Got Milk?

Global cow’s milk production has steadily increased over the years. It has risen from 497 million metric tons in 2015 to 532 metric tons in 2020, partly due to the increase in the global population but also due to migration from rural to urban areas. This is particularly obvious in China where demand has surged.  

 

Milk has always been a volatile commodity, with prices influenced by many factors: changing consumer demand, weather conditions and the impact of global warming, the cost of resources needed to provide cows with a balanced diet, etc. 

 

COVID-19 has created unexpected additional demand (15% in Europe) as people stayed at home and cooked more, which can be seen as a driver for the 10% price increase between June 2020 and June 2021 (Milk III). During the same period, the EUR/USD rose by 7%.  

 

For a US producer selling into the Eurozone, this would have been great. In the US, a cow produces about 23,400 pounds of milk per year. If a farmer had 1,000 cows, the sale of 23.4 million pounds of milk would have generated about $3.69 million in June 2020. All else being equal, he would have made $4.32 million in June 2021, an increase of 17%. 

 

The situation would have been completely different for the European producer who sells in a USD zone. As an assumption, let’s ignore the fact that European cows produce 30% less than their American counterparts and therefore, margins are much lower. The European producer, for the same quantity of milk, would have received the same amount in dollars in June 2020, i.e., 3.27 million euros. In June 2021, 3.3 million euros would have been paid into his bank account. That’s an increase of barely 1%. 

 

In the first example, the cumulative changes in milk and the EUR/USD are favorable, and unfavorable in the second, leading the European milk producer to believe that he would be happy to lock in a possible future margin, given the current market conditions.  

 

With Milk III Dec 2021 trading at 18.37 and EUR/USD Dec2021 at 1.2033, buying the former and selling the latter contracts would freeze the milk selling price for December delivery and the currency conversion rate at the same horizon. This would obviously not allow the European producer to benefit from the unexpected rise in milk prices, but it would ensure that he would receive €3.57 million for the same quantity of milk. This is better than what he has today. 

 

Hedging strategies can be simple or sophisticated. They can range from what is described above to more complex set-ups using several options. Trading schemes can be even more advanced with, for example, gamma neutral strategies to anticipate the increase or decrease in volatility. 

 

The key to success is not to design the best hedging or trading strategy but to be able to measure its effect on the risk profile of the portfolio or business, what might happen if markets moved within reasonable margins or became completely erratic, what would be the maximum loss over a one-day or seven-day horizon. The same questions can be phrased differently: what would allow me to manage my trading and risk management activities without having to install or upgrade software, benefit from ready-made and maintained libraries of indices and contract definitions and be operational in a limited number of weeks. 

 

CTRMCloud offers CTRM as a service, allowing for data to be collected, analyzed and reported in near real time from all areas of the business. Contact us to learn more. 

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