1. Livestock Gross Margin-Dairy Craig Thomas MSU-Extension Dairy Educator Sanilac, Huron, Tuscola, St. Clair, Lapeer, Genesee, Macomb, & Oakland Counties

2. Dairy Price Risk Management  Coop-sponsored forward (fixed) price contracts:  Similar to Class III short hedge: Locks in a price, no upside potential, no daily margin requirements, flexible contract size, administrative cost  Coop-sponsored minimum price contracts:  Similar to Class III put option: Establish a milk price floor, retain upside potential, no margin requirements, flexible contract size, cost of insurance + administrative cost

3. Dairy Price Risk Management  Traditional hedging and options strategies:  Broad range of alternative strategies: lock in a Class III price, establish a minimum Class III price, etc.  Contract size “lumpiness”  May be subject to margin calls & may need margin loc  Puts/calls: cost of “insurance” may be quite high  Requires established contract with a broker

4. Dairy Margin Risk Management  Margin risk management establishes a floor (minimum) on income over feed costs (IOFC).  Class III put options: Creates milk revenue floor  Feed call options: Establishes feed cost ceiling  Bundled options strategy: you establish an IOFC floor $/cwt Minimum IOFC Milk revenue floorFeed cost ceiling

5. Dairy Margin Risk Management  Revenue risk management establishes a floor on income over feed costs (IOFC).  Class III put options: Creates milk revenue floor  Feed call options: Establishes feed cost ceiling  Bundled options strategy: you establish an IOFC floor $/cwt Minimum IOFC Milk revenue floorFeed cost ceiling

6. Dairy Margin Risk Management $/cwt IOFC M Class III Put Option Feed Call Options Does Not Limit Upside Milk Price Potential Announced Class III  Put option not exercised IOFC A IOFC A > IOFC M

7. Dairy Margin Risk Management $/cwt IOFC M Class III Put Option Feed Call Options Does Not Limit Upside Milk Price Potential Announced Class III  Put option not exercised IOFC A IOFC A > IOFC M

8. Dairy Margin Risk Management Does Not Limit Downside Feed Price Potential $/cwt IOFC M Class III Put Option Feed Call Options Feed Price  Feed call options not exercised IOFC A IOFC A > IOFC M

9. Dairy Margin Risk Management Does Not Limit Downside Feed Price Potential $/cwt IOFC M Class III Put Option Feed Call Options Feed Price  Feed call options not exercised IOFC A IOFC A > IOFC M

10. Overview of LGM-Dairy  Livestock Gross Margin Insurance for Dairy (LGM- Dairy)  Insurance policy to guarantee a minimum IOFC  Administered by USDA/RMA but purchased from firms selling Federal crop insurance  Crop insurance agents must be certified to sell LGM-Dairy and have ID number on file w/Federal Crop Insurance Corporation (see handout of approved agents)

11. Overview of LGM-Dairy  Similar to bundled options (Class III put/feed calls) except:  LGM-Dairy has no minimum size limit  LGM-Dairy upper limit of 240,000 cwt over any insurance period (10 months) or insurance year  No actual options market activity  Cheaper than bundled options due to subsidized premiums  Premium not due until after contract matures

12. Overview of LGM-Dairy  LGM-Dairy is customizable with respect to:  Number of months insured w/one contract: 1-10 months  Farm specific in regards to milk production & feeding profiles (amounts & types of feeds)  Percentage of monthly IOFC (production) covered  0-100% of certified milk production each month  Percent coverage can vary across months

13. Overview of LGM-Dairy  LGM-Dairy premiums are subsidized  Premiums equal long run expected indemnity + 3%  Premium subsidy

14. GMG Gross Margin Guarantee GMG Gross Margin Guarantee AGM Actual Gross Margin AGM Actual Gross Margin EGM Expected Gross Margin EGM Expected Gross Margin DL Deductible Level DL Deductible Level EFC Expected Feed Cost EFC Expected Feed Cost EMP Expected Class III Price EMP Expected Class III Price EMR Expected Milk Revenue EMR Expected Milk Revenue ECC Expected Corn Cost ECC Expected Corn Cost ESC Expected SBM Cost ESC Expected SBM Cost CME Class III Futures CME Class III Futures CME Corn Futures CME Corn Futures CME SBM Futures CME SBM Futures AGM Actual Gross Margin AGM Actual Gross Margin AFC Actual Feed Cost AFC Actual Feed Cost CME Actual Class III Price Settlement CME Actual Class III Price Settlement AMR Actual Milk Revenue AMR Actual Milk Revenue CME Actual Feeds Costs Settlement CME Actual Feeds Costs Settlement TM Target Marketings TM Target Marketings PREM Premium Cost PREM Premium Cost EFQ Expected Feed Quantity EFQ Expected Feed Quantity IND Indemnity IND Indemnity Producer Data/Decision Policy Rules Exogenous Data Overview of LGM-Dairy

