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  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 Today’s Presentation

3 Monthly Mailbox Price: CA and UMW % Change in Mailbox Prices UMW CA Nov ʹ 07–Jul ʹ 09 −47.3 −53.4 Jul ʹ 09– Aug ʹ Correlation Coefficient = 0.96 % Change in Mailbox Prices UMW CA Nov ʹ 07–Jul ʹ 09 −47.3 −53.4 Jul ʹ 09– Aug ʹ Correlation Coefficient = 0.96

4 DSA Ration (Per cwt of Milk) Weight: lbs 59% Corn 14% SBM 27% Alfalfa Hay DSA Ration (Per cwt of Milk) Weight: lbs 59% Corn 14% SBM 27% Alfalfa Hay Apr ʹ 10 – Aug ʹ 12: 105.9%↑ Dairy Security Act Feed Costs DSA = Dairy Security Act

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

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

7  Margin risk 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 How Would You Characterize the Degree of Your Margin Risk?

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. ($/cwt) FMMO UMW CA Average Std.Dev. ($/cwt) FMMO UMW CA % 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? DSA Ration (Per cwt of Milk) Weight: lbs 59% Corn 14% SBM 27% Alfalfa Hay DSA Ration (Per cwt of Milk) Weight: lbs 59% Corn 14% SBM 27% Alfalfa Hay 20.2% Probability that Ration Cost is ≥ $12/cwt 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 30.8% Probability that IOFC is ≥ $9/cwt

12 Objectives of Margin Risk Management

13  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 Example of risk management There is a cost for this protection There is a cost for this protection What are you willing to pay to avoid major financial hit? What are you willing to pay to avoid major financial hit?  Analogous to undertaking financial risk management efforts What is Margin Risk Management?

14  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? What can one actually achieve given market? What is Margin Risk Management?

15  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 #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 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 What is Margin Risk Management?

16  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 → IOFC will stay at IOFC* regardless of market prices Does IOFC* cover non-feed production costs? Does IOFC* cover non-feed production costs? $/cwt milk IOFC* Milk/Feed Prices Fixed Milk Price Fixed Feed Cost Examples of Margin Risk Management

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

18  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 IOFC* Milk/Feed Prices Fixed Milk Price $C Feed Call C* IOFC** Examples of Margin Risk Management

19  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 Examples of Margin Risk Management

 Strategy #3: Class III put options and fixed forward feed price contract → IOFC Floor  → IOFC will able to be increased with Announced Class III price more than $P 20 $/cwt Milk IOFC* Milk/Feed Prices Feed Price: $C Class III Put: $P $P IOFC** 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 21 $/cwt Milk Milk revenue floor Feed cost ceiling $A $C $B $P Class III Put: $P Feed-Based Call: $C Feed-Based Call: $C $C Milk/Feed Prices Examples of Margin Risk Management

22  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 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 Examples of Margin Risk Management

23  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 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 24 $/cwt Milk Milk revenue range Feed cost ceiling $A $C $B $P L Min Milk Price: $P L Feed-Based Call: $C C* Milk/Feed Prices Max Milk Price: $P U $P U Examples of Margin Risk Management

25  Strategy #7: Livestock Gross Margin Insurance for Dairy (LGM-Dairy) → IOFC Floor  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 no. of months’ insured Premium not due until after 11-month insurance period regardless of no. of months’ insured Subsidized premiums (i.e., 18% - 50%). Subsidized premiums (i.e., 18% - 50%).  Pilot program with limited funding (<$20 Mil) Examples of Margin Risk Management

26  LGM-Dairy is customizable with respect to:  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 of marketings insured Amount 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 and contract design Premium specific to farm and contract design  Available for purchase on last business Friday each month 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  No futures market transactions  Actual farm prices not used  No local basis added to prices  Expected prices known at sign-up 27 Examples of Margin Risk Management

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

 Total Actual Gross Margin (TAGM) = Total Actual contract milk value – Total Actual contract feed cost  = Sum of monthly (Actual milk prices x Insured milk) – Sum of monthly (Actual feed 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 Examples of Margin Risk Management

 Current House and Senate versions  Replaces current Federal dairy programs with: Voluntary Dairy Producer Margin Protection Program (DPMPP) in Senate and House versions Voluntary Dairy Producer Margin Protection Program (DPMPP) in Senate and House versions A voluntary Dairy Market Stabilization Program (DMSP) in Senate version 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 Same feed ration for all participants All feed assumed to be purchased All feed assumed to be purchased  IOFC margin defined as the difference between U.S. average All-Milk price and ration cost 30 Margin Risk Management: 2013 Farm Bill

31  DPMPP Insurance:  $4.00 Base Margin $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 80% of production history divided by 6 or Actual quantity of milk marketed during consecutive 2-month period Actual quantity of milk marketed during consecutive 2-month period  Growth option for base is possible Margin Risk Management: 2013 Farm Bill

32  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 Annual production history divided by 6 or Actual amount of milk marketed over the previous 2-month period Actual amount of milk marketed over the previous 2-month period Margin Risk Management: 2013 Farm Bill

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

34 $4.00 Margin Risk Management: 2013 Farm Bill

35  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 (Your Farm’s IOFC − LGM-Dairy IOFC) basis? Margin Risk Management and Your Farm

36  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 → Expected Mailbox = Expected Class III + the above basis Component % of Vol. Water87.82 Butterfat3.50 Protein2.99 Other Solids 5.69 Standard Class III Milk Composition Margin Risk Management and Your Farm

37  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 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) Margin Risk Management and Your Farm

38  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 Ability to estimate milk value and feed basis How variable are they? How variable are they? Margin Risk Management and Your Farm

39  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? Margin Risk Management and Your Farm

40 Contact Information  The Univ. of Wisconsin Understanding Dairy Markets Website:  Livestock Gross Margin Insurance Website:  Copy of this presentation:  Brian W. Gould