LGM-Dairy: A Risk Management Tool for Small and Large Dairy Farms Brian W. Gould Department of...

LGM-Dairy: A Risk Management LGM-Dairy: A Risk Management Tool for Small and Large Dairy FarmsTool for Small and Large Dairy Farms

Brian W. GouldBrian W. GouldDepartment of Agricultural and Applied EconomicsDepartment of Agricultural and Applied Economics

Victor E. CabreraVictor E. CabreraDepartment of Dairy ScienceDepartment of Dairy Science

University of Wisconsin-MadisonUniversity of Wisconsin-MadisonUniversity of Wisconsin ExtensionUniversity of Wisconsin Extension

June, 2011

Price risk in the U.S. Dairy IndustryPrice risk in the U.S. Dairy Industry

What are the objectives of the use of LGM-What are the objectives of the use of LGM-Dairy as a risk management tool?Dairy as a risk management tool?

Overview of the “Black-Box” of LGM-DairyOverview of the “Black-Box” of LGM-Dairy

What are the future prospects of LGM-DairyWhat are the future prospects of LGM-Dairy

OverviewOverview of This Presentation of This Presentation

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4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00

20.00

22.00

Class III/BFP/MW Prices ($/cwt)

Jan 70 - Dec 81

Jan 82 - Dec 87

Jan 88 - April 1995

May 95 - Dec 99

Jan 00 - Present

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Price Risk in Today’s Dairy IndustryPrice Risk in Today’s Dairy Industry

We have seen a tremendous increase in the We have seen a tremendous increase in the volatility of farm milk prices over the last 20 yearsvolatility of farm milk prices over the last 20 years

Parity milk price support

Federal Order Reform

Use of BFP formula

Modern dairy-based futures and options

Modern dairy-based futures and options

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2.5

4.0

5.5

7.0

8.5

10.0

11.5

13.0

14.5

U.S. Exports and Imports as a Percent of Total U.S. Milk Solids Production

Dairy Exports

Dairy Imports

% of Milk Solids

Source: U.S. Dairy Export Council

5


0.50

0.70

0.90

1.10

1.30

1.50

1.70

1.90

2.10

2.30

2.50

02 03 04 05 06 07 08 09 10 11

U.S. (NFDM)

Northern Europe

Oceania

Comparison of Internatonal and Domestic Milk Powder Prices$/lb

Correlation CoefficientOceania-U.S.:

0.939Europe-U.S.:

0.822Oceania-Europe: 0.962

Correlation CoefficientOceania-U.S.:

0.939Europe-U.S.:

0.822Oceania-Europe: 0.962

0.50

0.75

1.00

1.25

1.50

1.75

2.00

2.25

2.50

16% Dairy Feed

Class III

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Revenue Risk in Today’s Dairy IndustryRevenue Risk in Today’s Dairy Industry

16% Dairy Ration and Class III Price Indexes (Jan. ‘85 = 1)16% Dairy Ration and Class III Price Indexes (Jan. ‘85 = 1)

16% dairy ration composedof 51% (by weight) corn, 8% soybeans and 41% alfalfa hay

16% dairy ration composedof 51% (by weight) corn, 8% soybeans and 41% alfalfa hay

How have dairy farmers been able to control their How have dairy farmers been able to control their milk price milk price in the past?in the past? Plant-sponsored Plant-sponsored fixed price fixed price contractscontracts

Similar to Class III short hedge: Similar to Class III short hedge: No upside potentialNo upside potential

Plant-sponsored Plant-sponsored minimum price minimum price contractscontracts Similar to a Class III put option used to establish Similar to a Class III put option used to establish

milk price floor: milk price floor: Allows for higher priceAllows for higher price Producer use of Producer use of hedging and optionshedging and options systems systems

Outcomes vary across strategy: Outcomes vary across strategy: lock inlock in a Class III a Class III price, establish price, establish minimumminimum Class III prices, etc. Class III prices, etc.

