prices - Extension Risk Management Education

Report
Risk Management Practices by the U.S.
Dairy Industry: Industry Complexities,
Learning Curves and Producer Adoption
Brian W. Gould
Professor
Department of Agricultural and Applied Economics
University of Wisconsin-Extension
University of Wisconsin
([email protected])
National Extension Risk Management Conference
April 2, 2013
1
Overview of Today’s Presentation
 Overview of Price Volatility in the U.S.
Dairy Industry
 Use of Traditional Futures and Options for
Price and Revenue Risk Management
 Revenue Protection via Margin Insurance
Programs
 LGM-Dairy
 Dairy Sub-Title Margin Insurance Proposal
 What Does the Future Hold?
2
Price Risk in Today’s Dairy Industry
 We have seen a tremendous increase in the
volatility of farm milk prices over the last 20 years
Class III/BFP/MW Prices ($/cwt)
22
20
18
16
Jan 70 - Dec 81
Jan 82 - Apr 95
May 95 - Dec 99
Jan 00 - Present
Support
14
12
10
8
6
Parity milk
price support
Use of
BFP
formula
Federal Order
Reform
4
3
Price Risk in Today’s Dairy Industry
 U.S. dairy industry
14.5
13.0
% of U.S. Total Milk Solids

is devoting more
resources to the
development of
international
markets
For some dry
products like
NFDM, Dry Whey,
Lactose, etc., more
than 50% of U.S.
production is
exported
U.S. Exports and Imports as Percent of
Total U.S. Milk Solids Production
11.5
10.0
8.5
Dairy Exports
Dairy Imports
7.0
5.5
4.0
2.5
 Major drop in milk prices last
half of 2008 and most of 2009
 June 2008 Class III: $20.25/cwt
 Feb. 2009 Class III: $9.31/cwt
4
Price Risk in Today’s Dairy Industry
5
Price Risk in Today’s Dairy Industry
Comparison of International and Domestic Powder Prices
2.50
2.30
2.10
U.S. (NFDM)
Northern Europe
Oceania
Commodity prices have
direct impact on
domestic milk prices
due to classified pricing
1.90
$/lb
1.70
1.50
1.30
Correlation Coefficient
Oceania-U.S.: 0.939
Europe-U.S.:
0.890
Oceania-Europe: 0.964
1.10
0.90
0.70
0.50
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
6
Margin Risk in Today’s Dairy Industry
 Purchased feed costs represent a major portion
of total operating costs for dairy farms
 ERS 2011 Estimates: CA: 59% WI: 34%
Average 16% Dairy Ration Cost Index
3.00
Index: Jan 1995 = 1.0
2.75
2.50
2.25
2.00
Composition (by wgt)
Corn: 51%
Soybeans: 8%
Alfalfa Hay: 41%
1.75
1.50
1.25
1.00
0.75
7
Margin Risk in Today’s Dairy Industry
16% Ration vs. Class III Index Comparison
2.25
Index: Jan 1995 = 1.0
2.00
1.75
1.50
Ratio > 1.0 → ration price has ↑
at a higher rate relative to Class
III milk price using Jan. 95 base % of Months With Ratio > 1
1995-1999: 60.0
2000-2004: 46.7
2005-2009: 63.3
2010+: 100.0
1.25
1.00
0.75
0.50
8
Margin Risk in Today’s Dairy Industry
Estimated U.S. Milk Income Over Feed Cost
$14.65
14.50
IOFC = Avg All-Milk Price – Avg Feed Costs
13.25
(2012 Senate Farm Bill Feed Cost Formula Used)
12.00
10.75
$9.97
8.25
7.00
$6.64
5.75
4.50
3.25
2010
Nov
Jul
Sep
Mar
Jan
Nov
Jul
2011
Sep
May
Jan
Mar
Sep
Nov
Jul
May
Jan
Mar
Nov
Jul
2009
Sep
Mar
May
Jan
Nov
Jul
2008
Sep
May
Jan
Mar
Nov
Jul
2007
Sep
May
Jan
Mar
Nov
Jul
2006
Sep
May
Jan
Mar
Nov
Sep
Mar
Jul
2005
May
$2.74
$2.25
May
2.00
Jan
$/cwt
9.50
2012
9
The Pricing of Milk in the U.S.
