Annual Report Price Risk Management: A California Dairy Perspective. *Pei Xu Todd Lone Patrick Berends

Transcription

1 Annual Report Price Risk Management: A California Dairy Perspective *Pei Xu Todd Lone Patrick Berends Department of Agricultural Business California State University Fresno * Corresponding author, pxu@csufresno.edu;

2 Background Dairy production is an important subsector in California s agricultural economy. In 2008 the dairy industry; 1) sent over 41 billion pounds of milk to the State s 117 dairy processing plants; 2) supported 443,574 jobs in the production, input and retail sectors; and 3) added $63 billion in economic activity to California(California Milk Advisory Board, 2010). However, California s dairy industry is faced with significant financial challenges and many of its producers are experiencing substantial financial hardship. Economic recessions, uncertain demand for dairy products, enhanced variability in milk prices, and skyrocketing feed costs have all contributed to the challenges facing California s dairy industry. The impact of these factors on the number of dairy farms is clear, 109 California dairies ceased operations in 2009 (representing 6% of the state s dairy herds) and 37 more announced bankruptcy in 2010 (CDFA, Dairy Marketing Branch, 2009; 2011). Uncertainty in milk price and feed costs are two major sources of financial risks borne by dairy producers (Valvekar et al. 2011). Starting in 2000, milk price variation became a common occurrence while government sponsored milk price supports fell below market clearing levels (Gould&Cabrera, 2011;Valvekar et al. 2011). On the cost side, compared to Midwest and Northeast dairy farming states, the impact of feed cost uncertainty is more significant for California dairies because California producers typically purchase more of their feed, while Midwest and Northeast producers grow more of their feed (Public Hearing Report, 2008). USDA cost of production data reveal that compared to 2007 levels, the cost paid by California dairy producers in 2008 for alfalfa hay and corn went up by 65% and 45%, respectively(sumner, 2008; Erba, 2008). Given milk represents more than 90% of a typical farm s dairy income and feed costs represent over 40% of its variable costs of 2

3 production (ERS, 2009; Ishler et al., 2009), the ability to lock in a higher milk price or a lower feed cost through futures and options contracts could be crucial for farm success. Recently, the California Center for Cooperative Development conducted a USDA funded project which analyzed the recent dairy crisis and proposed six management strategies individual dairy farmers could practice to improve farm-level economic returns (Ellerby, 2010). Among these six strategies, the ability to manage price risk was listed as a critical skill that all California dairy managers should have in order to remain profitable. However, to many California dairy producers, futures and options trading is a concept that they know little about. Futures and options contracts for dairy products currently available at the Chicago Mercantile Exchange (CME) include class III (cheese) and class IV milk (dry milk), and since May 2010, the trading of skim milk powder has been available (Jesse and Cropp, 2009). These futures contracts trade across all twelve months, with the class III milk futures trading unit specified as 200,000 pounds per contract (CME 2010). It is recommended that if a producer hedges their milk price, he/she should hedge feed cost to reduce its variability as well. Besides futures and options contracts, a federal reinsured financial instrument called the Livestock Gross Margin Insurance for Dairy Cattle (LGM-Dairy) program has been available to dairy farmers in the lower 48 States since 2008 (Valvekar at el. 2010). This program allows dairy farmers to establish a milk price floor in advance of milk sales, helping to offset unanticipated variability in feed costs. Compared to futures option contracts which require a premium payment at the time of contracting and have a high margin call, the LGM- Dairy contract: 1) allows delayed premium payment; 2) does not require a margin call 3

4 payment; and 3) provides significant premium subsidies to all adopting dairy producers (Gould&Cabrera, 2011). Recent studies about dairy producers adoption of price risk management instruments focused on Wisconsin dairy producers (Gould and Cabrera, 2011; Valvekar et al. 2010; Valvekar et al. 2011). Valvekar et al. identified the lowest cost price insurance contract for targeted income over feed cost under the LGM-Dairy program for a typical 120-cow Wisconsin dairy producer in Gould and Cabrera (2011) found the optimal producer paid premium to obtain targeted gross revenue for a 150-cow farm in Wisconsin and that with $1.1 deductible the net premium was $6,445 or $0.30/cwt of covered milk. However, the results of these studies cannot be applied to highly concentrated California dairies that typically average 800 cows (Western United Dairymen, 2010). Despite the availability of price risk management instruments, not many California dairy producers have reported using them. Time constraints and complexity of the price risk management mechanism are the two main reasons given for the lack of utilization (Ellerby, 2010). Indeed, many producers are worried about being locked into low milk prices due to their unfamiliarity with futures and options trading. However, many agricultural lenders require dairy producers to use price risk management as a covenant in the loan documents to protect their investments. Therefore, without actively using futures and options contracts to help minimize price risks, dairy producers may face increased difficulties securing financial support from their lenders. California is the largest dairy producer in the United States, accounting for 18.9% of the nation s total products sales. Its producers adoption of price risk management instruments remains low despite ongoing efforts of the USDA s dairy assistance programs to 4

