1 Risk Management Practices by the U.S. Dairy Industry: Industry Complexities, Learning Curves and Producer Adoption Brian W. Gould Professor Department of Agricultural and Applied Economics University of Wisconsin-Extension University of Wisconsin ([email protected]) National Extension Risk Management Conference April 2, 2013
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1 Risk Management Practices by the U.S. Dairy Industry: Industry Complexities, Learning Curves and Producer Adoption Brian W. Gould Professor Department.
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Risk Management Practices by the U.S. Dairy Industry: Industry Complexities, Learning Curves and Producer Adoption
Brian W. GouldProfessor
Department of Agricultural and Applied EconomicsUniversity of Wisconsin-Extension
IOFC = Avg All-Milk Price – Avg Feed Costs(2012 Senate Farm Bill Feed Cost Formula Used)
Margin Risk in Today’s Dairy Industry
10
The Pricing of Milk in the U.S.
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To understand effectiveness of milk price (revenue) risk management one needs to understand how producer prices are established A majority of U.S. milk produced under
classified pricing Minimum farm milk price based on how it is
used and associated component values
Two major milk pricing systems: CA and 10 Federal Milk Marketing Orders (FMMO) % of U.S. milk marketed in 2012
CA: 20.9% FMMO: 61.1%
82.0%
The Pricing of Milk in the U.S.
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Theoretically with classified pricing one segregates milk according to demand elasticity
Set different minimum prices according to milk use Higher prices for most inelastic uses (i.e. fluid)
Higher price → consumption reduced relative to competitive market
Divert excess milk from reduced fluid use to uses with more elastic demand (e.g., cheese)Prices will be reduced so as to clear markets
Hoped for net effect: Higher average price and more production
The Pricing of Milk in the U.S.
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The Pricing of Milk in the U.S.
Two variants of the classified pricing system: Milk price being the sum of the value of multiple
components: Protein Milkfat Other Solids Non-Milkfat solids 6 FMMO’s & CA
Fat/Skim PricingMilk value based on value of butterfat and skim milk Four FMMO’s: SE, Appalachian, FL and AZ
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Class-specific minimum prices: Based on class specific formulas relating above
milk component values via the use of:Wholesale dairy product pricesAssumed product yieldsFixed manufacturing (non-milk) costs (i.e., product-
specific make allowance) Milk class minimum price ($/cwt) obtained by:
Determining component quantity/cwt Multiplying per cwt component amounts by
component prices (net of make allowances) Net price depends on product produced from this milk
Sum class-specific component values per cwt
The Pricing of Milk in the U.S.
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A complicating factor for risk management Under both FMMO and CA systems there is
pooling of milk used for different purposes Uniform or blend price
Within each order producers receive a: Uniform price for their milk of equal quality and
composition Uniform price per lb of component
Uniform price is weighted average of class specific milk or component prices
Applies only to milk sold to a plant that is participating in the FMMO system
The Pricing of Milk in the U.S.
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When are Minimum Milk Prices Determined?
Timing of producer milk price determination Under CA and FMMO systems class-specific
component values determined once a month Fluid milk (i.e., Class I) component values
determined prior to production month Other milk classes’ component values
determined after production month → Can be up to 6 weeks difference in price
determination for same month but different class
In volatile markets makes risk management difficult
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Use of Dairy-Based Futures and Options Price Risk Management
Strategies
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Futures/options contracts for farm milk and manufactured dairy products developed with the onset of increased volatility 1993: 1st modern futures market developed at
New York Coffee, Sugar and Cocoa Exchange (NYCSCE)
1997: Chicago Mercantile Exchange (CME) assumes leadership Only exchange with dairy-based contracts
Contract types have evolved over time From physical delivery to most being cash settle
contracts
Evolution of Dairy-Based Futures/Options
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Contract Contract Size Settlement Start Date
Class III Fluid Milk 200,000 lbsCash Settle: Announced Class III
February 1, 2000 (Replaced BFP)
Class IV Fluid Milk 200,000 lbsCash Settle: Announced Class IV
Butter 4,126 2,934 Cheddar 5,805 6,931Note: Data as of March 22, 2013. The above numbers represent the open interest in each commodity/contract type. Each contract represents the following quantities: Class III and IV milk – 2,000 cwt, Butter and Cheddar – 20,000 lbs, Dry Whey and NFDM – 44,000 lbs, SMP – 20 Metric Tonnes
Farm operators, processing plants and product purchasers can use traditional futures/options tools 24 monthly contracts traded daily
Dairy-Based Futures and Options Open Interest
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Futures and Options OpenInterest Commodity Equivalents
Commodity Units Amount Covered
2012 U.S. Production
% of 2012 U.S.
