Livestock Gross Margin-Dairy

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

2. 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 minimumprice 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

3. 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

4. Dairy MarginRisk Management • Marginrisk 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 Milk revenue floor $/cwt Minimum IOFC Feed cost ceiling

5. Dairy MarginRisk Management • Revenue risk management establishes a floor on income over feed costs (IOFC). No margin calls, but pay an “insurance premium” • Class III put options: Creates milk revenue floor • Feed call options: Establishes feed cost ceiling • Bundled options strategy: you establish an IOFC floor Milk revenue floor $/cwt Minimum IOFC Feed cost ceiling

6. Dairy MarginRisk Management Does Not Limit Upside Milk Price Potential Announced Class III  Put option not exercised Class III Put Option $/cwt IOFCA IOFCA>IOFCM IOFCM Feed Call Options

7. Dairy MarginRisk Management Only out the cost of the insurance Does Not Limit Upside Milk Price Potential Announced Class III  Put option not exercised Class III Put Option $/cwt IOFCA IOFCA>IOFCM IOFCM Feed Call Options

8. Dairy MarginRisk Management Does Not Limit Downside Feed Price Potential Class III Put Option IOFCA>IOFCM IOFCM $/cwt IOFCA Feed Call Options Feed Price  Feed call options not exercised

9. Dairy MarginRisk Management Only out the cost of the insurance Does Not Limit Downside Feed Price Potential Class III Put Option IOFCA>IOFCM IOFCM $/cwt IOFCA Feed Call Options Feed Price  Feed call options not exercised

10. 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)

11. Overview of LGM-Dairy • 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

12. Overview of LGM-Dairy • 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

13. Overview of LGM-Dairy • LGM-Dairy premiums are subsidized • Premiums equal long run expected indemnity + 3% • Premium subsidy

14. Overview of LGM-Dairy GMG Gross Margin Guarantee AGM Actual Gross Margin IND Indemnity AGM Actual Gross Margin PREM Premium Cost EGM Expected Gross Margin DL Deductible Level EMR Expected Milk Revenue EFC Expected Feed Cost AMR Actual Milk Revenue AFC Actual Feed Cost CME Actual Class III Price Settlement CME Actual Feeds Costs Settlement ESC Expected SBM Cost EMP Expected Class III Price ECC Expected Corn Cost CME Class III Futures CME SBM Futures CME Corn Futures Policy Rules TM Target Marketings EFQ Expected Feed Quantity Exogenous Data Producer Data/Decision

15. Overview of LGM-Dairy • Expected Gross Margin (GM) = expected market value of milk minusexpected feed cost • Gross Margin Guarantee (GMG) = GM minusdeductible • One GMG (and GM) per contract • Evaluated over entire contract period

16. Overview of LGM-Dairy • Actual Gross Margin (AGM) = Actual market value of milk minusactual feed cost • One AGM per contract • Evaluated over entire contract period • Indemnity (payout) occurs if: AGMT < GMGT

17. Overview of LGM-Dairy • Class III, corn, and SBM futures markets used as information source to determine: • Expected prices • Actual prices • Importantly… • No actual farm prices are used • No futures market transactions • No local basis used to adjust prices

18. Overview of LGM-Dairy • 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

19. 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)

20. 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)

21. LGM-Dairy: Expected Gross Margin • All feed valued as if purchased even if homegrown • Feed prices: Corn (CME futures), SBM (CME futures) • Milk price: CME Class III futures • Standardized milk: 12.5% solids (3.5% fat, 3.1% protein, 5.9% OS) • Importantly: the gross margin guarantee (GMG) is for the entire contract period whether contract is for 1, 2, …9, or 10 months

22. 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!

23. LGM-Dairy: Coverage Calendar • Hypothetical insurance strategy: Purchase insurance at the end of March By rule: no coverage the month after purchase Contract Length: 1-10 months

24. LGM-Dairy: Coverage Calendar • 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

25. LGM-Dairy: Coverage Calendar Insurance sign-up period: ~27 hrs from 6:00 PM Friday till 9:00 PM Saturday (EDT) Futures market settlement prices on these 3 days determine expected prices Limited funds, first come, first served; sign-up early!

26. LGM-Dairy: Coverage Calendar • 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 deductibleLower premium • Producer assumes more risk • Subsidy increases with higher deductible

27. 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.

28. 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 AGMindemnity paid • Total refers to sum over all insured months in contract • Only 1 possible indemnity per contract

29. Determining Actual Prices and Gross Margin Settle prices used to calculate actual March corn/SBM prices Last March corn/SBM trading day Last March Class III trading day Settle prices used to calculate actual March Class III price

30. 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. • 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.

31. 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)

32. LGM-Dairy: Summary • LGM-Dairy is a flexible insurance program • Don’t have to insure all months or all production • May overlap contracts • Substantial premium subsidies & variable deductible • Similar to bundled options strategy using Class III puts and corn/SBM calls • Coverage amount much more flexible (no lumpiness) • Drawbacks • Short sign-up window at end of each month • Must wait for indemnity until end of last covered month; after last actual price is determined

33. LGM-Dairy: Example • Farm characteristics: • 500 milk cows w/25,200 lbs. milk sold per cow • Estimate premium costs for March 2011 contract • For simplicity assume 2,100 lbs/cow/month (2,100 x 0.85 x 500 = 8,925 lb. milk per month) • Expected monthly feed use • 170.4 tons corn eq.; 42.6 tons SBM eq.

34. LGM-Dairy: Example • Target marketings: May, July, August, September Only partial coverage for four months

35. LGM-Dairy: Example • Expected Gross Margin (GM) = expected market value of milk minusexpected feed cost • Gross Margin Guarantee (GMG) = GM minusdeductible • One GMG (and GM) per contract • Evaluated over entire contract period

36. 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 • Gross Margin Guarantee (GMG) = GM minusdeductible

37. LGM-Dairy: Example • Expected Gross Margin (May) = $47,888 • Gross Margin Guarantee (GMG) = GM minusdeductible • 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

38. LGM-Dairy: Example • One GMG (and GM) per contract • Evaluated over entire contract period

39. LGM-Dairy: Example • Actual Gross Margin (AGM) = actual market value of milk minusactual feed cost • 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 Same process used to calculate AGM’s for other months

40. LGM-Dairy: Example $23,593 • Indemnity =GMGT - AGMT = $171,007 - $152,878 = $18,129 • One GMG and one AGM per contract • Evaluated over entire contract period

41. LGM-Dairy: Example Calculating Feed Equivalents Understanding Dairy Markets (future.aae.wisc.edu) LGM-Dairy (tab) Supporting Software Spreadsheet-Based Grain/Concentrate/Forages Feed Conversion Program Save to your hard disk if you have Microsoft Excel

42. UW Feed Conversion Excel Spreadsheet

43. LGM-Dairy: Example Estimating Premiums Understanding Dairy Markets (future.aae.wisc.edu) LGM-Dairy (tab) Supporting Software LGM-Dairy Analyzer (V 2.0) Opens in your browser window

44. LGM-Dairy: Example

45. LGM-Dairy: Example Select program to use Use previously saved data Contract to analyze Deductible Method for entering feed

46. LGM-Dairy Analyzer (V 2.0) Only need to supply four pieces of information

47. LGM-Dairy Analyzer (V 2.0) Only need to supply four pieces of information Calculate LGM Premium

48. LGM-Dairy Analyzer (V 2.0)

49. LGM-Dairy Analyzer (V 2.0)

50. LGM-Dairy Analyzer (V 2.0)