Are You Playing Blackjack With Your Milk Price?

We all have played the card game Blackjack at one time or another. In this card game, we are dealt two cards, one face up and the other face down. The dealer also gets two cards, one face up and the other face down. The object is to get a score on our cards as close to 21 but not 'bust' by going over 21 points, and to have a score or point total that is greater than the dealer's point total. We get to see the one card from the dealer and then we can request additional cards for our hand. In Blackjack, there are rules guiding whether or not we request additional cards or 'stand-pat' with what we have on the table. For example, if our two card total is 19 points, we do not request another card, hoping to get an ace or deuce for 21, but we 'stand-pat' and wait to see what the dealer has for total points.

The current Chicago Mercantile Exchange (CME) cash and Class III futures market is very much like the Blackjack game. You, the producer, have been dealt a very good hand. The dealer, that is the market, is showing cash prices for both Grade AA butter and Cheddar cheese (blocks and barrels) at levels that have not seen before at this time of the year. The Grade AA cash butter price rose above the $2.00/lb mark on March 5th to settle at $2.11/lb. The Grade AA CME cash price average for the week of March 1 to 5 was $2.00/lb. This will calculate to a milk fat price of $2.262/lb. The last time producers earned this much for milk fat was back in August of 2001. As for cheese, the CME average price for the same week will pay producers $1.9198/LB of protein. Put both of these cash market prices together, along with expected prices for nonfat dry milk and whey, and the implied Class III price is $13.69/cwt.

The CME March Class III futures contract is currently trading in the $13.58 to $13.63/cwt range. The last time producers experienced $13/cwt plus milk in March, under current Federal Order pricing rules, was, well never. Even if we do not constrain ourselves and look back to the decade of the 90's, we still cannot find a March price anywhere near this high. Now, looking at the CME Class III futures prices for April ($14.60 to 14.71/cwt), May ($15.23 to 15.39/cwt), June ($15.20 to 15.45/cwt), July ($15.33 to 15.50/cwt), August ($15.35 to 15.65/cwt), and September ($15.50 to 15.75/cwt), our 'price hand' is showing CME futures prices that start at $14.70/cwt for April and go up from that month through September (Figure 1). On March 8th, the average for the April through September contracts is $15.38/cwt. As it stands, this is a very good hand indeed! In fact, to achieve this average milk price, we require an average of $2.30/LB Grade AA butter and $1.65/LB Cheddar cheese to hold over the next six months.

Like the Blackjack player, having been dealt a hand of 19, or even 20, you must make a decision. Do you stand-pat and price your milk at the current level, or do you take the risk that you will draw a deuce or an ace and win out with even higher milk prices over the next six months? Current prices for the CME futures contracts are the cards that you see on the dealer's side of the table. What you do not see is the market card still face down. That card will play out over the next six months. Will the impact of the reduced availability of bovine somatotropin (rBST) be greater or less than anticipated? Will dairy cow numbers continue to decline or will higher prices slow the rate or even reverse the direction? Have we seen a significant slow-down in dairy cow culling? Will the border with Canada be opened? Will the general economic recovery be stronger or weaker than anticipated? Will product inventories continue to decline or begin to build? What will the weather be like over the next six months? Will the market deal an even tighter supply to demand balance and push prices up or will the final card dealt result in better that expected production and lower that expected commercial demand and lower prices?

The final result for each of these questions is difficult to anticipate. Right now, you have been dealt an excellent hand and you should be pricing a good share of your monthly milk shipment through forward price contracts, futures contracts, or using options on futures to put floors under the current Class III market prices. In fact, and you may think I have lost my mind, you should price your milk at these CME futures prices, produce milk like gang-busters, and hope for a decline in the actual Class III price for each of these coming months. Why? With lower actual Class III prices you will receive higher Producer Price Differential (PPD) payments (Class III prices and PPD are negatively correlated), and with a lower Class III price, you may even receive a Milk Income Loss Contract (MILC) payment on top of your locked-in $15/cwt plus Class III price. What better 'price-hand' could you expect!

How are you going to respond? Do you 'stand-pat' with the 'price-hand' already dealt or do wait it out and hope to draw an Ace or a Deuce and risk 'going bust'?