Production
Class III Mil. Lbs. 19,891 200,3241 9.9Class IV Mil. Lbs. 697 200,3241 0.3
across farms to determine number of Put options to purchase Plant decreases contract offer to cover commission
and own administrative costs
If cash price less than contract price → milk check is increased by difference times contracted quantity
Type of pricing products available same as with fixed price contracts
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Purchase a Min/Max (Collar) price contract to set floor and ceiling milk price Producer select’s floor and ceiling that fits
price goal Floor protects from low prices Ceiling reduces contract cost Contract price is the Announced price should
USDA price between floor and ceiling
Type of pricing products available same as with fixed price contracts
Min/Max Contracts Available
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Plant collects min/max offer across farms
Plant purchases Class III Put to establish minimum Only active fluid
milk options market
Min/Max Contracts
Plant sells Class III Call to establish maximum
Plant decreases contract offer to cover commission and own administrative cost
$14.50
$14.85
$15.20
$15.55
$15.90
$16.25
$16.60
$16.95
$17.30
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
$/cw
t
Minimum/Maximum Contract
Minimum
Maximum
2008-12 Class III Avg. Price
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How Can Dairy Producers Manage Margin (IOFC) Risk?
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Use of fixed price contracts in managing IOFC volatility For both milk and feed to lock in an IOFC
margin Fixed milk price contract and feed call
options to establish a minimum IOFC Class III PUT options and fixed feed price
contracts to establish a minimum IOFC
Margin Risk Management Examples
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Purchase both Class III PUT and feed equivalent CALLS to establish IOFC floor
Could be expensive Possible thin Class III options market
$/cwt Milk
Milk revenue floor
Feed cost ceilingA CB
P*
$P* Class III Put
$C* Feed-Based Call
C*Milk/Feed Prices
Margin Risk Management Examples
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Aug. 2008: Livestock Gross Margin Insurance for Dairy (LGM-Dairy) became available Objective is to establish minimum IOFC Similar to a bundled options strategy except:
No options purchased No minimum size limit Upper limit: 240,000 cwt over 10 mo. or within
insurance year Premium not due until after contract period
USDA-RMA administered and purchased from firms selling Federal crop insurance July 2010: Available in lower 48 states
LGM-Dairy: An Overview
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LGM-Dairy is very customizable: 1 – 10 month’s production insured by 1 contract % of monthly production covered
0 – 100% of certified production each month % coverage can vary across months
Farm specific production, feed use, deductible & premium No farm level prices used 2013 Farm Bill margin insurance proposal less flexible
Dec. 2010: Direct subsidy of insurance premiums $0 deductible: 18% subsidy $1.10 − $2.00 deductible: 50% subsidy
LGM-Dairy: An Overview
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Minimum Gross Margin Guarantee (GMG) for entire contract determined when insurance purchased Regardless of # of covered months GMG = Total expected milk revenue – Total
expected purchased feed costs – Total deductible Total refers to sum over all insured months
If Total GMG > Total Actual Gross Margin (AGM) → Indemnity paid Payout amount = GMG – AGM 1 indemnity per contract regardless of length
LGM-Dairy: Indemnity Determination
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LGM-Dairy available for purchase once a month Up to 12 contracts offered each year
depending on funding availability Each contract covers up to 10 months Contracts can over-lap contract months so long
as one does not insure more than 100% of a month’s anticipated production
Purchase period Starts: 4:30 p.m. (CDT) on last business Friday
each month Ends: 8:00 PM CDT Saturday
LGM-Dairy: When Purchased?
LGM-Dairy: An Overview
Insurance Year
Policies Sold (No.)
CWT Insured (000)
GMG ($000)
Premium ($000)
Indem. Paid
($000)
Subsidy ($000)
09/10 134 1,872 24,915 782 280 0
10/11 1,224 46,173 769,645 25,013 65 10,736
11/12 900 40,524 704,864 19,163 1,318 8,871
12/13 660 30,720 599,992 15,533 0 7,060
Note: The 46.2 million cwt insured in 2010/11 represented approximately 2.4% of 2010 U.S. milk production.
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Unclear as to increased funding for LGM-Dairy LGM-Dairy is a livestock pilot program
$20 million/year for all programs Substantial pressure on Congress to ↑
funding from farm groups, financial industry, etc.
