Getting Smarter on Dairy Price Risk

Transcription

1 Getting Smarter on Dairy Price Risk

2 1. Price Risk a. What is PRICE Risk? b. Why is Price Risk Management something I should be concerned about? 2. Price Risk Management a. WHAT IS HEDGING AND WHO IS HEDGING? b. HOW CAN I HEDGE AGAINST PRICE RISK? c. WHAT ARE DERIVATIVES? d. OTC vs EXCHANGE TRADED? e. SYSTEMATIC vs DYNAMIC HEDGING? G. WHERE DOES globaldairytrade (gdt) FIT IN? F. HOW CAN FONTERRA HELP? 3. Call Options a. What are Call Options and how do they work? b. What are the Benefits and Limitations of Call Options? 4. Long Term Contracts a. What are Price Risk Adjusted Fixed Price Contracts? b. What are the Benefits and Limitations of Long-Term Fixed Price Contracts? 5. contracts for difference a. What is a contract for difference and how does it work? b. What are the Benefits and Limitations of Swaps/CfDs? 6. Futures a. What are Futures and how do they work? b. What are the Benefits and Limitations of Futures? 7. Buyers Needs 8. In Summary 9. Where to from here? Disclaimer The comments in this booklet are necessarily generalised, and do not constitute investment advice or a securities recommendation or any offer or solicitation to buy, sell, or subscribe for, any securities, contracts or any derivative. Fonterra, its officers, employees, and agents do not warrant its accuracy, adequacy, currency, or that it is suitable for your intended use.

3 PAGE 1 1. Price Risk a. What is PRICE RISK? It is the uncertainty around the price you will need to pay for your dairy ingredients at some time in the future. Your risk is the chance that adverse changes in price in the future will result in increased purchase costs and/or an uncompetitive margin position compared with your competitors. b. Why is Price Risk Management something I should be concerned about? If you buy dairy ingredients to manufacture dairy food products you are continuously trying to manage your margins in the face of volatile input costs and sales prices. Your margins can easily be reduced. Global commodity food markets have fundamentally changed in recent years. The causes are complex, inter-related, vary depending on the commodity concerned and continue to be the subject of debate. Amongst the contributing factors are the use of biofuels in developed countries, an increasing demand for a more varied diet across the expanding middle-class populations of Asia, reduced world-food stockpiles, structural changes in trade and agricultural production, changes in agricultural price supports and subsidies in developed nations, diversions of food commodities to high input foods and fuel, commodity market speculation and also climate change. Whatever the causes, it and it now appears increased volatility is here to stay.

4 PAGE 2 1. Price Risk - continued Dairy markets are no different: USDA Oceania Price Series 5, , , USD per MT 4,000 3,500 3,000 2,500 2, US: NZ Cross rate 1, , Jun-94 Jun-95 Jun-96 Jun-97 Jun-98 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Oceania WMP Oceania SMP Oceania Cheese Oceania Butter USD:NZD 12 mth Xrate Avg There was a relatively stable period pre-2005 supported by large government stocks and price control mechanisms in both the EU and USA A general reduction in government interference has seen markets moving up and down faster driven by perceptions of supply versus demand and ever changing sentiment. Evidence the 2007 high price peak, 2008 rapid price drops and Q recovery. The ANZ Commodity Price Index for dairy products more than doubled between August 2006 and November 2007, before dropping 58.4 per cent by February An over 80% WMP price movement on globaldairytrade Aug-Nov 2009 This increase in volatility equates to greater risk. Risk is the probability of incurring a loss or having an unfavorable outcome. Risk is a combination of likelihood and consequence. Price is not necessarily the most important factor to a successful business, but, margin is. If fluctuations in input prices can simply be passed along to buyers without affecting sales, price risk is a much smaller threat, because it does not threaten the margin. The problem is this is seldom the case in the real world

