US Dairy Markets – Digitalizing to address complexity and volatility

WHITEPAPER

US DAIRY MARKETS

DIGITALIZING TO ADDRESS COMPLEXITY AND VOLATILITY

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US Dairy Markets – Digitalizing to address complexity and volatility

A ComTechAdvisory Whitepaper

INTRODUCTION US dairy markets are one of, if not the most, unique and complex commodity markets. Dairy production has unique physical characteristics not found in any other agricultural commodities, including continuous production, rapidly spoiling milk inventories, and multiple derivative products with a varying ability to store over time (i.e., fresh milk vs. cheese products).

These factors, when combined with changes in seasonal demand, the impacts of variable weather conditions that can affect both production and the ability to transport that

production to processors, and changes in productive herd levels that will impact supply on any given day, result in highly volatile prices for producers and cooperatives.

A ComTechAdvisory Whitepaper

US Dairy Markets – Digitalizing to address complexity and volatility

A COMPLEX MARKET Unlike most commodity markets in which the value producers receive for their production is based almost entirely on the forces of supply and demand, most US dairy production falls into a complex regulated pricing scheme called the Federal Milk Marketing Orders (FMMO) system.

This program was originally designed to provide some level of price stability for producers of what is considered a highly nationally valuable resource and to help offset the risks inherent in the unique nature of milk production (continuous round-the-clock daily production vs. seasonal harvesting, and the inability to store rapidly spoiling inventories at its source). In its current iteration, the scheme does help limit downside exposures for producers, but may also limit their ability to maximize the value of the product they produce. Even though some of the products produced from milk, such as cheese, can be stored/inventoried for longer periods, high levels of price volatility in this market persist.

Under the FMMO, milk is priced based on four classes of end use for the milk they sell to processors: Class I – Liquid milk processed for direct consumption. In any given year, that volume can account for 25 – 35% of total production, though the percentage has fallen in recent years as more consumers turn to alternative plant-based milk.

Class II – Milk that is used in the production of soft dairy products like yogurt, ice cream or sour cream. This class usually makes up about 10-15% of production.

Class III – Milk used for most types of cheese and whey. This is the largest class, accounting for anywhere between 40-45% of production.

Class IV – This is the remaining products class, including butter, butter-based spreads and dry products like powdered milk (can be whole mild or nonfat). This class usually accounts for 10-15% of production.

Adding to the complexity of pricing, milk sold under the Class I designation is priced on a formula driven by the prices of Class III and IV, the more highly processed classes, and the Class I price for a given month is announced before the start of that month’s production.

Prices for the other classes (II, III and IV) are based on average prices of commodities or products produced in those classes, with the price of the milk consumed to produce the products under those classes announced in the following month. That means processors of milk in Class II, III or IV won’t know what they will pay, or producers know what they will receive for their milk, until the month after they received/produced it.

Additionally, given that the prices paid for milk sold to any individual processor is calculated on a regionally based pool price, which is an average across the region in which the milk is sold and processed, the producer has no real ability to affect their revenues by negotiating among processers.

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US Dairy Markets – Digitalizing to address complexity and volatility

Operationally, dairy producers can do little on their own to address this margin squeeze short of selling their herds and operations. They face a broad array of fixed and variable costs over which they have little control - from amortization of the cost of their farms’ capital equipment to highly variable costs for feed to maintain their herds which can be more than 50% of their total operating expenditures.

Though milk prices reached record highs in 2022, the margin on the milk produced and sold by dairy farmers and coops declined. With inflation hitting all corners of the economy in 2022, dairy farmers struggled to remain profitable as their costs of production increased.

As noted by the American Farm Bureau in July of that year, “Analyzing production and operating costs on the dairy farm more deeply further highlights this margin problem….Though numbers for 2022 will not be available for some time, 2021 can serve as a proxy for describing the extent to which operating costs have largely outpaced market values of dairy production under more recent market conditions… Feed, including purchased feed, homegrown feed and grazed feed has taken up the largest portion of expenses, ranging from

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$9.28/cwt in 2017 to $14.04/cwt in 2021- a shift from 45% of total expenses to 52%...In 2021 capital recovery cost dairy farmers an average of $4.62/cwt or 17% of all expenses. Hired labor…has increased by 12% since 2016…”. 1 Though prices did peak in mid-2022, the perishable nature of milk limits the ability to build buffering inventories and dairy markets continue to be highly sensitive to changes in supply and demand, and prices have quickly fallen back. Despite some price support from FMMO market rules, highly volatile pricing has and will continue to be a significant issue in this market, exacerbating the difficulties in managing budgets and maintaining profitable operations for both buyers and sellers of dairy products (Figure 1).

Source: https://fred.stlouisfed.org/series/WPU01610102

1

https://www.fb.org/market-intel/strong-dairy-prices-overshadowed-by-farm-operating-expenses

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US Dairy Markets – Digitalizing to address complexity and volatility

A ComTechAdvisory Whitepaper

MANAGING PRICE VOLATILITY FOR IMPROVED PROFITABILITY Given the financial exposure created by this volatility, the dairy industry has increasingly adopted a more proactive approach to managing price risk.

