Back to the futures

Sept. 17, 2003

When the block cheese price on the Chicago Mercantile Exchange (CME) plunged to 99 cents on Feb. 28, 2003, pizza operators celebrated and dairy producers grabbed the antacids.

Six months later, the block party has shifted to the dairy producers' corner. The CME price has held at $1.60 for three weeks, leaving pizza operators wondering if Tums would make a good topping.

Why so dramatic and sudden a price shift? Even experts admit it's not easy to put a finger on exactly what starts and stops the annual milk market roller-coaster ride.

"There's no question this is a very complicated system," said Al Levitt, a dairy industry analyst in Crystal Lake, Ill. "Explaining it to people keeps me in a job."

The good news is pizza operators don't have to understand every nuance of the dairy market to navigate it successfully. Multiple tools — such as forward contracting, futures and options purchases - are available to help operators of all sizes build a hedge around their profits.

But according to trader Jeff DeGrand, those tools are terribly underutilized by pizza operators. California Pizza Kitchen, for example, said it wouldn't pursue forward contracts this year, though Pizza Hut did hedge a third of its cheese for 2003. Several sources interviewed for this story chose not to reveal pizza clients' names, but all agreed too few have entered the milk market futures fray.

"(Pizza companies) have been one of the last sectors of the dairy industry to acclimate themselves to the hedging process," said DeGrand, a principal with Downes-O'Neill in Chicago. "That's unfortunate because I'd say (pizza is) the most competitive sector in the dairy business because of its tightness in profit margins and the percentage of ingredient costs to the overall expense of the operation."

Futures Speak

Following is a short list of some definitions of terms used by commodities brokers.

* Source: "The Short Book on Options," by Mark D. Wolfinger.

Call — An option contract giving its owner the right to buy the underlying asset at the strike price for a specified time.
Exercise — The election by the owner of an option to do what the option allows: either buy or sell the underlying at the strike price.
Hedge — An investment made to reduce the risk of holding another investment. It involves taking an offsetting position in a related asset.
Long — The position resulting from ownership of an asset.
Margin — The amount that must be deposited in the account in the form of cash or eligible securities. The deposit is required to protect the broker against the risk of loss.
Margin Account — An account in which an investor can (but is not required to do so) buy securities on credit, using other securities held in the account as collateral. A margin account is required for all options trades.
Obligations — Attributes forced upon the seller of an option.
Offsetting — Moving in the opposite direction. A position acting as a hedge.
Option — A contract that gives its owner the right, but not the obligation, to either buy or sell a specified underlying asset at a specified price for a specified period of time.
Premium — The price of an option. It is the sum of the intrinsic value (if any) and the time value.
Put — An option contract giving its owner the right to sell the underlying asset at the strike price for a specified time.
Short — The position resulting from selling an asset that is not owned. There is a future obligation to repurchase.
Strike Price — The price at which an option owner can buy or sell the underlying asset.
Underlying The asset from which the option derives its value. It is what the call owner may buy, or the put owner may sell.
Volatility — A measure of the price movement of a stock. It is a measure of the tendency of a stock to make a significant move in a short period of time.

DeGrand believes pizza operators have been slow to move into the market because of fear/ignorance of commodities trading, and misplaced goals.

Some who have given it a try, he said, got in it to make profits rather than to protect their margins. And "beating" the market is no mean task for novices.

"This is not about being outguessing the market, this is about smoothing out the peaks and valleys and being able to plan your business' budget 12 to 24 months out," said DeGrand. "This is about picking a price (for cheese) you'll know you'll be profitable at and locking it in."

Why the price swings?

What appears to perturb cheese end-users the most are the seemingly inexplicable swings in prices. During a recent industry meeting, one operator asked several others, "Why is it so high one time and so low the other. Other (food prices) don't change like that."

Levitt noted multiple factors that push and pull on cheese prices, not the least of which is its perishability.

"You've got a product that comes out of the cow twice a day, every day of year. It's not like corn, which you can harvest and store for a couple of months," Levitt said.

Buyers are to blame as well, he said.

