LGM-Dairy: Program Fundamentals Brian W. Gould Department of Agricultural and Applied Economics...

LGM-Dairy: Program Fundamentals

Brian W. GouldDepartment of Agricultural and Applied Economics

University of Wisconsin-MadisonUniversity of Wisconsin Extension

November 25, 2013

Overview

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How can dairy producers manage the volatility of their margins Margin ≡ Income over feed costs

Getting inside the LGM-Dairy Black-Box

Resources available for advanced planning

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Margin Risk Management: Options Based

How can dairy producers establish a floor on their Income over Feed Costs (IOFC) using feed and class III options? Class III put option: Creates milk revenue floor Feed call option: Establishes feed cost ceiling

IOFC ($/cwt)

Milk revenue floor

Feed cost ceiling

Min. IOFC

Market Prices

IOFC*

IOFC**

P*

$P* PutStrike Price

$C* CallStrike Price

C*

IOFC** > IOFC < IOFC*

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An alternative method for managing margin volatility: Livestock Gross Margin Insurance for Dairy (LGM-Dairy) Objective: Establish minimum IOFC Similar to put/call options strategy except:

No options actually purchased No minimum size limit Upper limit: 240,000 cwt over 10 mo./insurance yr Premium not due until after 11-month insurance

period regardless of number of insured months Subsidized premiums

Pilot program with limited funding (<$20 Mil) Reason for flat learning curve

Margin Risk Management: LGM-Dairy

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LGM-Dairy: An Overview

Historical Use of LGM-Dairy

# of Contracts

Sold

CWT (000)

GMG (000$)

Prem. (000$)

Premium Subsidy (000$)

Indem.(000$)

Subsidy Rate(%)

2008/09 45 402 4,716 287 0 718 0

2009/10 153 1,872 24,915 782 0 281 0

2010/11 1,412 46,173 769,644 25,013 10,736 65 42.9

2011/12 1,771 40,504 704,521 19,153 8,867 1,395 46.3

2012/13 1,698 34,189 664,254 16,878 7,659 1,995 45.4

Total 5,079 123,140 2,168,050 62,113 27,262 4,454 43.9

State

Policies Sold

CWT Insured

Liabilities Premiums SubsidiesSubsidy Rate (%)

No.% of Total 000$

% of Total 000$

% of Total 000$

% of Total 000$

% of Total

NY 46 2.7 2,181 6.4 41,207 6.2 1,017 6.0 475 6.2 46.7MI 167 9.8 2,701 7.9 51,840 7.8 1,137 6.7 545 7.1 47.9WI 742 43.7 10,989 32.1 213,274 32.1 5,179 30.7 2,409 31.5 46.5MN 324 19.1 4,237 12.4 83,081 12.5 2,360 14.0 1,110 14.5 47.0

CA 39 2.3 4,388 12.8 86,047 13.0 2,222 13.2 944 12.3 42.5

PA 92 5.4 707 2.1 13,702 2.1 352 2.1 158 2.1 44.9Total 1,698 ----- 34,189 ----- 664,254 ----- 16,878 ----- 7,659 ----- 45.4

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2012/2013 Sales

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We need to differentiate between producer demand for LGM-Dairy vs. utilization rate Producer demand : determined by producers’

willingness to purchase Utilization rate

% of producers using determined by Federal funding availability

Demand is much greater than indicated by participation rate given funding shortages Funding uncertainty has had an impact on contract

designs that has ↓ effectiveness of some contracts

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

1 – 10 months

% of monthly IOFC (marketings) insured 0 – 100% of certified marketings % coverage can vary across month

Farm specific insurance characteristics Amount and % of marketings insured Declared feed use: Only protect market-based risk? Deductible and resulting premium subsidy Premium specific to farm’s contract design


Class III, corn, and soybean meal futures and options markets used as information source Used to determine Expected (forward looking at

time of purchase) and Actual (observed for each month) prices

No futures market transactions Actual farm prices not used No local basis added to prices What does the insured Class III based IOFC mean

in-terms of farm mailbox IOFC? What is your Class III and feed basis?


