Further thoughts on hedging instruments for milk products

Yesterday I made some comments about the possibility of hedging milk product prices, since the subject came up in a debate on the France 24 satellite TV news channel.

In relation to the milk futures which are available on the Chicago Mercantile Exchange, it is my understanding that the most popular contract relates to milk itself. However, one has to be conscious that the milk price in the United States is very largely determined by the cheese price, since that is the dominant manufactured product and the liquid milk price is based on the manufacturing price plus various fixed differentials which are specific to various regions in the United States (the Federal Milk Marketing Orders). The problem about the US cheese price is that the market on the Chicago Mercantile exchange is very thin, dominated by two or three operators who consistently "trade against interest". In this it is very similar to its predecessor the Green Bay Exchange, which was the subject of a weighty academic investigation into market manipulation.

In the European Union the price was relatively stable up to 2006, being dominated by the structures of the Common Agricultural Policy. In 2007 prices took off spectacularly as a result of similar movements on the world market. As a result all milk subsidies are now set at zero and intervention prices became less relevant. The previous stability brought about by the structural surplus of milk in a support framework meant that there was no volatility in the market and therefore there was no scope for developing hedging instruments to manage risk.

Even in the present situation where prices have become much more volatile, the market is still dominated by the influence of the EU milk quota system. A good example of the way in which relaxation of the milk quota system could lead to significant increases in output is shown by recent developments in the management of the system in France. In the past, the French authorities managed the EU quota system in a very conservative way. On an EU Commission chart the French system was rated even more conservative than the Irish system of "ring fencing".

The apparent object of the French system was to maintain milk production in regions of France which were less suited to milk production but where it was an integral part of the traditional structure of the countryside. In addition, because France accounted for nearly a quarter of European milk production, restraint in France was likely keep up prices in Europe as a whole and hence also in France. As a result, the French authorities were quite slow even in handing out the increase of half percent in the quota to which the French farmers were entitled in 2006 2007 and 2008. However, during the course of 2007 became obvious that, possibly as a result of the introduction of decoupling, the higher cost regions in France were going to fall significantly behind their quotas and as a result milk production in France would be well below quota at a time of unprecedentedly high milk prices. The situation must have given rise to some irritation amongst farmers in the regions of France more suited to milk production, who saw themselves missing out on a glorious opportunity of producing more milk at very high prices. As a result the French authorities allowed farmers to produce over the quarter by a certain percentage. This percentage was set at 4% in June, 10 per cent in September and 15% in December. The regions of Brittany, Normandy and the surrounding areas responded quickly to this possibility with very dramatic increases in production. As a result it is very possible that France will come close to filling its milk quota in the year ending March 2008.

I would conclude from this case history that the European Union milk market is still very much subject to administrative market management and until this process is completed it will be difficult to manage on the basis of hedging instruments.

France 24 debate on agflation

On Tuesday 26 February, France 24, the English edition of the French news channel, hosted a debate about the worldwide rise in food prices. In the course of that debate, an Italian banking commentator criticised the dairy firm of Yoplait, whose marketing director was representing the food sector, for not offsetting the rise in his milk costs through appropriate hedging instruments.

There are a number of points to be made here. First of all using hedging instruments only protects one against short-term fluctuations. Where there is a long-term shift in prices, that will ultimately have to be passed on to the consumer, if only because the cost of the hedging instrument will also rise. Even the case of short-term fluctuations, it is quite possible to take out a hedge and then to find that prices fall unexpectedly and one's less sophisticated customers turn out to be more competitive. In a worst-case scenario one can then find that customers or suppliers seek to renegotiate contracts and the hedge then becomes a liability.

Apart from this broad point, there is the fact that hedging instruments are only generally available for foreign exchange rates and for bulk commodities like wheat and sugar. One reason for the limited availability of hedging instruments in the dairy sector is that this sector is the subject of intensive market management both by the common agricultural policy in Europe and by the USDA in the United States. Up to 2006 this resulted in milk prices being much more stable within the United States and the European Community than they were on the world market. This was particularly true in Europe where there was a natural surplus of milk held in check by the quota system. In the United States was no need for a quota system because supply and demand were more or less in internal balance. This situation resulted in more significant internal price fluctuations in the United States than in Europe. As a result there are hedging instruments for dairy products on the Chicago Mercantile Exchange. However these instruments are linked to the course of the internal US milk prices which are rather separate from those on the world milk market.