"There's a buying psychology and a selling psychology," Levitt added. "When it looks like prices are going up, people tend to buy more in order to build their inventories. ... Then when the market goes down, they don't buy. Even if they think the market is going to $1.25 next week, they sit back and say, 'I'll just wait and get it cheaper.' The market feeds on itself that way."

The calendar shoves prices back and forth as well. In the spring, when the weather is more pleasant for dairy cows, milk production peaks, sends supplies soaring and prices dropping.

But significant sales events such as the beginning of the school year, Thanksgiving, Christmas, Super Bowl and Easter drain supplies, and trigger price increases.

While that supply-and-demand scenario is real and influential, DeGrand said it's still an oversimplification of cheese price volatility.

"Things like the Super Bowl and the August sales spike for schools are priced into the market; the futures (traders) are smarter than that," said DeGrand. "There's probably a six to 12-month lag in which traders have to watch and anticipate the market's turn."

To anticipate the market's next move, DeGrand said analysts and traders rely less on government reports of product inventories (such as cheese already made and in warehouses), and far more on information gleaned daily from dairy producers and end users.

"When we got the last (USDA) milk production report for July on Aug. 15, some of the information in that was already 45 days old," DeGrand said. "But producers know every day what their production situation is like, and I talk to dozens of them each day to know something on a real-time basis. ... If you're waiting around to see what the milk production report is going to give you, that's old news."

Levitt said USDA reports, such as the weekly and monthly milk reports, and the Cold Storage Report, do help to build an historical market track record but that, like DeGrand, the information they supply paints only a vague picture of true market conditions.

"I think the industry is so starved for information that it will take whatever it can get," Levitt said. "We place a lot of stock in these reports, because it's all we have. But they're not perfect, they don't tell the whole story."

Greed leads

Greg Dryer, vice president of administration and services for Montreal-based Saputo Cheese, said one problem with the cheese market is the greed of some traders who want to make a lot of money rather than just protect their operation's profits.

"We had a long period of low prices, and now we're having a short period of pretty high prices," said Dryer, a 23-year veteran of the dairy industry. "So on the balance, (dairy producers and pizza operators are) doing very pretty well. But that's not the way both sides see it."

Dryer said pizza operators always want the lowest price but that milk producers need more to not only thrive, but survive. The last 18 months' depressed milk prices, he said, drove many dairy farmers out of the business.

"Prices were unrealistically low for so long, which put a big strain on the producing side," Dryer said. "Everybody has got to make a living in this supply chain, but if one fails all of us fail."

Finding that utopian balance is easier said than done in a free market. Despite exceptional controls on the nation's milk supply, an up or down shift of 1 percent to 2 percent can send prices tumbling or skyrocketing. Restraining it any further would meet harsh resistance from producers and buyers who fought for looser restrictions several years ago.

Using the protective tools available, said Dryer, will make the long-term market ride less bumpy.

Suppliers and users, however, are loathe to try them.

"We could offer operators a fixed price for their cheese, but unfortunately, people view that as taking a risk," said Dryer. "If you buy cheese at the fixed price of $1.40, you know what your cost is."

Forward contracting - guaranteeing a fixed price — allows a manufacturer like Saputo to hedge its own milk purchases out months in advance and better control its costs. The goal, Dryer stressed, is to minimize price volatility for every link in the supply chain.

"If I had a customer who guaranteed to buy a certain amount of cheese for a year, we

Cheese-related Resources

Jerry Dryer, Dairy & Food Market Analyst

Dave Deal, The Food Source

Jeff DeGrand, Downes-O'Neill

Alan Levitt, consultant


Blimling and Associates

Want to be included in our resource list? Simply e-mail your company's name and Web site to, and we'll see that your firm is listed.

could go lock in the cost of our milk," Dryer said. "But people are afraid because they see it as a risk. The way I see it, though, riding the market up and down is a much greater risk."

Dairy analyst Jerry Dryer (no relation to Greg Dryer) said if more pizza operators would consider forward contracts with cheese suppliers, more suppliers would lock in to milk prices for extended periods and help stabilize the market.