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Prior to LGM-Dairy contract purchase producer knows: All expected milk price and feed costs for

months in proposed contract The Class III-based IOFC floor that would be

established for insured production Since floor is based on Chicago prices what does

this IOFC protection mean in terms of producer’s actual mailbox-based IOFC?


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

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

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

No auditing of declared feed use Many producers only declare purchased feed Using minimum feed amounts → approximate

a weighted average put option

LGM-Dairy: Expected Feed Use

Total Expected Gross Margin (TEGM) = Total contract Expected value of milk – Total contract Expected feed costs = Sum of monthly (Expected milk prices x

Insured milk) – Sum of monthly (Expected feed prices x Insured feed use)

1 TEGM per contract regardless of the number of months insured One month’s low margin can offset another’s

relatively high value as only total value matters (i.e., TEGM)


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Expected Feed Cost

Profile of % Coverage Over Contract Life

CME Class III

CME Corn

CME SBM

Program Rules

Market Data

Producer Data

Contract Design

Expected Milk

Marketings

Total Expected

Gross Margin

Expected Milk Income

Declared Feed Use

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All 10 months of Expected Prices are known at sign-up

LGM-Dairy: Expected Prices

Insurance sign-up period

Insurance sign-up periodExpected Prices = Average of

futures settle prices on these days

Expected Prices = Average of futures settle prices on these days

Obtain March ʹ14 – Dec ʹ14 Expected Prices

Total Gross Margin Guarantee (TGMG) = TEGM – chosen deductible

Producer chooses insurance deductible Deductible = the portion of insured milk’s Total

Expected Gross Margin not protectedHow much gross margin must go down

before insurance coverage starts Program allows $0 - $2.00/cwt Gross Margin to

be excluded from coverage Higher deductible → Lower premium

Producer assumes more risk


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Total GrossMargin

Guarantee

Deductible Level

Expected Feed Cost


CME Class III

CME Corn

CME SBM

Program Rules

Market Data

Producer Data

Contract DesignExpected

Milk Marketings

Total Expected

Gross Margin


Declared Feed Use

Total Gross Margin Guarantee (TGMG) = TEGM – (Deductible [$/cwt] x cwt insured)

= minimum IOFC

Deductible Level

Expected Feed Cost


CME Class III

CME Corn

CME SBM

Net Premiu

m

Program Rules

Market Data

Producer Data

Contract Design

Subsidy

Expected Milk

Marketings

Total Expected

Gross Margin


Declared Feed Use

Total Net Gross Margin Guarantee

Program Outcom

e

Total Gross Margin Guarantee

(TGMG)

Deductible ($/cwt)

Subsidy (%)

Deductible ($/cwt)

Subsidy (%)

0.00 18 0.60 31

0.10 19 0.70 34

0.20 21 0.80 38

0.30 23 0.90 43

0.40 25 1.00 48

0.50 28 1.10 – 2.00 50

As noted above, prior to purchase producer knows all expected prices Insurance sold after Friday’s futures markets

have closed → Need to evaluate TGMG under alternative

contract designs Chosen deductible rates Coverage months and % coverage Alternative declared feed amounts

Should Use LGM-Dairy Analyzer for planning well in advance of purchase date

LGM-Dairy: Expected Prices

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As an insurance contract matures RMA needs to determine actual monthly milk value and feed costs Use the same production and feeding profile

used when contract was purchasedOnly prices change

Need actual Class III, corn and SBM prices

LGM-Dairy: Actual Prices

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Actual prices based on futures settlement prices at futures contract expiration Actual price = Average futures contracts settle

prices from 3 days prior to futures contract’s last trading day

Last trading day for corn and SBM is last business day prior to the 15th

Class III futures contract’s last trading day: Will usually be on a Tuesday The day prior to the Class III price announcement by

