Dairy risk management: Understanding the basics

(Editor’s note:  In his 2011 article below, Randy Greenfield shares the basics of various dairy risk management tools.  A new tool to add to the list is the Dairy Margin Protection Program, as explained in the following 2014 update.  Contact your Vita Plus consultant if you’re interested in further discussing these tools and strategies.)

2014 update
The new Dairy Margin Protection Program is administered through the Farm Service Agency (FSA) and will provide dairy producers with insurance against periods of low margins, measured as income over feed costs (IOFC), now through the end of 2018.

The program requires producers to sign up for the program annually (with a $100 annual fee), pick the amount of their base production they want to protect (5 to 90 percent in 5-percent increments of their base is allowed), and pick a margin level to protect ($4 to $8 per cwt in $0.50 increments is allowed). A producer’s base production is defined as their highest amount of annual milk marketed in 2011, 2012 or 2013. Coverage at the $4 per cwt margin has no additional cost once a producer is signed up. Coverage at higher levels will have additional costs.

While in some ways this program is a replacement for MILC, it is different and will require more decisions on the part of the producer. Sign-up periods will typically run July through September prior to the coverage year. The sign-up period for September through December 2014 and calendar 2015 is now through November 28, 2014.

Dairy risk management:  Understanding the basics (2011)
Starting a risk management plan can be a daunting task for many dairy producers.  You spend most of your time focusing on cow management – maximizing milk production, reproduction, cow comfort and cow health.  You fix equipment, plan this year’s crop rotation and buy next month’s loads of cottonseed or hay.  Suddenly, you’re being asked about your risk tolerance, futures contracts, long puts and short calls.  It’s not an easy or natural transition for most.

Why is a risk management plan necessary?  One word:  Volatility.  This means greater risk that a dairy business’ cash flow will be negative in any given month in the future.  Having a risk management plan allows producers to hedge their milk production.  A good definition of hedging is:  “To utilize futures markets to remove price risk on product that will be bought from or sold to the cash market.”

To develop a risk management plan, the risk must first be defined.  An accurate balance sheet and a good discussion with the lender will give some perspective on how much is at risk.  Because risk centers on cash flow, the cash flow needed to break even will be the zero mark.  The breakeven Class III price comes from projecting this year’s cash flow using a budget.  It is also very important to understand the difference between your mailbox price and the Class III price and to remove the basis to make sure a Class III breakeven price is used to develop the plan.

After budgeting, the next step is to select the hedging tool that works best for your operation.  The tools available certainly are not limited to what’s discussed below.  However, these tools can be used to start slow as you begin to manage risk.

Futures contract
One possible market position a hedging dairy producer can use is a futures contract.  By selling a futures contract, you are essentially fixing the price that you will receive for that unit of milk production.  If this is done with a brokerage on the CME, action on this contract will take place in your brokerage account, not on the milk check.  Because the contract is not a “deliverable” contract, the difference between the contract price and the cash price is “settled.”  The difference is either collected or made up by the producer in his or her brokerage account.

A futures position can also be established with the help of a milk processor.  In this case, the future price is actually settled on the milk check and the processor typically carries all of the margin risk. Processors usually have more flexible volume increments when compared to the CME’s 2,000 cwt increments.

Put option
A put option is another tool that can be used to hedge the future price of milk.  It is a contract on the CME that gives the buyer the option to “put” milk on the buyer at the agreed-upon price.  In effect, this allows hedging dairy producers to buy a floor price for their milk.

LGM Insurance for Dairy
The last tool considered here is LGM Insurance for Dairy.  This insurance program is offered through most crop insurance providers by the Risk Management Administration of the USDA.  It allows producers to look into the future and insure a gross margin value as implied by the CME futures markets.  Producers must input their milk production, corn purchases and soybean meal purchases into the program.  The gross margin takes these quantities and the futures prices to come up with a predicted gross margin.  The insurance policy can then be written to insure this amount.  A lesser amount can be insured (by using a deductible) in exchange for a decreased premium (subsidized by the USDA).

This program is similar to buying options, but combines milk and feed in the same tool.  The volumes and time periods allowed in LGM are very flexible as long as they are within the program’s rules.  Smaller operations will have more volume flexibility in this program than any other available to them.  Note that this program did run out of underwriting capacity for this past fiscal year, but it looks like it will be reinstated in October of 2011.

An extended version of this article originally appeared in the June 11, 2011 issue of Progressive Dairyman magazine. 

About the author:  Randy Greenfield is a Vita Plus dairy specialist.  For the past 13 years, he has worked with dairy producers to help them strengthen their nutrition and management programs.  Greenfield grew up on his family’s dairy farm near Waupun, Wis. and attended the University of Wisconsin-River Falls to earn his bachelor’s degree.  He went on to receive his master’s degree from Purdue University.  In addition to nutrition, Greenfield has taken a special interest in dairy records and business consulting.