LGM-Dairy: Program Fundamentals Brian W. Gould Department of Agricultural and Applied Economics University of Wisconsin-Madison University of Wisconsin Extension November 25, 2013

Overview 2  How can dairy producers manage the volatility of their margins  Margin ≡ Income over feed costs  Getting inside the LGM-Dairy Black- Box  Resources available for advanced planning

3 Margin Risk Management: Options Based  How can dairy producers establish a floor on their Income over Feed Costs (IOFC) using feed and class III options?  Class III put option: Creates milk revenue floor  Feed call option: Establishes feed cost ceiling IOFC ($/cwt) Milk revenue floor Feed cost ceiling Min.IOFC Market Prices IOFC * IOFC ** P* $P* Put Strike Price $C* Call Strike Price C* IOFC ** > IOFC IOFC < IOFC*

4  An alternative method for managing margin volatility: Livestock Gross Margin Insurance for Dairy (LGM-Dairy)  Objective: Establish minimum IOFC  Similar to put/call options strategy except: No options actually purchased No options actually purchased No minimum size limit No minimum size limit Upper limit: 240,000 cwt over 10 mo./insurance yr Upper limit: 240,000 cwt over 10 mo./insurance yr Premium not due until after 11-month insurance period regardless of number of insured months Premium not due until after 11-month insurance period regardless of number of insured months Subsidized premiums Subsidized premiums  Pilot program with limited funding (<$20 Mil) Reason for flat learning curve Reason for flat learning curve Margin Risk Management: LGM-Dairy

5 LGM-Dairy: An Overview Historical Use of LGM-Dairy # of Contracts Sold CWT (000) GMG (000$) Prem. (000$) Premium Subsidy (000$) Indem.(000$) Subsidy Rate (%) 2008/ , /101531,87224, /111,41246,173769,64425,01310, /121,77140,504704,52119,1538,8671, /131,69834,189664,25416,8787,6591, Total5,079123,1402,168,05062,11327,2624,

State Policies Sold CWT Insured LiabilitiesPremiumsSubsidies Subsidy Rate (%) No. % of Total 000$ 000$ 000$ 000$ NY , , , MI , , , WI , , , , MN , , , , CA , , , PA , Total1, , , , , LGM-Dairy: An Overview 2012/2013 Sales

7 LGM-Dairy: An Overview  We need to differentiate between producer demand for LGM-Dairy vs. utilization rate  Producer demand : determined by producers’ willingness to purchase  Utilization rate % of producers using % of producers using determined by Federal funding availability determined by Federal funding availability  Demand is much greater than indicated by participation rate given funding shortages Funding uncertainty has had an impact on contract designs that has ↓ effectiveness of some contracts Funding uncertainty has had an impact on contract designs that has ↓ effectiveness of some contracts

8  LGM-Dairy is customizable with respect t o:  Number of months insured by 1 contract 1 – 10 months 1 – 10 months  % of monthly IOFC (marketings) insured 0 – 100% of certified marketings 0 – 100% of certified marketings % coverage can vary across month % coverage can vary across month  Farm specific insurance characteristics Amount and % of marketings insured Amount and % of marketings insured Declared feed use: Only protect market-based risk? Declared feed use: Only protect market-based risk? Deductible and resulting premium subsidy Deductible and resulting premium subsidy Premium specific to farm’s contract design Premium specific to farm’s contract design LGM-Dairy: An Overview

 Class III, corn, and soybean meal futures and options markets used as information source  Used to determine Expected (forward looking at time of purchase) and Actual (observed for each month) prices  No futures market transactions  Actual farm prices not used  No local basis added to prices  What does the insured Class III based IOFC mean in-terms of farm mailbox IOFC? What is your Class III and feed basis? What is your Class III and feed basis? LGM-Dairy: An Overview 9

 Prior to LGM-Dairy contract purchase producer knows:  All expected milk price and feed costs for months in proposed contract  The Class III-based IOFC floor that would be established for insured production Since floor is based on Chicago prices what does this IOFC protection mean in terms of producer’s actual mailbox-based IOFC? Since floor is based on Chicago prices what does this IOFC protection mean in terms of producer’s actual mailbox-based IOFC? LGM-Dairy: An Overview 10

