Milk Basis and Its Importance in Dairy Risk Management

Dairy producers interested in locking in milk prices for a portion of their future delivery of milk can use the futures market to reduce their risk.
Milk Basis and Its Importance in Dairy Risk Management - Articles

Updated: August 17, 2017

The risk transfer characteristic of futures contracts is important for dairy farmers wishing to protect their profit margin and for dairy processors seeking to control costs. In either case, the objective is to reduce exposure to the variability of the cash market and ensure a more stable price of milk.

Futures Contracts

Futures contracts are available on the Chicago Mercantile Exchange for Class III and Class IV fluid milk, cheese, butter, dry whey, and non-fat dry milk. The most actively traded contract is for Class III milk (which is Grade A milk used to produce cream cheese and hard manufactured cheese). This contract is most commonly used by dairy farmers to hedge their risk. A futures contract in Class III milk is available for each month of the year, represents 200,000 pounds of production, and begins trading approximately 2 years in advance of the contract expiration. Dairy farmers can participate in the futures market using a brokerage firm, but often cooperatives provide this service for their members at a very reasonable cost while reducing some of the complications involved with having an individual account.

The futures market has three types of participants: sellers, buyers, and speculators. Futures contracts are traded each business day and price information for the various contracts is readily available through newspapers or on the Internet. A hedger uses the futures market to take a position in the futures market today that will be completed later in the cash market. A dairy farmer who wishes to lock in the price quoted for a particular contract would sell a futures contract (also known as a short hedge). A processor who wants to lock in the same price would purchase a futures contract (also known as a long hedge). Speculators are important because they provide necessary liquidity and trade volume so the market works effectively. When it nears the time for the futures contract to mature, a dairy farmer will offset his position by buying back his futures contract at the current price (also called lifting a hedge). If the price for the futures contract fell then the farmer will buy back the contract for less than the sales price and will have a trading gain (the difference between the earlier sales price and the later purchase price) that will help offset the lower price in the cash market. It the price of the futures contract rose, then the farmer has a trading loss (the difference between the earlier sales price and the later purchase price) that will help be offset by the higher price of milk in the cash market. In either case, the dairy farmer locked in the same milk price without having to worry about what might happen in the market between the time the futures contract was sold and the time it was purchased back for the amount of milk under contract.

Options

Options, a financial instrument related to futures, are also available. Options give the purchaser the right (but not the obligation) to purchase or sell the underlying futures contract. A put option could be purchased by a dairy farmer that would allow the farmer to sell a futures contract at a specified price (referred to as the "strike price"). A call option could be purchased by a dairy processor that would allow for the purchase of a futures contract at a specified strike price. Options are primarily used to protect against major price movements. Options often expire without being used because the price situation they were purchased to protect against does not happen. If a put is used, the owner is protected against major price declines without having to sell a futures contract. In a sense, options are similar to an insurance policy, with the cost (premium) varying with the strike price (similar to different levels of deductible).

LGM-Dairy Insurance

Another risk management option for dairy farmers is a crop insurance product called LGM-Dairy designed to protect their profit margin. LGM-Dairy provides protection against loss of gross margin (market value of milk minus feed costs) on milk produced from dairy cows. LGM-Dairy uses the futures prices for corn, soybean meal, and class III milk to determine the expected gross margin, which is later compared to the actual gross margin. If the actual gross margin is less than the level of protection selected by the dairy farm, a payment for the difference is then made by the insurance company. LGM-Dairy is similar to buying both a call option to protect against higher feed costs and a put option to set a floor on milk prices. This program is subsidized by the Federal government. LGM-Dairy can be tailored to any size farm and there are many choices for level of coverage (deductibles). Producers can sign up for LGM Dairy up to 12 times per year and insure all their milk production they expect to market over a rolling 11-month insurance period. For more information on LGM-Dairy, visit the Penn State Crop Insurance Education website and the Center for Dairy Excellence website.

Milk Basis

Futures prices reflect general market conditions in the United States as a whole and must be adjusted in order to reflect local prices. This adjustment is known as "basis". A dairy farmer using the futures market to hedge Class III milk must have an understanding of how basis works in order to effectively use futures, options, or LGM-Dairy to help manage price risk.

