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Navigate Dairy Revenue Protection and risk with your lender

Kurt Petik for Progressive Dairyman Published on 10 October 2018

In the ever-changing and ever-challenging dairy industry, the new Dairy Revenue Protection (Dairy-RP) program is a welcome sight for most in the industry as a way to manage or mitigate risk. Your participation in the program will likely be a topic of discussion with your ag lender in the upcoming months. What should you be prepared to talk about?

Dairy-RP is a federally reinsured crop insurance program that has been approved by USDA’s Risk Management Agency. The policy insures a dairy farmer against declines in milk revenue and area production for a given calendar quarter. 

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Manage your credit risk

You need to manage your business risk. Every farm has a unique risk tolerance, and you should have a risk management plan. While not required, Dairy-RP should be strongly considered as a part of that plan. 

With approved premium subsidies starting at 44 percent, Dairy-RP should be an economical tool that will help manage downside price risk. Coverage options range from 70 percent to 95 percent of expected price.

For example, a $16.25 per hundredweight (cwt) expected milk price at 70 percent coverage level provides a revenue guaranty at a whopping $11.38 per cwt.

Now, I am sure the premium would be extremely cheap, but the coverage probably doesn’t mitigate much price risk. On the other side of the spectrum, a 95 percent coverage option would provide a revenue guaranty based on a price of $15.44 per cwt. Spending a little more money on premiums may move your revenue guaranty up to a point that either protects a profit or at least limits potential losses to a manageable level. 

You need to continue dialogue with your lender so that both parties understand the price sensitivity of the business and the plan that is in place to mitigate that risk. Dairy-RP will not be a goose laying golden eggs that magically causes your dairy to be profitable, but I’d expect it to be a topic of conversation between you and your lender when you’re discussing comfortable risk levels to acquire financing approvals.

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In terms of loan collateral, Dairy-RP does not add to the security of a loan. However, if Dairy-RP is used as part of your comprehensive risk management plan, your business will be more secure, and a dedicated agricultural lender will recognize that. An operating budget that is supported by a minimum revenue protection – whether that is through utilization of Dairy-RP or other price risk management tools – just might help the farmer and the banker both sleep better at night.

Incorporate other risk management tools

This revenue protection policy may sound a lot like a put option. In a lot of ways, it is. You are able to select a portion (or all) of your production and purchase quarterly endorsements to protect that future revenue. Dairy-RP can essentially put a floor price on your milk. Be aware that there are a few details such as pricing options, yield adjustment factors and protection factors that you will also need to learn about. 

However, Dairy-RP is not a liquid market position that you can buy and sell. Once milk production is claimed under an endorsement, it can’t be exited, rolled up or rolled out. 

This is where your overall risk management plan needs to be followed. If market prices rise after you purchase an endorsement, you may still want to consider an options or contract strategy to capture that upward movement. You just will not be able to use Dairy-RP to purchase another endorsement on the same production for the same quarter.

How far out should you consider taking coverage? Dairy-RP allows you to purchase quarterly endorsements up to five quarters into the future. For example, when reviewing your 2019 operating budget with your lender in November 2018, you would have the ability to insure a given portion of your revenue all the way out to the first quarter of 2020. Obviously the available milk price and the premium cost will need to be considered whenever making a quarterly endorsement buying decision. There is not a minimum quantity of milk that needs to be claimed with each quarterly endorsement. So the good news is that you have the opportunity to add quarterly endorsements at almost unlimited decision points. For some of us that don’t like making decisions, this could also be the bad news.

I would encourage you to consider placing protection on at least a portion of your production as far out as possible. You can rest assured that at least some of your downside price risk is protected, without giving up the top side. Again, each business has a unique risk tolerance profile. Hopefully, you and your lender agree on where that tolerance level falls.

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Account for cash flow

Remember that Dairy-RP provides quarterly revenue protection. Monthly milk prices in a given quarter may have significant price swings that could make cash flow in one month a lot tighter than the next. So it is always important to monitor your monthly cash flow and have an adequate line of credit established to manage through the ups and downs. Although Dairy-RP will not insure a specific month’s revenue, you can still use your broker or milk plant to supplement the quarterly revenue protection provided by Dairy-RP.

Another consideration for cash flow is the cost of Dairy-RP premiums, especially if you want to buy coverage 15 months into the future. Many dairy farms are short on working capital, and some don’t feel comfortable taking on a large hedge line to cover option premiums or fund potential margin calls. Dairy-RP premiums are billed after the endorsement period is over. So theoretically, you will have the milk revenue from the claimed production to pay the premium. In the event of a loss, you will have an insurance claim to supplement your operating cash flow. 

It may not be safe to assume that the insurance claim will be applied to your premium. Due to the amount of time that it may take to process a loss claim, the premium may become due before a claim is paid out. Talk to your crop insurance agent, as the timing may vary slightly from company to company. And, of course, make sure your lender is aware of premium payments and potential loss claims. Once again, having an adequate line of credit available to cover timing of payments is crucial. Funding premium payments through a hedge line of credit would not be prudent, since the production has already been sold.

I encourage all dairy farms to learn more about Dairy-RP insurance. Be informed, know your risks, have open communication with your lender – and be proud of the food you produce for the world.  end mark

Kurt Petik is senior relationship manager with Rabo AgriFinance, based in Madison, Wisconsin. Email Kurt Petik. 

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