Be real when assessing your dairy risk


People are particularly bad at assessing risk. The human species has evolved in a world where the threats were entirely different from those we are experiencing nowadays.

Hence, we are awful at assessing risk and make too many decisions based on the wrong gut feelings.

Recent cases

A few days ago, Air Asia flight 8501 carrying 162 people on board crashed in the Java Sea; the plane was an Airbus A320. Since then thousands upon thousands of air travelers have rebooked or cancelled their trips based on their perceived risk of flying an Airbus plane.

Meanwhile, over just the three days that have elapsed since the crash, 10,500 people have died of malaria, 4,000 have died of traumatic injuries, and 16,500 from tuberculosis.

If you think that these statistics are not relevant to Americans, then consider that in the United States, 9,900 people have died of heart disease, more than 600 died in car accidents, and 250 were likely murdered just in the last two days.

Ebola has certainly received plenty of attention. Yet so far in the United States, there have been only four cases and one death related to Ebola.

In the most affected country, Liberia, the total number has only reached 6,822 cases and 2,836 deaths. This is not to diminish the possible consequences of a spreading virus, nor the pain for the affected families, but to most Americans, there are far more consequential risks than Ebola.

Dairy risk

Dairy producers are often no better at assessing risk than their urban comrades. Markets ups and downs. In general, dairy producers underestimate the magnitude of the lows (the really bad “crashes”), underestimate the highs, and severely overestimate the length of the highs.

It is hard for me to blame them because the same phenomenon can be observed in the writings of advisors and economists. Just a month ago, Ohio producers were told: “Milk prices to drop; profits, maybe not,” and that “feed inputs are falling faster than the milk prices.”

As of today (early January), March corn futures are up and trading near $4/bushel (not the anticipated low $3s and not much lower than corn prices at this time last year), while the Class III milk futures for the first six months of 2015 are averaging $15.56/cwt, a drop of $7.11/cwt (31.3 percent) compared to the same six months of 2014.

And what I am telling you is that the futures markets are probably underestimating the lows. Where are we?

On Jan. 2, the USDA announced the minimum Class prices in Federal Orders (FO). The December Class III price was announced at $17.82/cwt, a drop of $4.12/cwt (18.8 percent) from November. Class IV price was even less, at $16.70/cwt.

Because of the pricing lag, Class I prices still look very appealing: around $24.73/cwt for producers shipping in FO 33. However, those who understand how class prices are calculated already know that Class I prices will plummet next month.

Grim outlook

So the economics of dairying won’t look very good in a few months from now.

But what about the Dairy Margin Protection Program? The much talked about MPP program should serve as a safety net to U.S. dairy producers. At least, that’s what its primary objective was.

This safety net, however, has some huge gaping holes. First, the insurance is for an average national margin: not yours.

The national margin is calculated from a national feed costs index that may have little to do with your actual feed costs (or even regional ones). The same applies to milk prices.

In a way, the program has shifted most of the risk onto your local feed and milk bases. In a sad way, you might be more at risk than without any insurance at all.

Second, payments lag the market. If it gets bad enough for producers to receive money from the program, it will take a minimum of two months to see the benefits through a payment. This will bring obvious cash flow issues to many dairy farms.

Past data

Third, all the forecasting tools that can be found on the Internet are mostly based on what happened in the past. These data may have little to do with a world where the United States is (was) exporting more than 16 percent of its milk solids production.

The probability of a given margin for a given month provided by these tools doesn’t mean the same thing as what most people (and statisticians) think ‘probability’ means.

The coin being flipped keeps changing … while in the air.

Don’t shoot the messenger. If this looks depressing, it was meant to be. Producers need to sit down and figure out how they will make it through a minimum of six consecutive months of $14/cwt Class III prices ($15-$16/cwt mailbox prices) in 2015.

If I am completely wrong and markets do not reach abysmal prices, then you won’t be any worse off from the exercise. But if my predictions are correct, then you should be able to avoid disastrous outcomes.

It is a bit like a fire emergency drill: you hope that you will never have to implement what you learned, but you are much better off in the event of a fire. And right now, I smell smoke.

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