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Learn to use milk price risk management

Zach Myers for Progressive Dairy Published on 01 October 2020

Modern milk price risk management has been around for more than 20 years. As we have seen in 2020, with the impact of COVID-19 on the dairy market, milk price volatility is not going away.

This year proves how difficult it is to predict what milk prices will be until they happen. Actual milk prices since April have been quite different than what was projected in December 2019. Having a risk management plan in place can help reduce the amount of volatility in the long term. The following two questions are the most common risk management questions I hear.

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1. What are some things I should consider prior to developing a risk management plan?

The first thing you should consider is understanding the purpose of risk management. The basic purpose of risk management is to make sure that cost of production (COP) is covered. If you can lock in a profit, even better. To accomplish this, you must first know what your COP is. Not having an accurate COP may lead to erroneously locking in a loss. If you do not have an accurate COP, work with someone to help you calculate it so you are better able to match your risk management plan to your actual costs.

The second thing to consider is the idea that risk management plans should be thought of as insurance policies. Risk management should be considered a cost of doing business, just like farm insurance or automobile insurance. I like to use fire insurance as an analogy. You do not purchase fire coverage hoping your barn burns down; you purchase it in case it does. Risk management is the same. If your plan is implemented correctly and it does not pay, then your milk price was more than adequate to cover your COP and you have positive cash flow without the risk management plan paying.

Once you have an accurate COP and an understanding of the purpose of risk management, the third thing that needs consideration is what programs are available and what the associated cost is relative to each program. Risk management is not free, so it is important to consider how much you are willing to spend and then build that into your production costs. You are not guaranteed a return on your risk management plan. Including the cost of risk management into your COP ensures you have the money to pay your plan costs in case it does not provide you with a return.

2 .What are some advantages and disadvantages of each of the risk management tools?

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There are several risk management tools available to dairy farmers (see Risk management: Forward strategy based on 2020 hindsight), and one may be a better option than another based on your dairy.

Let’s start with Dairy Margin Coverage (DMC). DMC is a USDA program designed to be the most beneficial for dairies with less than 5 million pounds of annual production, even though any size of dairy can participate in the program. The premium per 1 million pounds of production enrolled for up to the first 5 million pounds of production is just over $1,500. In my opinion, the main advantages are: It is relatively cheap insurance for up to 5 million pounds of production, it sets a milk price floor without giving up the top side of the market, it has a feed cost component, and it is a once-a-year decision.

This program is relatively easy to understand and may provide adequate coverage for dairies with 5 million pounds of annual production or less without the use of any of the other tools. For smaller dairies, I do not see any disadvantages. However, DMC will not provide adequate coverage for larger dairies. DMC enrollment for 2021 begins Oct. 12 at your local Farm Service Agency office.

Livestock Gross Margin for Dairy (LGM-Dairy) is another USDA insurance program that sets a milk price floor without giving up the top side of the market. Other advantages include a feed cost component, subsidized premiums and its ability to work for any size of dairy. Disadvantages include policies only being available for purchase the last Friday of each month, only corn and soybean meal being considered as part of the feed cost, only Class III milk being considered and more complexities to the program.

Dairy Revenue Protection (Dairy-RP) is also a USDA insurance program that sets a milk price floor without giving up the top side of the market. Dairy-RP is very customizable. Dairy farmers can design their insurance policy to match their actual milk check more closely. Dairy-RP is advantageous because it offers subsidized premiums, it is a great option for larger dairies not adequately protected by DMC, and policies are available nearly every day milk and milk products are traded. Disadvantages include more complexities relative to DMC, and it does not consider feed cost.

Forward contracting is available through some cooperatives and privately through a broker on the Chicago Mercantile Exchange (CME). In general, these two tools are more expensive than the USDA programs because premiums are not subsidized. One advantage to forward contracting through a cooperative compared to a private broker is: There is no brokerage account that must be maintained. Forward contracting through a private broker requires the farmer to actively maintain a brokerage account that is subject to margin calls. Another advantage to cooperative contracting is: Smaller volumes of milk may be contracted. Most cooperatives will allow contracts as low as 20,000 or 25,000 pounds of monthly production, whereas direct trading on the CME requires a minimum of 200,000 pounds per monthly contract.

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A big disadvantage to forward contracting through a cooperative compared to USDA programs is: Forward contracts are fixed contracts. Farmers can set a floor but give up the top side of the market on any contracted milk. This is not necessarily true for contracting through a broker. However, the cost of the milk price floors may only be affordable by “selling” a milk price ceiling. The net result of buying a milk price floor and setting a milk price ceiling is a lower premium cost for the floor that gives a milk price range to the contract. It still results in giving up the top side of the market.

The last risk management tool I will mention cannot be counted on every year but should be considered when it becomes available. During extreme economic downturns, like we have seen this year, the U.S. government may provide direct payments to farmers. In 2018 and 2019, we had the Market Facilitation Program that partially compensated dairy farmers for revenue losses due to trade conflicts. This year the Coronavirus Food Assistance Program (CFAP) has helped mitigate revenue losses due to the impact of COVID-19 on dairy markets.

As you can tell, there is a lot to understand and consider when developing a risk management plan. The biggest thing to remember is: Farm managers who are the most successful using risk management are those who view it as a work in progress and stick with their plan month after month, year after year. They do not try to guess the market and jump in and out.

In the case of risk management, practice does not necessarily make perfect – but with experience, it will better enable you to protect your bottom line and reduce milk price volatility.  end mark

Zach Myers
  • Zach Myers

  • Risk Education Manager
  • Center for Dairy Excellence
  • Email Zach Myers

Questions to answer prior to developing a risk management plan

What do I want to accomplish with risk management?

What is my cost of production?

What risk management options are available?

What options are best for me?

What do these options cost?

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