"If the cheese guy gets those contracts, then that forces him to go and hedge for himself," said Dryer, a Chicago-based consultant and author of Dairy & Food Market Analyst newsletter. "A supplier and a customer should be able to sit down and say I'll guarantee your cheese for $1.40 for the year. Then the pizza guy can't bitch when the price goes to $1, and the supplier can't bitch when it goes to $1.60."

That includes milk producers, too, he added.

"So much of this is about greed," he said. "Milk producers hesitate to participate in the futures market because they need $12 per hundredweight to make money. But then when the futures market goes to $14, they won't sell their milk because they're hoping it'll go to $14.05! Just forget it, and take the $2 profit!"

Locking in long-term

Several years of watching the erratic rise and fall of cheese prices was enough for Kevin Kellstrom, inventory control buyer for Bosco Foods, a Troy, Mich.-based manufacturer of pizzas for institutional sales. The horrors of 1998 (when the block market peaked at $1.90 and stayed there for 15 trading days) cheese market drove his company to the futures market in 2001.

With the help of DeGrand at Downes-O'Neill and Dave Deal, a procurement and distribution consultant for The Food Source in Lathrup Village, Mich., Kellstrom waded into the futures market.

His first-year results weren't terribly impressive, Kellstrom recalled. But as he became better acquainted with the market, the performance of his buys improved dramatically.

"I just had to become comfortable with the market," said Kellstrom, whose company buys 2 million pounds of cheese annually. Nearly three years later, Kellstrom's hit his stride. "We're not trying to look at the market as a way to make money, we're just trying to limit our risk. Basically, all we're saying is, 'We're not going to pay any more than this, or any less than this.'"

DeGrand believes fear of the unknown, plus concerns over the cash outlay required, keep operators from entering the futures market. Kellstrom understands: "That's the one downside to this, because it creates a cash flow problem for some."

While DeGrand believes pizza operations of 10 or more stores could benefit the most from playing the futures market, the fee to get in to the options market actually is quite affordable, even for small operators.

An option (see glossary of terms for definitions of market terms) for one milk contract costs about $1,000, give or take a few hundred dollars, depending on market conditions and the date on which it can be exercised.

If an average pizza operator — based on one shop generating $500,000 in sales per year — wants to set a ceiling on the block rate price he will pay for cheese (say at $1.50 per pound), a broker may advise him to purchase an option for a July milk futures contract at a strike price (or market sale price) of $13.50 per hundredweight. Come July, if the price of milk rises to $14.50, the operator exercises that option and makes a $1 dollar profit on the option he bought at $13.50, minus the cost of the option.

The proceeds from that sale would serve as a buffer against cheese price increases later in the year.

However, if the market price falls below the original set price of $13.50, the operator doesn't exercise the option and he loses only the money he spent to purchase it. But he still enjoys the cheap cheese prices.

(For a more detailed description of larger milk hedging strategies, see related story Hedging On Price.)

DeGrand simplified it another way: "Options are basically buying insurance on your cheese prices. You say, 'I'll pay a premium to make sure I'll pay no more than $1.30 for my cheese, and if it goes to $1.50, I'll exercise that option. However, if the market falls to $1.10, I'll not exercise that option, and I'll get all the benefits of the lower cheese prices on the open market, less what I paid for the premium."

Kellstrom said he buys options for Bosco, which affords the company the protection it needs to be safe and reasonably profitable. Both he and Saputo's Dryer said that arriving at that comfort range is the biggest hurdle for new hedgers who yearn to beat the market.

Newcomers "have a hard time overcoming the urge to outguess the market and buy the bottom," said Dryer. Like most others interviewed, Dryer said forward contracts are a great starting point for any operator. "All they need to do is pick a price they know they'll be profitable at and lock it in. After that, they can run their businesses a heck of a lot easier knowing what they're going to pay for your cheese for the next 12 to 24 months."

Topics: California Pizza Kitchen , Cheese , Financial Management , Pizza Hut

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