Livestock Gross Margin-Dairy Craig Thomas MSU-Extension Dairy Educator Sanilac, Huron, Tuscola, St. Clair, Lapeer, Genesee, Macomb, & Oakland Counties.

Livestock Gross Margin-Dairy

Craig ThomasMSU-Extension Dairy EducatorSanilac, Huron, Tuscola, St. Clair, Lapeer, Genesee, Macomb, & Oakland Counties

Dairy Price Risk Management

Coop-sponsored forward (fixed) price contracts: Similar to Class III short hedge: Locks in a price, no

upside potential, no daily margin requirements, flexible contract size, administrative cost

Coop-sponsored minimum price contracts: Similar to Class III put option: Establish a milk price

floor, retain upside potential, no margin requirements, flexible contract size, cost of insurance + administrative cost

Dairy Price Risk Management

Traditional hedging and options strategies: Broad range of alternative strategies: lock in a Class III

price, establish a minimum Class III price, etc.

Contract size “lumpiness” May be subject to margin calls & may need margin loc Puts/calls: cost of “insurance” may be quite high Requires established contract with a broker

Dairy Margin Risk Management

Margin risk management establishes a floor (minimum) on income over feed costs (IOFC). Class III put options: Creates milk revenue floor

Feed call options: Establishes feed cost ceiling

Bundled options strategy: you establish an IOFC floor

$/cw

t

Minimum IOFC

Milk revenue floor

Feed cost ceiling


Revenue risk management establishes a floor on income over feed costs (IOFC). Class III put options: Creates milk revenue floor

Feed call options: Establishes feed cost ceiling

Bundled options strategy: you establish an IOFC floor

$/cw

t

Minimum IOFC

Milk revenue floor

Feed cost ceiling

No margin calls, but pay an “insurance

premium”


$/cw

t

IOFCM

Class III Put Option

Feed Call Options

Does Not Limit Upside Milk Price Potential

Announced Class III Put option not

exercised

IOFCAIOFCA > IOFCM


$/cw

t

IOFCM


Feed Call Options

Does Not Limit Upside Milk Price Potential

Announced Class III Put option not

exercised

IOFCAIOFCA > IOFCM

Only out the cost of the insurance


Does Not Limit Downside Feed Price Potential

$/cw

t IOFCM


Feed Call Options

Feed Price Feed call options not

exercised

IOFCA

IOFCA > IOFCM


Does Not Limit Downside Feed Price Potential

$/cw

t IOFCM


Feed Call Options

Feed Price Feed call options not

exercised

IOFCA

IOFCA > IOFCM

Only out the cost of the insurance

Overview of LGM-Dairy

Livestock Gross Margin Insurance for Dairy (LGM-Dairy) Insurance policy to guarantee a minimum IOFC

Administered by USDA/RMA but purchased from firms selling Federal crop insurance

Crop insurance agents must be certified to sell LGM-Dairy and have ID number on file w/Federal Crop Insurance Corporation (see handout of approved agents)


Similar to bundled options (Class III put/feed calls) except: LGM-Dairy has no minimum size limit

LGM-Dairy upper limit of 240,000 cwt over any insurance period (10 months) or insurance year

No actual options market activity Cheaper than bundled options due to subsidized

premiums Premium not due until after contract matures


LGM-Dairy is customizable with respect to: Number of months insured w/one contract: 1-10 months

Farm specific in regards to milk production & feeding profiles (amounts & types of feeds)

Percentage of monthly IOFC (production) covered 0-100% of certified milk production each month

Percent coverage can vary across months


LGM-Dairy premiums are subsidized Premiums equal long run expected indemnity + 3%

Premium subsidyDeductible Subsidy Deductible Subsidy

($/cwt) (%) ($/cwt) (%)

$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%

GMGGross Margin Guarantee

AGMActual Gross Margin

EGMExpected Gross Margin

DLDeductible Level

EFCExpected Feed Cost

EMPExpected

Class IIIPrice

EMRExpected Milk Revenue

ECCExpected

Corn Cost

ESCExpected

SBM Cost

CMEClass IIIFutures

CMECorn

Futures

CMESBM

Futures

AGMActual Gross Margin

AFCActual Feed Cost

CMEActualClass III

PriceSettlement

AMRActual Milk Revenue

CMEActualFeedsCosts

Settlement

TMTarget Marketings

PREMPremium

Cost

EFQExpected Feed Quantity

INDIndemnity

Producer Data/Decision

Policy Rules

Exogenous Data



Expected Gross Margin (GM) = expected market value of milk minus expected feed cost

