Dairy Futures and Options Tutorial

Basis: What is it and Why is it Important

Dairy producers sell their milk to a dairy processor and users of milk, such as a cheese plant, purchase their milk for use as an input in the cash market. For both producers and purchasers of milk, the futures market may be used to manage the risk of changing output (farm milk) price or input (milk) costs. In order to effectively use dairy futures and options for price risk management, both producers and users of milk need to know the historical relationship between the cash and futures markets. This relationship involves the concept of basis.

Basis Defined

Basis is the difference between a cash price at a specific location and the price of a particular futures contract for the same commodity. There are a number of ways of defining a basis even for the same commodity. The following are two basis examples:

• Farm Operator We can define one type of farm basis as the difference between a producer's mailbox price and the Class III futures contract price (cash - futures). This is referred to as the mailbox-Class III basis. The mailbox price is the net price received by dairy farmers at their farm gates. It includes all payments received for milk sold and all deductions for costs associated with marketing the milk. All payments include, where applicable: over-order premiums; quality, component, breed, and volume premiums; payouts from State-run over-order pricing pools; payouts from superpool organizations or marketing agencies in common; payouts from programs offering seasonal production bonuses; and monthly distributions of cooperative earnings. The mailbox price also does not include any Milk Income Loss Contract (MILC) payments. Since dairy producers sell milk to different milk plants and/or receive different premiums and discounts the basis is not the same across producers.
• Cheese Plant A milk cost-Class III basis for the cheese plant can be calculated as the difference between plant's milk cost (i.e., payments to producers/cwt) and the Class III futures contract price. This basis could be impacted by the average milk quality received versus the standard used in the definition of the Class III futures contract as well as any over-order premiums paid to producers. A Cheese-class III futures basis could be obtained as the difference between the cheese value obtained/cwt of milk and a Class III futures price.

Why is Basis Important?

• The net outcome of hedging in futures is effected by the change in the basis. This is known as basis risk. The less a producer or manufacturer knows about their basis, the greater the basis risk and the less effective are dairy futures and options as price risk management tools.
• Knowing the basis is essential for a dairy producer to translate a dairy futures price into an expected cash milk price to be paid in the future.

A Unique Aspect of the Class III Futures Contract

One advantage of Class III futures contracts are that they are cash settle against the announced Class III. That is, the last day of trading for a particular Class III contract is on a Thursday, the day before the announced prices are released by USDA and which occurs on a Friday and is no later than the 5th of the month following production. A large proportion of the Grade A milk produced in the U.S. is priced under a federal milk marketing order. Most milk that isn't price under a federal order is priced under a state order like California, for example. Most basis risk is due to changes in premiums and discounts received. Even in California, there is a strong relationship between the Class III and California producer milk prices.

The role of basis risk when undertaking a hedging strategy can be seen in the Understanding Hedging section.

How is Basis Calculated?

Basis is calculated by a particular cash price minus a particular futures price As noted above, for farm milk, the mailbox price minus Class III futures price is one type of basis. As an example, if a producer's mailbox price is $15.90 and announced Class III price is $13.75, the basis is $2.15 . Remember that the Class III futures cash-settles to the announced Class III price.

• Farm Milk Pricing Under Federal Orders: As noted in earlier sections of this tutorial, minimum pay prices are established monthly for different uses of milk, called classes:
  • Class I: Milk used for beverage purposes.
  • Class II: Milk used for soft manufactured dairy products like ice cream, yogurt and cottage cheese.
  • Class III: Milk used to make hard cheeses and cream cheese.
  • Class IV: Milk used for dry milk products and butter.
  • Dairy producers under the Federal Milk Marketing Order (FMMO) system receive from regulated milk plants a weighted average price, called the blend or uniform price.
• Calculation of Alternative Farm Milk Basis Under the Federal Order System: Given the complexity of the Federal Order system you may want to take into account the utilization of farm milk in your order. Here are some examples of how you go about calculating alternative basis depending on milk utilization
  • Primarily Manufacturing: Basis = Mailbox Price - Current Month's Class III
  • Primarily Beverage Milk: Basis = Mailbox Price - Advanced Class I Price
  • Mixture of Uses: Calculate manufacturing and beverage milk bases and then take a weighted average (percent milk used between manufacturing and beverage) of these bases to estimate the expected mailbox price for a given month.
• Calculation of Farm Milk Basis for California: The pricing system in California is very similar to the classified pricing in the FMMO's but has 5 instead of 4 classes.
  • Class 1: Beverage products.
  • Class 2: Milk used for fluid creams, sour cream, cottage cheese, buttermilk, sterilized creams and yogurt.
  • Class 3: Milk used for ice cream, ice milk, light dairy desserts, frozen mixes and frozen yogurt.
  • Class 4a: Milk used for butter and dried milk.
  • Class 4b: Milk used for cheese.
• For More Detailed Discussion of California System Click Here.
• Relationship Between Class III and California Producer Pay Prices for Class 4b milk. The correlation between California's class 4b price and the Class III for the period of January 1995 through April 2007 was .979 A perfect relationship has a correlation of 1.00. The similarity of the Class III and 4b price series can be seen by clicking here.

How Can You Use Your Previous Price History to Calculate Your Basis?

• It is usually considered sufficient that three years of history sufficient are sufficient to calculate basis.
• For Class III you will want to calculate monthly basis given that basis will vary seasonally.
• The associated spreadsheet shows as an example the calculation of the Upper Midwest Mailbox - Class III basis over January 1995 - August 2007:
• Note that a majority of the milk in the Upper Midwest is used for manufacturing purposes
• The following shows the calculation of this basis:

• The following is a representation of the monthly average basis:

• If most of the milk used for beverage: basis = current mailbox - advanced Class I price.
• If in your order, milk use is in between these two extremes two basis could be calculated for each fluid versus hard manufactured products. A weighted average basis is calculated.
• Some individuals use the lowest calculated basis for a given month rather than the average.
  • If the basis becomes greater, the net mailbox price is also greater by this same amount.
  • For more detail with respect to classified pricing refer to the classified pricing section of this tutorial.

© 2007 Brian W. Gould, Agricultural and Applied Economics, University of Wisconsin Madison