Basis is the month-to-month difference between an individual dairy producer's gross milk price and the USDA announced Class III price. Since both are reported as a single price for an entire month, the basis has a unique value for each month. Figure 1 shows the relationship between the Pennsylvania all-milk price and the Class III price. While not a perfect relationship, the all-milk price generally rises and falls with changes in the Class III price. The difference between these two prices is thus a "basis."

The Class III basis in Figure 1 has an average value of $3.08 per cwt over the period January 2000 to March 2013, with a maximum value of +$5.93 and a minimum value of -$1.66. In other words, the decision to use the Class III price for hedging milk is not a perfect choice because the basis is unstable from month to month (Figure 2). Because of the complex way milk is priced, the all-milk price slightly lags the Class III market. This means that when Class III prices rise, the all-milk price is lower than expected, and when Class III prices fall, the all-milk price is higher than expected. Unfortunately, any alternative available for use in forward pricing milk has this lag.

Some cooperatives offer their members the opportunity to forward contract the price for a portion of their milk production relative to the cash price of block cheese. Under this arrangement, if the cash price of cheese falls below the preset level, then dollars will be added to the milk check. On the other hand, if the cash price of cheese rises above a preset level in a given month, the producer will have a deduction taken from the milk check. In order to compare the milk check to the cheese price, the cheese price is multiplied by a factor of 101. In most situations the cheese price makes an excellent alternative to the Class III price (Figure 3). This is because the cheese price is a major driver of the Class III price. The latter is defined under federal milk marketing orders as the price of milk used to make cheese.

The Class III price may not be a perfect choice in computing the local basis for all dairy producers. This is because an individual producer's monthly basis can vary due to the following factors:

  • Over-order premiums. Many farmers receive over-order premiums, which depend on local market factors that change from month to month.
  • Producer price differential (PPD). The PPD for the local federal order accounts for much of the monthly basis. It is equal to a weighted price computed by the federal market administrator less the Class III price. The PPD also explains why the basis can occasionally be negative.
  • Component levels. The PPD is priced based on standard component levels for butterfat, protein, and dairy solids. If individual dairy producers consistently produces above these levels, this will inflate their basis.

Figure 1. Pennsylvania Milk Basis, January 2000-March 2013 (in $/cwt).

Figure 2. Pennsylvania All-milk Price and Class III Milk Price, January 2000-March 2013 (in $/cwt).

Figure 3. Class III Milk Price versus 10 Times the Chicago Mercantile Exchange Cheddar Cheese Price (in $/cwt).

Relationship to Federal Orders

Federal and state milk marketing orders have a large impact on the basis calculation. Dairy producers who are located in federal orders that sell a majority of their milk for beverage purposes should have the highest average annual basis in the country (e.g., Northeast and Southeast federal orders). For example, the Class I utilization rate (percent of milk used in the order for beverage purposes) in the Northeast order 1 is typically around 40 percent. Thus, Pennsylvania dairy producers should expect a basis calculation of around $2 to $3 per cwt. The Class I utilization, and therefore the basis calculation, is much lower in the Upper Midwest (around $1 to $2 per cwt). The basis could be zero or negative in areas of the United States with no federal order and where most milk is used for cheese production (e.g., Idaho).

Milk Components

The formula used by the USDA for computing the Class III price of milk each month depends on the implied value of the milk components, that is the prices of butterfat, protein, and other dairy solids. The numbers multiplied by the prices are component levels in percentage. The Class III price announced each month by the USDA is quoted using standard component levels of 3.5 percent butterfat, 2.99 percent protein, and 5.69 percent other dairy solids.

If your farm consistently produces components above these minimum levels each month your components would add a premium to your milk check. This will increase your effective milk price, and therefore your basis.

How Basis is Calculated

Table 1 shows the historic averages, minimum and maximum prices, and basis for a typical dairy farm in Pennsylvania (the basis for each individual dairy farm will vary by location and milk quality). To calculate your own basis (Table 2), take the gross price of milk from your milk check and subtract the announced Class III price each month. To determine your annual average basis, add the monthly basis calculations together and divide by 12. To calculate your expected milk price get the Class III futures prices from the CME and put it in Column 1, put your calculated average basis for your farm from Table 2 in column 2, and add them together in column 3.

Table 1. Pennsylvania basis using the all-milk price, 2000-2012.