10
The Pricing of Milk in the U.S.
 To understand effectiveness of milk price
(revenue) risk management one needs to
understand how producer prices are established
 A majority of U.S. milk produced under
classified pricing
 Minimum farm milk price based on how it is
used and associated component values

Two major milk pricing systems: CA and 10
Federal Milk Marketing Orders (FMMO)
 % of U.S. milk marketed in 2012
 CA: 20.9%
 FMMO: 61.1%
82.0%
11
The Pricing of Milk in the U.S.
 Theoretically with classified pricing one segregates
milk according to demand elasticity
 Set different minimum prices according to milk use
 Higher prices for most inelastic uses (i.e. fluid)
 Higher price → consumption reduced relative to
competitive market
 Divert excess milk from reduced fluid use to
uses with more elastic demand (e.g., cheese)
 Prices will be reduced so as to clear markets
 Hoped for net effect:
Higher average price and
more production
12
The Pricing of Milk in the U.S.
 Two variants of the classified pricing system:
 Milk price being the sum of the value of multiple
components:




Protein
Milkfat
Other Solids
Non-Milkfat solids
 6 FMMO’s & CA
 Fat/Skim Pricing
 Milk value based on value of butterfat and skim milk
 Four FMMO’s: SE, Appalachian, FL and AZ
13
The Pricing of Milk in the U.S.
 Class-specific minimum prices:
 Based on class specific formulas relating above
milk component values via the use of:
 Wholesale dairy product prices
 Assumed product yields
 Fixed manufacturing (non-milk) costs (i.e., productspecific make allowance)
 Milk class minimum price ($/cwt) obtained by:
 Determining component quantity/cwt
 Multiplying per cwt component amounts by
component prices (net of make allowances)
 Net price depends on product produced from this milk
 Sum class-specific component values per cwt
14
The Pricing of Milk in the U.S.
 A complicating factor for risk management
 Under both FMMO and CA systems there is
pooling of milk used for different purposes
 Uniform or blend price
 Within each order producers receive a:
 Uniform price for their milk of equal quality and
composition
 Uniform price per lb of component
 Uniform price is weighted average of class specific
milk or component prices
 Applies only to milk sold to a plant that is
participating in the FMMO system
15
When are Minimum Milk
Prices Determined?
 Timing of producer milk price determination
 Under CA and FMMO systems class-specific
component values determined once a month
 Fluid milk (i.e., Class I) component values
determined prior to production month
 Other milk classes’ component values
determined after production month
 → Can be up to 6 weeks difference in price
determination for same month but different
class
 In volatile markets makes risk management
difficult
16
Use of Dairy-Based Futures and
Options Price Risk Management
Strategies
17
Evolution of Dairy-Based Futures/Options
 Futures/options contracts for farm milk and
manufactured dairy products developed with the
onset of increased volatility
 1993: 1st modern futures market developed at
New York Coffee, Sugar and Cocoa Exchange
(NYCSCE)
 1997: Chicago Mercantile Exchange (CME)
assumes leadership
 Only exchange with dairy-based contracts
 Contract types have evolved over time
 From physical delivery to most being cash settle
contracts
18
Current CME Dairy-Based Futures/Options
Contract
Contract Size
Settlement
Deliverable NFDM
Cash Settle:
Announced Class III
Cash Settle:
200,000 lbs
Announced Class IV
Cash Settle: NASS
20,000 lbs
Butter
Cash Settle: NASS
44,000 lbs
Dry Whey
Cash Settle: NASS
44,000 lbs
NFDM
44,000 lbs Physical Delivery
International SMP
20 MT
Class III Fluid Milk
Class IV Fluid Milk
Cash-Settle Butter
Dry Whey
Nonfat Dry Milk
Cheddar Cheese
200,000 lbs
20,000 lbs
Physical Delivery
Cash Settle: NASS
Cheddar
Start Date
February 1, 2000
(Replaced BFP)
July 10, 2000
Sept. 19, 2005
March19, 2007
Oct.10, 2008
April 20, 2009
May 10, 2010
June 21, 2010
19
Current Futures and Options Open Interest
 Farm operators, processing plants and product
purchasers can use traditional futures/options tools
 24 monthly contracts traded daily
Dairy-Based Futures and Options Open Interest
Contract
Futures Options
Class III 23,417
Class IV
1,580
Butter
4,126
67,040
1,905
2,934
Contract
Futures
Options
Dry Whey
NFDM
Cheddar
1,697
1,216
5,805
524
376
6,931
Note: Data as of March 22, 2013. The above numbers represent the open
interest in each commodity/contract type. Each contract represents the
following quantities: Class III and IV milk – 2,000 cwt, Butter and Cheddar
– 20,000 lbs, Dry Whey and NFDM – 44,000 lbs, SMP – 20 Metric Tonnes
20
Futures and Options Open
Interest Commodity Equivalents
Commodity
Units
Class III Mil. Lbs.