5 PAGE 3 The increased price risk associated with this volatility can play havoc with forecasting, budgeting, product margins, cash flow management and profitability and at times price shocks could possibly even threaten the sustainability of your business. In the past a poor purchasing decision was not as important to a business as it is today. As a customer of Fonterra we believe we can help insulate you from much of the supply side risk. This risk can of course never be eliminated completely, especially in an industry as dependent on nature as the dairy business. However, Fonterra s scale and diversification of supply sources and the opportunity to purchase into the future go a long way to reducing the supply risk you face as a buyer of dairy ingredients. However, increasingly volatile global dairy markets mean that your cost of goods have become harder than ever to predict. Actively managing your price risk through a risk management strategy can help you insulate your business from fluctuations in dairy prices giving you more control and certainty about your cost of goods.

6 PAGE 4 2. Price Risk Management A. What is Hedging and Who is Hedging? Hedging is a price risk management strategy designed to minimise a company s exposure to the market risks associated with changes in supply and price. End-users are typically working to secure a measure of cost certainty in environments where they have limited price flexibility for their finished goods. Hedging Company A - Hedges price risk Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Company B - Does not hedge price risk For Example: A processed cheese manufacturer buys input ingredients, ships and stores the ingredients, produces consumer cheese products and sells to wholesale and retail customers some months later. Buy milk protein and fat today the input costs are fixed Ship and store the raw ingredients, manufacture and store the finished cheese products Sell the finished products several months after the initial ingredients purchase If cheese prices rise, margins are increased and the manufacturer makes more money If cheese prices fall, margins are reduced, inventories devalued and the manufacturer makes less money The manufacturer can simply accept this physical market price risk or they can use a hedging strategy to better manage risk and lock in profit margins. Rarely will you find a company 100 per cent hedged and a mix of strategies tends to provide better results.

7 PAGE 5 It is important to have a clear commercial objective for hedging. For example: To achieve the average market price over a year To ensure purchases are at or below a target price level To lock-in a target profit margin A company s approach to hedging activity will depend on the objective. Some companies will say they are hedging but act/react as though they were speculating. They want to be hedged and be right about the market both at the same time. It is important to have realistic expectations about a hedging strategy. Things also go more smoothly if there is buy in throughout your organization; at least with key executive and finance management personnel. Most prominent restaurant chains are looking to protect menu price. Many end-users such as packaged food producers and confectioners are protecting their input costs. For example, many chocolate makers are hedging cocoa, sugar, milk fat and even packaging costs Promotional activity is also better orchestrated when a measure of commodity price risk is removed from the equation. Where retail price flexibility is not an issue the need to hedge is not as pressing. For example, gasoline retailers tend to move retail pump prices around from month-to-month mitigating the need for risk management. This is unfortunately not the case for most products.

8 PAGE 6 2. Price Risk Management - continued B. How can I Hedge against Price Risk? The global dairy market is relatively under-developed in terms of many of the traditional risk management tools. Many of Fonterra s customers are active in price risk management of foreign exchange, interest rates and other commodity purchases. However, to date most companies outside the USA have not had the ability to actively engage in a comprehensive risk management strategy for their dairy purchases. In North America there is a well developed commodities market operating through the 150 year old Chicago Mercantile Exchange (CME) that serves as a pricing basis for the US dairy market. The CME offers derivatives as tools that dairy buyers and sellers can both use to better manage their price risk exposure. In the USA manufacturers buy input goods and sell their products as you normally do. However they can also use futures or options traded through the CME as a mechanism to manage risk and protect their margin. Such exchange traded futures and options are not readily available outside the USA. Because the US local dairy market is heavily regulated by the government prices do not generally reflect global market price levels making these tools and the CME of limited use outside North America. Fonterra is developing different ways of contracting the business we do together to better manage price volatility to our mutual benefit. We are assisting with hedging tools to help you better manage your price risk. A company s hedging activity should depend on its cost structure, competitive environment, market view and the nature of the price risk to be offset. Fonterra is committed to the whole process, from understanding your individual hedging needs, through to the development and correct application of new derivative products. These hedging products are intended to be simple to understand and versatile in their application. The advantage of these products is the reduction of risk and increase in the stability and the predictability of your bottom line.

