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
Today’s Presentation
 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
2
Monthly Mailbox Price: CA and UMW
California and Upper Midwest Mailbox Prices
23.25
22.00
20.75
19.50
% Change in Mailbox Prices
UMW
CA
Nov ʹ07–Jul ʹ09 −47.3 −53.4
Jul ʹ09– Aug ʹ11 98.0 106.8
Correlation Coefficient = 0.96
UMW
CA
17.00
15.75
14.50
13.25
12.00
10.75
9.50
Jan
Jul
Jan
Jul
Jan
Jul
Jan
Jul
Jan
Jul
Jan
Jul
Jan
Jul
Jan
Jul
Jan
Jul
Jan
Jul
Jan
Jul
Jan
Jul
Jan
Jul
Jan
Jul
Jan
Jul
Jan
Jul
Jan
Jul
Jan
Jul
Jan
$/cwt
18.25
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 20122013
3
Dairy Security Act Feed Costs
U.S. Average DSA Ration Costs
16.00
$15.09
Apr ʹ10 – Aug ʹ12: 105.9%↑
14.50
13.00
DSA Ration
$12.64
(Per cwt of Milk)
10.00
Weight: 102.2 lbs
59% Corn
14% SBM
27% Alfalfa Hay
$11.11
$11.03
8.50
$7.33
7.00
5.50
DSA = Dairy Security Act
$4.49
4.00
Jan
May
Sep
Jan
May
Sep
Jan
May
Sep
Jan
May
Sep
Jan
May
Sep
Jan
May
Sep
Jan
May
Sep
Jan
May
Sep
Jan
May
Sep
$/cwt of Milk
11.50
2005
2006
2007
2008
2009
2010
2011
2012
2013
4
Dairy Margin Volatility
FMMO Average Mailbox Over Feed Cost Margin
16.00
$14.56
Margin = FMMO Mailbox Price – DSA Ration Cost
14.00
12.00
8.00
$7.54
6.00
4.00
FMMO = Federal Milk Marketing Orders
$2.73
2.00
$2.25
0.00
Jan
Apr
Jul
Oct
Jan
Apr
Jul
Oct
Jan
Apr
Jul
Oct
Jan
Apr
Jul
Oct
Jan
Apr
Jul
Oct
Jan
Apr
Jul
Oct
Jan
Apr
Jul
Oct
Jan
Apr
Jul
Oct
Jan
Apr
Jul
$/cwt of Milk
10.00
2005
2006
2007
2008
2009
2010
2011
2012
2013
5
How Would You Characterize the
Degree of Your Margin Risk?
Expected
IOFC
Risk
Actual
IOFC
Sum to 100%
Probability
of 5%
Probability
of 15%
Probability
of 60%
Probability
of 15%
Probability
of 5%
Potential
IOFC Range
#1
Potential
IOFC Range
#2
Potential
IOFC Range
#3
Potential
IOFC Range
#4
Potential
IOFC Range
#5
$3 −
$5/cwt
$5 −
$7/cwt
$7 −
> $9/cwt
$9/cwt
All Possible Outcomes6
< $3/cwt
How Would You Characterize the
Degree of Your Margin Risk?
 Margin risk exists if there are
Alternative IOFC outcomes
Unsure as to which outcome will actually occur
 Margin risk increases the more you don’t know about:
Potential outcomes (i.e., alternative IOFC levels)
Outcome probability (i.e., likelihood of an IOFC
range occurring)
Implications of each outcome on farm profitability
7
WRT Your Farm’s IOFC Do You Know:
 The range of IOFC’s you’ve achieved over the last 5,
10, 15 or 20 years?
 These are the potential IOFC outcomes
 The proportion of months a particular IOFC range
have occurred since 2000?
 IOFC ($/cwt): $4, $6, $8
 Can use to provide an estimate of event probability
 Implications of alternative IOFC’s on sustainability?
 What are your non-feed costs of production?
 What are your fixed versus variable costs of production?
8
How Would You Characterize the
Degree of Your Margin Risk?
Upper Midwest
16
California
Cummulative
Distribution of Mailbox Prices
14
12
10
8
6
4
2
0
Average Std.Dev.
($/cwt)
100
Cummulative % of Months (Jan. '95 - May '13)
% of Months (Jan. '95 - May '13)
18
Distribution of Monthly Mailbox Prices
90
80
29.9% Probability that
CA Mailbox ≥ $15/cwt
FMMO 15.04
UMW 15.07
CA
13.77
2.99
3.06
2.68
70
60
Upper Midwest
50
California
40
44.8% Probability that
UMW Mailbox ≥ $15/cwt
30
20
10 Mailbox Price Range ($/cwt)
0
Mailbox Price Range ($/cwt)
9
How Would You Characterize the
Degree of Your Margin Risk?
Distriubtion of DSA Ration Cost
20.0
Cummulative % of Months (Jan.'05 - May '13)
100
90
80
70
60
50
% of Months (Jan.'05 - May '13)
17.5
Cummulative
Distriubtion of DSA Ration Cost
15.0
20
10
(Per cwt of Milk)
Weight: 102.2 lbs
59% Corn
14% SBM
27% Alfalfa Hay
12.5
10.0
7.5
5.0
40
30
DSA Ration
20.2% Probability that
Ration Cost is ≥ $12/cwt
2.5
0.0
Feed Cost Range ($/cwt of Milk)
0
Feed Cost Range ($/cwt of Milk)
10
How Would You Characterize the
Degree of Your Margin Risk?
