. Table 2 illustrates this process of estimating monthly basis.   Adding the latest year’s data and dropping the earliest years creates a running average monthly basis.

Table 2. Three-year average basis calculation for a central Texas dairy. 

Using the Basis

By knowing the basis, the hedger can estimate a potential cash price for the point in the future when milk will be sold.  Dairy producers hedge to protect themselves against a decline in prices by the time of milk delivery.   Dairy producers want to assure themselves they will receive a milk price at least high enough to cover all cash out flows for the period.  Adding an estimate of basis to a futures price being considered gives the producer an estimate of his or her cash price at the time milk is sold if the producer sells the futures contract or buys a put option (the right but not the obligation to sell) using the futures price.

Basis Risk

If basis can be predicted perfectly, future cash price can be known with certainty and all risk can be eliminated.  Unfortunately no one knows exactly what the basis will be.   This uncertainty is known as basis risk.  Reducing basis risk requires knowledge of the factors that can alter it.  The most obvious factors are milk quality, milk utilization, producer market location, and milk components.  The Producer Price Differential (PPD)[5] is one part of the basis.  It reflects the utilization of Class I, Class II, and Class IV relative to Class III, and the locations of the Class I plants receiving producer milk.   Producers can influence quality, and component content.  Producers can move and in some instances, producers can choose the handler receiving the producer’s milk.  Figures 3 and 4 illustrate the effect on producer prices when the basis changes with an inverted market. 

The producer with a highly predictable basis faces less basis risk and can eliminate more risk.  An effective hedge is one where basis risk is less than the original price risk.   Even though a basis change may be ‘bad’ for the producer, a hedge is better than no hedge in most situations.

Summary

The futures and options markets are viable tools to those producers who have large enough quantities of milk to hedge.  Basis is fundamental, and every producer has a unique basis.   Market conditions, individual producer conditions, and the classes of milk marketed affect basis.  Basis has some inherent risk.  Futures and options contracts should not be used if the basis risk is greater than the underlying milk price risk.  Understanding basis can help the producer to decide if futures and options are tools that can reduce risk.

Partial funding support has been provided by the Texas Wheat Producers Board, Texas Corn Producers Board, the Texas Farm Bureau and the Houston Livestock Show and Rodeo.