15.  Expected Gross Margin (GM) = expected market value of milk minus expected feed cost  One GMG (and GM) per contract  Gross Margin Guarantee (GMG) = GM minus deductible  Evaluated over entire contract period

16. Overview of LGM-Dairy  Actual Gross Margin (AGM) = Actual market value of milk minus actual feed cost  One AGM per contract  Indemnity (payout) occurs if:  Evaluated over entire contract period

17. Overview of LGM-Dairy  Class III, corn, and SBM futures markets used as information source to determine:  Expected prices  Importantly…  Actual prices  No actual farm prices are used  No futures market transactions  No local basis used to adjust prices

18. Overview of LGM-Dairy  Once LGM-Dairy is purchased you have established an IOFC floor for the insured milk production  Determined using expected prices  Feed usage based on corn & SBM equivalents (adjustable)  IOFC floor also adjusted by deductible selected

19. Overview of LGM-Dairy  At sign-up producer declares milk production and feed equivalents to be insured  Must certify milk production when contract matures  Producer defines expected feed usage using corn (energy) and SBM (protein) equivalents  Wide range for allowable declared feed equivalents  Corn: 0.13 – 1.36 bu/cwt of milk (7.28-76.2 lbs/cwt of milk)  SBM: 1.61 – 26.00 lbs/cwt of milk  Program defaults (Corn, 0.5 bu/cwt; SBM, 4.0 lbs/cwt)

20. Overview of LGM-Dairy  At sign-up producer declares milk production and feed equivalents to be insured  Must certify milk production when contract matures  Producer defines expected feed usage using corn (energy) and SBM (protein) equivalents  Wide range for allowable declared feed equivalents  Corn: 0.13 – 1.36 bu/cwt of milk (7.28-76.2 lbs/cwt of milk)  SBM: 1.61 – 26.00 lbs/cwt of milk  Program defaults (Corn, 0.5 bu/cwt; SBM, 4.0 lbs/cwt)

21. LGM-Dairy: Expected Gross Margin  All feed valued as if purchased even if homegrown  Feed prices: Corn (CME futures), SBM (CME futures)  Importantly: the gross margin guarantee (GMG) is for the entire contract period whether contract is for 1, 2, …9, or 10 months  Milk price: CME Class III futures  Standardized milk: 12.5% solids (3.5% fat, 3.1% protein, 5.9% OS)

22. LGM-Dairy: Purchasing  LGM-Dairy is available for purchase each month  12 contracts offered each year  Each contract covers 1 to 10 months  Purchase period starts at end of last business Friday of each month (after numbers crunched ~6:00 PM EDT)  Feb 25 th, Mar 25 th, Apr 29 th, etc.  Purchase period ends at 9:00 EDT the next day (Saturday)  ~27 hour sign-up window  Work with your agent well ahead of time!

23. LGM-Dairy: Coverage Calendar  Hypothetical insurance strategy: Purchase insurance at the end of March Contract Length: 1-10 months By rule: no coverage the month after purchase

24. LGM-Dairy: Coverage Calendar  All 10 months of expected prices are known at sign- up  Expected milk, corn, and SBM prices are the average of last 3 days of futures settlement prices for each month/commodity including the sign-up Friday

25. LGM-Dairy: Coverage Calendar Futures market settlement prices on these 3 days determine expected prices Insurance sign-up period: ~27 hrs from 6:00 PM Friday till 9:00 PM Saturday (EDT) Limited funds, first come, first served; sign-up early!

26. LGM-Dairy: Coverage Calendar  Producer chooses amount of gross margin not covered by insurance (i.e., deductible)  Portion of gross margin (GM) unprotected  Program allows $0 to $2.00/cwt deductible on GM  Higher deductible  Lower premium  Producer assumes more risk  Subsidy increases with higher deductible

27. LGM-Dairy: Premium Subsidy  No subsidy for a 1-month contract. To receive subsidy must have target marketings in 2 or more months of an insurance period. The subsidy % is the percentage by which premium is reduced.

28. Determining Actual Prices and Gross Margin  Actual prices determined as futures contracts expire over insurance contract period  Actual price = Class III, corn & SBM average futures settlement prices from 1 st, 2 nd, and 3 rd days prior to futures contract last trading day  Actual gross margin (AGM) = Actual milk revenue – Actual feed costs  If total GMG > total AGM  indemnity paid  Total refers to sum over all insured months in contract  Only 1 possible indemnity per contract

29. Determining Actual Prices and Gross Margin Last March corn/SBM trading day Settle prices used to calculate actual March corn/SBM prices Last March Class III trading day Settle prices used to calculate actual March Class III price

30. Premium Billing/Indemnity Payment  Clarification of USDA Memo: PM-10-067  Assume contract purchased in March 2011 w/coverage chosen for May, July, Aug, and Sep w/$5,500 total premium.  Assume indemnity of $4,500.  Two options: 1) producer pays net due ($1,000) end of Sep, or 2) producer receives $1,000 indemnity ~late Oct and pays premium ($5,500) Mar 2012.