Distriubtion of FMMO Mailbox IOFC
25.0
Cummulative Distriubtion of FMMO Mailbox IOFC
22.5
100
90
17.5
15.0
12.5
10.0
7.5
5.0
2.5
% of Months (Jan.'05 - May '13)
% of Months (Jan.'05 - May '13)
20.0
80
70
60
30.8% Probability that
IOFC is ≥ $9/cwt
50
40
30
20
0.0
10
0
IOFC Range ($/cwt)
IOFC Range ($/cwt)
11
Objectives of Margin Risk
Management
12
What is Margin Risk Management?
 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
There is a cost for this protection
 What are you willing to pay to avoid major
financial hit?
 Analogous to undertaking financial risk
management efforts
13
What is Margin Risk Management?
 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?
14
What is Margin Risk Management?
 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 #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
15
Examples of Margin Risk Management
 With current mechanisms how can a
producer manage his/her margin risk?
 Strategy #1: Use forward price contracts for
milk and feed → fixed IOFC
$/cwt milk
Fixed Milk Price
IOFC*
Fixed Feed Cost
Milk/Feed Prices
→ IOFC will stay at IOFC* regardless of market prices
Does IOFC* cover non-feed production costs?
16
Examples of Margin Risk Management
 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 (+)
17
Examples of Margin Risk Management
 Strategy #2:
Forward milk price contract
and feed call options → IOFC floor
$/cwt Milk
Fixed Milk Price
IOFC**
IOFC*
$C Feed Call
C*
Milk/Feed Prices
 → IOFC will able to be increased when feed
price goes below $C* by exercising call
18
Examples of Margin Risk Management

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
19
Examples of Margin Risk Management
 Strategy #3: Class III put options and fixed
forward feed price contract → IOFC Floor
$/cwt Milk
Class III Put: $P
IOFC**
IOFC*
Feed Price: $C
$P
Milk/Feed Prices
 → IOFC will able to be increased with
Announced Class III price more than $P
20
Examples of Margin Risk Management
 Strategy #4:
Purchase both Class III puts and
feed equivalent calls → IOFC Floor
$/cwt Milk
Milk revenue floor
$C
Class III Put: $P
Feed cost ceiling
$A
Feed-Based Call: $C
$B
$C
$P
Milk/Feed Prices
 $A is the minimum IOFC = $P − $C
 Higher IOFC: $A + $B, $A + $C, or $A + $B + $C
21
Examples of Margin Risk Management
 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
 If cash price less than contract price → milk
check is increased by difference times
contracted quantity
22
Examples of Margin Risk Management
 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
23
Examples of Margin Risk Management
 Strategy #6:
Combining Min/Max milk price
and feed calls → IOFC Floor
$/cwt Milk
Max Milk Price: $PU
$C
Milk revenue range
Min Milk Price: $PL
Feed cost ceiling
$A
Feed-Based Call: $C
$B
C*
$PL
$PU
Milk/Feed Prices
 Minimum IOFC = $A
 Higher margins: $A+ $C, $A+ $B, or $A+ $B + $C
24
Examples of Margin Risk Management
 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)
25
Examples of Margin Risk Management
 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
26
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
 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
Margin Risk Management: 2013 Farm Bill
 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
30
Margin Risk Management: 2013 Farm Bill
 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
31
Margin Risk Management: 2013 Farm Bill
 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
$4.00
 Coverage is purchased coverage % times the
lesser of:
 Annual production history divided by 6 or
 Actual amount of milk marketed over the
previous 2-month period
32
Margin Risk Management: 2013 Farm Bill
• DPMPP premiums vary by farm size
•
•
•
4 Mil. Lbs. is the boundary between premium
schedules
House and Senate versions have similar
premium schedules
Premiums still subsidized, although not at
100%, even at higher coverage
33
Margin Risk Management: 2013 Farm Bill
DSA Income Over Feed Cost Margin
16.00
House
Senate
Net
Net
Coverage Prem.
Prem.
Coverage
Coverage
($/cwt)
4.00
0.030
3.970 0.000
4.000
6.00
0.185
5.815 0.150
5.850
8.00
1.060
6.940 1.060
6.940
$14.65
14.00
12.00
8.00
6.00
4.00
$2.73
$2.25
$4.00
2.00
0.00
Jan
Apr
Jul
Oct
Jan
Apr
Jul
Oct
Jan
Apr
Jul
Oct
Jan
Apr
Jul
Oct
Jan
Apr
Jul
Oct
Jan
Apr
Jul
Oct
Jan
Apr
Jul
Oct
Jan
Apr
Jul
Oct
Jan
Apr
Jul
$/cwt of Milk
10.00
2005
2006
2007
2008
2009
2010
2011
2012
2013
34
Margin Risk Management and Your Farm
 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?
35
Margin Risk Management and Your Farm
 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?
Standard Class III
Milk Composition
Component
% of
Vol.
Water
87.82
Butterfat
3.50
Protein
2.99
Other Solids
5.69
 → Expected Mailbox = Expected
Class III + the above basis
36
Margin Risk Management and Your Farm
 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)
37
Margin Risk Management and Your Farm
 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?
38
Margin Risk Management and Your Farm
 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?
39
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)263-3212
bwgould@wisc.edu
40