Adoption of Revenue Risk Management and Why Knowing Your Income Over Feed Cost is Important

1. Adoption of Revenue Risk Management and Why Knowing Your Income Over Feed Cost is Important Brian W. Gould Department of Agricultural and Applied Economics University of Wisconsin-Madison University of Wisconsin Extension October 4, 2013

2. Today’s Presentation • Overview of Income Over Feed Cost (IOFC) trends • Some examples of relatively simple margin risk management strategies • What does using these strategies mean with respect to your own operation

3. Monthly Mailbox Price: CA and UMW % Change in Mailbox Prices UMWCA Nov ʹ07–Jul ʹ09 −47.3 −53.4 Jul ʹ09– Aug ʹ11 98.0 106.8 Correlation Coefficient = 0.96

4. Dairy Security Act Feed Costs Apr ʹ10 – Aug ʹ12: 105.9%↑ DSA Ration (Per cwt of Milk) Weight: 102.2 lbs 59% Corn 14% SBM 27% Alfalfa Hay DSA = Dairy Security Act

5. Dairy Margin Volatility Margin = FMMO Mailbox Price – DSA Ration Cost FMMO = Federal Milk Marketing Orders

6. How Would You Characterize the Degree of Your Margin Risk? Actual IOFC Expected IOFC Risk Sum to 100% Probability Probability Probability Probability Probability of 5% of 15% of 60% of 15% of 5% Potential IOFC Range #4 Potential IOFC Range #2 Potential IOFC Range #5 Potential IOFC Range #3 Potential IOFC Range #1 $7 − $9/cwt $3 − $5/cwt $5 − $7/cwt < $3/cwt > $9/cwt All Possible Outcomes

7. How Would You Characterize the Degree of Your Margin Risk? • Marginrisk exists if there are • Alternative IOFC outcomes • Unsure as to which outcome will actually occur • Margin risk increases the more you don’t know about: • Potential outcomes (i.e., alternative IOFC levels) • Outcome probability (i.e., likelihood of an IOFC range occurring) • Implications of each outcome on farm profitability

8. WRT Your Farm’s IOFC Do You Know: • The range of IOFC’s you’ve achieved over the last 5, 10, 15 or 20 years? • These are the potential IOFC outcomes • The proportion of months a particular IOFC range have occurred since 2000? • IOFC ($/cwt): $4, $6, $8 • Can use to provide an estimate of event probability • Implications of alternative IOFC’s on sustainability? • What are your non-feed costs of production? • What are your fixed versus variable costs of production?

9. How Would You Characterize the Degree of Your Margin Risk? Average Std.Dev. ($/cwt) FMMO 15.04 2.99 UMW 15.07 3.06 CA 13.77 2.68 29.9% Probability that CA Mailbox ≥ $15/cwt 44.8% Probability that UMW Mailbox ≥ $15/cwt

10. How Would You Characterize the Degree of Your Margin Risk? DSARation (Per cwt of Milk) Weight: 102.2 lbs 59% Corn 14% SBM 27% Alfalfa Hay 20.2% Probability that Ration Cost is ≥ $12/cwt

11. How Would You Characterize the Degree of Your Margin Risk? 30.8% Probability that IOFC is ≥ $9/cwt

12. Objectives of Margin Risk Management

13. What is Margin Risk Management? • If you purchase worker’s compensation insurance for your employees, do you hope that you have to use it? • Assures your asset base is protected if an accident should occur • Example of risk management • There is a cost for this protection • What are you willing to pay to avoid major financial hit? • Analogous to undertaking financial risk management efforts

14. What is Margin Risk Management? • Margin Risk Management Principle: By undertaking a management strategy one can increase the probability of achieving a desired margin outcome where: • Desired outcome needs to be realistic • Outcome target needs to account for current market conditions • What can one actually achieve given market?

