Livestock > Markets > Basis

Understanding and Using Milk Price Basis

File B2-44
Written April, 2006

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Until just a few years ago dairy producers had no need or ability to manage price risk. During the early 1990’s, university and futures exchange representatives worked on developing and refining tools that the dairy industry could use to reduce price risk. The most successful tool to date has been the Class III cash settlement contract. Dairy producers need to understand the concept of basis to use the Class III contract as well as options and forward contracts that result from the futures market.

Definition of Basis

Basis is the difference between a cash price at a specific location and the price of a complementary futures contract. Basis for raw milk is the difference between a dairy producer's "mailbox price" and the Class III futures contract.

Each dairy producer must calculate their own basis. Milk basis is individualized due to the differences in quality and volume discounts or premiums received by each milk producer.

Use of Basis

Basis calculation has at least three uses for dairy producers. These include: analyzing a forward cash price, analyzing the possible outcome of a hedge and calculation of a target options strike price.

Several dairy plants operating in Iowa offer dairy producers forward milk price contracts, monthly, yearly and three years milk production. Knowing your monthly milk basis allows you to determine if the forward price offered in a contract will be profitable or as good as the outcome of a hedge. To do this, add the basis calculated to the cash price being offered. Compare the result to your cost of production and/or the outcome of a hedge. The cash price should be a little less, 5-10 cents per hundredweight, than if you were to place a hedge. The lower price is due to the costs that a dairy plant will have in offering a cash contract.

Basis is also necessary to calculate the strike price that a dairy producer may want to use for an options purchase. A dairy producer will first set a price goal. Subtract the expected basis from this price goal. The result is a price that can be used as the strike price at which a dairy producer may purchase an option.

Lastly, basis will help predict the cash outcome of milk hedging. By adding the expected basis to a hedge price, a dairy producer can estimate the cash price that will be received.

A term "basis risk" needs to be explained here. Basis risk refers to the possibility that the real basis isn't equal to the predicted basis, it may be more or less. The cash price earned will vary by the change in basis. You can get a sense of basis risk by looking at the variability of monthly basis over a three year period. Basis may vary as much as $3 per hundredweight during the same month in different years. A higher than expected basis will yield a higher than expected cash outcome while the opposite is true as well.

Calculating Milk Basis

Basis calculation should be made for each month of the past three years. This recommendation is made due to the variability of basis from year to year. As mentioned earlier, basis may vary by as much as $3 per hundredweight. An average of three years basis calculations for each month will reduce the possibility that the basis used will vary excessively from the basis that actually takes place.

Table 1 is an example of the calculation of milk price basis. Table 2 is a worksheet that dairy farm mangers can use to easily calculate and save their basis. Use a separate sheet for each year. Table 3, 'Historical Class III' provides the historical price necessary to calculate basis.

Tables 1-3

 

Robert Tigner, Nebraska extension educator, rtigner2@unl.edu