Balancing Dairy Processor Price Risk: Harnessing Inventory as a Natural Hedge

Balancing Dairy Processor Price Risk: Harnessing Inventory as a Natural Hedge

Most people think price risk starts and ends with fixed price sales. The starting point for most conversations on dairy processor price risk looks something like this; milk is purchased from suppliers on a indexed basis, processed into products, and then sold on to customers either a fixed or index-linked basis. Then follows the assumption that if the input is bought on a indexed basis, the portion that is sold on to customers on an index-linked basis must be risk-free, and therefore risk enters the processor’s P&L through those fixed price sales.

Now this isn’t wrong per se (setting aside for a moment the inevitable basis risk that comes through temporal and market differences between pricing the input and output relative to an index). But it’s not the whole picture. And because it is not the whole picture, there is the very real possibility that what looks like a balanced book from a risk perspective is actually simultaneously both long and short in all the wrong places.

Of course, I’m talking about natural offsets, and most importantly, utilizing inventory as a natural hedge.

One of the most significant areas of risk in the dairy industry is inventory price risk. This is the risk that the value of dairy products held in inventory will decrease relative to price paid to produce them, resulting in lower profits or even losses. There are several factors that can contribute to inventory price risk, including changes in demand, supply chain disruptions, and fluctuations in wider commodity prices. Understanding how inventory can be turned from a risk into a hedge is key to balancing your portfolio.

But how do you actually do this?

The process is relatively straightforward. First, you need to appropriately group your risks by time period into their various portfolios. An example would be to view your butter position by month as one portfolio and your SMP position by month as another. Doing this will allow you to see where you are long and when you are short.

What you would typically expect to see is that your long-dated fixed priced sales give you short exposure, and your near-term fixed price sales reduce your long exposure.

What do I mean by that?

Let’s start with the long-dated sales. When you make a commitment to sell at a fixed price, you have introduce risk into your portfolio by taking a short position. That is, you now want price to fall – after all, if price were to rise you wouldn’t be happy with the sale. This is a short position – meaning you benefit when pricing falls. In order to reduce the negative impact in the event that pricing is to rise, you could take an offsetting derivatives position to neutralise your exposure. So this is what is meant by long-dated fixed priced sales induce short exposure.

Conversely, in a typical dairy processing environment, the processor has physical inventories. This can be a mixture of stock on hand to meet future orders, product in QA waiting to be released, and bits and pieces sitting around in a warehouse that have been forgotten. Whatever the reason, it all results in the same risk: The risk that you sell it for less than you paid for it. This is called being long – which is when you benefit from prices rises, and loose out from price falls.

So how do you piece the two sides together?

If we are short long-dated fixed sales and we choose to hedge these to remove the price risk, we in effect become neutral. However, as we move through time and those long-dated sales become near-term deliveries, we need to unwind our long derivatives position so that we don’t become “double-long” through both derivatives and inventory.

The rate at which you unwind your derivatives position is a function on the size, age, and fungibility of the inventory relative to the fixed price sales. Understanding the relationship between the two is key to understanding your risk and balancing your portfolio.

Ultimately, managing price risk in the dairy industry requires a deep understanding of the factors that can impact pricing and a willingness to be proactive in implementing strategies to mitigate risk. By taking a comprehensive total portfolio approach to risk management, dairy companies can better protect themselves against unexpected losses and position themselves for long-term success in an increasingly complex and challenging market.

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