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Minnesota-Wisconsin Dairy Policy Conference Brian W. Gould

Livestock Gross Margin for Dairy Revenue Insurance: Recent Experience and Alternatives for Increased Adoption. Minnesota-Wisconsin Dairy Policy Conference Brian W. Gould Department of Agricultural and Applied Economics University of Wisconsin-Madison University of Wisconsin Extension

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Minnesota-Wisconsin Dairy Policy Conference Brian W. Gould

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  1. Livestock Gross Margin for Dairy Revenue Insurance: Recent Experience and Alternatives for Increased Adoption Minnesota-Wisconsin Dairy Policy Conference Brian W. Gould Department of Agricultural and Applied Economics University of Wisconsin-Madison University of Wisconsin Extension April 3, 2012

  2. Overview of Today’s Presentation • U.S. Dairy Industry Price and Margin Volatility • Use of LGM-Dairy as a Revenue Insurance Program • Program Overview • Recent History of Use by Dairy Farm Operators • Performance Under Alternative Market Conditions • Possible Program Changes to Increase Adoption • Subsidy Schedule • Coverage Limitations • Pilot Status 2

  3. Output Price Risk in Today’s Dairy Industry • We have seen a tremendous increase in the volatility of farm milk prices over the last 25 years BFP Pricing Federal Order Reform Parity milk price support

  4. Output Price Risk in Today’s Dairy Industry • The U.S. dairy industry is devoting more resources to international market development • Increased reliance → continued price volatility The past decade has seen more volatile dairy markets, driven by increasing global demand, tighter global supply and rising input prices. The forecast latent demand gap described above will likely lead to even more volatile markets… (U.S. Dairy Innovation Center, 2009)

  5. Output Price Risk in Today’s Dairy Industry % of Dairy Solids Dramatic Drop In Milk Prices Dairy Exports Dairy Imports

  6. Output Price Risk in Today’s Dairy Industry NFDM, Whey, Butter Cheese Milk Price Collapse

  7. Feed Cost Volatility and the Dairy Industry 16%, Peterson and DF65 Dairy Feed Ration Indexes (2005 = 1) Mar ʹ10 – Aug ʹ11 16% Ration: 76.0%↑ Peterson: 76.0%↑ DF65: 75.2%↑ 16% Dairy Ration= 51% corn, 8% soybeans and 41% alfalfa hay Peterson Ration =59% corn, 14% SBM and 27% alfalfa hay DF65= 44% corn, 5% SBM and 51% alfalfa hay 2005 Prices ($/cwt of milk) Peterson: $5.45 DF65: $3.57

  8. Feed Cost Volatility and the Dairy Industry % of Total Feed Costs from Purchased Feeds Differences reflect wide range in technologies used, scale of production and feed market risk Source: ERS Cost of Milk Production, 2012

  9. Dairy Margin Volatility Margin = All Milk Price – Feed Cost $ /CWT Milk August Margin Estimates 2007: $13.82 2008: $11.44 2009: $6.62 17.2%↓ 52.8%↓

  10. Dairy Margin Volatility Peterson Margin ($/cwt) $ /CWT Margin = All Milk Price – Feed Cost % of Months With Indemnity $4: 9.4% $6: 12.9% $8: 65.9% DSA$8 Target w/ $0.922/cwt revenue insurance premium, $7.078 net target DSA$6 Target w/ $0.155/cwt revenue insurance premium, $5.845 net target DSA $4 Target for 100% subsidized revenue insurance

  11. Dairy Revenue Risk Management • How can dairy producers establish a floor on their margin (i.e., Income over Feed Costs,IOFC) using existing tools? • One could use a Put/Call-based options strategy • Class III put options: Creates milk revenue floor • Feed call options: Establishes feed cost ceiling Milk revenue floor $/cwt • Could be very expensive • Thin Class III options market • Problem of option contract size • Class III − 200,000/100,000 lbs • Lack of continuous grain trading • Corn: 5 months • SBM: 8 months Minimum IOFC Feed cost ceiling 11

  12. DairyRevenue Risk Management $/cwt Announced Class III ↑, → Don’t use Class III Put Class III Put IOFC* IOFC IOFC*greater than IOFC Feed Calls Put Premium < Class III↑? $/cwt Class III Put IOFC IOFC* greater than IOFC IOFC* Feed Calls Call Costs < Feed Cost ↓? Feed Price ↓ → Don’t use Corn/SBM Calls 12

  13. LGM-Dairy: Introduction • Aug. 2008: Livestock Gross Margin Insurance for Dairy (LGM-Dairy) became available • Objective: Establish minimum IOFC • Similar to put/call options strategy except: • No options purchased • Nominimum size limit • Upper limit: 240,000 cwt over 10 mo./insurance yr • Premium not due until after11-month insurance period • Subsidized premiums • USDA-RMA administered and purchased from firms selling Federal crop insurance

  14. LGM-Dairy: Introduction • LGM-Dairy is an RMA pilot program as are all LGM products (i.e., swine, fed cattle, feeder cattle) • $20 mil. for all LGM products • Expenditures set by statute not administratively • 2010/11: $16 mil. in RMA LGM-Dairy expenditures • Premium subsidies and A&O payments • Funds used up with March 2011 offering • 2 hours: 318 contracts, 11.6 mil cwt insured

  15. LGM-Dairy: Introduction • 2011/12 LGM-Dairy funding • Started w/October contract offering (Oct. 28th) • $7 mil initial allotment • After 30 minutes, system crashed • 440 contracts • 19.3 mil cwt insured • > $6 mil in RMA commitments • Nov. 9th $6.2 mil. added to allowable commitment limit • Funds were exhausted with Nov. 18th contract offering

  16. LGM-Dairy: History of Adoption Note: There was no premium subsidy prior to Dec. 2010. Premiums shown are prior to subsidy.