9 PAGE 7 C. WHAT ARE DERIVATIVES? Derivatives A derivative is a financial contract or instrument whose value is derived from the value of someething else (known as the underlying). Futures A standardised exchange traded contract to buy or sell a specific quantity & quality of product at a certain date and price in the future. Options A contract that conveys the right but not the obligation to buy or sell an underlying assest at some point in the future. Swaps A contract where two counterparties agree to exchange one stream of cash flows against another. i.e: The value of a Class III milk futures contract on the CME is based on the combined underlying value of Cheese, Whey and Butter. Derivatives are used to mitigate the risk of financial loss arising from changes in the value of the underlying. D. OTC vs Exchange Traded? An over-the-counter (OTC) trade in derivatives occurs directly between two parties. This is in contrast to exchange trading which occurs via facilities constructed for the purpose of trading such as a futures exchanges (like the CME) or stock exchanges (like the London Stock Exchange or NZX). Unfortunately at present the dairy sector is lacking exchanges offering liquid derivatives contracts for buyers and sellers operating outside the USA. Fonterra is actively encouraging the establishment of appropriate independent exchange traded derivatives. However, it will take some time to establish these and build adequate liquidity whilst our customers need some price risk management options today.

10 PAGE 8 2. Price Risk Management - continued Due to the lack of exchange traded derivatives Fonterra may be able to offer OTC risk management instruments to assist you. OTC or off-exchange derivative products are tailored to your specific risks and needs. They can offer flexibility in strike prices, expiration dates and quantities. Note: Futures contracts are by definition exchange traded and hence not available OTC. However, Fonterra is supporting their development and hope to be able to offer you access to futures in the near future. E. Systematic vs Dynamic Hedging Systematic hedging enables you to secure your dairy input costs in advance and gives you limited exposure to market prices. This can be achieved by systematically procuring parts of all future dairy ingredient volumes in advance at fixed prices. You are likely doing this already as part of your procurement strategies. For Example: Assume your forecast SMP requirement for next January is 600MT. Let s say you don t want to be exposed to the January spot market price alone, so you decide to spread your price risk by buying over several months. Starting in June and ending in November you may seek to systematically purchase ~200MT every second month. By October you will have procured 400MT for January. Your forecast is revised up in November by your sales people so you need to purchase a balance of 250MT on spot giving you a total 650MT SMP for January delivery.

11 PAGE 9 Your purchase price each month will be linked to the current spot market prices at the time of contracting. This gradual procurement helps average out price fluctuations to a certain extent and delays their impact. It allows you to benefit from falling prices (with a delay), but if market prices have been rising you have effectively hedged your price risk and hence you suffer less negative impact: Month of Contracting Spot Purchase MT Contracted Systematic Hedging MT Contracted Spot Price (USD/MT) Spot Purchase Contract Cost Systematic Hedging Contract Cost July September November Total Av Cost/MT This regular purchasing gives you more surety around your input costs than you would have simply holding off and purchasing the whole quantity spot in November. However, it is simply impractical and too costly to try and negotiate purchases with suppliers every second month. As a rule of thumb Fonterra s default is to negotiate 3 monthly (quarterly) supply contracts. This represents what Fonterra believes is a good compromise between managing the price risk associated with long contracts and the practical cost effectiveness of the frequency of negotiation. Dynamic hedging differs from systematic hedging in that it seeks to also alter hedge levels based on a forward market view. With dynamic hedging you would be leveraging off your insights into dairy market dynamics and adjusting your hedge levels and the type of risk management tools you use to protect downside while still being in a position to benefit from favourable price movements. Dynamic hedging involves taking positions and inherently carries a greater degree of price risk.