Need to recognize contract lumpinessNeed to recognize contract lumpiness Possibility of margin calls with use of futuresPossibility of margin calls with use of futures

Dairy Dairy PricePrice Risk Management Risk Management

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30-Day Moving Average Class III30-Day Moving Average Class IIIFutures Open InterestFutures Open Interest

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

Open InterestOpen Interest

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How can a producer establish a How can a producer establish a floorfloor on on Income over Income over Feed CostsFeed Costs (IOFC)? (IOFC)? Class III put options: Creates milk revenue Class III put options: Creates milk revenue floorfloor Feed call options: Establishes feed cost Feed call options: Establishes feed cost ceilingceiling Using this Using this bundled optionbundled option strategy, producer can strategy, producer can

establish an IOFC floorestablish an IOFC floor$/cwt$/cwt

Milk revenue floorMilk revenue floor

Feed cost ceilingFeed cost ceiling

Minimum IOFCMinimum IOFC

Dairy Dairy RevenueRevenue Risk Management Risk Management

$/cwt$/cwt

IOFCIOFCIOFC*IOFC*

Class III PutClass III Put

Announced Class III ↑,→ Don’t use Class III Put

Announced Class III ↑,→ Don’t use Class III Put

$/cwt$/cwt

IOFCIOFC

Class III PutClass III Put

Feed CallsFeed Calls

Feed CallsFeed Calls

Feed Price ↓ → Don’tuse Corn/SBM Calls

Feed Price ↓ → Don’tuse Corn/SBM Calls

IOFC* greater than IOFCIOFC* greater than IOFC

IOFC* greater than IOFCIOFC* greater than IOFCIOFC*IOFC*

Dairy Dairy RevenueRevenue Risk Management Risk Management

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Aug. 2008: Livestock Gross Margin Insurance Aug. 2008: Livestock Gross Margin Insurance for Dairy (for Dairy (LGM-DairyLGM-Dairy) became available) became available Objective: Establish minimum IOFCObjective: Establish minimum IOFC Similar to bundled options strategy except:Similar to bundled options strategy except:

NoNo options purchased options purchased NoNo minimum size limitminimum size limit Upper limitUpper limit: 240,000 cwt over 10 mo. or within : 240,000 cwt over 10 mo. or within

insurance yearinsurance year Premium not due until Premium not due until afterafter contract period contract period Subsidized premiumsSubsidized premiums

USDA-RMA administered and purchased from USDA-RMA administered and purchased from firms selling Federal crop insurancefirms selling Federal crop insurance July 2010: Available in lower 48 statesJuly 2010: Available in lower 48 states

LGM-Dairy: An OverviewLGM-Dairy: An Overview

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LGM-Dairy is customizable with respect to: LGM-Dairy is customizable with respect to: Number of months insured by 1 contractNumber of months insured by 1 contract

1 1 –– 10 months 10 months % of monthly IOFC (production) covered% of monthly IOFC (production) covered

0 – 100% of certified production each month0 – 100% of certified production each month % coverage can vary across months% coverage can vary across months

Farm specific Farm specific production, declared feed use, production, declared feed use, deductible and premiumdeductible and premium NMPF proposed revenue insurance program would NMPF proposed revenue insurance program would

be much less flexiblebe much less flexible


Gross Margin (GM) = Total contract Gross Margin (GM) = Total contract Expected Expected value of milk value of milk –– Total contract Total contract ExpectedExpected feed costs feed costs Sum of monthly (Sum of monthly (Expected Expected milk price x milk price x

InsuredInsured milk) milk) – – Sum of monthly (Sum of monthly (ExpectedExpected feed price x feed price x Insured Insured feed use) feed use)

1 GM per contract regardless of number of 1 GM per contract regardless of number of months insuredmonths insured One month’s low value can offset another month’s One month’s low value can offset another month’s

relatively high value as only total sum mattersrelatively high value as only total sum matters