5 involve California dairy farmers in price risk management strategies. From 1999 to 2002, the USDA s Risk Management Agency administered a Dairy Options Pilot Program which offered various seminars to inform dairy producers about futures and options trading. Unfortunately, the agency did not publish the results of interviews from California producers regarding feedback about the seminars. A summary of interviews with market administrators in eleven regions, including California, was published but these results cannot be used to explain a typical California dairy farm s engagement in price risk management activities (California Department of Food and Agriculture, 2002). Since 2002, no further academic research on the topic was published. This ARI seed grant funded study aims to: 1. understand the farm level costs associated with price risk management strategies; 2. understand the factors affecting California dairy farmers use of price/cost risk management tools; 3. determine producers opinions towards the effectiveness of these tools; 4. identify the barriers and the motivations to adopt price risk management tools; and 5. determine what is needed to improve CA dairy farmers involvement in effective price/cost risk management strategies. Methods Milk price risk has been pervasive in California s dairy markets. Participating in futures trading is one effective way to minimize price risk and improve farm revenues, and this linkage is well established by numerous agricultural economics studies (Berck 1981; Miller & Kahl, 1981; Goodwin & Schroeder 1994; Mishra & Goodwin, 2006; Gould and Cabrera, 2011; Valvekar et al. 2010; Valvekar et al. 2011). To gather data and analyze 5

6 California dairy producers participation in futures trading, face-to-face interviews were administered during the Western United Dairymen s 2013 annual conference held from March 27 to 29 in Sacramento, CA. The organization represents more than 60% of the milk produced in California and has been providing annual price risk management seminars to California dairy producers since The risk management educational sessions are often made available during each spring s annual conference. One of the researchers has built a strong connection with Western United Dairymen and was able to obtain their support for administering a survey during the annual conference. The organization provided us with booth space at the entrance to the main convention floor that enabled us to display information regarding the survey's purpose, plus sponsorship banners and paraphernalia for Fresno State, the Department of Agricultural Business, and the Center of Agricultural Business. Thirty-two dairy farmers out of a total of 135 that attended the conference (a 24% response rate) completed the survey. Discussions with the dairymen as they were completing the survey revealed that many did not utilize the risk management tools of interest, primarily due to a lack of knowledge about them. The few that did use the tools were enthusiastic about their use and were very willing to share their experiences. In addition, a common comment with regard to the survey was that some of the classifications were too broad or too narrow and they felt more stratification would be useful in determining the choices. The dairy farmers were very supportive of college education workshops in general and mentioned strong support for not only Fresno State, but also UC-Davis and Cal Poly, San Luis Obispo's Colleges of Agriculture. The user questionnaire was 10 pages in length and contained 48 questions regarding: 1) general farm business information; 2) dairy farmers use of price and cost risk management 6

7 tools; and 3) barriers and motivations to adopt price risk management strategies. A shorter version comprised of 14 of the 48 questions in the full questionnaire was used to interview non-users of price risk management instruments. This version asked questions about general farm business information; the reasons for not using risk management tools; and what help would be needed to get started using risk management tools. A copy of the questionnaires is provided in the end of this report. Results Farm Business Information Participating dairy farms business information is shown in Figures 1 through 6. Analysis results indicate approximately 23% of the dairy farms have been in family ownership for at least 8-25 years and 47% of the respondents stated that the family has owned the farm for more than 41 years. All participating dairy managers reported at least 12 years of management experience in dairy farming, with 47% of them reporting more than 36 years of experience. The sample included smaller dairy farms of 500 cows or less (25%), mid-sized dairies of cows (50%), and larger dairies with more than 1500 cows (25%). Over two thirds of the participating dairy farms hired at least six full time workers (72%) and 48% of them hired at least one part time worker. In terms of land ownership, 31% of the farms were 200 acres or less; 35% owned acres and the remaining 33% owned at least 500 acres. 7

