PwC supports NZ Milk Futures to manage milk price risk

PwC supports NZ Milk Futures to manage milk price risk

The NZX today launched a NZ Milk Futures contract that will eventually provide the opportunity for large and small dairy farmers to proactively risk manage milk price movements and volatility.

“The new futures contract essentially replaces, and considerably enhances, the Guaranteed Milk Price (GMP) contract previously offered by Fonterra,” says Roger Kerr, PwC Partner and Treasury Advisor.

“While the new futures contract has been expected, it will need support from the market to ensure its viability. This means that industry players with resources available to make this commitment, should be encouraged to participate,” says Mr Kerr.

The NZ Milk Futures contract has been widely anticipated in the absence of any risk management tools in the market, especially with the increasing volatility in milk prices.

“Those with a vested interest in an active forward price market for the largest commodity our economy produces should get behind and support the new futures contract. That includes dairy farming milk suppliers, local and offshore buyers of both raw milk and dairy products, milk processors, speculators, banks, brokers and agriculture service providers.”

According to Mr Kerr, any new futures contract can take a few years to gain traction, volume and liquidity and it will need market support to become viable. However, once established the Milk Futures contract should benefit all concerned as risk, volatility and future uncertainty will be greatly reduced.

The contract is aimed at dairy farming suppliers of milk, local and offshore buyers of milk and dairy products and local milk processors and will be priced in New Zealand dollars on a per kilogram of milk solids basis. These parties will use the futures contract to hedge milk price risk, however like all futures markets the new market also needs speculators/traders who are willing to take contrary positions and in doing so provide important market liquidity. It will therefore give local dairy farmers the ability to more effectively manage the risk of fluctuating milk prices. For many this will bring a huge degree of certainty and discipline.

Mr Kerr recommends that the following questions and issues should be carefully considered before embarking on any form of price protection or hedging activity:

•What is the risk appetite and tolerance levels of shareholders in respect to the volatility of profits/cashflows as a result of changes in milksolids pay out over multiple years?

•What is the ability to adjust milk production costs when milk prices reduce i.e. what is the mix of variable and fixed costs in the business and thus financial performance outcomes under flexed milk price scenarios?

•What is the balance sheet gearing of the entity? Are interest costs fixed or floating? The need to understand the inter-relationships between NZ interest rate movements, the NZD/USD exchange value and international dairy prices will be an important consideration of the risk analysis.

•How strong is the motivation to spread milk price risk over multiple years? Reducing risk is about reducing volatility (or percentage change) of income from one period to the next. How will the percentage and term of hedging change that price risk profile? Dairy farmers invest considerable sums in herd, pasture and general farm management development to spread and reduce financial risk. A similar long-term investment approach would seem advisable for the management of the price risk on the income line.

•An acceptance and recognition that fixed price hedging to reduce income/profit volatility comes with trade-offs i.e. there will be periods of “regret factor” and “opportunity cost” when milk prices subsequently increase above fixed/hedged prices. Understanding that this may be a small price to pay for the certainty and corralling of price outcomes within acceptable bands would seem prudent.
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