With the availability of a mature and liquid futures market across multiple classes of milk-derived products; processors, coops, and large producers are increasingly availing themselves of these hedging tools (including futures, swaps, options, and derivative instruments such as accumulators) to help mitigate some of their price exposures. Additionally, many of the inputs of production, including costly feed, fuels and electricity are also being actively price managed via hedging programs to help offset volatile and escalating production expenses, providing increased price surety to help improve operating margins.

Unfortunately, without a systematic approach to managing hedging programs, it is difficult to “right size” hedging volumes and value open positions, particularly if that hedging portfolio includes options or accumulators. Additionally, as the size of a cooperative’s and/or processor’s business grows, so does the complexity of the operation and the need to scale beyond the capabilities of commonly used spreadsheets.

that can lead to wrong decision-making in volatile markets; and accurately tracking intraday price movements, updating volumetric data and valuing positions using spreadsheets is time-consuming and error prone. Their use can potentially result in wrongsized hedges which will lead to sub-optimal outcomes or worse, increase financial exposures leading to significant losses.

For cooperatives that offer price risk protection programs to their members, improving the communication with those producers and providing timely visibility of open positions, market prices, and accumulator volumes helps ensure they can make the best decisions relative to their operations and better manage their own exposures as prices move in these volatile market conditions. Relying on spreadsheets or older, non-web enabled systems offers little or no ability to provide this type of critical and timely market information outside of phone conversations between member producers and the coop’s risk management team, an inefficient process and one that adds latency in the decision-making process.

Relying on brokerage statements introduces latency

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US Dairy Markets – Digitalizing to address complexity and volatility

A ComTechAdvisory Whitepaper

THE NEED TO DIGITALIZE Price volatility, complex derivatives management and elaborate supply chain in the dairy industry is driving digital transformation across its value chain. Pressure to reduce risk, settle effectively and decrease reaction times, and forge stronger relationships with trading partners, cooperatives, and milk producers is at an all-time high.

Though traders hedge the risk with the use of derivative products such as futures, options, swaps, and accumulators, managing the operation becomes difficult at times because of the intricacies involved.

Scaling the operations of dairy products such as milk, butter, cheese, and whey is difficult without a robust and scalable platform that provides a single source of truth.

Eka’s Trading and Risk Management (TRM) solution provides a single source of truth for the dairy industry with salient features such as: • Cloud native application reduces total cost of ownership.

• An integrated solution to manage position and exposure and derivatives including forwards, futures, swaps, options, and accumulators etc.

• Forecast member production to accurately predict volume.

• Allowing members to lock the price/hedge to avoid price fluctuations and tracking the price locks.

• 65+ types of data via connectors for seamless integration ensuring faster configuration within weeks vs months.

Additionally, with the post-Covid surge in inflation

“Volatility in the dairy industry is driving the need for more sophisticated hedging programs which include an array of resting order types and complex instruments such as accumulators. This increased sophistication requires greater technological capabilities to be successful. A cloud based, digital solution eliminates the pressure of hosting costs or limitation of spreadsheets allowing coops to amend their hedging programs as the dairy markets dictate.”

Brian Quinn, SVP Global Revenue

and price volatility across all inputs into the dairy value-chain, Eka provides producers, processors and coops the required capabilities to hedge and manage exposures across all relevant commodities, including energies (diesel, gasoline, and electric power) and feed. By adopting a fully featured commodity trading and risk management solution, like Eka, these market participants will gain increased visibility and accelerate decision making to better optimize the value of their products, and those of their suppliers, and improve bottom line performance in a volatile market.

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ABOUT EKA Are your ready to find the best CTRM/CM solution for your organization? An extensible cloud platform can help you create an agile, digital business – automating processes and delivering the depth of insight you need to make better decisions for trading and risk, supply chain and financial management.

Eka empowers you to prioritize and scale a solution that meets your unique business. Customize and develop the best-fit solution for your: • Scope of functionality: Unlock the value of your data from sourcing to trading and risk, supply chain and financial management.

• Commodity and market versatility: Manage a broad set of asset classes across geographies by selecting the best solutions from our library of 50+ applications. Our solutions serve the entire trading value chain across agriculture, energy, metals and mining and manufacturing markets.

• Functional requirements: Perform on-demand analysis using trusted data with custom dashboards, drill downs, visualizations, and embedded machine learning algorithms for anomaly detection.

• System integrations: 20+ built-in connectors and open APIs enable you to easily bring exter-

nal data from ERP systems and other sources including market, weather, compliance, and your database.

Eka’s Cloud Platform provides advanced analytics, one source of data and an automation engine, providing maximum flexibility and investment protection as business needs and market requirements change. With our fully mobile platform enables insight and analytics on the go, Eka is committed to ensuring our 100+ clients can work from anywhere and collaborate across ecosystems within a secure and trusted environment.

If you’re ready to find a solution that can address your specific business requirements, learn more about at www.eka1.com

ABOUT Commodity Technology Advisory LLC Commodity Technology Advisory is the leading analyst organization covering the ETRM and CTRM markets. We provide the invaluable insights into the issues and trends affecting the users and providers of the technologies that are crucial for success in the constantly evolving global commodities markets.

Patrick Reames and Gary Vasey head our team, whose combined 60-plus years in the energy and commodities markets, provides depth of understanding of the market and its issues that is unmatched and unrivaled by any analyst group.

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