Dairy Futures Guide essential information
CONTENTS Introduction 2 Dairy Commodities 4 Global Dairy Market 5 Futures - The Basics 6 Using Dairy Futures - Value To Customers 9 Using Dairy Futures - To Manage Risk 11 Dairy Market Information and Data 13 Contract Specification 14 Getting Started 15 DISCLAIMER The information contained in this document is a guide only. This publication is for information only and does not constitute an offer, solicitation or recommendation to acquire or dispose or an opinion related to acquiring or disposing of any financial product, investment or to engage in any other transaction. Those wishing either to trade in or to clear or settle any products made available by NZX Limited (NZX) or its subsidiaries, including New Zealand Clearing and Depository Corporation Limited (NZCDC) and its subsidiaries, or to offer and sell them to others should consider their legal, tax, financial and regulatory position, including the relevant market rules, and the risks associated with such products before doing so. All information, descriptions, examples and calculations contained in this publication are for guidance purposes only, and should not be treated as definitive. Participation in, and trading on, any NZX market or NZCDC s clearing house is subject to compliance with the relevant rules and procedures, and this document is not a substitute for those rules. No part of this publication may be redistributed or reproduced in any form or by any means or used to make any derivative work without written permission from NZX. NZX (including its subsidiaries, and its and their respective directors, officers, employees, contractors and agents) shall not be liable (except to the extent required by law) for the use of the information contained in this document however arising in any circumstances connected with trading, clearing and settlement or otherwise. NZX is not responsible for any errors or omissions contained in this publication. NZX Limited 2010 1
Introduction This guide provides information on dairy commodities and the dairy industry, NZX Dairy Futures (how they might be used to manage risk or to invest) and where and how to trade Dairy Futures. NZX Limited (NZX) is a dynamic market operator with integrated services in information, markets and markets infrastructure. NZX is the hub of trading in New Zealand debt and equity markets, bringing buyers and sellers together through its Trayport GlobalVision electronic trading platform. World class clearing and settlement services will be provided by NZ Clearing Corp. Futures trading at NZX will initially be centered around Dairy Futures. NZX believes information is a core building block in the successful development of markets. To support Dairy Futures, we have integrated a wide range of news and data services, for agricultural commodities under our NZX Agri brand. See page 11 of this guide for more information. 2
Dairy Commodities Dairy products are amongst the most important of all traded food products. Milk matters to people everywhere. Traded dairy products are equally fundamental and trade is dominated by a few particular dairy commodities: Whole Milk Powder (WMP), Skim Milk Powder (SMP), Butter, Anhydrous Milk Fat (AMF) and Cheese. Of these, WMP and SMP are the most basic and important - containing all the vital proteins. New Zealand is a major global player in these products, exporting 95% of its milk production in the form of dairy commodities 1. Nearly half of all WMP exports come from New Zealand. 1 Source: Dairy NZ, 2010 Milk Powder Milk powder manufacture involves the gentle removal of water under stringent hygiene conditions, retaining all the desirable natural properties of the milk - colour, flavour, solubility and nutritional value. Whole (full cream) milk contains, typically, about 87% water and skim milk contains about 91% water. During milk powder manufacture, this water is removed by boiling the milk under reduced pressure at low temperature in a process known as evaporation. The resulting concentrated milk is then sprayed in a fine mist into hot air to remove further moisture, resulting in a fine powder. Milk is a perishable product. Milk is processed into finished goods such as dried milk powder that can be stored for several years and is traded globally. New Zealand manufactures more than 100 varieties of spraydried milk powder to meet the diverse and special needs of customers. Milk powders may vary in their gross composition (milk fat, protein, lactose), the heat treatment they receive during manufacture, powder particle size and packaging. Special high heat or heat-stable milk powders are required for the manufacture of certain products such as recombined evaporated milk. Milk powders of various types are used in a wide range of products such as baked goods, snacks and soups, nutritional drinks, chocolates and confectionery, ice cream and infant formulae. Approximately 13 kg of WMP or 9 kg of SMP can be made from 100 litres of whole milk. 3