12 PAGE Price Risk Management - continued F. Where does globaldairytrade (gdt) fit in? With gdt you have access to a straight forward and cost effective procurement channel by which to apply your own systematic or dynamic hedging strategy. gdt events occur once every month and provides seven different opportunities to contract for fixed price supply for any given delivery month. gdt has also provided a transparent means of market price discovery. This may prove a useful reference price for exchanges in the development of futures contracts and bi-lateral variable priced supply contracts. gdt also offers the added benefit of effectively guaranteeing supply as long as you are prepared to pay the clearing price. G. How ELSE can Fonterra help? Depending on your individual requirements we can consider offering the following contracts: Revocable Supply Contracts or Price Options (such as Call Options) Price Risk Adjusted Long-term Fixed Price Contracts Contracts for Difference (A Swap) Variable Priced Contracts Note: What risk management tools we can offer you depends on your individual requirements and prevailing market conditions. Please contact your Fonterra Account Manager to discuss.

13 3. Call Options PAGE 11 a. What are Call Options and how do they work? A call option is a contract between a buyer and seller that gives the buyer the right, but not the obligation, to buy a particular product at an agreed date in the future at an agreed price. In return for granting the option the buyer makes a payment (the premium) to the seller. If you wish to guarantee you don t pay more than a fixed maximum price at a time in the future whilst still being able to benefit if the market price actually decreases below an agreed strike price, Fonterra may be be able to offer you a Revocable Supply Contract or Price Option. These contracts work a lot like a Call Option or Price Cap by linking an option with a physical supply contract). For a buyer call options are essentially insurance against higher prices. Like car insurance, the premium paid is not refundable. Key factors to determine the option premium are Spot Price, Strike Price, Term of Contract, Risk Free Rate and Volatility (Volatility is the key parameter): Terminology Explanation Car Insurance Analogy Spot Price Current market price Market value of the car Strike Price Contract price agreed between the buyer and the seller Agreed insured value of the vehicle Time of Expiration or Term Length of contract Policy covered period (i.e. 1 year) Risk Free Interest Rate Volatility Measures cost of financing usually government bond rate Use of historical data to estimate expected market price changes in the future - Use of past driving record and the type of vehicle to estimate future accident risk Effect of each factor on the call option premium: Key Factors Spot Price Increases Strike Price increases Time of Expiration or Term Increases Risk Free Interest Rate Increases Volatility Increases Premium Increases Decreases Increases Decreases Increases

14 PAGE Call Options - continued For Example: Assume it s December and you want to purchase 2,000MT of SMP for delivery over the five months from April through to August. Your particular product-market application for this SMP may mean that you can t afford to pay over a certain maximum viable cost price for the SMP to be competitive. You may also hold the view there is a chance the market prices for SMP may possibly drop in the coming months. Fonterra may be able to offer you a Revocable Supply Contract : 400MT per month of SMP delivered from April through to August. Exercise Date February 1. Strike Price USD/MT Option Premium USD/MT You would select the Strike Price and Option Premium combination that you prefer. For this example say you choose the Strike Price of USD 3500/MT at an Option Premium of USD 245/MT. You would enter into a Revocable Supply Contract with Fonterra and pay the premium. On or before the Exercise Date you can decide not to proceed with the supply contract at the agreed Strike Price. Otherwise the physical supply contract associated with the option goes ahead. If by late January the spot market price has gone up above the strike price (say to USD 3800/MT) you would proceed with the contract having achieved an effective total input cost of USD 3745/MT (Strike Price + Premium) for your SMP. However, if by late January the spot market price has actually dropped down below the strike price (say USD 3100/MT) you can cancel the contract having only cost yourself the premium paid. You can enter into a new supply contract at USD 3100/MT achieving an effective total cost of USD 3345/MT (Spot Price + Premium) for your SMP.

15 PAGE 13 This can be illustrated: Revocable Supply Contract Net Price Market Price Effective total price paid 3745 Premium 245 Strike Price Spot/Market Price b. What are the Benefits and Limitations of Call Options? For the buyer, call options are essentially protection/insurance against higher prices, while still allowing for them to benefit in market downside if it occurs. You can cap prices at or below a budget, but still provide opportunity for a favourable product price variance against your budget. Options can sometimes seem expensive; especially during periods of high volatility.