8 Years farm in family ownership (Count: n=32) 25% 22% 22% 31% 8-25 years years or more Years of management experience in dairy farming (count: n=32) 25% 22% 22% 31% years Total number of cows (count: n=32) Number of full- me workers (count: n=32) 16% 31% 9% 25% 19% 500 or below or more 19% 13% 28% % Number of part- me workers (count: n=25) Acres owned in 2013 (count: n=32) 20% 4% 4% % 31% 200 acres or below % % % 5 19% 16% 1001 or more Figures 1-6: Participating Dairy Farms General Business Information Farm managers profile information is presented in Table 1. The number of family members supported by the dairy appeared to be relatively small, with 42% of them comprised of only 1-3 family members and about one third of them comprised of six to seven family members. Sixteen percent of the managers were 35 years of age or younger, 28% were years old and 16% of the managers were 65 years and over. Thirty-eight percent of the managers have never attended a college, 42% of them have attended or graduated from 8

9 a two-year college and the remaining 20% have attended or graduated from a four-year college. Table 1: Farm Managers Profile (Sample Size = 32) Count Percentage Number of family members: % % 7 and over 10 32% Total % Owner's age: under 35 years 5 16% % % % 65 and over 5 16% Total % Highest level of education: Attended high school 2 6% High school graduate 10 32% Some 2-year college experience 6 19% Graduate of 2-year College or technical school 7 23% Some 4-year college 3 10% College graduate 3 10% Total % Most of the participating dairy managers were members of a dairy cooperative (84%) (Figure 7). The surveyed managers also held leadership positions in local (72%), state (66%) and regional (28%) dairy organizations (Figure 8). Dairy ownership structure was approximately evenly split between partnerships and sole proprietorships, with very few structured as a corporation, cooperative or a limited liability company (Figure 9). 9

10 Member of a dairy coopera ve (count: n=32) 16% Yes No 84% Leadership in dairy organiza ons (count: n=32) 15% 13% 38% Local State Regional Na onal 34% Ownership classific a (count: n=32) on 3% 3% 13% 42% 39% Sole proprietorship Partnership LLC Coopera ve Corpora on Figures: 7-9: Leadership Positions and Ownership Classification The Use of Price and Cost Risk Management Tools Of the 32 responses, 13 represented existing users of risk management tools and 19 were non-users. Responses from those using management tools to reduce milk price risks are shown in Table 2. Participation in forward contracts, futures contracts and the Livestock 10

11 Gross Margin (LGM) Insurance was low. A total of 8 farms were involved in risk management activities to reduce milk price risks: five have used futures contracts; two have used forward contracts; and only one had used LGM insurance. Some users of risk management tools had started using the tool before Futures contracts were used to cover 25-50% of the farm s milk; forward contracts were used to cover 20-30% and the LGM insurance was used to cover 5% of their milk. Forward contracts were found to be the most costly type of risk management tool, with estimates reaching more than $4,000 per year. The federal reinsured financial instrument of the insurance program had a cost of less than $500 per year. The cost of the futures contracts varied from less than $500 to more than $4,000/year, depending on the level of price risk protection. The time needed to manage each of the management tools differed: the insurance program required less than an hour per week; forward contracts required 1-3 hours per week; and futures contracts varied from less than an hour per week to 1-3 hours per week. The more expensive forward contracts resulted in profits of $4,000 per year while the less expensive insurance program brought in a smaller profit of less than $500 per year. The profit from futures contracts varied from $500 - $3,000 per year but the two managers who started in 2011 had lost more than $3,000 per year. Participants of risk management activities believed that forward contracts, futures contracts and the insurance programs were useful risk management tools. Table 2: The Use of Management Tools to Reduce Milk Price Risks Forward Contracts Futures Contracts Gross Margin Insurance Number of farmers using the tool 2 out of 13 5 out of 13 1 out of 13 11