31. Premium Billing/Indemnity Payment  Must file a marketing report to receive indemnity  Must submit a marketing report within 15 days of a notice of probable loss  Marketing report must be supported by milk sales receipts showing evidence of actual marketings each month  In the event that the total of actual marketings are less than 75 percent of the total of targeted marketings for the insurance period, indemnities will be reduced by the percentage by which the total of actual marketings for the insurance period fell below the total of target marketings for the period. No limits on milk production, but indemnities limited to covered milk (240,000 cwt max)

32. LGM-Dairy: Summary  LGM-Dairy is a flexible insurance program  Don’t have to insure all months or all production  Similar to bundled options strategy using Class III puts and corn/SBM calls  Drawbacks  Short sign-up window at end of each month  May overlap contracts  Substantial premium subsidies & variable deductible  Coverage amount much more flexible (no lumpiness)  Must wait for indemnity until end of last covered month; after last actual price is determined

33. LGM-Dairy: Example  Farm characteristics:  Estimate premium costs for March 2011 contract  Expected monthly feed use  500 milk cows w/25,200 lbs. milk sold per cow  For simplicity assume 2,100 lbs/cow/month (2,100 x 0.85 x 500 = 8,925 lb. milk per month)  170.4 tons corn eq.; 42.6 tons SBM eq.

34. LGM-Dairy: Example  Target marketings: May, July, August, September Only partial coverage for four months

35. LGM-Dairy: Example  Expected Gross Margin (GM) = expected market value of milk minus expected feed cost  One GMG (and GM) per contract  Gross Margin Guarantee (GMG) = GM minus deductible  Evaluated over entire contract period

36. LGM-Dairy: Example  Expected Gross Margin (May) = (8,925 cwts X $17.27/cwt X 50%) –.5*(170.4 tons corn X $7.08/bu + 42.6 tons SBM X $358.90/ton)  Gross Margin Guarantee (GMG) = GM minus deductible  Expected Gross Margin (May) = $77,076 – $21,543 – $7,645  Expected Gross Margin (May) = $47,888

37. LGM-Dairy: Example  Gross Margin Guarantee (GMG) = GM minus deductible  Expected Gross Margin (May) = $47,888  Gross Margin Guarantee (GMG) = $47,888 – (8,925 cwts X 50% X $1.00/cwt)  Gross Margin Guarantee (GMG) = $47,888 – $4,463  Gross Margin Guarantee (GMG) = $43,416 Same process used to calculate GMG’s for other months

38. LGM-Dairy: Example  One GMG (and GM) per contract  Evaluated over entire contract period

39. LGM-Dairy: Example  Actual Gross Margin (May) = (8,925 cwts X $16.64/cwt X 50%) –.5*(170.4 tons corn X $7.35/bu + 42.6 tons SBM X $364.20/ton)  Actual Gross Margin (May) = $74,264 – $22,365 – $7,757  Actual Gross Margin (May) = $39,679  Actual Gross Margin (AGM) = actual market value of milk minus actual feed cost Same process used to calculate AGM’s for other months

40. LGM-Dairy: Example  One GMG and one AGM per contract  Evaluated over entire contract period  Indemnity = GMG T - AGM T = $171,007 - $152,878 = $18,129 $23,593

41. LGM-Dairy: Example Calculating Feed Equivalents Understanding Dairy Markets (future.aae.wisc.edu) LGM-Dairy (tab) Supporting Software Spreadsheet-Based Grain/Concentrate/Forages Feed Conversion Program Save to your hard disk if you have Microsoft Excel

42. UW Feed Conversion Excel Spreadsheet

43. LGM-Dairy: Example Estimating Premiums Understanding Dairy Markets (future.aae.wisc.edu) LGM-Dairy (tab) Supporting Software LGM-Dairy Analyzer (V 2.0) Opens in your browser window

44. LGM-Dairy: Example

45. Select program to useUse previously saved dataContract to analyzeDeductibleMethod for entering feed

46. LGM-Dairy Analyzer (V 2.0) Only need to supply four pieces of information

47. LGM-Dairy Analyzer (V 2.0) Only need to supply four pieces of information Calculate LGM Premium

48. LGM-Dairy Analyzer (V 2.0)

51. Calculate Options Cost

52. 50% coverage; $1 deductible LGM-Dairy Analyzer (V 2.0)

53. 50% coverage; $1 deductible LGM-Dairy Analyzer (V 2.0)

54. LGM-Dairy  LGM-Dairy is definitely worth every producers consideration regardless of farm size, production level, etc.  Find an LGM-Dairy agent and establish a relationship  Work with your LGM-Dairy agent well in advance of the sign-up period so if you do use LGM-Dairy you can get your application in early.  The LGM-Dairy program has limited funds, RMA recently increased LGM-Dairy funds, but still limited (first come, first served); get it while it’s hot!