How UK farmers could use milk futures

Milk production in the world’s seven biggest exporting regions rose 18% in the first quarter of this year. The EU – anticipating the lifting of quotas in April 2015 – accounted for half of that growth.

That extra milk flushing around free markets means prices are likely to head up and down more sharply.

Farmers can soften the cycles of boom and bust, winning big one year and losing out the next, by using risk-management strategies.

Buying feed forward to fix a large part of costs is common practice but options for securing a farmgate return are much more limited.

Some can sell a proportion of their milk on a commodity-basket formula and others, if they’re lucky, can sign up to a cost-of-production tracker.

But another tool, well known to arable growers and widely used on the other side of the Atlantic, is starting to be tentatively explored in the UK – milk futures.

Smoothing out

A futures contract is an obligation to buy or sell a set amount and quality of product at a set time and date in the future.

The contract can be fulfilled by delivery or “closed out” by selling or buying an equivalent contract.

In dairy, it means a farmer choosing to sell a percentage of their milk at a particular price in a particular month.

Irish processor Glanbia and New Zealand dairy giant Fonterra have started offering a first step with fixed-term, fixed-price contracts for one or three years.

Using cash from Defra’s dairy fund, suppliers’ group Dairy Crest Direct (DCD) is researching how a similar price management tool could be offered to British producers.

“What we would like to achieve is to offer farmers a fixed price for a proportion of their milk,” says DCD secretary Michael Masters.

“From a farmer perspective he can fix his feed and a lot of other inputs, but can do nothing about his milk price.

“If I am a farmer who wants to borrow some money from the bank I can lock in a lot of volume [by selling forward].

“Particularly for our larger farmers, there is a big appetite out there for it.”

DCD is working with commodity trader INTL FC Stone to explore a British model.

Commodity risk manager Charlie Hyland says milk market volatility has been increasing since 2007 and farmers will need to be prepared to cope with it.

“Farmers want to get a fair price for their milk and they want to have secure profitable margins,” he says.

“But people need to understand you are not always going to beat the market. It is not about getting the best price at all times.

“It is about smoothing out volatility and when the market collapses you are not going out of business.”

How it works

Before milk futures find a place in a farmer’s finance toolkit, a European system of milk futures contracts will have to be created and processors will have to offer some new schemes. There are two ways farmers could get involved.

The first is to engage a broker directly, instructing them to sell a futures contract on the financial exchange for a certain month when the market price seems favourable.

They also take out an opposite position so, however the market moves, the farmer is protected. That is a called a hedge.

This route offers the greatest flexibility and where it is used in the USA it is not overly expensive but, without experience, it is fairly complicated to manage.

Also the farmer has to place a deposit with the broker, which has to be immediately topped up if the market moves dramatically, leading to a big call for cash from the farm business.

One issue for European farmers is that there is no market for milk futures on the big continental exchanges.

The butter or powder futures could be used instead, as these are already traded in Europe, but it adds extra risk, as milk and dairy commodity prices do not move precisely in tandem.

The second, more straightforward, route is to sell forward through a milk processor.

At its simplest, the farmer logs on to his milk buyer’s website and sees what price is being offered for milk delivered in a particular month in the future.

If he likes what is offered, he can lock in that price for a proportion of his milk.

In the USA, that proportion is up to a maximum of 75%.

The processor takes a small slice of the price for the service and it can choose to trade into the futures market or go back-to-back, fixing a price with their eventual customer.

With feed costs booked ahead and a guaranteed return for much of the milk, the farmer has a firmer grasp of what his margin will be.

He can then plan and invest for the future with that extra confidence.

Reality check

Useful as this tool might be, futures are a fairly distant prospect for UK farmers.

NFU chief dairy adviser Rob Newbery says that, in time, futures could be one of a number of voluntary tools processors offer farmers to smooth out their market returns.

But first a number of things need to be in place, including getting milk on to the financial exchanges.

“There is not the market there yet,” he says.

“You need buyers and sellers for it to work and we need some middlemen to sell the contracts.”

The UK also needs up-to-date, published milk prices that would allow traders to see where the market is sitting so that farmers can judge whether it makes sense to fix a price.

In the short term, that could be a formula price linked to a basket of commodities.

Or the Brussels-based European Milk Market Observatory, which aims to provide objective and accurate information, could turn into an almost real-time source of data.

Also, the dairy processors need to work out what forward-pricing models they can offer producers.

The fixed-term, fixed-price deals such as those currently offered by Glanbia and Fonterra could be the first steps.

“We want to investigate and try and develop something,” says DCD’s Mr Masters.

“Even if we don’t use it next year it is something ready for the years to come.”