Livestock Gross Margin for Dairy Revenue Insurance: Recent Experience and Alternatives for Increased Adoption Minnesota-Wisconsin Dairy Policy Conference Brian W. Gould Department of Agricultural and Applied Economics University of Wisconsin-Madison University of Wisconsin Extension April 3, 2012

Overview of Today’s Presentation 2  U.S. Dairy Industry Price and Margin Volatility  Use of LGM-Dairy as a Revenue Insurance Program  Program Overview  Recent History of Use by Dairy Farm Operators  Performance Under Alternative Market Conditions  Possible Program Changes to Increase Adoption  Subsidy Schedule  Coverage Limitations  Pilot Status

3  We have seen a tremendous increase in the volatility of farm milk prices over the last 25 years Parity milk price support Federal Order Reform BFP Pricing Output Price Risk in Today’s Dairy Industry

4  The U.S. dairy industry is devoting more resources to international market development  Increased reliance → continued price volatility The past decade has seen more volatile dairy markets, driven by increasing global demand, tighter global supply and rising input prices. The forecast latent demand gap described above will likely lead to even more volatile markets… (U.S. Dairy Innovation Center, 2009) Output Price Risk in Today’s Dairy Industry

5 Dairy Exports Dairy Imports % of Dairy Solids Dramatic Drop In Milk Prices Output Price Risk in Today’s Dairy Industry

6 Cheese NFDM, Whey, Butter Output Price Risk in Today’s Dairy Industry Milk Price Collapse

7 16%, Peterson and DF65 Dairy Feed Ration Indexes (2005 = 1) 16% Dairy Ration = 51% corn, 8% soybeans and 41% alfalfa hay Peterson Ration = 59% corn, 14% SBM and 27% alfalfa hay DF65 = 44% corn, 5% SBM and 51% alfalfa hay 16% Dairy Ration = 51% corn, 8% soybeans and 41% alfalfa hay Peterson Ration = 59% corn, 14% SBM and 27% alfalfa hay DF65 = 44% corn, 5% SBM and 51% alfalfa hay Feed Cost Volatility and the Dairy Industry 2005 Prices ($/cwt of milk) Peterson: $5.45 DF65: $ Prices ($/cwt of milk) Peterson: $5.45 DF65: $3.57 Mar ʹ 10 – Aug ʹ 11 16% Ration: 76.0%↑ Peterson: 76.0%↑ DF65: 75.2%↑ Mar ʹ 10 – Aug ʹ 11 16% Ration: 76.0%↑ Peterson: 76.0%↑ DF65: 75.2%↑

8 % of Total Feed Costs from Purchased Feeds Source: ERS Cost of Milk Production, 2012 Feed Cost Volatility and the Dairy Industry CA75.8NM88.7 FL81.8NY49.2 GA74.8OH52.8 ID82.1OR81.1 IL40.3PA49.1 IN64.7TN57.5 IA47.9TX68.4 KY40.5VT50.0 ME57.7VA52.8 MI54.9WA73.8 MN38.1WI33.7 MO62.0US59.9 Differences reflect wide range in technologies used, scale of production and feed market risk

9 Dairy Margin Volatility $ /CWT Milk Margin = All Milk Price – Feed Cost August Margin Estimates 2007: $ : $ : $ %↓ 52.8%↓

10 Dairy Margin Volatility $ /CWT Margin = All Milk Price – Feed Cost Peterson Margin ($/cwt) DSA $4 Target for 100% subsidized revenue insurance DSA $4 Target for 100% subsidized revenue insurance % of Months With Indemnity $4: 9.4% $6: 12.9% $8: 65.9% % of Months With Indemnity $4: 9.4% $6: 12.9% $8: 65.9% DSA $8 Target w/ $0.922/cwt revenue insurance premium, $7.078 net target DSA $8 Target w/ $0.922/cwt revenue insurance premium, $7.078 net target DSA $6 Target w/ $0.155/cwt revenue insurance premium, $5.845 net target DSA $6 Target w/ $0.155/cwt revenue insurance premium, $5.845 net target