11  Expected feed use converted to Corn (Energy) and SBM (Protein) equivalents  Allowable range of feed equivalents: Corn: 0.13 – 1.36 bu/cwt of milk Corn: 0.13 – 1.36 bu/cwt of milk SBM: 1.61 – lb/cwt of milk SBM: 1.61 – lb/cwt of milk  Program default feed coefficients can be used: Corn: 0.5 bu/cwt SBM: 4.0 lbs/cwt Corn: 0.5 bu/cwt SBM: 4.0 lbs/cwt  No auditing of declared feed use  Many producers only declare purchased feed  Using minimum feed amounts → approximate a weighted average put option LGM-Dairy: Expected Feed Use

 Total Expected Gross Margin (TEGM) = Total contract Expected value of milk – Total contract Expected feed 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 the number of months insured One month’s low margin can offset another’s relatively high value as only total value matters (i.e., TEGM) One month’s low margin can offset another’s relatively high value as only total value matters (i.e., TEGM) LGM-Dairy: An Overview 12

Expected Feed Cost Expected Profile of % Coverage Over Contract Life CME Class III CME Corn CME Corn CME SBM CME SBM ProgramRulesProgramRules Market Data Market Data Producer Data Contract Design Expected Milk Marketings Total Expected Gross Margin Expected Milk Income Declared Feed Use Declared Feed Use

14  All 10 months of Expected Prices are known at sign-up LGM-Dairy: Expected Prices Insurance sign- up period Expected Prices = Average of futures settle prices on these days Obtain March ʹ 14 – Dec ʹ 14 Expected Prices

 Total Gross Margin Guarantee (TGMG) = TEGM – chosen deductible  Producer chooses insurance deductible  Deductible = the portion of insured milk’s Total Expected Gross Margin not protected How much gross margin must go down before insurance coverage starts How much gross margin must go down before insurance coverage starts  Program allows $0 - $2.00/cwt Gross Margin to be excluded from coverage  Higher deductible → Lower premium Producer assumes more risk Producer assumes more risk LGM-Dairy: An Overview 15

Total Gross Margin Guarantee Total Gross Margin Guarantee Deductible Level Expected Feed Cost Expected Profile of % Coverage Over Contract Life CME Class III CME Corn CME Corn CME SBM CME SBM ProgramRulesProgramRules Market Data Market Data Producer Data Contract Design Expected Milk Marketings Total Expected Gross Margin Expected Milk Income Declared Feed Use Declared Feed Use  Total Gross Margin Guarantee (TGMG) = TEGM – (Deductible [$/cwt] x cwt insured) = minimum IOFC

Deductible Level Expected Feed Cost Expected Profile of % Coverage Over Contract Life CME Class III CME Corn CME Corn CME SBM CME SBM Net Premium ProgramRulesProgramRules Market Data Market Data Producer Data Contract Design SubsidySubsidy Expected Milk Marketings Total Expected Gross Margin Expected Milk Income Declared Feed Use Declared Feed Use Total Net Gross Margin Guarantee Program Outcome Total Gross Margin Guarantee ( TGMG ) Deductible ($/cwt) Subsidy (%) Deductible ($/cwt) Subsidy (%) –

 As noted above, prior to purchase producer knows all expected prices  Insurance sold after Friday’s futures markets have closed  → Need to evaluate TGMG under alternative contract designs Chosen deductible rates Chosen deductible rates Coverage months and % coverage Coverage months and % coverage Alternative declared feed amounts Alternative declared feed amounts  Should Use LGM-Dairy Analyzer for planning well in advance of purchase date LGM-Dairy: Expected Prices 18

 As an insurance contract matures RMA needs to determine actual monthly milk value and feed costs  Use the same production and feeding profile used when contract was purchased Only prices change Only prices change  Need actual Class III, corn and SBM prices LGM-Dairy: Actual Prices 19

 Actual prices based on futures settlement prices at futures contract expiration  Actual price = Average futures contracts settle prices from 3 days prior to futures contract’s last trading day  Last trading day for corn and SBM is last business day prior to the 15 th  Class III futures contract’s last trading day: Will usually be on a Tuesday Will usually be on a Tuesday The day prior to the Class III price announcement by USDA: Announcement typically on a Wed not later then the 5 th of the month following production The day prior to the Class III price announcement by USDA: Announcement typically on a Wed not later then the 5 th of the month following production LGM-Dairy: Actual Prices 20

 Total Actual Gross Margin (TAGM) = Total Actual contract milk value – Total Actual contract feed cost  TAGM = Sum of monthly (Actual milk prices x Insured milk) – Sum of monthly (Actual feed prices x Insured feed use)  Note there is not a monthly determination of actual monthly gross margin → Only 1 TAGM regardless of months insured → Only 1 TAGM regardless of months insured → A month with a low IOFC can be offset by a month with a relatively high IOFC value → A month with a low IOFC can be offset by a month with a relatively high IOFC value LGM-Dairy: Actual Gross Margin 21

