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

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  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