• Hedging on Price

    Tags: Cheese

Few in the pizza business can forget the hellish year of 1999, when block cheese costs hit an all-time U.S. high of $1.97 per pound. Bitter price wars already had bruised operator's books, and grossly inflated cheese prices simply bloodied them.

But the following year was a sweet time for the industry. Block cheese opened and closed the year 2000 trading at $1.12 per pound. Prices went no higher than that September's acceptable $1.32, and then they dropped to a gloriously low 98 cents on Nov. 3.

And then came 2001, a price odyssey. The market opened the year at $1.09, but marched upward to a high of $1.78 by Aug. 24. With profits pounded and food costs clobbered yet again, operators gave up hope for a profitable year.

Until cheese prices plummeted to $1.16 on Oct. 24.

Just reading about such market ups, downs and loop-to-loops can give an operator motion sickness. But dairy experts say operators needn't suffer such Maalox moments, that they can trade the annual cheese rollercoaster ride for something akin to a peaceful cruise through the commodities tunnel of love.

Or, said Dave Deal, a procurement and distribution consultant, operators can ignore such options and choose to white-knuckle it through every market twist and turn. As a buyer for Little Caesars many years ago, Deal said no financial Dramamine will smooth out that ride.

"When you're an operator, and you've gotten your head handed to you like these guys have over the past few years, you rationalize that it was happening to everybody else and that there was nothing you could do about it," said Deal, who works with The Food Source, in Detroit. "When you had no dairy futures market, that's all you could do."

In an attempt to straighten out market swings for producers and users of dairy-related commodities, the federal government introduced new guidelines on milk pricing in the mid-'90s. A dairy supplier or a dairy user (such as a cheese manufacturer or pizza company) could sell and buy contracts for Class III milk (the grade of milk used to make cheese) on the Chicago Mercantile Exchange (CME).

" If you're not hedging, you're speculating. You're taking what the market dishes out to you, and that's the purest sense of speculating."

Jeff DeGrand
E-Dairy, Inc.

Purchasing milk futures contracts allowed those suppliers and users to build a financial cushion against price fluctuations in dairy products by profiting from the ultimate sale of those contracts.

For example, if a pizza company wanted to counter rising cheese prices, it could buy and sell milk futures contracts. Historically, when the price of cheese rises, the price of milk rises along with it (a common supply-demand scenario based on the use of milk to make cheese). Therefore, milk futures contracts purchased at a lower price are sold later at a higher price. Ideally, the transaction yields a profit that provides enough cash to offset a similar rise in cheese costs.

The practice is commonly called price hedging, because the extra cash made from the sale of those futures contracts forms a hedge of protection around the owner/seller of the contracts. And ultimately knowing that profits from those milk contracts can counter rises in cheese costs, the pizza company in this example is able to build margins into its menu prices that will yield profits in the long term, despite cheese market swings.

"It allows you to smooth out the peaks and valleys a normal buyer would endure in a normal year," said Jeff DeGrand, a junior partner with E-Dairy, Inc., part of the Downes-O'Neill commodities brokerage in Chicago. "The primary function of using this is to have a tool that helps you lock in profit margins."

"If you run a restaurant company, this allows you to forecast the cost of product underneath your menu cost," said Brent Brown, director of foodservice for DCI Cheese, an independent dairy manufacturing and contracting company in Mayville, Wis. "You have the opportunity to lock into a fixed price based on what the average market has been and probably will be. And by doing that, you protect yourself against a possibly volatile market."

Won't Anyone Come Play?

Like the proverbial party to which many were invited but few came, so has gone the traffic on the dairy futures market. Compared to grain markets, where hundreds of thousands of contracts are bought and sold daily, on average 400 milk futures contracts change hands daily.

Some of this is due to the fact that few know how to use dairy futures to their advantage, not to mention that the futures market's complexity terrifies undereducated buyers and sellers.

"Here's the number-one reason I hear from people who don't want to get involved in this: 'It's too freakin' complicated, and I'm used to doing what I'm already doing,' " Brown said. "The second-most common answer I get is, 'I don't know you, I've never bought cheese from you, and I'm not about to sign a year-long a contract with you.' And at least that's a legitimate concern."