15. What is Margin Risk Management? • Margin risk management is like any other input with both cash and opportunity costs • ↓risk may involve either reduced returns or range of returns: Risk-Return Tradeoff • What tradeoff level is acceptable to you? • Associated tradeoffs vary across strategy: • Objective #1: Set a fixed IOFC → can’t take advantage of higher milk price/lower feed costs without incurring additional costs • Objective #2: Establish an IOFC floor → Can take advantage of higher IOFC’s either due to higher milk prices and/or lower feed costs without additional costs

16. Examples of Margin Risk Management • With current mechanisms how can a producer manage his/her margin risk? • Strategy #1: Use forward price contracts for milk and feed → fixed IOFC • → IOFC will stay at IOFC* regardless of market prices • Does IOFC* cover non-feed production costs? $/cwt milk Fixed Milk Price IOFC* Fixed Feed Cost Milk/Feed Prices

17. Examples of Margin Risk Management • Strategy #2: Forward milk price contract and feed call options → IOFC floor • Purchasing a CALL option conveys the right, but not the obligation,to purchasea futures contract at a given price • Option price (i.e., the premium) depends on: • Option’s strikeprice relative to current futures price (+) • Time to expiration (+) • Futures price volatility (+)

18. Examples of Margin Risk Management • Strategy #2: Forward milk price contract and feed call options → IOFC floor • → IOFC will able to be increased when feed price goes below $C* by exercising call $/cwt Milk Fixed Milk Price IOFC* IOFC** $C Feed Call Milk/Feed Prices C*

19. Examples of Margin Risk Management • Strategy #3: Class III put options and forward feed price contract → IOFC Floor • Purchasing a PUT option conveys the right – but not the obligation – to SELL a futures contract at a given price • → Results in you receiving a net milk price at a future date at the option’s strike price net your costs

20. Examples of Margin Risk Management • Strategy #3: Class III put options andfixed forward feed price contract → IOFC Floor • → IOFC will able to be increased with Announced Class III price more than $P $/cwt Milk Class III Put: $P IOFC** IOFC* Feed Price: $C Milk/Feed Prices $P

21. Examples of Margin Risk Management • Strategy #4: Purchase both Class III puts and feed equivalent calls → IOFC Floor • $A is the minimum IOFC = $P−$C • Higher IOFC: $A + $B, $A + $C,or $A + $B + $C $/cwt Milk Milk revenue floor $C Class III Put: $P Feed cost ceiling $A Feed-Based Call: $C $B Milk/Feed Prices $C $P 21

22. Examples of Margin Risk Management • Strategy #5: Instead of Class III Put option, purchase minimum price contract from processing plant→ IOFC Floor • Plant collects minimum price contract offers across farms to determine number of Put options to purchase on their behalf • 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

23. Examples of Margin Risk Management • Strategy #6: Use a Min/Max(Collar) milk price contract to set a Class III price range → IOFC Floor • Producer select’s milk price floor and ceiling that fits price goal • Floor protects from low milk prices • Ceiling on revenue reduces contract cost • Contract price is the USDA Announced price should that price be between floor and ceiling

24. Examples of Margin Risk Management • Strategy #6: Combining Min/Max milk price and feed calls → IOFC Floor • Minimum IOFC = $A • Higher margins: $A+ $C,$A+ $B, or $A+ $B + $C $/cwtMilk Max Milk Price: $PU Milk revenue range $C Min Milk Price: $PL Feed cost ceiling $A Feed-Based Call: $C $B Milk/Feed Prices $PU C* $PL 24

25. Examples of Margin Risk Management • Strategy #7: Livestock Gross Margin Insurance for Dairy (LGM-Dairy) → IOFC Floor • Similar to put/call options strategy except: • Nooptions actually purchased • Nominimum size limit • Upper limit: 240,000 cwt over 10 mo./insurance yr • Premium not due until after11-month insurance period regardless of no. of months’ insured • Subsidized premiums (i.e., 18% - 50%). • Pilot program with limited funding (<$20 Mil)

26. Examples of Margin Risk Management • LGM-Dairy is customizable with respect to: • Number of months insured by 1 contract • 1 – 10 months • % of monthly IOFC (marketings) insured • 0 – 100% of certified marketings • % coverage can vary across month • Farm specific insurance characteristics • Amount of marketings insured • Declared feed use: Only protect market-based risk? • Deductible and resulting premium subsidy • Premium specific to farm and contract design • Available for purchase on last business Friday each month

27. Examples of Margin Risk Management • LGM-Dairy: 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 local basis added to prices • Expected prices known at sign-up 27