Implications of DIAC recommendations 2013 Farm Bill: There will be ↓ in direct
producer payments ↑ reliance on producer risk management
LGM-Dairy: An Overview
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Demand for LGM-Dairy very high in 2011/12 insurance year Funds lasted only 2-months Industry is still in the learning curve Knowledge of limited funds caused many
producers to undertake a naïve and ill-advised 10-month, 100% coverage strategy
This resulted in few indemnities being paid in spite of a relatively bad year Due to entire contract performance determining
indemnity payments not individual months Limited activity this year (still funds
available)
LGM-Dairy: 2011/12 Post-Mortem
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We have a dedicated section to the University of Wisconsin Understanding Dairy Markets website devoted to LGM-Dairy: Understanding Dairy Markets website:
http://future.aae.wisc.edu LGM-Dairy website:
http://future.aae.wisc.edu/lgm_dairy.html LGM-Dairy Analyzer software system http://future.aae.wisc.edu/lgm_analyzer_new/
To join the LGM-Dairy Mailing List: http://future.aae.wisc.edu/lgm_dairy.html#5
LGM-Dairy: UW Website
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With extension of the 2008 Farm Bill to Sept. 30, 2013, deliberations for 2013 Farm Bill will start anew Dairy Production Margin Protection Plan
(DPMPP)
Below is a summary of the margin insurance program within the Bill approved by U.S. Senate in June 2012 Very surprised if the 2013 Farm Bill does
not have similar language
Farm Bill Margin Protection Program
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The DPMPP pays participating farmers an indemnity when 2-month national average IOFC falls
below insured level Insured margin can range from
$4-$8/cwt $4.00 protection level is 100%
subsidized for 80% historical prod. No payment or herd size limitation
If you sign up for DPMPP you must participate in supply management program
Farm Bill Margin Protection Program
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DPMPP Margin ≡ Milk Revenue – Feed Costs Ration: Corn, corn silage, SBM, alfalfa hay U.S. All-Milk Price used for revenue Feed costs: Fixed rations for 3 cow and heifer
types
U.S. avg. corn and alfalfa hay price received Monthly avg. Central Illinois SBM price
Farm Bill Margin Protection Program
Cow Type% of Herd
Cow Type% of Herd
Milking Cows 52.5Heifer: To calve
in 1 year 18.5
Hospital Cows 1.1 Heifer: 500 lbs + 9.6
Dry Cows 8.8 Heifer: < 500 lbs 9.6
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Annual administrative Fees
Annual Milk Marketings (Mil. Lbs)
Fee ($)Herd Size
with20,000 lb/cow
Marketings < 1 $100 < 50
1≤ Marketings < 5 $250 50-250
5≤ Marketings <10 $350 250-500
10≤ Marketings <40 $1,000 500-2,000
Marketings ≥40 $2,500 ≥ 2,000
Farm Bill Margin Protection Program
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Supplemental Program Producer can elect to cover a range of 25-
90% of historical production
Farm Bill Margin Protection Program
Coverage Level
($/cwt)
Premiums ($/cwt)
≤ 4 Mil. Lbs > 4 Mil. Lbs
$4.50 $0.010 $0.020
$5.00 $0.020 $0.040
$5.50 $0.035 $0.100
$6.00 $0.045 $0.150
$6.50 $0.090 $0.290
$7.00 $0.400 $0.620
$7.50 $0.600 $0.830
$8.00 $0.950 $1.060
2.00
3.25
4.50
5.75
7.00
8.25
9.50
10.75
12.00
13.25
14.50
Jan
Mar
May Ju
l
Sep
Nov Jan
Mar
May Ju
l
Sep
Nov Jan
Mar
May Ju
l
Sep
Nov Jan
Mar
May Ju
l
Sep
Nov Jan
Mar
May Ju
l
Sep
Nov Jan
Mar
May Ju
l
Sep
Nov Jan
Mar
May Ju
l
Sep
Nov Jan
Mar
May Ju
l
Sep
Nov
2005 2006 2007 2008 2009 2010 2011 2012
$/cw
t
Estimated U.S. Milk Income Over Feed Cost
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Revenue Risk in Today’s Dairy Industry
$4.00
$8.00
$6.00
Premiums ($/cwt)≤ 4 Mil. > 4 Mil.
$6.00 $0.045 $0.150
$8.00 $0.950 $1.060
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Brian W. GouldDepartment of Agricultural
and Applied EconomicsUniversity of Wisconsin-MadisonUniversity of Wisconsin Extension(608)[email protected]