LGM-Dairy: A New Risk Management Tool for California Dairies

Transcription

1 LGM-Dairy: A New Risk Management Tool for California Dairies Brian W. Gould Associate Professor Department of Agricultural and Applied Economics and University of Wisconsin Extension University of Wisconsin-Madison (bwgould@wisc.edu) August, 2010

2 Overview of Today s Presentation Provide a fundamental understanding of LGM-Dairy and its use as a risk management tool Review web-based decision tools developed at the University of Wisconsin-Madison LGM-Dairy Premium Estimator LGM-Dairy Least Cost software Comparison with the NMPF s Dairy Producer Margin Protection Program (DPMPP) 2

3 Dairy Price Risk Management How can dairy farmers control their milk price? Plant-sponsored fixed price contracts Similar to Class III short hedge used to lock in a milk price: No upside potential Plant-sponsored minimum price contracts Similar to a Class III put option purchase used to set milk price floor: Allows for higher price Traditional hedging and options strategies Many alternative strategies: lock in a Class III price, establish minimum Class III prices, etc. Contract lumpiness Margin calls with hedging 3

4 Dairy Revenue Risk Management How can a producer establish a floor on Income over Feed Costs (IOFC)? Class III put options: Creates milk revenue floor Feed call options: Establishes feed cost ceiling Using this bundled option strategy, producer can establish an IOFC floor $/cwt Milk revenue floor Minimum IOFC Feed cost ceiling 4

5 Dairy Revenue Risk Management $/cwt Announced Class III, Don t use Class III Put IOFC IOFC * IOFC * > IOFC Class III Put Feed Calls $/cwt Class III Put IOFC IOFC * IOFC * > IOFC Feed Calls Feed Price Don t use Corn/SBM Calls 5

6 LGM-Dairy: An Overview Livestock Gross Margin Insurance for Dairy (LGM- Dairy) Insurance policy used to set an IOFC floor First contracts offered in August 2008 Administered by USDA, Risk Management Agency and purchased from firms selling Federal crop insurance products Similar to use of bundled options except LGM-Dairy has no minimum size limit Upper limit of 240,000 cwt over 10 mo./fiscal yr. No actual futures market activity 6

7 LGM-Dairy: An Overview LGM-Dairy customizable with respect to: Number of months insured using 1 contract 1 10 months % of monthly IOFC (production) covered 0 100% of certified production each month % coverage can vary across months No direct subsidy of insurance premiums Premiums = long run expected indemnities + 3% Premiums specific to each producer s contract A&O payment to providers 20% of premium Paid by USDA indirect subsidy 7

8 LGM-Dairy: An Overview Gross Margin Guarantee (GMG) = Expected market value of milk Expected feed cost Declared Deductible 1 GMG per contract Evaluated over entire contract period Actual Gross Margin (AGM) = Actual Market Value Actual Feed Cost 1 AGM per contract Evaluated over entire contract period Gross Margin (GM) Indemnity (payout) occurs if AGM is less then GMG 8

9 LGM-Dairy: An Overview Class III, corn, and soybean meal futures markets used as information source to determine Expected and Actual prices Important: No futures market transactions associated with LGM-Dairy Actual farm prices not used Once LGM-Dairy purchased, the insured IOFC calculated using above prices can not be lower than the GMG 9

10 LGM-Dairy: When Purchased? LGM-Dairy available for purchase at end of each month and contract covers up to 10 months Purchase period starts at end of last business Friday of each month This month: July 30 th Purchase period ends at 8:00 PM CDT Saturday Total premium due at sign-up This could be significant Future changes may allow for multiple partial premium payments although not in 2011 IY 10

11 LGM-Dairy: Coverage Calendar Example of one possible insurance strategy Purchase insurance at end of August Possible Production Months Covered Aug 10 Sep 10 Oct 10 Nov 10 Dec 10 Jan 10 Feb 11 Mar 11 Apr 11 May 11 Jun 11 Jul Purchase at End of Month No Coverage Purchased Coverage Insurance Contract Period Feb 25% Mar 75% Apr 75% May 50% 11