Experts say another reason for the light traffic on the milk futures market is because it simply isn't as well established as other commodities markets. With so few players, the market lacks the liquidity to: 1. be influenced favorably by large players (such as a large cheese maker or pizza company); and 2. attract enough speculators (be they independent investors or deep-pocketed mutual fund managers) to make the potential financial rewards more interesting. Additionally, said Deal, the amount of brokers and traders needed to handle large numbers of orders -- such as on grain exchanges -- doesn't yet exist. Growth over time in the number of market players, he said, will increase the number of traders required to handle their contracts.

"When you're an operator, and you've gotten your head handed to you like these guys have over the past few years, you rationalize that it was happening to everybody else and that there was nothing you could do about it. When you had no dairy futures market, that's all you could do."

Dave Deal
The Food Source

"If a company wants to hedge its position with a large order, it's going to take days to get that done, maybe even a week," said Deal. "By comparison, if you put in an order for IBM stock, you don't have to want to wait three days and see the price go up 10 dollars before you can take your position. Your broker places that order immediately, and there's someone there to handle it.

"But if there's an order now to buy 50 (milk) contracts in a market where the volume is 10 a day, the guys thinking about taking the other side of that trade are going to start raising their prices, aren't they? They're thinking, 'I got a live one out there who wants 50,' and suddenly the price starts going up." Were the volume of trades much larger, say several thousand per day, he added, 50 milk contracts (which one day will yield 1 million pounds of cheese) wouldn't influence the overall market volume that much, and could be quickly absorbed by a larger number of traders.

"There'll be enough volume of activity that when they place their buy orders or their sell orders, they're going to get filled in a relatively short period of time," Deal said.

Mike Reidy, senior vice president of procurement, logistics and business development at Denver-based Leprino Foods Company, agreed that the market's small size keeps even his company, the world's largest producer of mozzarella, from playing the futures market. "Right now there isn't sufficient liquidity for (hedging) to be a good tool for us. We're excited about the market's growth, but there's still tremendous opportunity there compared to other longer-established commodities, like cotton or petroleum."

The reality of the situation, said DeGrand, is that the market must become more of a, pardon the expression, cash cow, in order to attract more attention.

"Relative to other commodities contracts, it's not a world beater," said DeGrand. "But on a growth basis, it is the fastest-growing agricultural commodity market."

Toes in the Water

Though most restaurant operators are understandably timid about investing in futures, a growing number are stepping into the water -- albeit with the guidance of consultants and brokers. Battered into submission by high cheese prices, Brown said many restaurant operators simply are ready to try something new, even something they don't fully understand it.

"We have customers coming to us saying, 'I use 3 million pounds of cheese a year, I'm tired of the market going up and down on me, and I understand you can help me with that,' " he said. "What we'll do is show him how the CME cash market has performed over the past six years, and then show him what he could have done if he had contracted in certain periods."

Following is a highly simplified example of how a milk futures contract is bought and sold, and how the market player can benefit:

A buyer purchases one July milk futures contract, which means he now controls 200,000 pounds of milk. That milk is priced per hundredweight (symbolized as "cwt"), meaning a dollar value is attached to each 100 pounds of milk in the contract. Therefore, one contract controls 2,000 ctws of milk.

Suppose that, in January, a July futures contract is priced at $12 per hundredweight. Someone buying that contract would pay $24,000 for that contract ($12 x 2,000 = $24,000). As the year wears on, the July milk futures price could rise to $16/cwt, making that contract worth $32,000 ($16 x 2,000 = $32,000). The contract then could be sold at a profit of $8,000 ($32,000 - $24,000 = $8,000).

If that sounds like too much cash for the average pizzeria operator to put up, don't worry: he doesn't have to.

Just like mortgaging a home, buyers of milk futures contracts can leverage their purchases with as little as 5 percent down. So, using the example above, the buyer gets his contract for $1,200 ($24,000 x 5% = $1,200) instead of $24,000. The good part is that, like a home that rises in value, he can sell the contract later and gain the same profit, in this case, $8,000.

The bad part is that, just as with any investment, if that contract loses value, the owner of the contract is responsible for that full loss.