11 $/cwt Milk revenue floor Feed cost ceiling Minimum IOFC Dairy Revenue Risk Management Could be very expensive Thin Class III options market Problem of option contract size  Class III − 200,000/100,000 lbs Lack of continuous grain trading  Corn: 5 months  SBM: 8 months Could be very expensive Thin Class III options market Problem of option contract size  Class III − 200,000/100,000 lbs Lack of continuous grain trading  Corn: 5 months  SBM: 8 months  How can dairy producers establish a floor on their margin (i.e., Income over Feed Costs, IOFC) using existing tools?  One could use a Put/Call-based options strategy  Class III put options: Creates milk revenue floor  Feed call options: Establishes feed cost ceiling

$/cwt IOFC IOFC* Class III Put Announced Class III ↑, → Don’t use Class III Put Announced Class III ↑, → Don’t use Class III Put $/cwt IOFC Class III Put Feed Calls Feed Price ↓ → Don’t use Corn/SBM Calls Feed Price ↓ → Don’t use Corn/SBM Calls IOFC* greater than IOFC IOFC* Dairy Revenue Risk Management 12 Put Premium < Class III↑? Call Costs < Feed Cost ↓?

13  Aug. 2008: Livestock Gross Margin Insurance for Dairy (LGM-Dairy) became available  Objective: Establish minimum IOFC  Similar to put/call options strategy except: No options purchased No options 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 Premium not due until after 11-month insurance period Subsidized premiums Subsidized premiums  USDA-RMA administered and purchased from firms selling Federal crop insurance LGM-Dairy: Introduction

14  LGM-Dairy is an RMA pilot program as are all LGM products (i.e., swine, fed cattle, feeder cattle)  $20 mil. for all LGM products  Expenditures set by statute not administratively  2010/11: $16 mil. in RMA LGM-Dairy expenditures  Premium subsidies and A&O payments  Funds used up with March 2011 offering 2 hours: 318 contracts, 11.6 mil cwt insured 2 hours: 318 contracts, 11.6 mil cwt insured LGM-Dairy: Introduction

15  2011/12 LGM-Dairy funding  Started w/October contract offering (Oct. 28 th )  $7 mil initial allotment  After 30 minutes, system crashed 440 contracts 440 contracts 19.3 mil cwt insured 19.3 mil cwt insured > $6 mil in RMA commitments > $6 mil in RMA commitments  Nov. 9 th $6.2 mil. added to allowable commitment limit Funds were exhausted with Nov. 18 th contract offering Funds were exhausted with Nov. 18 th contract offering LGM-Dairy : Introduction

LGM-Dairy: History of Adoption 16 # of Contracts Sold CWT (000) GMG (000$) Prem. (000$) Subsidies (000$) Indem.($000) Subsidy Rate (%) 2008/ , /101531,87224, /111,41246,173769,64425,01310, /121,78340,553705,36019,1818, Total3,39389,0001,504,63545,26319,6141, Note: There was no premium subsidy prior to Dec Premiums shown are prior to subsidy.

State Policies Sold CWT Insured GMGPremiumsSubsidies Subsidy % No. % of Total 000 $000 $000 $ /11 NY , , , MI , , , WI , , , , CA , , , , Total1, , , , , /12 NY533.02, , , MI , , , WI , , , , CA543.06, , , , Total1, , , , , LGM-Dairy: 2010/11 & 2011/12 Activity Note: 2011/12 data as of Mar 9, No subsidy existed prior to Dec

Insuranc e Payout Guaranteed Income Over Feed Cost Guaranteed Deductible Level Expected Feed Cost Expected Profile of % Coverage Over Contract Life CME Class III CME Corn CME Corn CME SBM CME SBM Actual Income Over Feed Cost Actual 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 Expected Income Over Feed Cost ? Expected Milk Income Declared Feed Use Declared Net Guaranteed Income Over Feed Cost Program Outcome Actual Feed Cost Cost

19  LGM-Dairy is customizable with respect to:  Number of months insured by 1 contract 1 – 10 months 1 – 10 months 12 contracts each year 12 contracts each year Difference between insurance vs. contract period Difference between insurance vs. contract period  % of monthly IOFC (marketings) insured 0 – 100% of approved marketings 0 – 100% of approved marketings % coverage can vary across coverage month % coverage can vary across coverage month  Other farm specific insurance characteristics 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 LGM-Dairy: An Overview

