LGM-Dairy: A Risk Management LGM-Dairy: A Risk Management ol for Small and Large Dairy Fa ol for Small and Large Dairy Fa Brian W. Gould Brian W. Gould Department of Agricultural and Department of Agricultural and Applied Economics Applied Economics Victor E. Cabrera Victor E. Cabrera Department of Dairy Science Department of Dairy Science University of Wisconsin-Madison University of Wisconsin-Madison University of Wisconsin Extension University of Wisconsin Extension June, 2011
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LGM-Dairy: A Risk Management Tool for Small and Large Dairy Farms Brian W. Gould Department of Agricultural and Applied Economics Victor E. Cabrera Department.
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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 ($/cwt)
Jan 70 - Dec 81
Jan 82 - Dec 87
Jan 88 - April 1995
May 95 - Dec 99
Jan 00 - Present
3
Price Risk in Today’s Dairy IndustryPrice Risk in Today’s Dairy Industry
We have seen a tremendous increase in the We have seen a tremendous increase in the volatility of farm milk prices over the last 20 yearsvolatility of farm milk prices over the last 20 years
Parity milk price support
Federal Order Reform
Use of BFP formula
Modern dairy-based futures and options
Modern dairy-based futures and options
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Price Risk in Today’s Dairy IndustryPrice Risk in Today’s Dairy Industry
2.5
4.0
5.5
7.0
8.5
10.0
11.5
13.0
14.5
U.S. Exports and Imports as a Percent of Total U.S. Milk Solids Production
Dairy Exports
Dairy Imports
% of Milk Solids
Source: U.S. Dairy Export Council
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Price Risk in Today’s Dairy IndustryPrice Risk in Today’s Dairy Industry
0.50
0.70
0.90
1.10
1.30
1.50
1.70
1.90
2.10
2.30
2.50
02 03 04 05 06 07 08 09 10 11
U.S. (NFDM)
Northern Europe
Oceania
Comparison of Internatonal and Domestic Milk Powder Prices$/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
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
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
LGM-Dairy: An OverviewLGM-Dairy: An Overview
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
LGM-Dairy: An OverviewLGM-Dairy: An Overview
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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
LGM-Dairy: An OverviewLGM-Dairy: An Overview
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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
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
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
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 $/cwt for all months
Higher deductible → Lower premiumHigher deductible → Lower premium Producer assumes more riskProducer assumes more risk
Subsidy Subsidy increasesincreases with higher deductible with higher deductibleDouble impact on reducing premium Double impact on reducing premium
LGM-Dairy: Current Premium Subsidy ScheduleLGM-Dairy: Current Premium Subsidy Schedule
Deductible ($/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
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
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
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
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
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