Global Dairy Market Global demand for protein has been rising for some time. Demand for protein is very income-sensitive. Rising income levels in emerging markets have led to changes in diet, incorporating more meat, eggs and milk. In recent years, the strongest growth in consumption of dairy products has come from emerging Asian markets, particularly China. On the supply side, some major producing countries such as the US or India can move from being a net exporter to a net importer of dairy over short periods of time. Adding yet more volatility to the picture is the bank financing cycle. Cows represent major capital expenditure for farmers, and banks have moved from a cycle of easy to tight credit in dairy farming. of milk s nutritional value and improvement in living standards in developing economies (and demand for proteins), including large players like China. This volatility, as a result of the spike in demand and multiple unpredictable supply side factors, creates a difficult operating environment for all those in the dairy supply chain. Globally, dairy trade is worth an estimated US$140 billion annually 1. This figure represents a variety of end products including liquid and powdered milk. The export market is dominated by milk powder. With over US$13.8 billion of Whole Milk Powder (WMP) produced globally in 2009, WMP dominates the milk powder export market and is the pricing benchmark for the dairy industry worldwide 2. Volatility in the global dairy industry has been unprecedented over the last five years. This is widely expected to continue as global demand increases on the back of a growing awareness 1 Source: FAOSTAT, 2007 2 Source: Global Trade Atlas, 2009 Graph: Whole Milk Powder Prices 5500 5000 4500 USD per metric tonne 4000 3500 3000 2500 2000 1500 Sep-04 Oct-04 Nov-04 Jan-05 Feb-05 Apr-05 May-05 Jun-05 Aug-05 Sep-05 Oct-05 Dec-05 Jan-06 Mar-06 Apr-06 May-06 Jul-06 Aug-06 Oct-06 Nov-06 Dec-06 Feb-07 Mar-07 Apr-07 Jun-07 Jul-07 Sep-07 Oct-07 Nov-07 Jan-08 Feb-08 Mar-08 May-08 Jun-08 Aug-08 Sep-08 Oct-08 Dec-08 Jan-09 Mar-09 Apr-09 May-09 Jul-09 Aug-09 Sep-09 Nov-09 Dec-09 Feb-10 Mar-10 Apr-10 Jun-10 Jul-10 globaldair y T rade average WMP spot contract Agrifax WMP 4
Futures - the basics The primary advantages of the NZX Dairy Futures market are: `` `` `` The ability to manage risk through the creation of price certainty (hedge); Price discovery, creating market transparency; and Forward view of market sentiment. In order to understand Dairy Futures, it is important to understand some basics about derivatives. If you are an expert, skip this section. Simply, futures and options are financial products known as derivatives. ` ` Derivatives: A derivative is a risk transfer agreement, the value of which is derived from the value of an underlying asset. A Dairy Future is in effect, a risk transfer agreement, the value of which is derived from the value of a dairy commodity product traded in the physical dairy market, such as WMP or SMP. ` ` Futures: A futures contract is a legally binding contract to buy or sell a standardised product, at a fixed price, for cash settlement or physical delivery on a given date in the future. In the case of Dairy Futures, the standardised product is the dairy commodity from which it is derived. For example, a Global WMP Future is a legally binding contract to buy or sell WMP at a fixed price for cash settlement in the future. The same is true of a Global SMP Future. ` ` Options: An option is the right, but not the obligation, to buy or sell something at a fixed price in the future. This price is called the strike price. There are two types of options: NZX Dairy Futures Market As a futures exchange, NZX is the central marketplace in New Zealand that facilitates the trading of futures between participants. An efficient robust market supported by a world class clearing system (NZ Clearing Corp TM ) participants can be assured of transparency and strong risk management when they trade with NZX. The NZX Dairy Futures market allows participants to manage price risk by creating opposing positions in the futures and physical market, effectively neutralising any movement in price. Participants can open a position by buying or selling and close a position by carrying out an opposing trade, i.e. open with a sell, close with a buy. NZX Dairy Futures will be exchange listed and cash settled to globaldairytrade (gdt) prices. Cash settlement of a futures contract means trading is much simpler and easier. Participants do not have to implement complicated delivery mechanisms or risk having to make, or take, delivery of the underlying product to which the futures contract relates. Cash settlement is particularly preferable for dairy commodities where food safety criteria, and the actual delivery process, are complex and not globally standardised. An important aspect of futures markets is that while they are representative of the price of the physical product (e.g. WMP), they operate separately to trading activity in the physical market regardless of the way the contract is settled. Futures markets are not generally used as a means to buy or sell physical product. A call option gives the holder of an option the right but not the obligation to buy the underlying asset at the strike price; and A put option gives the holder of an option the right but not the obligation to sell the underlying asset at the strike price. An option on a future (e.g. a Global WMP Option), gives the holder of an option the right, but not the obligation, to buy or sell a Global WMP Future at a set price in the future. 5
