Guest editorial/opinion:
The need for a dry whey futures contract

Chris Lindborg is a commodity analyst for Chicago-based Downes-O’Neill LLC. He is a guest columnist for this week’s issue of Cheese Market News®.

Recently, discussion among dairy traders and whey marketers and manufacturers has focused on the need for a new whey futures contract at the Chicago Mercantile Exchange (CME). Whey processors and users were a major force pushing for the introduction of a viable contract that began in 1998 and ended in 2000. The short time period the old whey contract was active resulted in the contract trading with varying degrees of volume and open interest. But recently, interest and activity in a new whey futures contract has come from across the board, including whey marketers, major manufacturers and market makers.

The unavailability of futures contracts for all commodities leads to the use of futures contracts underpinned by commodities merely related to the one for which risk protection is intended. This is known as cross-hedging. Currently, Class III futures contracts are available at the CME as the best cross-hedge for whey. Many cheese processors and buyers cross-hedge using CME Class III futures to manage whey price risk. However, the Class III complex’s multidimensional product mix makes hedging whey in the Class III market more difficult.

Cross-hedging, the effectiveness of which depends on the relationship between the futures and cash markets, has historically been an unreliable risk management tool. Recently, the correlation between Class III and whey broke down, causing cross-hedgers to suffer financial losses in both cash market activities as well as futures hedges. The risk associated with diverging cash whey and Class III futures market prices is illustrated in the chart on page 9.

Alternatively, the 1998 to 2000 old CME physical delivery whey futures contract demonstrated a strong correlation with the cash whey market. Therefore, a new contract may provide an effective hedging tool if resurrected. This market would allow sellers and buyers of whey to undertake hedging strategies by trading contracts which are correlated to prices of their raw materials.

In risk management, the goal of hedging your cash flows can be thought of as reducing the underlying volatility of your cash flows and minimizing the probability of large losses. Most whey processors and buyers are in the business of processing or buying whey and are not particularly skilled at predicting variables such as exchange rates, interest rates and other commodity prices. It makes sense for these companies to hedge their price exposure to these variables and concentrate their efforts on their main business in which they have particular skills and expertise. The whey futures contract fulfills a critical price risk management need, as the whey and Class III markets likely will be subject to unique supply and demand shocks for the foreseeable future.

The current situation may change if CME revitalizes a dry whey futures contract. If a whey contract catches on, this could become a very effective risk tool. After all, the whey market is growing. Whey and whey products have continued to expand as a food ingredient, with food uses growing in recent years at the expense of animal feed uses, according to USDA figures. In 2003 the average dry whey price was $0.1667. In 2004 it increased about 39 percent to average $0.2319. The dry whey price increased again in 2005, rising almost 20 percent to average $0.2782. In 2006, the dry whey price is projected to average $0.3200 by USDA’s National Agricultural Statistics Service and $0.3254 by eDairy, about 15 percent higher than 2005 and also the highest in the contract’s history. The USDA World Agricultural Outlook Board is forecasting a $0.3000 average dry whey price for 2007, suggesting the recent increase in dry whey prices might be an indication of a continued surge in whey prices and higher price volatility.

Due to the expressive performance reflected in the numbers shown here, traders who operate with whey and whey products are still in need of the same risk management tools that are available to other commodities. At the CME, specific futures contracts are available for several of the dairy industry complex products, while whey still is in need of a futures contract.

The advantages of a CME whey futures contract are clear. The tool offers the transparency, flexibility, strength and effectiveness needed to lock in profits and complement existing cash market whey commitments. Liquidity is the primary concern that is holding back the opportunities provided by the contract. This issue can be addressed in part if a significant number of processors and users of whey utilize this contract if it becomes activated in the near future.

CMN

The views expressed by CMN’s guest columnists are their own opinions and do not necessarily reflect those of Cheese Market News®.