Gross Margin Guarantee (GMG) = Gross Margin Guarantee (GMG) = GM GM –– Total Total DeductibleDeductible


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Expected Prices: Today’s estimate of future milk and feed prices

Expected Prices: Today’s estimate of future milk and feed prices

Actual Gross Margin (AGM) = Total contract Actual Gross Margin (AGM) = Total contract ActualActual milk value milk value – – Total contractTotal contract Actual Actual insuredinsured feed costfeed cost Sum of monthly Sum of monthly ((Actual Actual milk price x milk price x InsuredInsured

milk) milk) – – Sum of monthly Sum of monthly ((ActualActual feed price x feed price x InsuredInsured feed use) feed use)

1 AGM per contract regardless of number of 1 AGM per contract regardless of number of months insuredmonths insured A month with a low value can offset a month with A month with a low value can offset a month with

a relatively high valuea relatively high value


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Actual Prices: Milk and feed prices observed over insurance contract life

Actual Prices: Milk and feed prices observed over insurance contract life

Class III, corn, and SBM futures markets used as Class III, corn, and SBM futures markets used as information source of information source of Expected Expected (forward (forward looking) and looking) and ActualActual (“observed”) prices (“observed”) prices NoNo futures/options market transactionsfutures/options market transactions Actual farm prices not usedActual farm prices not used No local basis added to Expected/Actual No local basis added to Expected/Actual

pricesprices

Prices:Prices: Feed: Corn (Chicago), SBM (Chicago)Feed: Corn (Chicago), SBM (Chicago) Milk: Class III (standard composition)Milk: Class III (standard composition)

3.5% Fat3.5% Fat Skim Portion: 3.1% Protein/5.9 Other SolidsSkim Portion: 3.1% Protein/5.9 Other Solids

LGM-Dairy: Milk and Feed PricesLGM-Dairy: Milk and Feed Prices

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Approved target marketings Approved target marketings Maximum amount of milk that could be Maximum amount of milk that could be

producedproduced Milk production actually produced certified Milk production actually produced certified

once contract endsonce contract ends Milk production needs to be at least 75% Milk production needs to be at least 75%

insured without penaltyinsured without penalty

LGM-Dairy: Expected Milk ProductionLGM-Dairy: Expected Milk Production

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ExpectedExpected feed use converted to Corn (Energy) feed use converted to Corn (Energy) and SBM (Protein) equivalentsand SBM (Protein) equivalents Allowable range of feed equivalents:Allowable range of feed equivalents:

Corn: 0.13 – 1.36 bu/cwt of milkCorn: 0.13 – 1.36 bu/cwt of milk SBM: 1.61 – 26.00 lb/cwt of milkSBM: 1.61 – 26.00 lb/cwt of milk

Program default feed coefficients can be used:Program default feed coefficients can be used: Corn: 0.5 bu/cwt SBM: 4.0 lbs/cwtCorn: 0.5 bu/cwt SBM: 4.0 lbs/cwt

No auditing of declared feed useNo auditing of declared feed use May only want to declare May only want to declare purchasedpurchased feed feed Using minimum amounts → approximate Using minimum amounts → approximate

synthetic putsynthetic put

LGM-Dairy: Expected Feed UseLGM-Dairy: Expected Feed Use

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AllAll 10 months of10 months of Expected PricesExpected Prices are known at sign-up are known at sign-up Expected Prices = Average of last 3 days of futures Expected Prices = Average of last 3 days of futures

settlement prices for each month including sign-up Fridaysettlement prices for each month including sign-up Friday

LGM-Dairy: Expected Gross MarginLGM-Dairy: Expected Gross Margin

Futures market settle prices on thesedays used to determine Expected Prices

Futures market settle prices on thesedays used to determine Expected Prices Insurance sign-

up period

Insurance sign-up period

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With known expected prices, minimum With known expected prices, minimum GMG GMG for for entireentire contractcontract determined at sign-up determined at sign-up Regardless of contract length: 1,2,…,9, or Regardless of contract length: 1,2,…,9, or