MonthAverage Basis
($/cwt)
Minimum Basis
($/cwt)
Maximum Basis
($/cwt)
January$3.77$2.64$5.42
February$3.47$2.20$4.33
March$3.09$1.10$4.28
April$2.76$1.66$4.63
May$2.82
$0.02$5.58
June$2.60$0.05$4.24
July$2.66$1.22$4.36
August$2.61$0.10$3.87
September$2.89$1.60$4.73
October$3.14$1.78$4.80
November
$3.78$2.56$5.93
December$3.28
$1.82$5.33
Yearly Average$3.07$1.12$4.79

Table 2. Worksheet for computing your basis history

MonthGross Milk Price ($/cwt)
(a)
Class III Price ($/cwt)
(b)
Basis ($/cwt)
(a) - (b)
January
February
March
April
May
June
July
August
September
October
November
December
Sum of Columns
Annual Average
(Sum/12)

Producers often ask which of the prices listed on the milk check is used to calculate when computing the basis. The gross price is the best choice because it does not reflect marketing costs and other deductions. The gross price is simply the component values plus the PPD and any other premiums. Deductions should not be included when calculating basis since (1) these deductions have nothing to do with your basis and decisions to forward price milk, and (2) the basis is used to compute a "planning price" that is then compared to the cost of production (which should already include these deductions).

So, why compute the basis in the first place and how should it be used? For one thing, the basis is very important for planning purposes. The historic information in Table 1 provides a good example. Historically, a typical dairy farm in Pennsylvania has an average basis of $3.07 per cwt. The month-to-month and year-to-year basis, however, is unstable. To reflect this, when calculating your expected planning price you should consider a range of ±$0.50 of the Class III price plus basis to account for the likelihood that the actual basis will not match the average basis.

Basis information can also be used in deciding whether a particular futures offering on a particular day is worth locking in. For example, suppose the December Class III futures price for the current year is $18.50 per cwt. Given an average value of the basis of $3.07, this would result in a gross milk price of $21.57, or a planning price range of $21.07 to $22.07 per cwt (±$0.50 of the Class III price plus basis). One could then compare this planning price range to cost of production and to the December gross milk prices in previous years in order to decide whether to lock in this particular contract price.

Table 3. Worksheet for computing your expected milk price.

MonthClass III Futures Price ($/cwt)
(a)
Your Average Basis ($/cwt)
(b)
Expected Milk Price ($/cwt)
c = (a + b)
High Expected Milk Price ($/cwt)
c + $0.50
Low Expected Milk Price ($/cwt)
c - $0.50
January
February
March
April
May
June
July
August
September
October
November
December
Yearly Average

Basis Risk

The problem in using the basis for computing a planning price is that it varies significantly from month to month. A more complicated system might be to use some combination of cheese and butter prices for computing the basis. Although there are futures contracts for Class IV milk, cheese, butter, dry whey, and non-fat dry milk, they are very thinly traded compared to Class III milk. One way of dealing with this degree of uncertainty is to compute a mean basis for a period of time (6-12 months) and then use a range (for example, ±$0.50 per cwt.) when computing a planning price or making a forecast. This will at least provide a range for analysis that may be more realistic.

Conclusions

Knowing your basis is essential to understanding how to use the futures market to anticipate upcoming prices for your farm. Once you have an expectation for the milk price at your farm, you may wish to take some action to preserve this price from dropping. This may mean using futures contracts to forward price milk and/or risk management tools like LGM-Dairy. Basis can be used to forecast your gross milk price given a forecast of the Class III price of milk or cheese and butter prices. Basis can be used to compute a planning price when making a decision whether to forward price milk. Because basis is risky, some assumption must be made regarding how much your estimate may vary from the average that was calculated from historical data. Taking the average of the basis over a 6- to 12-month period of time and then setting a range of plus and minus $0.50 per cwt. to determine a planning price range is a good option. This should provide a reasonable range for the forecast of the actual basis.

Prepared by James W. Dunn, Professor of Agricultural Economics and Jayson K. Harper, Professor of Agricultural Economics, Department of Agricultural Economics, Sociology, and Education, The Pennsylvania State University

1 Approximately 10 pounds of milk are needed to make 1 pound of cheddar cheese

Authors

Farm Management Risk Management Production Economics

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