USDA: Announcement typically on a Wed not later then the 5th of the month following production


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Total Actual Gross Margin (TAGM) = Total Actual contract milk value – Total Actual contract feed cost TAGM = Sum of monthly (Actual milk prices

x Insured milk) – Sum of monthly (Actual feed prices x Insured feed use)

Note there is not a monthly determination of actual monthly gross margin → Only 1 TAGM regardless of months insured → A month with a low IOFC can be offset by a

month with a relatively high IOFC value

LGM-Dairy: Actual Gross Margin

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Total Actual Gross Margin

(TAGM)

Actual Milk Income

Final CME

Class III

Final CME Corn

Final CME SBM

Program Rules

Market Data

Producer Data

Contract Design

Expected Milk

Marketings

Declared Feed Use

Actual Feed Cost

Actual prices based on futures settlement prices at expirationActual price = Average futures contracts settle prices from 3 days prior to

futures contract’s last trading day

Final futures settlement prices

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Settle prices used to calculateActual July 2014 Class III price

Last Corn/SBMtrading day

Last July 2014Class III trading day

Settle prices used to calculateActual March Corn/SBM prices


If TGMG > TAGM → An insurance indemnity will be generated Payout amount = TGMG – TAGM

→ i.e., Market did not live up to expectations

Again: Only 1 indemnity calculation per contract

When is the indemnity determination made After last actual price is available from RMA May be 1 – 2 months after last covered month

Corn Example: Sept/Dec futures contracts vs. Oct/Nov LGM coverage months

LGM-Dairy: Indemnity Determination

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Insurance Payout

Deductible Level

Expected Feed Cost


CME Class III

CME Corn

CME SBM

Net Premiu

m

Actual Milk Income

Final CME

Class III

Final CME Corn

Final CME SBM

Program Rules

Market Data

Producer Data

Contract Design

Subsidy

Expected Milk

Marketings

Total Expected

Gross Margin

?


Declared Feed Use

Total Net Gross Margin Guarantee

Program Outcom

e

Actual Feed Cost

Total Actual Gross Margin

Total Gross Margin Guarantee

(TGMG)

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LGM-Dairy can be purchased monthly if funds available Each contract can cover up to 10 months Purchase period starts no earlier than 4:30

pm CDT on last business Friday of month Starts: 4:30 pm CDT, October 26th

Sales will start on the half hour if data not available at 4:30 (e.g. 5:00 pm, 5:30 pm, etc.)

Purchase period ends at 8:00 PM CDT the next day, e.g., Saturday Oct. 27th

Why planning by both agent and producer is needed well in advance of contract purchase

LGM-Dairy: When Purchased?

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Hypothetical insurance strategy Purchase insurance on Jan 31st – Feb 1st

Jan′14

Feb ′14

Mar ′14

Apr′14

May ′14

Jun ′14

Jul ′14

Aug ′14

Sep′14

Oct ′14

Nov ′14

Dec ′14

1 2 3 4 5 6 7 8 9 10

Purchase Jan 31st – Feb 1st

NoCover-

ageInsurance Contract Period

Production Coverage 25% 25% 20% 20%

Hypothetical LGM Contract

LGM-Dairy: Coverage Calendar

By rule: No coverage the month after purchase

By rule: No coverage the month after purchase

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

Similar to combined use of Class III puts and corn/SBM calls Premiums are very sensitive to chosen

deductible

LGM-Dairy: Summary

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Major Drawbacks Short sign-up window at the end of each month Need to wait until after the last actual price

determined before indemnity evaluated Very limited funding

Purchasers want a 10 month contract due to funding uncertainty: Should not use this design due to contract valuation

Would like to have a multi-month purchase risk management strategy

Question as to the impact of margin insurance program being considered in the new Farm Bill

LGM-Dairy: Summary

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Contact Information

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

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

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

Brian W. Gould(608)[email protected]

LGM-Dairy: Program Fundamentals Brian W. Gould Department of Agricultural and Applied Economics...

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