16 PAGE Long Term Contracts a. What are Price Risk Adjusted Fixed Price Contracts? Simply put they are longer term fixed price contracts. You may have done these in the past with Fonterra. These contracts worked reasonably well in low volatility circumstances. In some ways, forward contracting is the simplest form of risk management to understand. You simply contract a supplier to deliver a specified quantity of product at a predetermined fixed price for some period in the future. This gives both parties surety of the price as well as supply. Price volatility can still place either party s business under competitive distress at times of price shocks. The further forward in time we agree pricing, the greater the risk each of us faces that at the time of contract delivery and invoicing the spot market price will vary significantly from the level we have agreed in the contract. Yearly vs Quarterly Fixed Price Contracting Price Fixed price 12 month contract Prices Decrease Fonterra Benefits & You Suffer Fixed price 3 month contract Prices Increase You Benefit & Fonterra Suffers Time/Years

17 PAGE 15 One way to help reduce this risk is to contract at a fixed price quarterly; no longer, no shorter. However, if you wish to contract long we are happy to accommodate, however, we need to factor for a price risk adjustment in the price. In reality is you will likely only be looking for a longer term fixed price supply contract with Fonterra when your forward view of market prices is generally upward or uncertain. In offering a long contract a price adjustment is necessary for Fonterra on top of the basic spot contract price on offer to try to compensate for the increased market price risk the seller effectively bears when giving you the surety of a fixed price for an extended period of time. Spot Purchase Long Contract Spot Purchase Long Contract Month of Contracting MT Contracted MT Contracted Price (USD/MT) Contract Cost Plus150 USD/MT Price Risk Adjustment June September December March Total Av Cost/MT For Example: Assume you want to purchase 5,000MT of Heat Stable SMP over the next 12 months. You may need the SMP for a 12 month tender of your finished product at a fixed price and want to lock in your SMP cost price for the full 12 months. Your procurement options could include typical quarterly contracting where you carry the price risk. Or you may prefer to secure a long fixed price contract so that you know what your input costs will be up front and you can lock in your profit margin on the tender. Fonterra would seek a price risk adjustment on top of the basic short contract price to try to compensatefor the increased market price risk effectively transferred to the seller when the price is fixed for an extended period.

18 PAGE Long Term Contracts - continued b. What are the Benefits and Limitations of Fixed Price Contracts? You can be sure of a fixed input price and fixed supply volume for an extended period of time. Where you have sureity of your selling prices this may enable you to lock-in your profit margin. If the market prices rise, your margin will be greater than if you had bought spot on short fixed price contracts. If the market price drops, you are locked in and your margin will be less than if you had purchased spot on shorter-term fixed price contracts. The price risk adjustment can sometimes seem expensive, especially during periods of high volatility and / or where the commonly held view is that market prices are rising. In certain circumstances market conditions may mean that the buyer or the seller may not be interested to entertain a long fixed price contract.

19 PAGE Contracts for Difference a. What is a Contract for Difference and how does it work? In technical terms a Contract for Difference (CfD) is a Swap. A Swap is a derivative contract in which two parties agree to exchange one stream of cash flows against another stream. A CfD is a legally binding financial agreement that enables the buyer and the seller to agree a fixed price against a reference that has an uncertain value until the contract settles. A difference payment is made between the seller and the buyer depending on the relative level of the fixed price and the reference price. Components of a Contract for Difference: Strike Price The price agreed/negotiated between the buyer and seller. Reference Price A price that is not currently known, however will be determined at some point in the future by the market price level at the contract settlement time agreed. Difference Payment The difference between the strike price and reference price multiplied by the volume/number of contracts as per the contract terms. Difference Payment = Quantity x (Strike Price Reference Price) The physical and financial contracts operate completely independently of each other. The financial contract (CfD) effectively allows the buyer to fix the total realized price they pay. The quantity defined in the CfD may or may not match the physical quantity contracted.

