Managing Risk and Seizing Opportunity in 2012 and Beyond Dr. Marin Bozic I-29 Dairy Conference │ February 8, 2012

1)Recent events in the dairy markets 2)Risk factors in )Hedging margin risk 4)Long-run risk management Topics for today

April 2012 Class III Futures

April 2012 Class III Futures Components contribution to decline

Term structure of futures prices Based on options data, there is 20% chance Class III price will settle below the shaded area, and 20% it will settle higher.

Downside Risk

Risk factors U.S. recovery to stop? Eurozone collapse? War with Iran? Runaway inflation? Three year cycles? ( = 2012)

Implied Probabilities of Uncertain Events: 1. U.S. Economic Recovery

Implied Probabilities of Uncertain Events: 2. Dropping out of Euro zone

Implied Probabilities of Uncertain Events: 4. War with Iran

Implied Conditional Probabilities of Uncertain Events If air strike is to happen this year, what are the odds it will happen in summer:

Can we make use of prediction markets in dairy? Information discovery: E-verify to become mandatory before 12/31/2012 Farm bill to pass before 9/30/2012 Risk transfer: “The Secretary of Agriculture to announce that the stabilization program is in effect for June 2012”

Expected Inflation: Evidence from Treasury Securities

Historical Milk-Feed Margin Source: Katie Krupa, Rice Dairy, LLC.

Forward Margins Source:

1 cwt of milk bu of corn ton of SBM Rice Dairy Milk-Feed Margin Formula Source: Katie Krupa, Rice Dairy, LLC.

Three year cycles? Evidence from forward margins

Historical Perspective Source: Katie Krupa, Rice Dairy, LLC.

Historical Perspective Source: Katie Krupa, Rice Dairy, LLC.

Forward Dairy Profit Margins

Hedging by any other name… There are (at least) three very different way dairymen can manage risk: Contracting – i.e. futures and options, forward pricing through the coop, cash contracts for feed Strong equity/fast growth – increasing efficiency to keep costs below national average, possibly by attracting investors to keep debt/equity ratio low in face of fast expansion Dairying as a hedge – low cash-flow costs, but high opportunity costs of feed. Dairying as a hedge against lower future value of land/crops

S D D′D′ Quantity Price Short run (wish there was a fifth udder)

S D D′D′ Quantity Price Long run (eight udders are better than four)

What does the long run U.S. milk supply look like? Data period:

Change in Dairy Farm Technology

Percent of U.S. Milk Production by Large Dairy Farms Percent of US milk production by farms with cows grows on average by 2.2% a year.

Flat supply curve – what are the implications? In the long run… Dairy Darwinism: dairyman to businessman, or out of business. Demand-enhancing activities boost quantity, not price (think exports, check-off, product research & development) Increase in price of one milk fraction decreases the price of another (think whey vs. cheese) until returns to dairying revert to average Uncertainty = higher average returns Vertical integration as the 21 st century version of “cooperative revolution”

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Managing Risk and Seizing Opportunity in 2012 and Beyond presented at the I-29 Dairy Conference Sioux Falls, February 8, 2011 Dr. Marin Bozic Department of Applied Economics University of Minnesota-Twin Cities 317c Ruttan Hall 1994 Buford Avenue St Paul, MN You may download this presentation at