28. Examples of Margin Risk Management • Total Expected Gross Margin (TEGM) = Contract Expected milkvalue – feed costs • = Sum of monthly (Expectedmilk prices x Insured milk) – Sum of monthly (Expected feed prices x Declaredfeed use) • Single TEGM regardless of months insured • Insurance Deductible: Portion of TEGM not covered by insurance • Higher deductible → Lower premium • Producer assumes more risk • Subsidy increases with higher deductible 28

29. Examples of Margin Risk Management • Total Actual Gross Margin (TAGM) = Total Actual contract milk value – Total Actual contractfeed cost • = Sum of monthly (Actual milk prices x Insured milk) – Sum of monthly (Actualfeed prices x Insured feed use) • No monthly determination of TAGM • If TGMG > TAGM → Indemnity = TGMG – TAGM • Market did not live up to expectations • Only 1 indemnity calculation per contract 29

30. Margin Risk Management: 2013 Farm Bill • Current House and Senate versions • Replaces current Federal dairy programs with: • Voluntary Dairy Producer Margin Protection Program (DPMPP) in Senate and House versions • A voluntary Dairy Market Stabilization Program (DMSP) in Senate version • DPMPP Objective: Reduce margin volatility • Margin insurance program with limited contract flexibility: • Same feed ration for all participants • All feed assumed to be purchased • IOFC margin defined as the difference between U.S. average All-Milkprice and rationcost 30

31. Margin Risk Management: 2013 Farm Bill • DPMPP Insurance: • $4.00 Base Margin Insurance @ $0 cost • Indemnity = difference between average actual margin for consecutive 2-month period and $4.00 • Coverage is the lesser of • 80% of production history divided by 6 or • Actual quantity of milk marketed during consecutive 2-month period • Growth option for base is possible 31

32. Margin Risk Management: 2013 Farm Bill • Supplemental DPMPP Insurance: • From $4.50 to $8.00/cwt • Cover 25% to 90% of base • Indemnity = difference between target and higher of the actual average 2 month margin or $4.00 • Coverage is purchased coverage % times the lesser of: • Annual production history divided by 6 or • Actual amount of milk marketed over the previous 2-month period 32

33. Margin Risk Management: 2013 Farm Bill • DPMPP premiums vary by farm size • 4 Mil. Lbs. is the boundary between premium schedules • House and Senate versions have similar premium schedules • Premiums still subsidized, although not at 100%, even at higher coverage 33

34. Margin Risk Management: 2013 Farm Bill $4.00

35. Margin Risk Management and Your Farm • A commonly asked question: • What does establishing a particular risk management objective mean in terms of the actual level of protection for my farm? • Let’s use LGM-Dairy as an example • Establishing an IOFC floor • What is (YourFarm’s IOFC − LGM-Dairy IOFC) basis? 35

36. Margin Risk Management and Your Farm • The LGM-Dairy’s IOFC is calculated by valuing milk at Class III price and standard composition • How does your farm’s mailbox price compare with Class III • What is your (Mailbox – Expected Class III) basis? • → Expected Mailbox = Expected Class III + the above basis Standard Class III Milk Composition 36

37. Margin Risk Management and Your Farm • LGM-Dairy’s IOFC is calculated by valuing insured feed use by CME futures market valuation • Do you know your corn and SBM basis? • Feed price basis = your local price – futures price • With known basis Actual feed costs • = declared feed use x local feed price • = declared feed use x (futures price + feed basis) • = LGM-Dairy feed costs + (feed use x feed basis) 37

38. Margin Risk Management and Your Farm • Using the above we have • Actual IOFC= LGM-Dairy IOFC • + (Class III basis x cwt) • – (Feed basis x declared feed use) • With known basis you can determine what LGM-Dairy IOFC floor means in terms of your farm’s IOFC • Depends on • Ability to estimate milk value and feed basis • How variable are they? 38

39. Margin Risk Management and Your Farm • We have only covered a few of the alternatives available for managing margin volatility • Need to know your costs of production to establish appropriate target • No such thing as a free lunch • Risk-Return trade-offs • What level of trade-off is acceptable to you? 39

40. Contact Information • The Univ. of Wisconsin Understanding Dairy Markets Website: http://future.aae.wisc.edu • Livestock Gross Margin Insurance Website: http://future.aae.wisc.edu/lgm_dairy.html • Copy of this presentation: • http://future.aae.wisc.edu/publications/expo_13.pptx • Brian W. Gould • (608)263-3212 • bwgould@wisc.edu