adoption of revenue risk management and why knowing your income over feed cost is important

Adoption of Revenue Risk Management and Why Knowing Your Income Over

Feed Cost is Important

Brian W. GouldDepartment of Agricultural and Applied Economics

University of Wisconsin-MadisonUniversity of Wisconsin Extension

October 4, 2013

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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

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California and Upper Midwest Mailbox PricesUMWCA

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Monthly Mailbox Price: CA and UMW

% Change in Mailbox Prices UMW CA

Nov ʹ07–Jul ʹ09 −47.3 −53.4Jul ʹ09– Aug ʹ11 98.0 106.8Correlation Coefficient = 0.96

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$15.09

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U.S. Average DSA Ration Costs

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DSA Ration(Per cwt of Milk)

Weight: 102.2 lbs59% Corn14% SBM27% Alfalfa Hay

Apr ʹ10 – Aug ʹ12: 105.9%↑

Dairy Security Act Feed Costs

DSA = Dairy Security Act

$14.56

$2.25$2.73

$7.54

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FMMO Average Mailbox Over Feed Cost Margin

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Dairy Margin Volatility

Margin = FMMO Mailbox Price – DSA Ration Cost

FMMO = Federal Milk Marketing Orders

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Probabilityof 5%

Probabilityof 15%

Probabilityof 60%

Probabilityof 15%

Probabilityof 5%

PotentialIOFC Range

#1

< $3/cwt

Sum to 100%

> $9/cwt$5 − $7/cwt

ActualIOFC

PotentialIOFC Range

#2

PotentialIOFC Range

#3

PotentialIOFC Range

#4

PotentialIOFC Range

#5

How Would You Characterize the Degree of Your Margin Risk?

All Possible Outcomes

ExpectedIOFC Risk

$3 − $5/cwt

$7 − $9/cwt

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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


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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?

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Mailbox Price Range ($/cwt)

Distribution of Monthly Mailbox Prices

Upper Midwest

CaliforniaAverage Std.Dev.

($/cwt)

FMMO 15.04 2.99

UMW 15.07 3.06

CA 13.77 2.68

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Mailbox Price Range ($/cwt)

Cummulative Distribution of Mailbox Prices

Upper MidwestCalifornia

29.9% Probability that CA Mailbox ≥ $15/cwt

44.8% Probability that UMW Mailbox ≥ $15/cwt

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Feed Cost Range ($/cwt of Milk)

Distriubtion of DSA Ration Cost

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Feed Cost Range ($/cwt of Milk)

Cummulative Distriubtion of DSA Ration Cost DSA Ration(Per cwt of Milk)

Weight: 102.2 lbs 59% Corn 14% SBM 27% Alfalfa Hay

20.2% Probability thatRation Cost is ≥ $12/cwt

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0.0

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IOFC Range ($/cwt)

Distriubtion of FMMO Mailbox IOFC

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IOFC Range ($/cwt)

Cummulative Distriubtion of FMMO Mailbox IOFC

30.8% Probability thatIOFC is ≥ $9/cwt

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Objectives of Margin Risk Management

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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 occurExample of risk managementThere is a cost for this protectionWhat are you willing to pay to avoid major

financial hit?

Analogous to undertaking financial risk management efforts

What is Margin Risk Management?

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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?


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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 TradeoffWhat 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


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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 pricesDoes IOFC* cover non-feed production costs?

$/cwt milk

IOFC*

Milk/Feed Prices

Fixed Milk Price

Fixed Feed Cost

Examples of Margin Risk Management

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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 (+)

Time to expiration (+) Futures price volatility (+)


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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**


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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


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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

$/cwt Milk

IOFC*

Milk/Feed Prices

Feed Price: $C

Class III Put: $P

$P

IOFC**


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

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$/cwt Milk Milk revenue floor

Feed cost ceiling$A

$C

$B

$P

Class III Put: $P

Feed-Based Call: $C

$CMilk/Feed Prices


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Strategy #5: Instead of Class III Put option, purchase minimum price contract from processing plant→ IOFC FloorPlant 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


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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


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

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$/cwt Milk

Milk revenue range

Feed cost ceiling$A

$C

$B

$PL

Min Milk Price: $PL

Feed-Based Call: $C

C*Milk/Feed Prices

Max Milk Price: $PU

$PU


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Strategy #7: Livestock Gross Margin Insurance for Dairy (LGM-Dairy) → IOFC Floor Similar to put/call options strategy except:

No options actually purchased No minimum size limit 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 Subsidized premiums (i.e., 18% - 50%).

Pilot program with limited funding (<$20 Mil)


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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


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

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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 Subsidy increases with higher deductible

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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

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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-Milk price and ration cost

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Margin Risk Management: 2013 Farm Bill

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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


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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 orActual amount of milk marketed over the

previous 2-month period


• 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

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DSA Income Over Feed Cost Margin

Coverage

House Senate

Prem. Net Coverage Prem. Net

Coverage($/cwt)

4.00 0.030 3.970 0.000 4.0006.00 0.185 5.815 0.150 5.8508.00 1.060 6.940 1.060 6.940

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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

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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

Component % of Vol.

Water 87.82

Butterfat 3.50Protein 2.99

Other Solids 5.69

Standard Class IIIMilk Composition


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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)


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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?


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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?


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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)[email protected]

adoption of revenue risk management and why knowing your income over feed cost is important

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