12 Year farmer started using the tool One farmer started before 2009; one in 2010 Varies from before 2009 to 2010 and Started before 2009 Percentage of milk covered by tool 20-30% 25%-50% 5% Amount spent to purchase contracts More than $4,000/year Varies from less than $500/year to more than $4,000/year Less than $500/year Time spent managing the account 1-3 hours/week Varies from less than an hour per week to 1-3 hours/week. Less than 1 hour/week Profit made More than $4,000 One farmer started in 2010 made $500 profit and one started before 2009 made $3,000 per year. Two started in 2011 lost more than $3,000/year. Less than $500/year Consider an efficient risk management tool Both farmers agreed forward contracts are useful. All users agreed that futures contracts are useful. Agreed that gross margin insurance is useful. All 13 managers citing experience using risk management tools had used forward contracts to reduce feed cost risks; 12 of them started before 2009 and one started in 2010 (Table 3). Forward contracts were used to cover % of their feed, depending on the operation, with an average of 43% of the feed for all operations covered by forward contracts. Though seven of the respondents did not indicate the amount spent to purchase forward contracts, four of them mentioned that they had spent more than $4,000 per year; one spent between $1,000 and $1,999 per year; and another spent one less than $500 per year. The time spent managing the forward contracts account was small, with most respondents indicating they spent 1-3 hours per week or less. Respondents believed forward contracts were very useful to reduce their feed cost risks; eight of them said that it saved them more than $4,000 per year and one reported savings of $2,000-2,999 per year. 12

13 Five of the 13 respondents had used futures contracts to reduce feed costs risks; four of them started before 2009 and one started in Futures contracts were used to cover % of the feed costs, depending on the operation, with an average coverage rate of 43%. Three of the users spent more than $4,000 per year and one spent less than $500 per year on futures contracts. Managers reported spending about 4-6 hours per week managing their accounts. In addition, users indicated that futures contracts made them more than $4,000 profit per year and felt it was a useful risk management tools to reduce feed cost risks. Only one dairy farm manager had used the federal reinsured LGM insurance program to reduce feed cost risks. This dairy farm started using the insurance in 2011 and covered 10% of its feed. The manager spent less than $500 per year on the program and used about 1-3 hours per week managing the account. The profitability of using this tool ranged from $ per year. The manager believed that the insurance was useful tool for reducing feed cost risks. Table 3: The Use of Management Tools to Reduce Feed Costs Risks Forward Contracts Futures Contracts Gross margin insurance Number of farmers using the tool All 13 users 5 out of 13 1 out of 13 Year farmer started using the tool 12 started before 2009, one in Four started before 2009 and one in Started in 2011 Percentage of feed covered by the tool Amount spent to purchase contracts Ranges from 20% to 100% with an average of 43%. Four spent more than $4,000. One spent between $1,000 and $1,999 and one less than $500 per year. The rest of them did not answer. Varies between 15% and 100% with an average of 43% Three spent more than $4,000/year and one less than $500/year 10% Spent less than $500/year. Time spent managing Most spent 1-3 Spent about 4-6 hours/week 1-3 hours/week 13

14 the account hours/week or less Profit made Consider an efficient risk management tool Eight saved more than $4,000, and one saved $2,000-2,999/year. All agreed it is a useful tool with four of them strongly agreed. Made more than $4,000/year All five agreed it is a useful tool $ /year Agreed it is a useful tool Barriers and Motivations to Adopt Price Risk Management Ten of the thirteen existing users of risk management activities provided explanations about why they decided to adopt the available tools (see Table 4). Four of the respondents used the tools to help manage input cost risks and three of those respondents also used the tools to maintain a price over cost margin. One respondent used futures contracts in the past but, after substantial losses on futures positions, he/she had discontinued the pursuit. This respondent felt that margin management/authentic software that helps hold positions and calculate gains/losses would be useful. Other respondents requested educational programs to better understand each of the risk management tools. Table 4: Reasons to adopt and help needed to improve adoption Response Number If you have used milk price or feed cost price risk management tools, please help us understand why you decided to use these tools. 1 Up till now we have only forward contracted certain feeds, but we are educating ourselves on the futures market What additional help would you require in order to improve your involvement with price risk management tools? More education 2 Attempting to save money Seminars, other education 3 To help manage my input costs and maintain a margin 4 To set some of my costs a manageable price, but still put myself at risk because I did not tab up output figures 14