20 PAGE Contracts for Difference - continued For Example: Say you want secure a SMP contract covering 12 months supply. You are happy for your net effective purchase price to track the general spot market over the 12 months. You could agree a Skim Milk Powder USDA Oceania FAS price Contract for Difference (CfD): You agree with the seller a CfD quantity of 500MT per month for each contract referenced against a particular future USDA Oceania published price and also on the strike price of USD 2300/MT. The strike price is the effective FAS price that you will pay for the SMP this is negotiated and fixed. The CfD volume is agreed in advance, is binding on both parties and is cash settled. This CfD provides you and the seller with a fixed price for the CfD volumes irrespective of the USDA Oceania price Having signed the CfD you would go ahead and buy a monthly volume of 500MT or more referenced to USDA Oceania pricing. The seller then raises and delivers against a physical supply contract based on the purchase at the respective USDA Oceania price the reference price. The shipment is dispatched and the customer invoiced just like any normal physical supply contract at the reference price. On the financial side the seller calculates the difference payment for the CfD quantity of 500MT, sends a statement and the payment is made. Month Strike Price Reference Price Quantity * -ve means Fonterra pays the difference Difference Payment Jul $175,000 Aug $160,000 Sep $100,000 Oct $75,000 Nov $100,000 Dec $75,000 Jan $175,000 Feb $100,000 Mar $50,000 Apr $100,000 May $75,000 Jun $25,000

21 PAGE 19 b. WHAT ARE THE BENEFITS AND LIMITIATIONS OF CfDs/SWAPS? A CfD can give you certainty of price as well as supply over an extended period. In many respects a CfD performs a similar function to a futures contract. You know that you will effectively pay the CfD Strike Price for the quantity that is covered by the CfD and not more. The buyer can vary the number and quantity of CfDs in accordance with the proportion of their purchases they want to lock-in a price for over a given period. The buyer and seller need to be able to find and agree on a suitable market reference price. For certain products outside the USA, this is not always easy. Your effective realized purchase price will not better the spot market.

22 PAGE Futures a. What are Futures and how do they work? Futures are standardised exchange traded contracts to buy or sell a specified quantity of a commodity product of standardised quality at a certain date in the future at a price specified today: Uniform contract for future delivery Delivery dates and locations fixed Quantity fixed Quality specified Arrangements made by a clearing house Futures can be thought of as generic forward contracts. They do not require that the parties know each other or even do business together. All futures are exchange traded and they can be either physically deliverable or 100% purely financial and cash settled. With a Deliverable Contract you must make/take delivery of product if you don t offset (sell/buy) your position before the contract settles. With a Cash Settled Contract there is no physical delivery. Your position is cash settled to a reference price after the final day (expiration) for that contract. You can either buy or sell futures contracts. Producers typically sell and end users typically buy. Futures are used to lock-in a sale or purchase price. How They Work: Let s say you buy butter on a variable priced contract referenced to CME spot price (a physical transaction). As CME spot prices rise your cost price rises and vice versa. To hedge we need to create an exposure with the opposite effect. You would buy a futures contract to do this (a financial transaction). The two transactions (physical and financial) have opposing effects as one rises the other falls. The net effect is to effectively lock in a particular cost price.

23 PAGE 21 Hedging with Futures Buying Physical Buy Fututres Physical + Futures NET FLAT POSITION Example: You may need to buy 100 MT of cheese to cover supply for a cheese spread promotion planned for November in five months time. Fonterra may be able to offer you the 100MT of supply but the physical cheese will need to be variably priced against a market reference price for cheese at the time of delivery. You have removed your supply risk, but you may still be carrying a price risk if the promotion budget has to be fully costed in advance at a fixed input price. Once the physical contract is agreed you have a choice to buy a cheese futures contract to lock in the purchase price and remove the price risk. Let s say that at the time of agreeing the variably priced physical cheese contract with Fonterra, the futures market is offering cheese futures contracts at USD 2,500/MT. If this price is workable for the promotion budget you could buy futures contracts and effectively lock in your price at USD 2,500/MT. 1st Scenario. When December comes, let s say the reference price for cheese in the spot market is up to USD 2,900/MT. You will pay Fonterra USD 2,900/MT for the physical cheese contract but you will have made a gain of USD 400/MT on the cheese futures contract you had bought. Your net realized purchase price will remain USD 2,500/MT. 2nd Scenario. When December comes, let s say the reference price for cheese in the spot market is down to USD 2,200/MT. You will pay Fonterra USD 2,200/MT for the physical cheese contract but you will have made a loss of USD 300/MT on the cheese futures contract. Your net realized purchase price will remain USD 2,500/MT.