One GMG (and GM) per contract

Gross Margin Guarantee (GMG) = GM minus deductible

Evaluated over entire contract period


Actual Gross Margin (AGM) = Actual market value of milk minus actual feed cost

One AGM per contract

Indemnity (payout) occurs if:


AGMT < GMGT


Class III, corn, and SBM futures markets used as information source to determine: Expected prices

Importantly…

Actual prices

No actual farm prices are used No futures market transactions No local basis used to adjust prices


Once LGM-Dairy is purchased you have established an IOFC floor for the insured milk production

Determined using expected prices Feed usage based on corn & SBM equivalents (adjustable)

IOFC floor also adjusted by deductible selected

Overview of LGM-Dairy At sign-up producer declares milk production and

feed equivalents to be insured Must certify milk production when contract matures

Producer defines expected feed usage using corn (energy) and SBM (protein) equivalents Wide range for allowable declared feed equivalents

Corn: 0.13 – 1.36 bu/cwt of milk (7.28-76.2 lbs/cwt of milk) SBM: 1.61 – 26.00 lbs/cwt of milk

Program defaults (Corn, 0.5 bu/cwt; SBM, 4.0 lbs/cwt)

Overview of LGM-Dairy At sign-up producer declares milk production and

feed equivalents to be insured Must certify milk production when contract matures

Producer defines expected feed usage using corn (energy) and SBM (protein) equivalents Wide range for allowable declared feed equivalents

Corn: 0.13 – 1.36 bu/cwt of milk (7.28-76.2 lbs/cwt of milk) SBM: 1.61 – 26.00 lbs/cwt of milk

Program defaults (Corn, 0.5 bu/cwt; SBM, 4.0 lbs/cwt)

LGM-Dairy: Expected Gross Margin

All feed valued as if purchased even if homegrown Feed prices: Corn (CME futures), SBM (CME futures)

Importantly: the gross margin guarantee (GMG) is for the entire contract period whether contract is for 1, 2, …9, or 10 months

Milk price: CME Class III futures Standardized milk: 12.5% solids (3.5% fat, 3.1% protein, 5.9% OS)

LGM-Dairy: Purchasing

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

Each contract covers 1 to 10 months Purchase period starts at end of last business Friday of

each month (after numbers crunched ~6:00 PM EDT) Feb 25th, Mar 25th, Apr 29th, etc.

Purchase period ends at 9:00 EDT the next day (Saturday) ~27 hour sign-up window Work with your agent well ahead of time!

LGM-Dairy: Coverage Calendar

Hypothetical insurance strategy: Purchase insurance at the end of March

Contract Length: 1-10 monthsBy rule: no coverage the month after purchase

Mar '11 Apr '11 May '11 Jun '11 Jul '11 Aug '11 Sep '11 Oct '11 Nov '11 Dec '11 Jan '12 Feb '12

1 2 3 4 5 6 7 8 9 10

Purchase

at End of

Month

No

CoverageInsurance Contract Period

Production

Coverage

No

Coverage50% 0% 80% 40% 30% 0% 0% 0% 0% 0%


All 10 months of expected prices are known at sign-up

Expected milk, corn, and SBM prices are the average of last 3 days of futures settlement prices for each month/commodity including the sign-up Friday

MarchSunday Monday Tuesday Wednesday Thursday Friday Saturday

1 2 3 4 5

6 7 8 9 10 11 12

13 14 15 16 17 18 19

20 21 22 23 24 25 26

27 28 29 30 31


Futures market settlement prices on

these 3 days determine expected

prices

Insurance sign-up period:

~27 hrs from 6:00 PM Friday till 9:00 PM Saturday (EDT)

Limited funds, first come, first served; sign-up early!


