Is a Hedge Loan a Good Idea for Your Operation?
Published on Tue, 11/17/2015 - 3:58pm
By Greg Steele, Vice President & Team Leader Industry Specialist, AgStar Financial Services
Dairy producers who want to raise their game in the area of risk management may want to consider making a request to their lender for a hedge loan. A hedge line of credit is a loan used to finance hedging transactions which will generally be in the form of futures or options contracts. It is critical that the financing for these transactions be based upon a “true hedge,” whereby the dairy farmer is taking futures positions on milk yet to be produced and maintaining that position until the sale of the hedged milk occurs, at which time the financing is repaid.
Speculative transactions are not eligible to be funded by a hedge revolving line of credit, or RLOC. By agreeing to an RLOC Hedging Loan, your lender has established a commitment to fund margin requests associated with agreed upon milk contracts, recognizing that margin requirements are offset by corresponding gain in the value of the contract. A key reason for developing a hedging program for your operation is to manage market volatility.
If you are exploring the option of a hedge loan and want to learn more about whether or not it is right for you, your lender is a great resource. There are a few best practices to keep in mind when discussing the need for a hedge loan with your lender.
1. Develop a written marketing plan and know your break-even analysis (consider tools like Vault, www.vaultdairy.com). This will give your lender confidence that you understand your costs and you have established a policy that will lead to a successful hedging program.
2. Utilize the services of a reliable marketing consultant who can provide advice and help develop hedging strategies specifically for your dairy operation (Consider brokerage groups like Rice Dairy).
3. Use a margin approach. This is generally the best approach when hedging milk production. Non-feed costs are generally stable on a dairy operation, however, feed can and does fluctuate. In order to reduce these fluctuations generally feed should be priced at the same period that milk prices are. For example, if milk is marketed for the January–June then purchased feed costs should also be priced for this same time period. This will generally allow a producer to capture a true profit margin.
A key benefit to a hedge RLOC is that margin calls and marketing expenses do not deplete cash reserves or fill up operating loans. This in turn helps maintain the operation’s working capital position, which may give the dairy producer more reason to manage risk. Vault, a dairy decision-management software, simplifies this process for the producer in terms of how it affects cash flow. You are able to see the P&L associated with hedge positions that correctly corresponds to future months; then, recognize that P&L and cash appropriately.
Lawson Thalmann, Director of Business Development for Vault explains, “Vault is a capital allocation tool. Hedging is one of those capital allocation decisions. When hedging, using the Hedge Line of Credit and reconciling it with Vault is recommended.”
Ryan Yonkman of Rice Dairy agrees, “As a dairy broker for the last 5 years and hedger for my family’s dairy in northern Michigan, I strongly recommend having a RLOC for hedging in place in order to fulfill the strong cash flow needs of hedging 12-24 months out.” It is not the dairy’s job to use current cash or operating capital to fund margin calls on hedges for future milk production and feed needs. Let a RLOC do that work for you and stay square with the bank by using something like Vault to reconcile your hedges correctly on a month-to-month basis. Ryan’s other piece of advice: “Before any of this can occur, you must have a handle on your breakeven and be able to run some market scenarios in order to see risks and opportunities going forward.”
Vault is a tool that Ryan uses with many dairies to help steer and track hedging decisions. Vault compiles two-year P&L projections while integrating all their milk and feed hedges automatically. “It allows the dairies to see and share in real-time what they have hedged as well run price scenarios on milk and feed to get a better understanding of the risks that the dairy is holding” Yonkman adds.
In summary; develop a marketing plan, know your break-even cost, hire a qualified advisor and use a margin management approach to reduce the risk and manage price volatility in your dairy operation.
Visit www.agstar.com/edge for more industry expertise.
Also, visit www.vaultdairy.com/blog for more updates from Vault.