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

University of Wisconsin([email protected])

National Extension Risk Management ConferenceApril 2, 2013

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Overview of Today’s Presentation

Overview of Price Volatility in the U.S. Dairy Industry

Use of Traditional Futures and Options for Price and Revenue Risk Management

Revenue Protection via Margin Insurance ProgramsLGM-DairyDairy Sub-Title Margin Insurance Proposal

What Does the Future Hold?

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6

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10

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22Class III/BFP/MW Prices ($/cwt)

Jan 70 - Dec 81

Jan 82 - Apr 95

May 95 - Dec 99

Jan 00 - Present

Support

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Price Risk in Today’s Dairy Industry

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

Parity milk price support

Federal Order Reform

Use of BFP formula

2.5

4.0

5.5

7.0

8.5

10.0

11.5

13.0

14.5

% o

f U

.S. T

otal

Mil

k S

olid

s

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

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Dairy Exports Dairy Imports

U.S. dairy industry is devoting more resources to the development of international markets

For some dry products like NFDM, Dry Whey, Lactose, etc., more than 50% of U.S. production is exported

Major drop in milk prices last half of 2008 and most of 2009 June 2008 Class III: $20.25/cwtFeb. 2009 Class III: $9.31/cwt

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0.50

0.70

0.90

1.10

1.30

1.50

1.70

1.90

2.10

2.30

2.50

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

$/lb

U.S. (NFDM)

Northern Europe

Oceania

Comparison of International and Domestic Powder Prices

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Correlation CoefficientOceania-U.S.: 0.939Europe-U.S.: 0.890Oceania-Europe: 0.964

Commodity prices have direct impact on domestic milk prices due to classified pricing

0.75

1.00

1.25

1.50

1.75

2.00

2.25

2.50

2.75

3.00

Ind

ex:

Jan

199

5 =

1.0

Average 16% Dairy Ration Cost Index

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Margin Risk in Today’s Dairy Industry

Composition (by wgt)Corn: 51%Soybeans: 8% Alfalfa Hay: 41%

Purchased feed costs represent a major portion of total operating costs for dairy farms ERS 2011 Estimates: CA: 59% WI: 34%

0.50

0.75

1.00

1.25

1.50

1.75

2.00

2.25

Ind

ex:

Jan

199

5 =

1.0

16% Ration vs. Class III Index Comparison

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Ratio > 1.0 → ration price has ↑ at a higher rate relative to Class III milk price using Jan. 95 base % of Months With Ratio >

11995-1999: 60.02000-2004: 46.72005-2009: 63.32010+: 100.0

$6.64

$14.65

$2.25

$9.97

$2.742.00

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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IOFC = Avg All-Milk Price – Avg Feed Costs(2012 Senate Farm Bill Feed Cost Formula Used)


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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%


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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


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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


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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


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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

July 10, 2000

Cash-Settle Butter 20,000 lbsCash Settle: NASS Butter

Sept. 19, 2005

Dry Whey 44,000 lbsCash Settle: NASS Dry Whey

March19, 2007

Nonfat Dry Milk 44,000 lbsCash Settle: NASS NFDM

Oct.10, 2008

Deliverable NFDM 44,000 lbs Physical Delivery April 20, 2009

International SMP 20 MT Physical Delivery May 10, 2010

Cheddar Cheese 20,000 lbsCash Settle: NASS Cheddar

June 21, 2010

Current CME Dairy-Based Futures/Options

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Current Futures and Options Open Interest

Contract Futures Options Contract Futures Options

Class III 23,417 67,040 Dry Whey 1,697 524

Class IV 1,580 1,905 NFDM 1,216 376

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

Butter 000 Lbs. 141,200 1,857,040 7.6Dry Whey 000 Lbs. 93,764 1,009,130 9.3

NFDM 000 Lbs. 3,509 1,781,110 0.2Cheddar 000 Lbs. 254,720 3,143,290 8.1

1Total U.S. milk production. Note: Data as of March 22, 2013. 729 Mid-Class III option contracts (100,000 lbs) are not included in the above

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Fixed Price Forward Contracting

Sell milk to processing (i.e., cheese) plant offering fixed price forward contract Processor undertakes a short hedge

Collects forward contract offers across producers Decrease contract offer to cover

hedging/administrative costs Manufacturer usually covers the margin calls Expanded use allowed via 2008 Farm Bill and

current 1 year extension

Bottling plants not allowed to offer forward contracts of any typeConcern as to the impact on pooling function

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Fixed price contract may be due to processor’s customer wanting long-term constant price e.g., McDonalds enters into a 2 year contract

with a cheese plant at a fixed cheese price

Plant offers a fixed price for a: Given month, quarter, year, etc. Converts fixed output price customer

commitment to equivalent milk price using assumed product yields

Contracted volume usually limited to some percentage of a farm’s production

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Cash settled against monthly USDA Announced class price, NASS commodity prices or Announced component values

Milk check adjusted by difference per cwt between contracted and Announced price. Announced less than contract price → milk

check ↑ by difference times contracted quantity Announced higher than contract price → milk

check ↓

Contracts available for Class III price, Class IV price, component value, blend price, PPD/blend price, etc.

Typical Fixed Price Contracts

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Alternative Types of Forward Contracts

$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

Fixed Price Contract

2008-12 Class III Avg. Price

Fixed Price

$14.50

$14.85

$15.20

$15.55

$15.90

$16.25

$16.60

$16.95

$17.30


$/cw

t

Fixed Price Contract with Upside Rider

Fixed Price

Upside Rider


$14.50

$14.85

$15.20

$15.55

$15.90

$16.25

$16.60

$16.95

$17.30


$/cw

t

Fixed Price Contract with Capped Rider

Fixed Price

Upside Floor

Upside Ceiling


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Minimum Price Contracting Purchase a minimum price contract from a

processing (i.e., cheese, yogurt, etc.) plantPlant collects minimum price contract offers

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


$/cw

t

Minimum/Maximum Contract

Minimum

Maximum


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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


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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?


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


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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


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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


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


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Supplemental Program Producer can elect to cover a range of 25-

90% of historical production


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

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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]

My Contact Information

Documents

1 Risk Management Practices by the U.S. Dairy Industry: Industry Complexities, Learning Curves and Producer Adoption Brian W. Gould Professor Department