Futures - the basics CONTINUED Standardised futures contracts have set expiry dates. In the case of Global WMP Futures, the contracts will expire each calendar month. Global WMP Futures will be cash settled. Cash settlement is the difference between the price at which the trade was entered and the reference price at expiry. All NZX Dairy Futures will be cash settled. NZX selected cash settlement rather than physical delivery for NZX Dairy Futures as physical delivery can restrict participation. Cash settled futures contracts are much simpler, and enable much wider and deeper participation. NZX Dairy Futures Product Set The NZX Dairy Futures market is intended to have as its baseline product set: `` `` `` `` Global Whole Milk Powder (WMP) Futures; Global Skim Milk Powder (SMP) Futures; Global Anhydrous Milk Fat (AMF) Futures; and Options against both the WMP and SMP Futures The first product to be launched will be the Global WMP Future. Each of the NZX Dairy Futures will have as their reference price the price set on the globaldairytrade (gdt) auction. As stated earlier, NZX Dairy Futures will have expiry dates and the contracts will expire each calendar month. 6
Using Dairy Futures - value to customers A wide range of participants in the dairy and financial sectors can benefit from using NZX Dairy Futures. Some of the largest groups are outlined below. Dairy Processors For any dairy processor the foundation to its business is the ability to secure, retain and increase the supply of milk. Providing certainty in advance over the price paid for either all or part of that milk supply means the processor can make investment and production decisions ahead of time with a much greater degree of confidence. The ability for a processor to provide fixed price contracts to farmers will undoubtedly be a drawcard in retaining supply and attracting new farmers. Dairy Buyers Providing certainty in advance over the price received/paid for dairy commodities means the processor and the purchaser can better plan for the future and have confidence over sales and delivery of product. This certainty helps to retain and grow the purchaser customer base and means the processor can lock in price for supply. Locking in revenue lines means you can also lock in cost lines. Farmers Farmers are the bedrock and most important players in the industry. As one farmer said to us cows are machines for turning grass (or grain) into milk. For each litre of milk produced, depending on where in the world they farm, that litre will go to produce a mix of WMP, SMP, AMF, cheese, or other value added product. The prices for the ingredients - WMP, SMP, AMF are all highly correlated. If the price for WMP falls today, the amount of money farmers receive as a payout will also fall shortly. There is a definite and strong correlation between the price of WMP and the payout farmers receive for their milk. NZX Dairy Futures, in particular, the Global WMP Future, will for the first time provide farmers with a daily, transparent indication of sentiment around dairy commodity prices, and provide the opportunity to lock in a portion of production. By using Global WMP Futures to hedge, farmers can take the downside risk out of their cash flow position. While their processor may also hedge, Global WMP Futures give farmers control of their cashflow, and assist them to minimise downside. Banks Banks in rural countries and communities have a direct line into agriculture. Around the world, banks work with farmers to provide lending facilities, as well as hedging tools for currency and interest rates. Banks, like their customers, like to have stable cash flows, and to reduce payment risk as far as possible. Given the volatility in the milk price, and hence in farmers cash flows, NZX Dairy Futures will give banks a product they can provide to farmers. Improving cash flow certainty is in both the banks and farmers best interests. At a macro level, banks around the world have a significant amount of capital allocated to the dairy sector. NZX Dairy Futures provide products for banks to manage their portfolio exposure to the dairy sector as a whole. Funds More and more funds are starting to recognise the importance of dairy to the global political economy and as a traded product. NZX Dairy Futures provide funds with a product set to gain exposure to long-term trends in dairy and demand for proteins, and thus to expand their portfolios to include this very important sector. 7
