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Dairy trading experts offer strategies and practical perspectives to optimize market performance.

Base Your Margin Protection Program Decision on the Math

Mar 28, 2014

Although it might be nice to sign up for margin protection and forget about it, a sharp pencil is still required.

Patrick PattonBy Patrick Patton, Stewart-Peterson Inc.

In an article here on agweb.com earlier this week, Dairy Today’s Jim Dickrell said, "The devil is in the farm bill details." That is very well-put. There is much rule-writing that needs to happen before Sept. 1 implementation. Nevertheless, everywhere we go, producers are asking us whether they should take the insurance or not.

There seems to be more buzz about this particular farm bill than previous ones, with the addition of the margin protection program. Maybe that’s because the concept of margin management is in vogue right now. Many dairy producers want to lock in a profitable margin and in effect, forget about it.

Although it might be nice to sign up for margin protection and forget about it, a sharp pencil is still required. Our evaluation of whether producers should participate in these programs is rooted in the math and based on a holistic approach to risk and opportunity management.

Here is a basic summary of the math as we see it today:

Up to 4 million pounds of production, take the insurance. The math shows that dairy producers should take the insurance as part of their comprehensive price protection plan, typically at the highest level of protection, up to the 4 million-pound mark. The premiums are so advantageous, plus, there is a 25% discount the first year you enroll (2014-15). So why not take it?

A special note for dairy producers with 4 million pounds or less of production: If you plan to use the insurance as your only risk management tool, remember that payouts are calculated based on national averages, not your own individual farm’s margin. The risks associated with this feature of the program are further explained in the paragraphs ahead.

After 4 million pounds, do the math. The pricing in the tier above 4 million pounds of production is not necessarily advantageous. Producers should evaluate the protection available in the program at that level compared to what is available in the marketplace to provide equivalent levels of protection. For example, you may be able to protect similar margin levels using calls on feed and puts on milk, for less money. Do this evaluation for any milk production beyond 4 million pounds, especially if you are growing or expanding. In addition, if you choose to protect your production beyond 4 million pounds using hedging tools available in the marketplace, why not manage your price risk for your entire production of milk and feed needs? There is no reason why you cannot do both.

If you are growing or expanding, there’s not much here for you. Because of the way the MPP is set up, if you are growing or expanding, you leave much of your production unprotected. That means you will have to seek some sort of protection for milk produced beyond the initial amount you are eligible to insure.

The math shows that you should also continue commodity price risk management for all your feed and milk. This is especially true if you are growing/increasing production: If the insurance is your only form of price risk management, so much of your milk would be left unpriced and open to market volatility.

For all dairy producers, expanding or not, insurance under MPP is really catastrophic in nature. In the middle ground between a catastrophic price drop and today’s prices, producers could benefit from actively pricing their milk and hedging feed.

Remember, payouts are triggered by national averages, not your own individual situation. Unlike crop insurance, which insures your own farm’s production, the MPP protects a producer against industry- wide losses. It does not protect your individual operation or your region. If you are in an area of the country that is impacted by high feed prices and the rest of the country isn’t, you won’t see a dime in terms of a payout. It is still in your best interest, therefore, to capture as much price opportunity as you can beyond the basic insurance.

Participating in the MPP and maintaining a comprehensive price risk management approach on your own will put you in the best possible position to weather price volatility. Consider this: If you are in an area of the country that is better off than the national average, and you’ve actively managed your risk using tools beyond this program, and the national average triggers a payment, you receive the benefit of both your market positions and your insurance payment.

A concrete example of this is our clients’ experience during the 2012 drought. Our clients had corn prices locked in at an average of $5.50 in 2012 and were able to keep a healthy margin during the drought. Had this program been in place, it would have triggered a payment, and our clients would have benefited from both their own price risk management decisions and the government’s MPP.

So, the savvy producer will use the government program up to its financially advantageous point, and then continue to use all available tools to protect prices and create opportunity. The combination of this insurance and actively managing risk and opportunity is very powerful.

We’ve written a summary report that contains these thoughts plus more math to guide you through future decisions. Simply call me or email your questions, and I’ll be happy to talk you through the math, or provide you with the white paper.

Patrick Patton is Director of Client Services for Stewart-Peterson Inc., a commodity marketing consulting firm based in West Bend, Wis. You may reach Patrick at 800-334-9779, or email him at ppatton@stewart-peterson.com.

The data contained herein is believed to be drawn from reliable sources but cannot be guaranteed. This material has been prepared by a sales or trading employee or agent of Stewart-Peterson and is, or is in the nature of, promoting the use of marketing tools, including futures and options. Any decisions you may make to buy, sell or hold a futures or options position on such research are entirely your own and not in any way deemed to be endorsed by or attributed to Stewart-Peterson. Commodity trading may not be suitable for all recipients of this report. Futures trading involves risk of loss and should be carefully considered before investing. Past performance may not be indicative of future results. Copyright 2014 Stewart-Peterson Inc. All rights reserved.
 

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