Profile of % Coverage Over Contract Life Total Actual Gross Margin ( TAGM ) Total Actual Gross Margin ( TAGM ) Actual Milk Income Final CME Class III Final CME Corn Final CME SBM ProgramRulesProgramRules Market Data Market Data Producer Data Contract Design Expected Milk Marketings Declared Feed Use Declared Feed Use Actual Feed Cost Cost  Actual prices based on futures settlement prices at expiration  Actual price = Average futures contracts settle prices from 3 days prior to futures contract’s last trading day  Actual prices based on futures settlement prices at expiration  Actual price = Average futures contracts settle prices from 3 days prior to futures contract’s last trading day Final futures settlement prices

23 Settle prices used to calculate Actual July 2014 Class III price Last Corn/SBM trading day Last July 2014 Class III trading day Settle prices used to calculate Actual March Corn/SBM prices LGM-Dairy: Actual Prices

 If TGMG > TAGM → An insurance indemnity will be generated  Payout amount = TGMG – TAGM → i.e., Market did not live up to expectations → i.e., Market did not live up to expectations  Again: Only 1 indemnity calculation per contract  When is the indemnity determination made  After last actual price is available from RMA  May be 1 – 2 months after last covered month Corn Example: Sept/Dec futures contracts vs. Oct/Nov LGM coverage months Corn Example: Sept/Dec futures contracts vs. Oct/Nov LGM coverage months LGM-Dairy: Indemnity Determination 24

Insuranc e Payout Deductible Level Expected Feed Cost Expected Profile of % Coverage Over Contract Life CME Class III CME Corn CME Corn CME SBM CME SBM Net Premium Actual Milk Income Final CME Class III Final CME Corn Final CME SBM ProgramRulesProgramRules Market Data Market Data Producer Data Contract Design SubsidySubsidy Expected Milk Marketings Total Expected Gross Margin ? Expected Milk Income Declared Feed Use Declared Feed Use Total Net Gross Margin Guarantee Program Outcome Actual Feed Cost Cost Total Actual Gross Margin Total Actual Gross Margin Total Gross Margin Guarantee ( TGMG )

26  LGM-Dairy can be purchased monthly if funds available  Each contract can cover up to 10 months  Purchase period starts no earlier than 4:30 pm CDT on last business Friday of month Starts: 4:30 pm CDT, October 26 th Starts: 4:30 pm CDT, October 26 th Sales will start on the half hour if data not available at 4:30 (e.g. 5:00 pm, 5:30 pm, etc.) Sales will start on the half hour if data not available at 4:30 (e.g. 5:00 pm, 5:30 pm, etc.)  Purchase period ends at 8:00 PM CDT the next day, e.g., Saturday Oct. 27 th Why planning by both agent and producer is needed well in advance of contract purchase Why planning by both agent and producer is needed well in advance of contract purchase LGM-Dairy: When Purchased?

27  Hypothetical insurance strategy  Purchase insurance on Jan 31 st – Feb 1 st Jan ′14 Feb ′14 Mar ′14 Apr ′14 May ′14 Jun ′14 Jul ′14 Aug ′14 Sep ′14 Oct ′14 Nov ′14 Dec ′ Purchase Jan 31 st – Feb 1 st No Cover- age Insurance Contract Period Production Coverage 25% 20% Hypothetical LGM Contract LGM-Dairy: Coverage Calendar By rule: No coverage the month after purchase

28  LGM-Dairy a flexible insurance program  Need not insure all months or production  Could make sense to overlap contracts  Substantial premium subsidies  Similar to combined use of Class III puts and corn/SBM calls  Premiums are very sensitive to chosen deductible LGM-Dairy: Summary

29  Major Drawbacks  Short sign-up window at the end of each month  Need to wait until after the last actual price determined before indemnity evaluated  Very limited funding Purchasers want a 10 month contract due to funding uncertainty: Should use this design due to contract valuation Purchasers want a 10 month contract due to funding uncertainty: Should not use this design due to contract valuation Would like to have a multi-month purchase risk management strategy Would like to have a multi-month purchase risk management strategy  Question as to the impact of margin insurance program being considered in the new Farm Bill LGM-Dairy: Summary

30 Contact Information  The Univ. of Wisconsin Dairy Marketing Website:  Livestock Gross Margin Insurance:  To join the LGM-Dairy Mailing List:  Brian W. Gould