Amount 2012 U.S.
Covered Production
19,891
Class IV Mil. Lbs.
697
Butter 000 Lbs. 141,200
Dry Whey 000 Lbs.
93,764
NFDM 000 Lbs.
Cheddar 000 Lbs.
3,509
254,720
200,3241
200,3241
% of 2012
U.S.
Production
9.9
1,857,040
0.3
7.6
1,009,130
1,781,110
3,143,290
9.3
0.2
8.1
1Total
U.S. milk production.
Note: Data as of March 22, 2013. 729 Mid-Class III option
contracts (100,000 lbs) are not included in the above
21
Fixed Price Forward Contracting
 Sell milk to processing (i.e., cheese) plant offering
fixed price forward contract
 Processor undertakes a short hedge
 Collects forward contract offers across producers
 Decrease contract offer to cover
hedging/administrative costs
 Manufacturer usually covers the margin calls
 Expanded use allowed via 2008 Farm Bill and
current 1 year extension
 Bottling plants not allowed to offer forward
contracts of any type
 Concern as to the impact on pooling function
22
Fixed Price Forward Contracting
 Fixed price contract may be due to processor’s
customer wanting long-term constant price
 e.g., McDonalds enters into a 2 year contract
with a cheese plant at a fixed cheese price
 Plant offers a fixed price for a:
 Given month, quarter, year, etc.
 Converts fixed output price customer
commitment to equivalent milk price using
assumed product yields
 Contracted volume usually limited to some
percentage of a farm’s production
23
Typical Fixed Price Contracts



Cash settled against monthly USDA Announced
class price, NASS commodity prices or
Announced component values
Milk check adjusted by difference per cwt between
contracted and Announced price.
 Announced less than contract price → milk
check ↑ by difference times contracted quantity
 Announced higher than contract price → milk
check ↓
Contracts available for Class III price, Class IV
price, component value, blend price, PPD/blend
price, etc.
24
Fixed Price Forward Contracting
Alternative Types of Forward Contracts
Fixed
Fixed Price
Price
Fixed
Contract
Contract
Price with
with
Contract
Capped
Upside Rider
Rider
$17.30
$16.95
$16.60
$/cwt
$16.25
$15.90
$15.55
Fixed Price
Rider
Upside Floor
2008-12
Class III Avg. Price
2008-12Ceiling
Class III Avg. Price
Upside
Fixed Price
2008-12 Class III Avg. Price
$15.20
$14.85
$14.50
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
25
Minimum Price Contracting
 Purchase a minimum price contract from a
processing (i.e., cheese, yogurt, etc.) plant
 Plant collects minimum price contract offers
across farms to determine number of Put
options to purchase
 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
 Type of pricing products available same as with
fixed price contracts
26
Min/Max Contracts Available


Purchase a Min/Max (Collar) price contract to set
floor and ceiling milk price
 Producer select’s floor and ceiling that fits
price goal
 Floor protects from low prices
 Ceiling reduces contract cost
 Contract price is the Announced price should
USDA price between floor and ceiling
Type of pricing products available same as with
fixed price contracts
27
Min/Max Contracts
 Plant collects min/max
Minimum/Maximum Contract
$17.30
$16.95

$16.60
$/cwt
$16.25
$15.90
$15.55
Minimum
Maximum
$15.20
2008-12 Class III Avg. Price
$14.85
$14.50
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
offer across farms
Plant purchases Class III
Put to establish
minimum
 Only active fluid
milk options market
 Plant sells Class III Call to establish maximum
 Plant decreases contract offer to cover commission and
own administrative cost
28
How Can Dairy Producers
Manage Margin (IOFC) Risk?