 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 basis added to prices: All prices at Chicago  Feed converted to Corn and SBM equivalents  Once LGM-Dairy purchased producer has established an IOFC floor for insured production LGM-Dairy: An Overview 20

 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 months insured LGM-Dairy: An Overview 21

 Total Actual Gross Margin (TAGM) = Total contract Actual milk value – Total contract Actual insured feed cost  = Sum of monthly (Actual milk prices x Insured milk) – Sum of monthly (Actual feed prices x Insured feed use)  1 TAGM regardless of months insured LGM-Dairy: An Overview 22

 Total Gross Margin Guarantee (TGMG) = TEGM – (Deductible [$/cwt] x cwt insured)  Higher deductible → Lower premium Producer assumes more risk Producer assumes more risk Subsidy increases with higher deductible Subsidy increases with higher deductible $0 deductible: 18% subsidy, $ $2.00 deductible: 50% subsidy $0 deductible: 18% subsidy, $ $2.00 deductible: 50% subsidy  If TGMG > TAGM → Insurance indemnity paid  Payout amount = TGMG – TAGM  Again: Only 1 indemnity calculation per contract regardless of months insured LGM-Dairy: An Overview 23

24  We use the Peterson ration for this analysis  8 contracts: Jan 2005 – Jan 2012 contracts March –Dec. covered months March –Dec. covered months  Wisconsin average 2011 monthly yields  $0 deductible for LGM-Dairy  LGM-Dairy premiums do not include subsidies  $ $8.00 margins guarantees in $0.50 increments Targets are net targets adjusted using formula: Original DSA Targets − DSA Premium Targets are net targets adjusted using formula: Original DSA Targets − DSA Premium  Control for All-Milk/Class III Basis Month-specific basis calculated over 2000-Present Month-specific basis calculated over 2000-Present LGM-Dairy: A WI Case Study

25  We use the University of Wisconsin LGM-Dairy Optimizer to find least cost design to generate required net margin  Only concerned with protection, not likelihood of receiving an indemnity  For low margin targets less than 100% of milk needs to be insured to achieve target i.e., to achieve a $5.85/cwt target less than 50% of total production needs to be insured as $11.70/cwt margin achievable i.e., to achieve a $5.85/cwt target less than 50% of total production needs to be insured as $11.70/cwt margin achievable Spread the $11.70 across all production to achieve $5.85 average Spread the $11.70 across all production to achieve $5.85 average LGM-Dairy: A WI Case Study

26 LGM-Dairy: A WI Case Study Net Target % of 10-Month Milk Insured All Milk Feed Ratio

27  Premiums Under DSA and LGM-Dairy ($/cwt) Note: LGM-Dairy unsubsidized premiums are $/cwt of farm milk not just insured milk LGM-Dairy: A WI Case Study LGM vs. DSA Costs 2005 MF Ratio: MF Ratio: 1.40 * = DSA * = 2009 * = 2005 LGM vs. DSA Costs 2005 MF Ratio: MF Ratio: 1.40 * = DSA * = 2009 * = 2005 * * * * * * * * * * * * * * * * * * *

28  How can we increase participation?  I hypothesize the demand is there not the budget as evidenced by rapid sales when program is available  Most important would be to remove LGM- Dairy from pilot status to enable ↑ funding  Difficult to do as LGM-Dairy is privately owned and administered by the USDA  Owners may need to reduce significantly payments received LGM-Dairy: Possible Program Changes

29  Could eliminate/reduce premium subsidies  Even without subsidies insurance cost is low relative to options-based IOFC strategy  Agents received calls from producers willing to purchase w/o subsidy when funds exhausted LGM-Dairy: Possible Program Changes Deductible ($/cwt) Subsidy (%) Deductible ($/cwt) Subsidy (%) –

30  Establish a two-tier premium system  Have both subsidized and unsubsidized premiums After subsidized pool exhausted premiums not subsidized After subsidized pool exhausted premiums not subsidized  2012 Farm Bill could be used to increase the $20 million pilot funding while still a pilot  If nothing is changed fund will be exhausted with Oct offering LGM-Dairy: Possible Program Changes

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