10 months10 months GMG calculated using program rulesGMG calculated using program rules

If GMG If GMG >> AGM → Indemnity paid AGM → Indemnity paid Payout amount = GMG Payout amount = GMG –– AGM AGM

Remember GMG & AGM evaluated for entire Remember GMG & AGM evaluated for entire contractcontract

LGM-Dairy: Indemnity DeterminationLGM-Dairy: Indemnity Determination

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LGM-DairyLGM-Dairy available for purchase each month available for purchase each month 12 contracts offered each year12 contracts offered each year

Each contract covers Each contract covers up toup to 10 months 10 months Purchase period starts at end of last business Purchase period starts at end of last business

Friday of each monthFriday of each month July contract purchase period would have started July contract purchase period would have started

on July 29on July 29thth Purchase period ends at 8:00 PM CDT Purchase period ends at 8:00 PM CDT

SaturdaySaturday Points to the reason why planning is needed Points to the reason why planning is needed

well in advancewell in advance of contract purchase of contract purchase

LGM-Dairy: When Purchased?LGM-Dairy: When Purchased?

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Simple hypothetical insurance strategySimple hypothetical insurance strategy Purchase insurance at end of JulyPurchase insurance at end of July

Jul′11

Aug ′11

Sep ′11

Oct ′11

Nov ′11

Dec ′11

Jan ′12

Feb ′12

Mar ′12

Apr ′12

May ′12

Jun ′12

1 2 3 4 5 6 7 8 9 10

Purchase at End of

Month

NoCover-

ageInsurance Contract PeriodInsurance Contract Period

Production Coverage

75% 50% 25% 25%

Hypothetical LGM ContractHypothetical LGM Contract

LGM-Dairy: Coverage CalendarLGM-Dairy: Coverage Calendar

By rule: No coverage the month after purchase

By rule: No coverage the month after purchase

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Producer chooses amount of gross margin notProducer chooses amount of gross margin not covered by insurancecovered by insurance,, (i.e., Insurance (i.e., Insurance

Deductible)Deductible):: Portion of Portion of Gross Margin Gross Margin not protectednot protectedProgram allows $0 - $2.00/cwt Program allows $0 - $2.00/cwt Gross MarginGross Margin

to be excluded from coverageto be excluded from coverage Same $/cwt for all monthsSame $/cwt for all months

Higher deductible → Lower premiumHigher deductible → Lower premium Producer assumes more riskProducer assumes more risk

Subsidy Subsidy increasesincreases with higher deductible with higher deductibleDouble impact on reducing premium Double impact on reducing premium

LGM-Dairy: Insurance DeductibleLGM-Dairy: Insurance Deductible

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LGM-Dairy: Current Premium Subsidy ScheduleLGM-Dairy: Current Premium Subsidy Schedule

Deductible ($/cwt)

Subsidy (%)

Deductible ($/cwt)

Subsidy (%)

00 0.180.18 0.600.60 0.310.31

0.100.10 0.190.19 0.700.70 0.340.34

0.200.20 0.210.21 0.800.80 0.380.38

0.300.30 0.230.23 0.900.90 0.430.43

0.400.40 0.250.25 1.001.00 0.480.48

0.500.50 0.280.28 1.10 – 2.001.10 – 2.00 0.500.50

Note: There is no subsidy for a 1-month contract. The Note: There is no subsidy for a 1-month contract. The subsidy % is the percentage by which premium is subsidy % is the percentage by which premium is reduced.reduced.

