Futures Market Offers 'Premiums' to Cash: What you need to know?

Dr. Cameron Thraen, Milk Marketing Specialist, Ohio State University,
Additional milk marketing information by Dr. Thraen

In this offering for the Buckeye Dairy News, I am going to take a departure from the traditional policy and price outlook to show you how you can 'read' the prices being set on the Chicago Mercantile Exchange (CME) Futures & Option market and do a little forecasting on your own.

Ok, it has finally gone and happened. After an impressive run, which began back on July 31 of this year, the cash cheese market on the Chicago Mercantile Exchange has finally gone and taken the plunge! As I write this article the block cheese price has retreated $0.18/lb, from the high of $1.60/lb and the barrel cheese price $0.20/lb from its high of $1.57/lb. Of course, we all 'knew' that unless the whacky workings of the cheese market had gone completely off-kilter, these lofty prices just could not last. Good thing that it lasted long enough to set milk prices for August, September, and October, and Advanced prices for November! This shot in the arm moved the class III price steadily up from $9.75/cwt back in June to a welcomed $14.39/cwt for October. The Uniform Price in the Mideast Federal Order moved up from $10.63/cwt in June to $13.93/cwt for September and should be over $14.40/cwt when announced this week.

Now with cheese prices making a typical seasonal retreat back to what will likely be the $1.25 to 1.35/lb level, and the butter price trading in the $1.14 to 1.19/lb range, it may appear to you that all of the good times and market pricing opportunities are over for the foreseeable future (the next 6 months anyway). The good news is that this is just not the case. If you are a proactive pricer, that is, one who proactively takes action to secure your price when the opportunity appears, rather than waiting to see what the market will give you, then this column is just for you. By watching the Chicago Mercantile Exchange Class III futures prices and knowing what to expect as 'average cash prices', there may be 'premiums' or 'discounts' to what we might expect to receive in the cash market. Let me elaborate.

In Table 1, I show the average announced class III price, by month, for differing number of years used to compute the average. From these averages, I have computed the 'premium' or 'discount' that exists in the current CME futures class III prices. The premium is computed as the CME futures class III price (as of 11-05-2003) minus the average class III price using the following averages: (a) 3-year, (b) 5-year, (c) 7-year, (d) 10-year, and (e) 14 year periods.

Table 1. "Premium / Discount" currently in the Chicago Mercantile Exchange (CME) Class III Futures Price for 2004.

Class III Settle Price ($/cwt)
3-year average
5-year average
7-year average
10-year average
14-year average

Class III Settle Price ($/cwt)
3-year average
5-year average
7-year average
10-year average
14-year average

Let's take January as an example. If you think that this coming January will be very much like the average of the last three, e.g., 2001 to 2003, you can see from the entry in the table coinciding with the 3-year average that the current futures price is $0.95/cwt over the 3 year average class III price for January. If you wish to include more January cash class III prices, then look at the 5-year average in the next row down. The 'premium' is now a minus $0.09/cwt. No premium at all, but a discount. As you work down the column and take in even more January prices, you can see that the discount grows. Now you have to make a decision. Are the current conditions, supply versus demand, more likely to be represented by the last three years, five years, or 14 years? If you are thinking 'surely the January price cannot be less than $11.55/cwt, recall that in 2001, the class III price slid from a September high of $15.90 to 11.87/cwt by January of 2003! When the cheese market retreats, it can have a major impact on the Class III price. I am not saying that this is the current situation today, just that it can and has played out this way in the past.

Now look at the numbers in Table 1 for the February through April months. Up to the 7-year average, the current futures market Class III contract is offering a decent 'premium'. For example, February and March contain in excess, a dollar premium for the three and five year averages. At this time, buyers and sellers of Class III futures contracts do not see milk prices sinking toward the historical lows for these months.

As we get to the summer and early fall months of July through October, we can see that the current CME futures prices are all 'discounts' to what we have received, on average, during these months. This is exactly what you should expect. Futures prices for commodities that are not storable, such as milk, reflect the futures market participants' forecasts of what they expect the market price to be in the � what else? � future. And as the weather (and its impact on production) is the big uncertainty during the summer and early fall months (witness 2001 and 2003), these same market participants are conservative in forecasting bad weather and therefore unwilling to pay any premium at this time.

If you have access to a computer with an internet connection, you can find this 'Premium / Discount' table displayed on my website: http://aede.osu.edu/programs/ohiodairy. The table of premiums and discounts is updated after the close of trading each day. If you would like to become more knowledgeable about the milk and dairy markets, and would like to become a "ProActive Pricer", I will be offering my course Pricing Milk and Dairy Products in the United States through The Ohio State University - ATI, Wooster, Ohio, January 8 through March 13, 2004. This is a comprehensive course designed to broaden your knowledge of milk and dairy product pricing, Federal Milk Marketing Order pricing rules, and the factors that determine your milk check. The course provides practical hands-on experience with the dairy futures and options markets and pricing. The course meets each Thursday from 12:00 - 3:00 pm. If you would like more information on this course, contact Jan Elliott, Business Training & Education, The Ohio State University-ATI, (330) 287-7511, or email to elliott.3@osu.edu. The course Pricing Milk and Dairy Products in the United States will not be offered again until 2006, so do not miss this opportunity!