Opportunity in the dairy industry in 2019: Can we do more than hope?
2019 thus far has been a year of surprises. Excessive winter snow and record spring rains to start the year finally gave way to summer. For the first four months of the year weather concerns, combined with lower prices, made it seem that things just didn’t want to go well for the dairy industry.
Fortunately, as the calendar turned to May and into June, milk prices began to respond in a positive direction. A continued shrinking of the milk herd seemed to generate a continued slowdown in milk output, supported only by some modest gains in productivity year over year (YOY).
With the global milk supply tightening, higher milk prices are a possibility. At current Class III board prices as of July 12th if they would hold thru year end it would be at price levels we have not experienced in over 18 months. On the flip side, a very hard planting and growing season will potentially lead to rising feed costs — negatively impacting profitability — in the second half of this year.
While we hope prices will sustain, there are dairy management practices we can employ to secure higher revenue for many farm operations. Keeping in mind opportunities to secure profitability exist when prices relative to business costs are favorable.
While we may all want to believe that there is “no way prices could falter again” that, sadly, is not true. Any commodity operates on the basic principle of supply and demand. At this time those two components seem to be as balanced as they have been in recent memory. Continued strong demand (global) and a restrained supply would lead to potentially higher prices or lend support for existing prices. Faltering demand or an increase in supply would have the opposite effect. This leads many dairy producers to ask, “What am I supposed to do?”
Cost of production
First and foremost, every dairy business needs to be able to calculate what it costs to produce a cwt of milk. This can be done on a Cash Flow Break Even (CFBE) basis, which would take into account:
- purchased feed costs
- labor cost
- other cash operating expenses (including agronomy)
- principal and interest payments
- cash capital purchases for the year.
A more accurate calculation for Cost of Production (COP) is Feed Cost + Labor Cost + Net Herd Replacement Costs + Capital Costs + Overhead Production Costs less Other Income, calculated on a per cwt basis. I would encourage any dairy producer, to work with your ag lender or a business consultant or an advisor, in order to make a solid assessment in calculating either of those numbers, as it is the first required step for being able to “do more than hope.”
Once you have determined at what cost ($/CWT) that you can produce milk, the next phase is looking at the current market potential. As stated earlier, we want/hope prices go higher.
What to expect
By taking into account global supply and demand, milk production risks, feed production risks, geopolitical concerns etc… what is the next 12 months offering? Your response could very well be, “that is literally impossible to assess.” You’re right. Predicting with certainty which way the market will go is impossible.
For those who have solid risk management strategies it’s not about trying to outguess the market. It’s knowing what your cost drivers are and making management decisions that focus on lowering your operational costs while efficiently increasing your productivity/milk output. This will increase your margin spread allowing you opportunity to take advantage of profitable marketing windows, which, for an increasing number of dairy producers, is $15.00-$16.00 Class III milk.
Profitability is not guaranteed by operational size, it is determined by efficiency. While economies of scale do exist, risk management tools are available to dairies of all sizes.
Dairy Margin Coverage provides a substantial amount of protection for smaller operations (Up to about 250 cows depending on productivity of herd) to essentially lock up a profitable return with the enhanced Income Over Feed Cost (IOFC) protection of $9.50/cwt. For larger operations Dairy Revenue Protection (DRP), the forward cash market and the CME futures are risk mitigating tools to securing a profitable margin.
It’s hard to say which way the market will go until the end of 2019 and into 2020. If you have a sound foundation on your cost of production and it provides profit opportunity at the prevailing prices, I would encourage you to proactively look at ways to protect that margin.
As an example, and I am by no means encouraging one form of risk management over another, look at the last half of 2019 and the first quarter of 2020. It would be possible to secure floor on your milk of around $16.60 for Quarter 4 in 2019 and almost $16.00/cwt in Quarter One of 2020 utilizing Dairy RP.
Over the last 20 years, in any twelve month calendar year, the Class III average pay price for the year has not exceeded $16.00/cwt 65% of the time. It’s not a guarantee but statistically it merits consideration, along with other risk management tools available in today’s industry.
Baumgartner is a team leader in Dairy Lending at Compeer Financial.