29
Margin Risk Management Examples
 Use of fixed price contracts in managing IOFC
volatility
 For both milk and feed to lock in an IOFC
margin
 Fixed milk price contract and feed call
options to establish a minimum IOFC
 Class III PUT options and fixed feed price
contracts to establish a minimum IOFC
30
Margin Risk Management Examples
 Purchase both Class III PUT and feed equivalent
CALLS to establish IOFC floor
Milk revenue floor
$/cwt Milk
$P* Class III Put
A
B
C
Feed cost ceiling
$C* Feed-Based Call
C*
P*
Milk/Feed Prices
 Could be expensive
 Possible thin Class III options market
31
LGM-Dairy: An Overview
 Aug. 2008:
Livestock Gross Margin Insurance
for Dairy (LGM-Dairy) became available
 Objective is to establish minimum IOFC
 Similar to a bundled options strategy except:
 No options purchased
 No minimum size limit
 Upper limit: 240,000 cwt over 10 mo. or within
insurance year
 Premium not due until after contract period
 USDA-RMA administered and purchased from
firms selling Federal crop insurance
 July 2010: Available in lower 48 states
32
LGM-Dairy: An Overview
 LGM-Dairy is very customizable:
 1 – 10 month’s production insured by 1 contract
 % of monthly production covered
 0 – 100% of certified production each month
 % coverage can vary across months
 Farm specific production, feed use, deductible &
premium
 No farm level prices used
 2013 Farm Bill margin insurance proposal less flexible
 Dec. 2010:
Direct subsidy of insurance premiums
 $0 deductible: 18% subsidy
 $1.10 − $2.00 deductible: 50% subsidy
33
LGM-Dairy: Indemnity Determination
 Minimum Gross Margin Guarantee (GMG) for
entire contract determined when insurance
purchased
 Regardless of # of covered months
 GMG = Total expected milk revenue – Total
expected purchased feed costs – Total
deductible
 Total refers to sum over all insured months
 If Total GMG > Total Actual Gross Margin
(AGM) → Indemnity paid
 Payout amount = GMG – AGM
 1 indemnity per contract regardless of length
34
LGM-Dairy: When Purchased?
 LGM-Dairy available for purchase once a month
 Up to 12 contracts offered each year
depending on funding availability
 Each contract covers up to 10 months
 Contracts can over-lap contract months so long
as one does not insure more than 100% of a
month’s anticipated production
 Purchase period
 Starts: 4:30 p.m. (CDT) on last business Friday
each month
 Ends: 8:00 PM CDT Saturday
35
LGM-Dairy: An Overview
Policies CWT
Insurance
Sold Insured
Year
(No.) (000)
09/10
134 1,872
Indem.
GMG Premium
Subsidy
Paid
($000) ($000)
($000)
($000)
24,915
782
280
0
10/11
1,224 46,173
769,645
25,013
65
10,736
11/12
900 40,524
704,864
19,163
1,318
8,871
12/13
660 30,720
599,992
15,533
0
7,060
Note: The 46.2 million cwt insured in 2010/11 represented
approximately 2.4% of 2010 U.S. milk production.
LGM-Dairy: An Overview
 Unclear as to increased funding for LGM-Dairy
 LGM-Dairy is a livestock pilot program
 $20 million/year for all programs
 Substantial pressure on Congress to ↑
funding from farm groups, financial
industry, etc.