12 LGM-Dairy: Expected Gross Margin Gross Margin (IOFC) = Total Value of Covered Milk Total Purchased Feed Costs Feed valued as if purchased regardless if home produced Feed prices: Corn (Chicago) SBM (Chicago) Milk price: Class III (assume std. milk) What if you have a Jersey herd with significant difference in milk quality vs. Class III std. milk? Expected Gross Margin (IOFC) for entire contract determined at sign-up whether contract is for 1,2,,9, or 10 months 12

13 LGM-Dairy: Expected Gross Margin All expected prices (i.e., milk, corn, and SBM) are known at sign-up Average last 3 trading days at the CME futures market including the sign-up Friday Futures market settle prices on these days used to estimate expected prices Sign-up period 13

14 LGM-Dairy: Expected Production and Declared Feed Use At sign-up, producer declares milk production and feed equivalents to insure Milk production needs to be certified Producer defines Expected feed use in terms of Corn (Energy) and SBM (Protein) equivalents Allowable declared feed equivalents: Corn: bu/cwt of milk SBM: lb/cwt of milk Program default feed coefficients can be used: Corn: 0.5 bu/cwt SBM: 4.0 lbs/cwt No auditing of declared feed use 14

15 LGM-Dairy: Insurance Deductible Producer chooses amount of gross margin not covered by insurance Insurance Deductible: Portion of IOFC not protected Program allows $0 - $1.50/cwt Gross Margin (IOFC) to be excluded from coverage Higher deductible Lower premium Producer assumes more risk 15

16 LGM-Dairy: Premium Price Calculation We have a dedicated section to the University of Wisconsin Understanding Dairy Markets website devoted to LGM-Dairy: Understanding Dairy Markets website: LGM-Dairy website: 16

17 LGM-Dairy: Premium Price Calculation Wisconsin s LGM-Dairy Premium Calculator Historical and Forward looking web-based premium calculator system Forward looking uses previous 3 days futures/options data to estimate next month s LGM-Dairy premiums Historical uses actual premium data after July 09 and simulated data prior to July 09 User supplies desired contract design 17

18 LGM-Dairy: Least-Cost Contract Design Wisconsin s LGM-Dairy Least-Cost Optimization webbased software system Differentiates between all farm vs. insured milk All farm need not be insured System used to identify least-cost contract design to achieve desired IOFC for all farm milk Similar to premium calculator can undertake Historical and Forward-Looking analyses When looking forward, premiums based on most recent 3 days of futures and options data 18

19 Determining Actual Prices Actual prices determined as futures contracts expire over insurance contract life Average futures contracts settle prices from 1 st, 2 nd, and 3 rd days prior to futures contract last trading day 19

20 Determining Actual Prices Settle prices used to calculate Actual Sept. Corn/SBM prices Last Corn/SBM trading day Settle prices used to calculate Actual Sept. Class III price Last Sept. Class III trading day 20

21 Determining Indemnities Actual Gross Margin (AGM) = Actual Revenue Actual Feed Costs Note no deductible Actual Indemnity If Total GMG > Total AGM Indemnity paid Total refers to sum over all insured months If Total AGM > Total GMG No indemnity Market conditions more favorable than existed at sign-up Higher Class III, lower feed prices or both 21

22 LGM-Dairy: Summary LGM-Dairy a flexible insurance program Need not insure all months or all production in covered months Could make sense to overlap contracts Similar to a combined use of Class III puts and corn/sbm calls Premiums are very sensitive to elected deductible LGM-Dairy Drawbacks Short sign-up window at the end of each month Total contract premium due at sign-up 22

23 NMPF s Revenue Insurance Program We have reviewed the LGM-Dairy Program Lets compare the above with recently proposed revenue insurance program authored by the National Milk Producers Federation (NMPF) Referred to as the Dairy Producer Margin Protection Program (DPMPP) With this review make sure you keep LGM- Dairy in mind Program description can be obtained from here: 23