Options on Contracts

A more conservative approach to price hedging is buying call options on milk futures contracts. That allows the buyer to establish a ceiling price for cheese, while gaining the benefits of a lower market if prices fall.

Options work like insurance both in falling and rising markets. If the historic correlation between cheese and milk prices holds, then the owner of those options makes a profit if the market rises, but loses only the money he spent to buy his options if the market falls.

For example, if a pizzeria operator wants to set a ceiling on the block rate price he will pay for cheese (say at $1.50 per pound), a broker would advise him to purchase an option (or options, depending on the operator's cheese usage) for a July milk futures contract at $13.50. On average, said Deal, a broker would charge that operator somewhere around 50 cents per hundredweight per contract optioned, costing the buyer $1,000 ($.50 x 2,000 ctws = $1,000). (Options prices do fluctuate based on market prices at the time of purchase, as well as how far in advance the option is purchased.)

Come July, if the price of milk rises to $14.50, the pizzeria operator makes a dollar-for-dollar profit above his options price of $13.50, minus what it cost him to buy the option.

If the price falls below the originally set price of $13.50, that option becomes worthless, and the operator loses only the money he spent to purchase the option. Were he to have exercised that option, he would be responsible for the total loss of the contract's value, which could be many thousands of dollars more.

Deal said many of his clients make this more conservative choice because "it gives them the protection they're looking for."

I'm So Confused

If the process sounds at all technical, that's because it is. Most would find the nomenclature used by market masters about as familiar is Urdu, and the formulae used to calculate risk and cost are Einsteinian in their complexity.

" Right now there isn't sufficient liquidity for (hedging) to be a good tool for us. We're excited about the market's growth, but there's still tremendous opportunity there compared to other longer-established commodities, like cotton or petroleum."

Mike Reidy
Leprino Foods Company

Experienced brokers and consultants commonly use multiple people to monitor the dairy industry's every move and forecast what they think will happen. Others still are called upon to turn those forecasts into hard numbers that investors ultimately can use to weigh their risks.

And even then, with all that support at their fingertips, experienced traders say commodities investing still is a gamble.

"Eighty percent of people who trade in commodities lose money at some time or another. That's just a fact of the business," said Neil Klaber, a broker for Gulf Coast Futures and Options in Sarasota, Fla. Brokers and consultants can be reasonably confident in their recommendations, he added, but "nobody can be sure of anything when it comes to the market. It's very difficult to navigate."

What investors sometimes forget, added Chicago-based dairy market analyst Jerry Dryer, is that "the futures market is a zero-sum gain. For every dollar you make, someone had to give up a dollar. People like to think about making money, but they don't always consider the other side."

Despite the complexity, Deal insists the financial tools and the experts who know how to use them are available. That, he said, makes any futures market investment far less risky than subjecting oneself to the flux of cheese prices. Even with all its inherent hazards, hedging offers the operator a measure of control he cannot get otherwise. "The way to get more people (into the market) is to have the same volatility on cheese prices we've had in the last three years. It makes people ask why they have to take that punishment."

When a pizzeria operator understands that investing in the futures market is about reducing and controlling costs, said Brown, he comprehends the wisdom in taking a chance on futures.

"There is value in (price) consistency," said Brown, whose company also does forward contracting on cheese. "The fact that a large restaurant company doesn't have to change its costing internally -- every single week when market changes -- eliminates a lot of paperwork and a lot of worry."

Dairy market analyst Alan Levitt stressed that companies considering hedging need to start slowly.

"They don't have to hedge all their cheese purchases," said Levitt, who is based in Crystal Lake, Ill. "Start with one contract for one month, follow it to expiration and see how it goes. Crawl before you run. Open an account, work with a broker, establish some objectives, and when the market gets to your target price, buy (or sell) a contract. It's not really that hard."

In the end, said E-Dairy's DeGrand, hedging is not about hitting a money-making home run trying to time the market perfectly, it's about risk management.

"If you're not hedging, you're speculating," said DeGrand. "You're taking what the market dishes out to you, and that's the purest sense of speculating. You don't know what the price is going to be here or there, and you're taking your lumps. I'd say that's pretty risky."

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