Producer chooses amount of gross margin not covered by insurance (i.e., deductible) Portion of gross margin (GM) unprotected

Program allows $0 to $2.00/cwt deductible on GM

Higher deductibleLower premium

Producer assumes more risk

Subsidy increases with higher deductible

LGM-Dairy: Premium Subsidy

No subsidy for a 1-month contract. To receive subsidy must have target marketings in 2 or more months of an insurance period. The subsidy % is the percentage by which premium is reduced.

Deductible Subsidy Deductible Subsidy

($/cwt) (%) ($/cwt) (%)

$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%

Determining Actual Prices and Gross Margin

Actual prices determined as futures contracts expire over insurance contract period Actual price = Class III, corn & SBM average futures

settlement prices from 1st, 2nd, and 3rd days prior to futures contract last trading day

Actual gross margin (AGM) = Actual milk revenue – Actual feed

costs If total GMG > total AGMindemnity paid Total refers to sum over all insured months in contract Only 1 possible indemnity per contract

MarchSunday Monday Tuesday Wednesday Thursday Friday Saturday

1 2 3 4 5

6 7 8 9 10 11 12

13 14 15 16 17 18 19

20 21 22 23 24 25 26

27 28 29 30 31

Determining Actual Prices and Gross Margin

Last March corn/SBM trading day

Settle prices used to calculate actual March

corn/SBM prices

Last March Class III trading day

Settle prices used to calculate actual March

Class III price

Premium Billing/Indemnity Payment

Clarification of USDA Memo: PM-10-067 Assume contract purchased in March 2011 w/coverage

chosen for May, July, Aug, and Sep w/$5,500 total premium.Mar '11 Apr '11 May '11 Jun '11 Jul '11 Aug '11 Sep '11 Oct '11 Nov '11 Dec '11 Jan '12 Feb '12

1 2 3 4 5 6 7 8 9 10

Purchase

at End of

Month

No


Production

Coverage

No

Coverage50% 0% 80% 40% 30% 0% 0% 0% 0% 0%

Assume indemnity of $4,500.

Two options: 1) producer pays net due ($1,000) end of Sep, or 2) producer receives $1,000 indemnity ~late Oct and pays premium ($5,500) Mar 2012.

Premium Billing/Indemnity Payment

Must file a marketing report to receive indemnity Must submit a marketing report within 15 days of a notice of

probable loss

Marketing report must be supported by milk sales receipts showing evidence of actual marketings each month

In the event that the total of actual marketings are less than 75 percent of the total of targeted marketings for the insurance period, indemnities will be reduced by the percentage by which the total of actual marketings for the insurance period fell below the total of target marketings for the period.

No limits on milk production, but indemnities limited to covered milk (240,000 cwt max)

LGM-Dairy: Summary LGM-Dairy is a flexible insurance program

Don’t have to insure all months or all production

Similar to bundled options strategy using Class III puts and corn/SBM calls

Drawbacks Short sign-up window at end of each month

May overlap contracts Substantial premium subsidies & variable deductible

Coverage amount much more flexible (no lumpiness)

Must wait for indemnity until end of last covered month; after last actual price is determined

LGM-Dairy: Example

Farm characteristics:

Estimate premium costs for March 2011 contract

Expected monthly feed use

500 milk cows w/25,200 lbs. milk sold per cow

For simplicity assume 2,100 lbs/cow/month (2,100 x 0.85 x 500 = 8,925 lb. milk per month)

170.4 tons corn eq.; 42.6 tons SBM eq.

LGM-Dairy: Example

Target marketings: May, July, August, September

Mar '11 Apr '11 May '11 Jun '11 Jul '11 Aug '11 Sep '11 Oct '11 Nov '11 Dec '11 Jan '12 Feb '12

1 2 3 4 5 6 7 8 9 10

Purchase

at End of

Month

No


Production

Coverage

No

Coverage50% 0% 80% 40% 30% 0% 0% 0% 0% 0%

Only partial coverage for four

months

LGM-Dairy: Example

Expected Gross Margin (GM) = expected market value of milk minus expected feed cost

One GMG (and GM) per contract



LGM-Dairy: Example

Expected Gross Margin (May) = (8,925 cwts X $17.27/cwt X 50%) – .5*(170.4

tons corn X $7.08/bu + 42.6 tons SBM X $358.90/ton)