24 NMPF s Revenue Insurance Program Following principles guided DPPMP development Cover losses caused by low milk prices/high feed costs Subsidize cost for basic protection level Flexible voluntary supplemental protection National program, open to all producers without payment limitations Provide protection for catastrophic conditions without generating incentives to over-produce Must be easily accessible 24

25 NMPF s Revenue Insurance Program Dairy Producer Margin Protection Program (DPMPP) Program objective is to control margin risk similar to LGM-Dairy Gross margin ($/cwt) defined as: All-Milk Price Feed Cost Feed Cost = Shell Corn Cost + Corn Silage Cost + SBM Cost + Forage Cost for a fixed ration Ration varies by type of cow: Milking, Dry and 3 types of replacement heifers 25

26 NMPF s Revenue Insurance Program 26

27 NMPF s Revenue Insurance Program DPMPP similar to LGM-Dairy Corn price based on average daily settlement prices for nearest contract month Soybean meal price based on average daily settlement prices for nearest contract month Alfalfa hay price based on data from USDA s monthly Agricultural Prices report 27

28 NMPF s Revenue Insurance Program 28

29 NMPF s Revenue Insurance Program How would the DPMPP work? For an overview refer to National Milk Producers Federation website ( Two complementary coverage levels Base Plan: No premium Supplemental Plan: Partial premium subsidy 90% of farms historical production eligible Highest milk production over the last 3 years New milk capacity not allowed to be covered Milk base not transferable to other farms 29

30 NMPF s Revenue Insurance Program DPMPP Base Program 5-year sign-up period after Farm Bill passage No producer payment or size limitations Federal program administered by the FSA or RMA of USDA Support provided independent of other risk management activities 30

31 NMPF s Revenue Insurance Program How would the Base Program work? Fixed margin determined annually CBO will use historical data to project future base margins Base program margin will be 50% of CBO projection ± $1/cwt depending on level Each month the USDA Will calculate monthly margin Calculate average margin for 3 month period and compare it to the base margin 31

32 NMPF s Revenue Insurance Program How would the Base Program work? USDA calculates actual margins monthly and pays indemnity quarterly In contrast, under LGM-Dairy indemnity based on entire contract gross margin and payments paid after last coverage month if required 32

33 NMPF s Revenue Insurance Program How would the Supplemental Program work? Optional additional margin insurance up to the yearly average CBO established margin Partially subsidized producer premium Supplemental margin above Base Program level is subject to producer control 90% of farms historical production eligible Producers have until the 3 rd month of the 2 nd year of the 2012 Farm Bill to sign up 33

34 NMPF s Revenue Insurance Program How would the Supplemental Program work? The higher the supplemental guarantee, the lower the percentage of premium subsidized Producer assumes a larger portion of premium payment for greater protection 34

35 LGM-Dairy/DPMPP Comparison Characteristic LGM-Dairy DPMPP Premium Subsidized? Farm Specific Feeding Ration Can be Used Milk Value Based On: Corn/SBM Value Based on Futures Settlement Prices Allowed to Vary Coverage Across Months Allow Alternative Deductible Levels No, Could be substantial Yes Class III futures Yes Yes Yes Base program yes, Supplemental sliding scale No, But fixed ration varies by livestock type U.S. Average All-Milk Price Yes No No: Base Program Yes: Supplemental 35

36 LGM-Dairy/DPMPP Comparison Characteristic Indemnity Determination Producer can set IOFC target Can new production be insured? Variable contract length LGM- Dairy At end of contract life Yes Yes Yes DPMPP Quarterly based on monthly evaluations No: Basic Program, 50% of CBO Projection Yes (Partially): Supplemental, Can purchase additional coverage No: Based on 90% of recent historical production No, must enroll for entier length of Farm Bill 36

37 Contact Information Univ. of Wisconsin Dairy Marketing Website: Livestock Gross Margin Insurance: To join the LGM-Dairy Mailing List: Brian W. Gould (608)