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Margin protection options weighed

Dave Wilkins Published on 29 October 2012

Protecting a dairy’s milk income from soaring feed costs has never been more of a challenge. Historically, producers have turned to the futures and options market to hedge against milk price declines or increases in feed costs.

Now, thanks to the federal government’s willingness to subsidize insurance premiums, there are some other interesting choices available.

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The USDA Risk Management Agency’s Livestock Gross Margin-Dairy pilot program is one option. It’s aimed at ensuring a certain income level over feed costs. Policies are available through independent insurance agents, subject to available federal funding.

But you’ll have to act quickly. This is a popular program and strong demand is expected on the first two sales dates of the new fiscal year (Oct. 26 and Nov. 30).

LGM-Dairy is sold on the last business Friday of each month as long as funds are available. The program sold out within three months last year. If you miss out, there’s a chance a new farm bill will include some type of margin protection for dairy producers.

The Senate version of the bill approved earlier this year includes the Dairy Production Margin Protection Program. It would also require that producers participate in the industry’s supply management program as a condition for buying the subsidized insurance. Whether that provision makes it into the final version of the bill is anyone’s guess.

If you’re looking for a risk management strategy without a government component, your local commodity broker will be glad to help. Forward pricing both feed and milk may help a producer sleep at night, but it will also set the producer’s margin so he can’t take advantage of increases in the price of milk or decreases in feed costs, said Brian Gould, a University of Wisconsin extension agricultural economist.

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There’s no such constraint when buying a combination of put and call options. By purchasing both Class III puts and feed equivalent calls, producers can establish a floor on milk prices and a ceiling on feed costs.

“If milk prices go up, you can take advantage of it. If feed costs go down, you can take advantage of that and your margin can increase,” Gould told producers attending a workshop in Twin Falls, Idaho, in September.

The LGM-Dairy program aims to achieve precisely the same thing, Gould said. “The objective is the same: To establish a minimum income over feed costs,” he said. With LGM-Dairy, no futures or options are actually purchased to back up the insurance program.

“The futures and options market are only used as an information source,” Gould explained. “They are used as an information source to set the premium, to establish that minimum income over feed costs at sign-up and to evaluate whether or not there is going to be an insurance payment.”

Producers should be aware of some potential drawbacks with the options strategy. “Options can be very expensive,” Gould said. The Class III market is a thinly traded market with relatively few players.

“In a thinly traded market, there may not be anybody willing to sell you that put at whatever price and, therefore, you can’t do what you want to do,” he said. With LGM-Dairy, producers are guaranteed margin protection when they enroll.

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There could also be an issue for some small dairy operations when buying feed options because of minimum contract size, Gould said. The minimum option contract for corn is 5,000 bushels and the minimum soybean meal contract is 100 tons.

“If you buy a call or a put that’s smaller than the contract size, then you as a dairy operator are acting as a speculator in the options market,” he said. Don’t be a speculator, he advised.

The farm bill margin insurance provision as currently written would use the U.S. all-milk price to set revenue and the U.S. average price of corn, soybean meal and alfalfa to calculate feed costs.

“There is not going to be any region-specific formulation of these rations in the farm bill program,” Gould said. LGM-Dairy, on the other hand, can be customized to fit individual farms.

“What’s nice about LGM-Dairy is that you are going to be tailoring your ration to your operation. You won’t be using your own mailbox price but at least you will be able to define what your ration is,” he said.

Obviously, anyone venturing into the futures and options market needs to know what they’re doing. Participating in a government-sponsored program also requires some homework.

Producers will find some useful LGM-Dairy analyzer tools on the University of Wisconsin’s dairy marketing website. Click here to view.

Gould and his colleagues are also developing some tools that will allow producers to compare LGM-Dairy to the margin protection provision in the farm bill. “We’re developing software that will allow us to compare the impacts,” he said. “We know what the margin insurance in the farm bill looks like and we know what the LGM-Dairy looks like. We are going to put it together and see how they both perform.”

Increased participation in margin risk management strategies is a positive development, whether producers stick with the futures and options market or opt for a government-sponsored program, Gould said.

Nowadays, focusing on milk price alone is only half the battle, he said. “We’re no longer just concerned with output price. We’re concerned with margin volatility – that is, what’s going on with feed costs as well,” he said. PD

Wilkins is a freelance writer based in Twin Falls, Idaho.

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