Using Dairy Futures - to manage risk NZX Dairy Futures are designed to manage risk and smooth out volatility and are intended to create price certainty, transparency and a forward view of market sentiment. By trading on the NZX Dairy Futures market, participants can create price certainty. The ability to create price certainty for a participant is a fundamental competitive advantage in a volatile market. For a processor, hedging ensures certainty for themselves and the farmer over prices paid for liquid milk, as well as certainty over forward sales prices. This hedging activity also offers purchasers the ability to secure supply and manage their own price risk, providing certainty over future purchase prices. Price certainty is achieved by entering equal and opposite positions in the physical and futures markets. Any loss in the physical market will be offset by a profit in the futures market and vice versa (physical and futures market prices tend to move together i.e. mirror each other). The purpose is not to make a profit or avoid a loss in either market, but to lock in price ahead of time. Hedging Examples NZX Dairy Futures are tools to manage price risk through the practice of hedging. Hedgers are not attempting to beat the market; the purpose of hedging is to lock in a price. The following are examples only, and are not a recommendation or the giving of an opinion relating to the acquisition or disposal of NZX Dairy Futures. In the NZX Dairy Futures market a participant can open a position by buying or by selling. Producers (sellers) are effectively long in the physical WMP market before they fix a delivery price with buyers. Buyers are effectively short in the physical WMP market before they fix a delivery price with sellers. `` See hedging examples over page. Sell = Short hedge Buy = Long hedge A producer is at risk of the price falling. A buyer is at risk of the price rising. 8
Using Dairy Futures - to manage risk CONTINUED Short hedge example: (Zero basis and fees) Sell High, Buy Low Suppose it is April and a producer decides to hedge WMP to be sold in August because there is a risk the price could fall. (Remember that futures and cash prices move in a similar direction and so a profit in one market is offset by a loss in another). The producer sells one August Global WMP Futures contract at USD3,900/t. If the price declines in the futures and cash market (as they tend to move in the same direction): August Futures Price Futures WMP Physical (Cash) Price Physical (Cash) Net Purchase Price* USD3,700/t +200 USD3,700/t -200 USD3,900/t USD3,400/t +500 USD3,400/t -500 USD3,900/t If the opposite happens, i.e. futures and cash market prices rise: August Futures Price WMP Physical (Cash) Net Purchase Price* Futures Price Physical (Cash) USD4,400/t -500 USD4,400/t +500 USD3,900/t USD4,100/t -200 USD4,100/t +200 USD3,900/t In both of the above scenarios, the gain/loss in one market is offset by a loss/gain in another. Therefore, in either of the above, the producer has created price certainty for themselves ahead of time. 9
Using Dairy Futures - to manage risk CONTINUED Long hedge example: (Zero basis and fees) Buy Low, Sell High Suppose it is April and a manufacturer decides to hedge WMP to be bought in August because there is a risk the price could rise. The manufacturer buys one August Global WMP Futures contract at USD3,900/t. Assume the price rises in the futures and cash market: August Futures Price WMP Physical (Cash) Net Purchase Price Futures Price Physical (Cash) USD4,400/t +500 USD4,400/t -500 USD3,900/t USD4,100/t +200 USD4,100/t -200 USD3,900/t If prices decline: August Futures Price WMP Physical (Cash) Net Purchase Price Futures Price Physical (Cash) USD3,700/t -200 USD3,700/t +200 USD3,900/t USD3,400/t -500 USD3,400/t +500 USD3,900/t The goal of the hedger is not to beat the market but to create price certainty ahead of time. Therefore in either case the loss in one market is offset by the gain in another, effectively setting a price ahead of time. 10
Dairy Market Information and Data When hedging, a participant takes into account factors such as the cost of trading (exchange and broker fees), the cost of access to market (networks and software), capital dedicated to margin and the liquidity of the product traded. A risk management strategy can be designed to achieve the participant s goals, and the hedge can be managed throughout its life to ensure optimal performance in a dynamic and volatile market. Futures prices are mainly driven by prices in the physical (cash) market, however information and data points which support views on future price movements are essential. NZX provides a multitude of key data points, views and commentary to help traders price NZX Dairy Futures. gdt Data NZX Dairy Futures will be accompanied by a direct feed of gdt data from the gdt platform. The data on the NZX data feed will include current and historical data. Users of NZX data can be sure to have the latest, most current information, equal with any direct user on the gdt platform. Agri Inform Agri Inform produces NZ Dairy Exporter, Dairy Week, New Zealand Farmers Weekly and many more weekly and monthly news publications. All are respected for leading the way in the provision of management information and up to date news of value to the dairy industry and the wider agribusiness