Expected Gross Margin (May) = $77,076 – $21,543 – $7,645

Expected Gross Margin (May) = $47,888

LGM-Dairy: Example


Expected Gross Margin (May) = $47,888

Gross Margin Guarantee (GMG) = $47,888 – (8,925 cwts X 50% X $1.00/cwt)

Gross Margin Guarantee (GMG) = $47,888 – $4,463

Gross Margin Guarantee (GMG) = $43,416

Same process used to calculate GMG’s for other months

LGM-Dairy: ExampleCoverage Gross Margin

Month Guarantees (GMG's)

May-11 $43,416

Jun-11 $0

Jul-11 $66,479

Aug-11 $34,356

Sep-11 $26,756

Oct-11 $0

Nov-11 $0

Dec-11 $0

Jan-12 $0

Feb-12 $0

Total $171,007

One GMG (and GM) per contract Evaluated over entire contract period

LGM-Dairy: Example

Actual Gross Margin (May) = (8,925 cwts X $16.64/cwt X 50%) – .5*(170.4 tons

corn X $7.35/bu + 42.6 tons SBM X $364.20/ton) Actual Gross Margin (May) = $74,264 – $22,365 –

$7,757 Actual Gross Margin (May) = $39,679

Actual Gross Margin (AGM) = actual market value of milk minus actual feed cost

Same process used to calculate AGM’s for other months

LGM-Dairy: Example

One GMG and one AGM per contract Evaluated over entire contract period

Coverage Gross Margin Actual GMG minus

Month Guarantees (GMG's) Gross Margins AMG

May-11 $43,416 $39,679 $3,737

Jun-11 $0

Jul-11 $66,479 $55,028 $11,451

Aug-11 $34,356 $25,951 $8,405

Sep-11 $26,756 $32,220 ($5,464)

Oct-11 $0

Nov-11 $0

Dec-11 $0

Jan-12 $0

Feb-12 $0

Total $171,007 $152,878 $18,129

Indemnity = GMGT - AGMT = $171,007 - $152,878 = $18,129

$23,593

LGM-Dairy: ExampleCalculating Feed Equivalents

Understanding Dairy Markets(future.aae.wisc.edu)

LGM-Dairy(tab)

SupportingSoftware

Spreadsheet-Based Grain/Concentrate/Forages Feed

Conversion Program

Save to your hard disk if you have Microsoft Excel

UWFeed Conversion

Excel Spreadsheet

Concentrate lb/cow/day tons/month1

Shelled corn 15.0 101.8

SBM 5.0 33.9

HMSC 8.0 54.3

Wet Distillers 3.0 20.4

WCS 4.0 27.1

1A 3% loss factor added to total.

LGM-Dairy: ExampleEstimating Premiums

Understanding Dairy Markets(future.aae.wisc.edu)

LGM-Dairy(tab)

SupportingSoftware

LGM-Dairy Analyzer (V 2.0)

Opens in your browser window

LGM-Dairy: Example

LGM-Dairy: Example

Select program to use

Use previously saved data

Contract to analyze

DeductibleMethod for entering

feed


Only need to supply four pieces of

information


Only need to supply four pieces of

information

Calculate LGM Premium





CalculateOptions

Cost

50% coverage; $1 deductibleLGM-Dairy Analyzer(V 2.0)

50% coverage; $1 deductibleLGM-Dairy Analyzer(V 2.0)

LGM Bundled

Item Dairy Options

Total Premium $5,604 $28,967

Premium/cwt

Covered Milk $0.31 $1.70

Difference $1.39

% Difference 543%

LGM-Dairy

LGM-Dairy is definitely worth every producers consideration regardless of farm size, production level, etc.

Find an LGM-Dairy agent and establish a relationship

Work with your LGM-Dairy agent well in advance of the sign-up period so if you do use LGM-Dairy you can get your application in early.

The LGM-Dairy program has limited funds, RMA recently increased LGM-Dairy funds, but still limited (first come, first served); get it while it’s hot!

Livestock Gross Margin-Dairy Craig Thomas MSU-Extension Dairy Educator Sanilac, Huron, Tuscola, St. Clair, Lapeer, Genesee, Macomb, & Oakland Counties.

Documents

minimum price contracts

fixed price contracts

forward contracts

dairy producers

upside price potential

margin calls

dairy marketing tools

milk price floor