Guest Editorial
The brave new world of dairy derivatives

by Tom Gaughan

The dairy industry has always been the exception to the rule in the world of commodities. From its unique pricing structure to the array of government price support rules that for many years were the primary determinant of milk and dairy product prices, pricing and risk management in the dairy industry have long existed in a world of their own.

But beginning in the mid-80s when price supports were lowered, prices began to exhibit substantially greater volatility. This volatility, in turn, has inevitably led to a greater reliance on risk management tools, a trend that has accelerated in recent years with the successful introduction of Class III milk, cash-settled butter and dry whey futures at the Chicago Mercantile Exchange (CME). The CME also has seen growth in its options on dairy futures contracts. In short, dairy has just begun to catch up with other agricultural commodities when it comes to the management of price volatility.

But suddenly, just as the dairy industry has started to catch up, the rest of the globe is spinning ahead again. The introduction of so-called 24-hour electronic trading (in actuality, trading is conducted 23 hours a day) at the CME for its agricultural commodities complex means that, once again, dairy processors and producers must adjust to a new economic reality. The pending exchange-traded swaps program, the likelihood of new futures contracts and the increasing internationalization of the dairy markets also present new possibilities and new challenges. Some dairy industry participants undoubtedly wish that the pace of change would slow down a bit and allow them to absorb and adjust.

• It’s a good thing

It is true that ever since the lowering of dairy price supports, the dairy industry has had to respond quickly to a number of new innovations, whereas grain farmers, for example, have never lived in a world that didn’t have corn and wheat futures. It is important to remember, however, that these recent developments in dairy price risk management are to be welcomed, not feared. These innovations, which have been reasonable responses to the lowering of price supports, create more price transparency, better and more equitable access to the markets for all participants and greater efficiency in the pricing and trading of dairy commodities.

Twenty-three-hour electronic trading makes each one of these advantages that much more accessible to more participants around the globe and should be seen as a natural development for not only dairy but for all of the agricultural commodities traded by the CME. They are, indeed, not only a natural development but in many ways an inevitable one, just one more step in a long evolution for dairy price risk management. But, unlike some other risk management tools, it is important to remember that 23-hour markets are a convenience and not a necessity. No one in the business of dairy should fear that they will now need to be open 23 hours in order to track the markets.

To be sure, there are concerns about 23-hour electronic trading, particularly relating to liquidity in the middle of the night. But it is our expectation that, over time, dairy futures will follow the same pattern as the financial markets and grain markets and become fully liquid across all time zones. This, in turn, will allow overseas participants to have greater access to risk management tools, increasing the markets’ depth and encouraging the growth of export markets.

• Easy-to-use tools

Ultimately, the very same economic realities that gave rise to solutions such as futures trading and exchange-traded swaps have given rise to “solutions to the solutions” — new and easy ways for dairy industry participants to access and take advantage of risk management tools.

Dairy futures brokerage firms such as Downes-O’Neill, for example, are working with their clearing firms to provide access to 23-hour trade desks for industry participants who don’t have direct access themselves. With every new risk management tool — some of which, in fact, Downes-O’Neill has been instrumental in developing in conjunction with the CME — we are developing new and convenient ways to access these tools to make the risks of price fluctuation one less thing you have to worry about.

It’s a new world out there. But, for processors and producers who have found reliable guides to the world of risk management, there is nothing to fear in this new environment. As participants in other commodities have long ago learned, the use of futures and other derivatives allows you to concentrate on what you do best — producing products for the marketplace.

CMN

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