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Actual prices determined as futures contracts Actual prices determined as futures contracts expire over insurance contract life expire over insurance contract life Actual price = Average futures contracts settle Actual price = Average futures contracts settle

prices from 1prices from 1stst, 2, 2ndnd, and 3, and 3rdrd days days priorprior to to futures contract futures contract last last trading daytrading day

LGM-Dairy: Actual Prices and Gross MarginLGM-Dairy: Actual Prices and Gross Margin

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LGM-Dairy: Actual Prices and Gross MarginLGM-Dairy: Actual Prices and Gross Margin

Settle prices used to calculateActual March Class III price

Settle prices used to calculateActual March Class III price

Last Corn/SBMtrading day

Last Corn/SBMtrading day

Last March Class III trading day

Last March Class III trading day

Settle prices used to calculateActual March Corn/SBM prices

Settle prices used to calculateActual March Corn/SBM prices

LGM-Dairy: Measures of ActivityLGM-Dairy: Measures of Activity

Insurance Insurance YearYear

Policies Policies Sold Sold (No.)(No.)

CWT CWT Insured Insured (000)(000)

Liabilities Liabilities ($000)($000)

Premium Premium ($000)($000)

Indem. Indem. Paid Paid

($000)($000)

Subsidy Subsidy ($000)($000)

Loss Loss RatioRatio

20102010 153153 1,8721,872 24,91524,915 782782 280280 00 0.360.362011: 2011: 7/10-1/117/10-1/11 690690 19,02519,025 303,715303,715 9,1009,100 00 3,4943,494 002011: 2011: 2/112/11 401401 15,52315,523 271,972271,972 9,1219,121 1818 4,0614,061 002011: 2011: 3/113/11 318318 11,66011,660 194,583194,583 6,8206,820 4040 3,1873,187 0020112011 TotalTotal 1,4091,409 46,20946,209 770,270770,270 25,04125,041 5858 10,74210,742 00

Note:Note: The 46.2 million cwt insured in 2010/11 represents The 46.2 million cwt insured in 2010/11 represents approximately 2.4% of U.S. milk production in 2010.approximately 2.4% of U.S. milk production in 2010.

LGM-Dairy: 2010/11 Measures of ActivityLGM-Dairy: 2010/11 Measures of Activity

StateStatePolicies SoldPolicies Sold CWT InsuredCWT Insured LiabilitiesLiabilities PremiumsPremiums SubsidiesSubsidies

Subsidy Subsidy %%No.No.

% of % of TotalTotal

000000% of % of TotalTotal

$000$000% of % of TotalTotal



CACA 4040 2.8 4,3814,381 9.59.5 73,62873,628 9.69.6 2,4452,445 11.111.1 1,1321,132 10.510.5 46.346.3IDID 2828 2.0 1,4051,405 3.03.0 22,13222,132 2.92.9 628628 2.82.8 217217 2.02.0 34.534.5IAIA 4545 3.2 939939 2.02.0 16,65816,658 2.22.2 493493 2.22.2 231231 2.22.2 46.846.8MIMI 119119 8.4 4,7234,723 10.210.2 80,07280,072 10.410.4 2,5032,503 11.411.4 956956 8.98.9 37.937.9MNMN 163163 11.6 2,2682,268 4.94.9 38,15038,150 5.05.0 1,3421,342 6.16.1 548548 5.15.1 40.840.8NYNY 8686 6.1 3,2593,259 7.17.1 55,35555,355 7.27.2 1,9501,950 8.88.8 773773 7.27.2 39.639.6PAPA 133133 9.4 2,2692,269 4.94.9 37,54337,543 4.94.9 1,3761,376 6.26.2 548548 5.15.1 39.839.8VTVT 9494 6.7 4,7464,746 10.310.3 76,96576,965 10.010.0 2,1722,172 9.99.9 1,0661,066 9.99.9 49.149.1WAWA 4040 2.8 2,4272,427 5.35.3 39,41539,415 5.15.1 1,2161,216 5.55.5 560560 5.25.2 46.046.0WIWI 422 30.0 9,273 20.1 154,487 20.1 5,038 22.9 2,083 19.4 41.3

