Are forward price contracts relevant in Ireland?
The requirement for hedging or forward contracting is very much dependant on the competitive position of the producer. This is best explained by the diagram (right).
The erratic red line represents a volatile milk price, while the broken lines represents the cost of production of three different producers.
So, which producers would best benefit from hedging milk price?
Hedging milk price will be of little benefit to this producer, since managing competitiveness is the issue here instead of risk. This producer will eventually be forced to exit dairy farming unless he/she improves competitiveness.
This producer will benefit from risk management on milk price. However, hedging of milk price will not improve his/her average milk price. If anything, it will slightly reduce it. But hedging would help this farmer cope better financially with periods of low milk price, such as that in 2009. In my view, price-risk management, or hedging of milk price, is best suited to this profile of producer.
This producer has a low cost of production and can cope, relatively comfortably, with periods of very low milk price. Therefore, hedging milk prices is of little benefit given that milk price volatility does not have any significant long-term financial implications here. They would therefore gain more from not hedging, as a hedged milk price will be slightly lower on average in the medium-term than the unhedged market price.
Grazing versus confinement
The other factor that will determine whether a dairy producer should consider hedging milk price or not is the dairy production system that he/she is involved in.
Confinement dairy production systems account for up to 90pc of commercial world milk output.
They are dependent on a high level of bought-in feed and are more suited to hedging of milk price than those involved in grass-based production systems.
There are two reasons for this. Firstly, the confined system producer is likely to have a much higher cost of production than the grass-based producer.
Therefore producers involved in a confinement milk production system will have more inputs that they can hedge or fix against their outputs.
Large US dairy farms often hedge up to 70pc of their input costs against their milk price through the use of futures markets for wheat, corn and oil. In this way they 'lock in' a fixed margin for their milk.
Compare this with a low-cost, grass-based milk producer in Ireland or New Zealand, where bought-in feed may make up as little as 15pc of the total cost base.
This is one of the main reasons why forward-price contracts haven't caught on in a big way in New Zealand.