  17. LGM-Dairy: 2010/11 & 2011/12 Activity Note: 2011/12 data as of Mar 9, 2012. No subsidy existed prior to Dec. 2010

  18. Net Premium Net Guaranteed Income Over Feed Cost ? Subsidy Guaranteed Income Over Feed Cost Insurance Payout Deductible Level Expected Income Over Feed Cost Actual Income Over Feed Cost Expected Milk Income Expected Feed Cost Actual Milk Income Actual Feed Cost Final CME SBM CME Class III CME Corn CME SBM Final CME Class III Final CME Corn Profile of % Coverage Over Contract Life Program Rules Contract Design Expected Milk Marketings Declared Feed Use Producer Data Program Outcome Market Data

  19. LGM-Dairy: An Overview • LGM-Dairy is customizable with respect to: • Number of months insured by 1 contract • 1 – 10 months • 12 contracts each year • Difference between insurance vs. contract period • % of monthly IOFC (marketings) insured • 0 – 100% of approved marketings • % coverage can vary across coverage month • Other farm specific insurance characteristics • Declared feed use: Only protect market-based risk? • Deductible and resulting premium subsidy • →Premium specific to farm’s contract

  20. LGM-Dairy: An Overview • Class III, corn, and soybean meal futures markets used as information source to determine Expected (forward looking) and Actual (final) prices • Nofutures market transactions • Actual farm prices not used • No basis added to prices: All prices at Chicago • Feed converted to Corn and SBM equivalents • Once LGM-Dairy purchased producer has established an IOFC floor for insured production 20

  21. LGM-Dairy: An Overview • Total Expected Gross Margin (TEGM) = Total contract Expected value of milk –Total contract Expectedfeed costs • = Sum of monthly (Expected milk prices x Insured milk) – Sum of monthly (Expected feed prices x Insured feed use) • 1 TEGM per contract regardless of months insured 21

  22. LGM-Dairy: An Overview • Total Actual Gross Margin (TAGM) = Total contract Actual milk value – Total contractActual insured feed cost • = Sum of monthly (Actual milk prices x Insured milk) – Sum of monthly (Actualfeed prices x Insured feed use) • 1 TAGM regardless of months insured 22

  23. LGM-Dairy: An Overview • Total Gross Margin Guarantee (TGMG) = • TEGM – (Deductible [$/cwt]x cwt insured) • Higher deductible → Lower premium • Producer assumes more risk • Subsidy increases with higher deductible • $0 deductible: 18% subsidy, $1.10 - $2.00 deductible: 50% subsidy • If TGMG >TAGM → Insurance indemnity paid • Payout amount = TGMG –TAGM • Again: Only 1 indemnity calculation per contractregardless of months insured 23

  24. LGM-Dairy: A WI Case Study • We use the Peterson ration for this analysis • 8 contracts: Jan 2005 – Jan 2012 contracts • March –Dec. covered months • Wisconsin average 2011 monthly yields • $0 deductible for LGM-Dairy • LGM-Dairy premiums do not include subsidies • $4.50 - $8.00 margins guarantees in $0.50 increments • Targets are net targets adjusted using formula: Original DSA Targets − DSA Premium • Control for All-Milk/Class III Basis • Month-specific basis calculated over 2000-Present 24

  25. LGM-Dairy: A WI Case Study • We use the University of Wisconsin LGM-Dairy Optimizer to find least cost design to generate required net margin • Only concerned with protection, not likelihood of receiving an indemnity • For low margin targets less than 100% of milk needs to be insured to achieve target • i.e., to achieve a $5.85/cwt target less than 50% of total production needs to be insured as $11.70/cwt margin achievable • Spread the $11.70 across all production to achieve $5.85 average 25

  26. LGM-Dairy: A WI Case Study 26

  27. LGM-Dairy: A WI Case Study • Premiums Under DSA and LGM-Dairy ($/cwt) * LGM vs. DSA Costs 2005 MF Ratio: 2.78 2009 MF Ratio: 1.40 *= DSA *= 2009 *= 2005 * * * * * * * * * * * * * * * * * * 27 Note: LGM-Dairy unsubsidized premiums are $/cwt of farm milk not just insured milk

  28. LGM-Dairy: Possible Program Changes • How can we increase participation? • I hypothesize the demand is there not the budget as evidenced by rapid sales when program is available • Most important would be to remove LGM-Dairy from pilot status to enable ↑ funding • Difficult to do as LGM-Dairy is privately owned and administered by the USDA • Owners may need to reduce significantly payments received 28

  29. LGM-Dairy: Possible Program Changes • Could eliminate/reduce premium subsidies • Even without subsidies insurance cost is low relative to options-based IOFC strategy • Agents received calls from producers willing to purchase w/o subsidy when funds exhausted 29

  30. LGM-Dairy: Possible Program Changes • Establish a two-tier premium system • Have both subsidized and unsubsidized premiums • After subsidized pool exhausted premiums not subsidized • 2012 Farm Bill could be used to increase the $20 million pilot funding while still a pilot • If nothing is changed fund will be exhausted with Oct. 2012 offering 30

  31. Contact Information • The Univ. of Wisconsin Dairy Marketing Website: http://future.aae.wisc.edu • Livestock Gross Margin Insurance: http://future.aae.wisc.edu/lgm_dairy.html • To join the LGM-Dairy Mailing List: http://future.aae.wisc.edu/lgm_dairy.html#5 • Brian W. Gould • (608)263-3212 • bwgould@wisc.edu

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