OtherOther 239239 17.0 10,47310,473 22.822.8 175,864175,864 22.822.8 2,8782,878 13.113.1 2,6292,629 24.524.5 44.744.7TotalTotal 1,4091,409 ----- 46,20946,209 ---------- 770,270770,270 ---------- 25,04125,041 ---------- 10,74310,743 ------------ 42.942.9

Note: Data as of July 7, 2011. No subsidy existed for July-Nov., 2010Note: Data as of July 7, 2011. No subsidy existed for July-Nov., 2010

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March 2011: Last contract offering March 2011: Last contract offering More than 2% of U.S. milk supply (2010) More than 2% of U.S. milk supply (2010)

insured by end of March insured by end of March Most activity occurred after Nov. 2010Most activity occurred after Nov. 2010

$15 million expenditure by USDA this year:$15 million expenditure by USDA this year: Since Dec. 2010: Includes premium subsidySince Dec. 2010: Includes premium subsidy Insurance provider administrative & Insurance provider administrative &

overhead paymentsoverhead payments

Insurance year runs from October – SeptemberInsurance year runs from October – September Next possible contract offering: Oct. 28Next possible contract offering: Oct. 28 thth

LGM-Dairy: Future ProspectsLGM-Dairy: Future Prospects

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Unclear as to increased funding for LGM-DairyUnclear as to increased funding for LGM-Dairy Substantial pressure on Congress to ↑ Substantial pressure on Congress to ↑

funding from farm groups, financial funding from farm groups, financial industry, etc.industry, etc.

Implications of NMPF revenue insurance Implications of NMPF revenue insurance plan?plan? Impact on the 2012 Farm BillImpact on the 2012 Farm Bill

Implications of DIAC recommendationsImplications of DIAC recommendations Increased emphasis on risk managementIncreased emphasis on risk management

Rep. Ryan’s budget proposalRep. Ryan’s budget proposal Significant reduction in direct cash paymentsSignificant reduction in direct cash payments Increased reliance on individual producer risk Increased reliance on individual producer risk

managementmanagement

LGM-Dairy: Future ProspectsLGM-Dairy: Future Prospects

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LGM-Dairy a flexible insurance programLGM-Dairy a flexible insurance program Need not insure all months or productionNeed not insure all months or production Could make sense to overlap contractsCould make sense to overlap contracts Substantial premium subsidiesSubstantial premium subsidies

Similar to combined use of Class III puts and Similar to combined use of Class III puts and corn/SBM calls as in a bundled optioncorn/SBM calls as in a bundled option Premiums are very sensitive to elected deductiblePremiums are very sensitive to elected deductible

LGM-Dairy Major DrawbacksLGM-Dairy Major Drawbacks Short sign-up window at the end of each monthShort sign-up window at the end of each month Need to wait until end of contract for indemnity Need to wait until end of contract for indemnity

After last actual price is determinedAfter last actual price is determined

LGM-Dairy: SummaryLGM-Dairy: Summary

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Contact InformationContact Information

The Univ. of Wisconsin Dairy Marketing Website: The Univ. of Wisconsin Dairy Marketing Website: http://future.aae.wisc.eduhttp://future.aae.wisc.edu

Livestock Gross Margin Insurance: Livestock Gross Margin Insurance: http://future.aae.wisc.edu/lgm_dairy.htmlhttp://future.aae.wisc.edu/lgm_dairy.html

To join the LGM-Dairy Mailing List:To join the LGM-Dairy Mailing List:http://future.aae.wisc.edu/lgm_dairy.html#5http://future.aae.wisc.edu/lgm_dairy.html#5

Brian W. GouldBrian W. Gould Victor E. CabreraVictor E. Cabrera(608)263-3212(608)263-3212 (608)265-8506(608)[email protected]@wisc.edu [email protected]@wisc.edu

LGM-Dairy: A Risk Management Tool for Small and Large Dairy Farms Brian W. Gould Department of...

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