sector. Click here for more information: http://www.nzxagri.com Australian Crop Forecasters ACF publishes monthly subscription reports on Australian grain supply and demand. Australian Crop Forecasters has a long standing in the Australian grain market as the lead provider of high quality and independent crop forecasting services. Click here to see a range of ACF reports: http://www.cropforecasters.com.au/ Agrifax Agrifax is New Zealand s leading provider of independent information for the agribusiness sector. It provides timely and accurate data, insightful analysis as well as monitoring services for global market trends and commodity prices. Leading manufacturers, exporters, importers, economists, financial and farm advisers and farmers in New Zealand and internationally subscribe to Agrifax. Click here to see Agrifax Dairy Reports: http://www.nzxagri.com/agrifax 11
Contract Specifications GLOBAL WMP FUTURES Unit of Trading Price basis Minimum Price Movement (Tick Size and Value) Daily Price Limits Contract Months Trading Hours Last Trading Day Final Settlement Clearing House 1 tonne (MT) USD/tonne $5 per tonne ($5) 10% above or below the previous Trading Day s Daily Settlement Price Every calendar month out to 18 months are available for trading 08:00 hrs - 16:00 hrs NZST/NZDST Trading shall terminate on the last business day preceding the first gdt Auction of the month i.e. trading in the March WMP Futures Contract will expire on the last Business Day immediately preceding the first gdt Auction in April (See Expiry Calendar contained in the Contract Terms and Administrative Procedures - NZX Derivatives Market Contract No 1 ( Contract T&Ps )) Cash settled to the Final Settlement Price calculated by NZX according to an average of winning prices for Whole Milk Powder, Regular - NZ, Contract 1 in gdt Auctions as stipulated in the Contract T&Ps New Zealand Clearing Limited Common Trading Facilities Block Trading Facility Exchange for Physicals Facility Exchange for Swaps Facility Common Trading Facilities Minimum Volume Thresholds Exchange Code Cross Transactions Minimum Time Period Position Limits Exchange Rule Minimum Volume Thresholds for each Contract or Class of Contracts are specified in Part B Appendix One of the Procedures WMPF View vendor codes 15 seconds 20,000 Open Positions in any Contract Month The Contracts are Traded on the NZX Derivatives Market and subject to the NZX Derivatives Market Rules and Procedures This is an Individual Contract Specification for the purpose of the NZX Derivatives Market Rules ( Rules ) as amended or supplemented from time to time. Capitalised terms used herein have the meanings given in the Rules, Procedures and the Contract T&Ps unless otherwise defined. The information published here does not substitute the Rules, Procedures or Contract T&Ps. This Individual Contract Specification shall not constitute investment advice nor an offer, invitation, solicitation or recommendation to engage in any transaction. NZX and its subsidiaries take no responsibility for any errors or omissions or losses, direct, consequential or otherwise arising from actions based upon this information. Before entering into any transaction you should take steps to ensure that you understand the transaction and have made an independent assessment of its appropriateness in light of your own objectives and circumstances. You should also consider seeking advice from independent advisers. globaldairytrade gdt is an internet-based electronic trading platform for cross-border trade in physical commodity dairy products operated by an independent trading manager. For further information on globaldairytrade go to www.globaldairytrade.info NZX Limited 2010 all rights reserved 12
Getting Started To trade NZX Dairy Futures, you must trade through an NZX accredited broker. A list of accredited NZX Derivatives Market Participants is available on www.dairyfutures.com. Once you have chosen a participant, you will need to open an account with that participant. Those participants may offer advice and in many cases may provide you with electronic trading software for trading and data purposes. Firms wanting to become an accredited NZX Derivatives Market Participant must choose the participant status most appropriate to their business model. All trades on the NZX Derivatives Market must be cleared through an NZ Clearing Corp accredited Clearing Participant. Financial Institutions and Firms can choose to become accredited as a clearer themselves, or clear trades through a third party clearer - a General Clearing Participant. For additional information on NZX Derivative Market Participant categories and NZ Clearing Corp applications, please go to www.nzx.com. NZX understands that, with increasing volatility in the dairy industry and the emergence of new risk management tools like NZX Dairy Futures, there is a great need for traders and participants to become comfortable with using these tools. Please visit our website www.dairyfutures.com to access other materials that can help you to become better informed about trading NZX Dairy Futures. 13