This calculator is a simple way to see how NZX milk price futures contracts can be used to manage the risk of low milk price seasons. At the moment, it ignores both the Fonterra dividend and any brokerage fees. Read this if you don't know what a futures contract is or how they work.
Selling a futures contract is a way of hedging yourself against low milk prices. You can use them to reduce the chance that really bad years happen (and therefore needing to go to the bank to get a bigger overdraft). In return however, you need to give up a little bit of money on average. Think of it as a type of insurance.
The blue bars represent (based on our current forecast) possible Fonterra farmgate milk prices if you don't trade any futures contracts. The taller the peak of the graph, the more likely it is for that outcome to occur.
The orange bars are the possible milk prices after hedging some of your production. The price is a combination of the fixed price for the proportion you hedged, and the uncertainty in the Fonterra milk price for the production that is unhedged.
Try setting your break even cost, and sliding the percentage of your total production hedged lever to see how you can manage the risk of a low farmgate milk price by trading futures contracts.
Hedging 50% of your production at the current NZX futures price ($/kgMS) changed the chance of getting a milk price below your break even cost ($50/kgMS) from 20% before hedging to 20% after hedging.
However, in return your expected farmgate milk price changed from $20/kgMS before hedging to $20/kgMS after hedging.
The NZX milk price futures are what are called Exchange Traded Derivatives. They are an agreement between you (the farmer) and another person (a buyer) to give each other cash depending on the farmgate milk price.
If the Fonterra farmgate price is less than what you agreed to sell at, the buyer will give you the difference so that you make the price you agreed. If the Fonterra farmgate price is more than what you agreed to sell at, you need to give the buyer the difference.
Because you are a farmer producing milk, you end up earning the amount you agreed to sell at regardless of the Fonterra farmgate milk price!
You agree to sell 10 units (60,000kgMS) at $5/kgMS.
If the final Fonterra milk price is $6/kgMS.
Fonterra gives you $6/kgMS ($6/kgMS x 60,000kgMS = $360,000)
You need to give NZX $1/kgMS ([$5/kgMS - $6/kgMS] x 60,000kgMS = -$60,000)
You end up making $5/kgMS ($360,000 - $60,000 = $300,000)
You lose $60,000 compared to taking the Fonterra payout, but you get paid the same as if the farmgate milk price had been $5/kgMS.
If the final Fonterra milk price is $4/kgMS.
Fonterra gives you $4/kgMS ($4/kgMS x 60,000kgMS = $240,000)
NZX gives you $1/kgMS ([$5/kgMS - $4/kgMS] x 60,000kgMS = $60,000)
You end up making $5/kgMS ($240,000 + $60,000 = $300,000)
You make $60,000 compared to taking the Fonterra payout, but you get paid the same as if the farmgate milk price had been $5/kgMS.
Either way, by selling 10 units at $5/kgMS, you have "locked in" that milk price.
Futures can be good thing for you as a farmer as you can lock in a price for your milk now without worrying about the farmgate milk price dropping. They can good thing for buyers (who are probably people making food that uses milk) as they can lock in a price for their milk without worrying that the price will skyrocket.
Don't go rushing in as there are some potentially serious cash flow implications you need to wrap your head around that we haven't discussed. You should talk to a NZX accredited broker for more information.