24 PAGE Futures - continued You can see how the total realised price remains hedged whether the spot reference price at delivery time moves up or down: Cheese Futures Contract Purchased Cost USD Loss on Futures counters drop in spot price Variable market Price Futures Value Spot Price of Cheese at Expiration USD/MT Gain on futures counters increase in spot price Effective Total Price Paid = USD 2500/MT b. What are the Benefits and Limitations of Futures? Enable you to quickly lock-in a price with a futures hedge. With a liquid market if you don t want to remain in the contract you can easily get out of the market whenever you wish. Potentially lower transaction costs with a simple exchange trade. No need to find a counter party to contract and define all the terms with. Market price is readily available; updated every minute during trading times. However, an exact match to the cash market may not be available and you can miss out on favorable price movements. But this is no different than with a forward contract. The effectiveness of futures can be limited by a lack of liquidity in relevant markets. Where liquid market traded futures are not available OTC products can sometimes assist. Entering into exchange traded derivatives is not a trivial exercise and requires a significant investment in time and money. Typically a broker or bank is the most common window to an exchange.

25 7. Buyers Needs PAGE 23 In many cases, buyers care less about being right than is often assumed. The value of certainty is more important than a fear of lost opportunity. Effective price risk management can help you to: More effectively meet and manage budgets Enhance and protect margin goals Increase bottom line profitability Like most other commodities dairy should be readily managed and suppliers should be willing and able to provide risk management products and services to their customers. Cost of production versus future prices shouldn t be the only consideration, nor is it in practice. Having options widely broaden your ability to manage price risk and to help protect cash flow as well. The concern for adequate market liquidity to get meaningful coverage will be increasingly addressed through the active participation of Fonterra and Fonterra s customers.

26 PAGE In Summary Dairy commodity prices will continue to be volatile and impacted by an ever-changing world. This volatility creates margin risk for dairy processors. Fonterra is at the forefront of development of creative risk management tools and strategies for the global dairy industry We are here to try and help you better manage your dairy price risk for the mutual long-term sustainability of our businesses.

27 9. Where to from here? PAGE 25 Fonterra is working with our customers to: Understand your cost structure and correlate input costs to market prices Develop risk management strategies Evaluate and present suitable risk management instruments Fonterra currently has the following risk management instruments available: Revocable Supply Agreements (Price Options) Price Risk Adjusted (Long-term) Fixed Price Contracts Variable Priced Contracts Contracts for Difference The USA has a well developed commodities exchange and a sophisticated array of exchange traded and OTC instruments already available to support dairy price risk management for buyers and sellers alike. Derivative contracts relevant to the globally traded dairy market outside the USA are still in the early development stages. Fonterra is actively encouraging the development of exchange traded international futures contracts in WMP and SMP and hopes to be in a position to discuss these and other risk management products and services in more detail in the near future. Fonterra will be there to support customers in securing a suitable window to an exchange when the time arrives. The price risk management related products and services Fonterra is able to offer will vary depending on a customer s specific needs and the product-market concerned. The instruments discussed in this brochure will not be suited to all dairy ingredient buyers and product-markets. If you are interested in discussing price risk management further, please contact your Fonterra Account Manager in the first instance.

28 Want to know more? Please contact your Fonterra Account Manager directly or Fonterra Co-operative Group Limited Private Bag 92032, Auckland Fonterra Centre, 9 Princes Street Auckland, New Zealand Ph Fax Fonterra Co-operative Group Limited 2010