Can volatility be managed?

As the current cycle runs its course, there is predictable discussion about how dairy market volatility can be somehow curbed or at least managed.

In New Zealand, the industry most exposed to price volatility, the discussion has taken an interesting turn with the imminent disappearance of Fonterra's guaranteed milk price scheme (GMP) after this season.

The GMP was introduced in April 2013, and allowed participating farmers to lock in 75% of their production at a guaranteed price, announced at the start of the season. At the time of the GMP launch Fonterra said: "As well as providing farmers with the certainty they are looking for, GMP also has benefits for the co-op. That's because we know how much a certain proportion of our milk will cost us for the season and this in turn provides us with another selling tool when talking to our customers, some of whom are also looking for price certainty."

After an apparently successful pilot involving 328 farmers and 15 million kgMS the scheme was expanded for the 2014-15 season to 60m kgMS and farmers were given two opportunities to lock in prices – for 40m kgMS June and the remainder in December. In June this year, with the commodity market clearly sliding, there were reports that the initial June offering of 40m kgMS locked in at up to NZ$5.25/kgMS was oversubscribed, with more than 400 farms applying to use the scheme. So far so good, right?

Well, no, in September came a brief announcement that GMP would cease because, said Fonterra, it hadn't gained the widespread support of farmers: "While some have used it to smooth onfarm incomes, others felt it did not treat all farmers equally and fairly." The GMP covered less than 4% of Fonterra's 1614m kgMS intake, so in a year in which it offered the greatest attraction for suppliers, many would have missed out.

The initiative has now been handballed to the NZX, which has been working on a milk price risk management tool, but with no launch date as yet. So it seems futures and derivatives are at least part of the answer to help manage price volatility.

The Irish industry, one of the most exposed to global commodity markets in the EU, certainly thinks so. The Irish Cooperative Organisation Society (ICOS) recently called for a fully functioning European dairy futures market to allow farmers, or cooperatives on their behalf, to hedge their milk price positions. However, a trickle of trades in an SMP futures product offered on the Eurex exchange dried up in May this year and the trade was suspended. Despite the apparent need, it seems the European dairy sector has little appetite for futures.

In the US a well-established futures exchange covers milk and key dairy products, and though it is a growing exporter most of the milk output is still consumed domestically. It should all be sunshine, lollipops and snooze-ville when it comes to price volatility, right? Wrong. We have tracked the all-milk price for US dairy farmers before and after milk futures were introduced in the mid-1990s; since then price volatility has increased, not lessened. It is almost inevitable that if a futures market is to develop enough liquidity it will include players not directly involved in the physical market – sometimes with more or less information than those who are! This can potentially give rise to even greater variability in prices that is often not supported by market fundamentals, just the result of pure speculation.

From the other end of the supply chain, major UK retailer Tesco has recently said it will expand its Tesco sustainable dairy group of direct milk suppliers, citing the removal of EU quotas and increased volatility as key factors.

While it seems no one benefits from volatility – from farmers to end users – and the discussion seems to peak when the market bottoms, we are no closer to finding the desired silver bullet.

Also, very little discussion in the industry touches on the whole volatility story for farmers, who must also deal with input prices – mostly feed – that are often just as variable.

For many Australian dairy producers, the answer to effective risk management may be much less sexy than futures and derivatives. It may be entering into a long-term supply contract where that option is available, and at the same time locking in feed – and knowing with certainty what the margin will be for the next three years. For others it may be the deft use of farm management deposits – which will hopefully become even more amenable in future – to smooth income over years.

Whatever the tool or strategy, there also has to be the realisation that managing price risk often means sharing some of the upside, as well as the downside, with partners up and down the supply chain. This requires a marked cultural change for our industry, and the realisation that while you may not always 'win', you may sleep better at night.

• Jo Bills is a director of Victoria food consultancy firm, Fresh Agenda.