 Implications of DIAC recommendations
 2013 Farm Bill: There will be ↓ in direct
producer payments
 ↑ reliance on producer risk management
37
LGM-Dairy: 2011/12 Post-Mortem
 Demand for LGM-Dairy very high in 2011/12
insurance year
 Funds lasted only 2-months
 Industry is still in the learning curve
 Knowledge of limited funds caused many
producers to undertake a naïve and illadvised 10-month, 100% coverage strategy
 This resulted in few indemnities being paid
in spite of a relatively bad year
 Due to entire contract performance determining
indemnity payments not individual months
 Limited activity this year (still funds
available)
38
LGM-Dairy: UW Website
 We have a dedicated section to the University of
Wisconsin Understanding Dairy Markets website
devoted to LGM-Dairy:
 Understanding Dairy Markets website:
http://future.aae.wisc.edu
 LGM-Dairy website:
http://future.aae.wisc.edu/lgm_dairy.html
 LGM-Dairy Analyzer software system
http://future.aae.wisc.edu/lgm_analyzer_new/
 To join the LGM-Dairy Mailing List:
http://future.aae.wisc.edu/lgm_dairy.html#5
39
Farm Bill Margin Protection Program
 With extension of the 2008 Farm Bill to Sept.
30, 2013, deliberations for 2013 Farm Bill will
start anew
 Dairy Production Margin Protection Plan
(DPMPP)
 Below is a summary of the margin insurance
program within the Bill approved by U.S.
Senate in June 2012
 Very surprised if the 2013 Farm Bill does
not have similar language
40
Farm Bill Margin Protection Program
 The DPMPP pays participating farmers an
indemnity when
 2-month national average IOFC falls
below insured level
 Insured margin can range from $4$8/cwt
 $4.00 protection level is 100%
subsidized for 80% historical prod.
 No payment or herd size limitation
 If you sign up for DPMPP you must
participate in supply management program
41
Farm Bill Margin Protection Program
 DPMPP Margin ≡ Milk Revenue – Feed Costs
 Ration: Corn, corn silage, SBM, alfalfa hay
 U.S. All-Milk Price used for revenue
 Feed costs: Fixed rations for 3 cow and heifer
types
Cow Type
% of
Herd
Milking Cows
52.5
Heifer: To calve
in 1 year
18.5
Hospital Cows
1.1
Heifer: 500 lbs +
9.6
Dry Cows
8.8
Heifer: < 500 lbs
9.6
Cow Type
% of
Herd
 U.S. avg. corn and alfalfa hay price received
 Monthly avg. Central Illinois SBM price
42
Farm Bill Margin Protection Program
 Annual administrative Fees
Annual Milk
Marketings
(Mil. Lbs)
Marketings < 1
Fee ($)
Herd Size with
20,000 lb/cow
$100
< 50
1≤ Marketings < 5
$250
50-250
5≤ Marketings <10
$350
250-500
10≤ Marketings <40
$1,000
500-2,000
Marketings ≥40
$2,500
≥ 2,000
43
Farm Bill Margin Protection Program
 Supplemental Program
 Producer can elect to cover a range of 2590% of historical production
Premiums ($/cwt)
Coverage
Level
($/cwt) ≤ 4 Mil. Lbs > 4 Mil. Lbs
$4.50
$5.00
$5.50
$6.00
$6.50
$7.00
$7.50
$8.00
$0.010
$0.020
$0.035
$0.045
$0.090
$0.400
$0.600
$0.950
$0.020
$0.040
$0.100
$0.150
$0.290
$0.620
$0.830
$1.060
44
Revenue Risk in Today’s Dairy Industry
Estimated U.S. Milk Income Over Feed Cost
14.50
Premiums ($/cwt)
≤ 4 Mil. > 4 Mil.
$0.045 $0.150
$0.950 $1.060
13.25
$6.00
$8.00
12.00
10.75
8.25
$8.00
7.00
5.75
$6.00
4.50
3.25
2006
2011
Nov
Jul
Sep
May
Jan
Mar
Sep
Nov
Jul
May
Jan
Mar
Nov
Jul
2010
Sep
May
Jan
Mar
Nov
Jul
2009
Sep
Mar
May
Jan
Nov
Jul
2008
Sep
May
Jan
Mar
Nov
Jul
2007
Sep
May
Jan
Mar
Sep
Nov
Jul
May
Jan
Mar
Nov
Jul
2005
Sep
May
Jan
2.00
$4.00
Mar
$/cwt
9.50
2012
45
My Contact Information
 Brian W. Gould
Department of Agricultural
and Applied Economics
University of Wisconsin-Madison
University of Wisconsin Extension
(608)263-3212
[email protected]
46

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