Weak GDT prompts big trade in dairy derivatives

Unexpectedly weak prices for whole and skim milk powder at this week's GlobalDairyTrade auction have resulted in market participants piling into a record volume of dairy derivatives on the NZX. Most of the jump was in options to buy or sell the products.

The record volume was 6415 lots on July 3, according to NZX Dairy Derivatives data. That beat the previous record set in 2015 of 5994.

At the GlobalDairyTrade auction on Tuesday night, prices fell, led by an unexpectedly big decline in whole milk powder.

The auction was held after Fonterra Co-operative Group, one of the biggest market participants, released production figures showing its New Zealand milk collection for May was up 7% from a year earlier to 71 million kilograms and it forecast a 1.3% increase for the 2018-19 season.

Whole milk powder sank 7.3% to $US2905 a tonne and skim milk powder shed 4.6% to $US1913 a tonne, prompting AgriHQ dairy analyst Amy Castleton to say it looked like the market "had the jitters, especially for whole milk powder".

"Yesterday, the market had a record day. People wanted to jump in and manage their risk," Nigel Brunel, director of institutional commodities at OMF, said.

"GDT went down and that made the market more volatile. It was more than I expected but there seems to be a lot of milk out there globally and New Zealand is setting itself up for a good season."

Some 4000 contracts were in options, the biggest volume in at least three months, based on NZX data. A similar volume of futures contracts traded a week earlier, also a three-month high. It was the busiest day for options trading since May 2015.

The contracts are for one metric tonne for GDT-based contracts and 6000kg/ms for New Zealand milk price contracts.

Nick Morris, NZX head of derivatives, said it was "pleasing to see record levels of activity" in dairy derivatives.

"Higher volatility at the recent GDT auction is driving large volumes of trade."

NZX said its data showed the majority of options traded yesterday were at strikes of $2900 and $3000. Call options, which give the owner the right to buy the underlying commodities at an agreed price, were traded at $3000 and puts, an option to sell at a specified rate and time, at $2900.

It added that some options "appear to be trading as structures". It said participants typically use options as insurance should the price move against them, without having to be committed to such a position.

Traders use contract structures to suit their needs including a collar, where the holder seeks to put a cap and a floor on the price.

Within that, there is a "long collar", where the trader buys a call option and sells a put option, and a "short collar", where they take the opposite position.

NZX's June metrics show that the notional value of dairy derivatives traded rose 16% from June 2017 to $132million. There were 26,417 futures lots traded, up 10%, and 7332 options lots, up almost 30%. The "options to futures ratio" rose 18% to about 28%.

According to Mr Brunel, the participants in the market are also participants in the dairy sector and are hedging their actual risks and potentially offsetting positions elsewhere, such as being long in the futures market or to offset risks in the actual cash market. OMF's clients do seek structured positions and Mr Brunel declined to comment on actual trading.

Market participants range from producers and sellers of milk to distributors and buyers of dairy products. Up until this latest week, volatility in the market had actually reduced, he said.

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