15 5 Hope to lock in a favorable price, when the potential for this commodity seems to increase in the near future. 6 Had ideas and hope we could hedge to save money, but after substantial loss on futures positions we have stayed away 7 Protected my bottom line on 20-30% of my income/cost 8 My pockets are not large enough to Margin management/authentic software that helps hold/calculate positions on the market Education survive the downturns in the market 9 To prevent volatility in manage margins Need to understand "basics" better for feed and milk 10 To cover risks Table 5 contains the reasons why eighteen of the nineteen non-users did not use risk management tools. Nine respondents stated it was because they did not understand the concept of risk management well. For example, one respondent said risk management has not been explained in a layman s language. A similar sentiment was expressed by two other respondents. In addition, one of the respondents indicated they had used risk management activities in the past but stopped due to their limited knowledge and skills using the tools. Two respondents felt they did not need additional risk management protection due to their involvement with other risk reduction activities such as marketing show cattle and the milk pool quota. One respondent said they would not participate because fellow dairymen who had tried risk management indicated they had all lost money doing it. However, most respondents requested educational programs to help them better understand the programs. Table 5: Reasons not to adopt and help needed to Use Risk Management What help would you require in Number Please help us understand why you not to use risk management tools. order to get you started using price risk management tools? 1 Looked at it doesn t pencil out Understanding them better 2 I don't understand the risk and what would it cost. 15

16 3 Stop shortly after starting using futures contracts due to unleveled skills playing with the processor 4 I do not trust them yet. I would need to meet someone I could trust. 5 California pricing is different than CMI Not sure 6 I feel you will lose more than gain. More education on subject. 7 Small registered herd provides extra income by showing at fairs and marketing show cattle. 8 I have taken a few classes on it but it is still complicated and it takes an investment that we do not have at the moment. Not too many people want to lose the upside for a small margin lock especially when there are such high & lows that we need to capture as much highs to make up for the losses. If we could get our equity back maybe we would start locking in margins. 9 The education to use of risk management 10 Did not understand enough Ambition to attend classes Grow 50% of my feed, invest in pool 11 quota now at 90-95% of production 12 Risk management has not been explained in a layman s language. Better information at an easier language 13 There is still risk 14 From fellow dairymen who have tried risk management, overall all lost money doing it. 15 Never thought about it Someone to work with 16 Explain it to us Do not understand and no experience Explained in layman terms 17 involved 18 Do not understand well. Tutoring Future Research Suggestions Identify three producer scenarios to analyze the net benefits of using futures contracts and LGM insurance. Possible scenarios include: one small (<500 cows); one midsized (about 1600 cows); and one large dairy (over 3,000 cows). 16

17 Develop a website with resources to educate dairy farmers on the use of futures, options and the LGM-insurance program. Conduct a series of workshops related to forming risk management strategies that utilize futures, options and the LGM-insurance program. References Baumgart-Getz, A., Prokopy, L.S., Floress, K. (2012) Why Farmers Adopt Best Management Practice in the United States: A Meta-analysis of the Adoption Literature. Journal of Environmental Management, 96:17-25 Berck, P. (1981) Portfolio Theory and the Demand for Futures: The Case of California Cotton. American Journal of Agricultural Economics, 63(August): California Department of Food and Agriculture, Report to the Senate Committee on Agriculture and Water Resources and the Assembly Committee on Agriculture: Dairy Marketing Study. Washington: GPO, April Online. Available: California Department of Food and Agriculture, Dairy Information Bulletin Cover Pages. Available: January 31, California Milk Advisory Board, (2010) New Study: California Dairy Industry Responsible for More than 443,000 Jobs Three Percent of State s Job Production, Online, Available: (January 2012). Davis, T. D., Patrick, G.F., Coble, K.H., Knight, T.O., & Baquet, A. E. (2005) Forward Pricing Behavior of Corn and Soybean Producers. Journal of Agricultural and Applied Economics. 37(1): Ellerby, J. (2010) Challenges and Opportunities for California s Dairy Economy, California Center for Cooperative Development. Online. Available: Erba, E. M. (2008) Dairy Situation and Outlook Proceedings, 2008 California Alfalfa & Forage Symposium and Western Seed Conference, San Diego, CA, December, Garrett, P., & Schulman, M.D. (1984) Division of Labor and Decision Making among Smallholders: A Male/Female Comparison. Paper presented at the Annual Meetings of the Rural Sociology Society, College Station, Texas. 17

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