Know Your Market
Life Without LGM
May 09, 2011
Although USDA’s Livestock Gross Margin for Dairy Insurance program is on hiatus until later this year, other alternatives can protect the margin between your milk price and feed costs.
By Katie Krupa, Rice Dairy
The USDA’s Livestock Gross Margin for Dairy (LGM-Dairy) Insurance program has been available for nearly three years, but its producer popularity was nearly non-existent until recent months. Unfortunately, the popularity for this one-stop margin insurance program was so great that it exhausted the government’s allocation of $15 million of underwriting capacity.
Currently, the sale of LGM-Dairy is halted, and will not resume until October unless Congress authorizes additional funding prior to then. Assuming no additional funding is authorized, December 2011 will be the first month dairy producers can protect through LGM-Dairy. (If bought in October, coverage could start for December).
With so many producers now interested in LGM-Dairy, it’s a good time to point out some alternatives to the USDA’s margin insurance program.
First, let’s review the concept behind LGM. Rather than just protecting the milk price, LGM protects the margin (difference) between the milk price and the feed costs. The margin is determined by a model and, at its simplest, the producer can cover the feed needs for a set amount of milk. While LGM is simple, it isn’t always the most accurate for producers since their feed ration is not evaluated but rather a fixed model. The biggest perk to LGM was that it could be purchased for as little as one cwt. of milk per month, which made it very usable especially by smaller producers.
Most dairies have shied away from using the exchange to trade both their feed and milk due to:
· contract size
· lack of education on exchange trading
· margin account requirements
· varied feed ingredients in the ration
LGM simplified and standardized the process by converting a typical ration into corn and soybean meal equivalents. The good news is that producers can do this ration conversion themselves (or with the help of a broker/consultant). I work with producers on a daily basis to convert their ration, which is often very diverse, into corn and soybean meal equivalents. This conversion enables them to trade their feed costs on the exchange. By trading feed and milk, we can protect the margin between the milk price and the feed costs.
Taking this process one step further, we can trade milk and feed through various hedge strategies on the exchange. That means we have the opportunity to either lock in a margin, or protect a margin. For example, we can fix the milk price and fix the feed costs, or we can protect the milk price from dropping and protect the feed costs from increasing. With the second scenario we are protecting the margin, but if the milk price should rise and/or the feed prices decline, the producer will benefit from these price changes. But if the milk price drops, and feed prices rise, the producer will be protected.
Unfortunately, there are some hold-ups when trading on the exchange. The biggest one is contract size. From a 10,000-foot level, trading both milk and feed on the exchange is best suited for a dairy with at least 300 cows. Due to contract size for corn and soybean meal, a producer with less than 300 cows will typically be over-contracting his or her feed needs if trading through the exchange. Additionally, producers are required to fund a margin account when they place the trades. In short, money is due upfront on the exchange, as opposed to LGM-Dairy, where it is due at the end of the insurance period.
So are there any options for the herds with less than 300 cows? Maybe. Several of the co-ops are now offering margin, or feed contracts that can be used with milk contracts to protect the margin between milk and feed. I would check with your co-op or milk plant to see if any options are available.
The bad news is that price volatility is here to stay, and currently LGM-Dairy is unavailable. The good news is that hedge programs are evolving to combat price volatility and allow producers to protect their milk to feed price margin. Trading on the exchange offers a wide variety of hedge strategies for both milk and feed prices, and can be user-friendly when working with a knowledgeable broker.
Katie Krupa is the Director of Producer Services with Chicago-based Rice Dairy, a boutique brokerage firm offering guidance, analysis, and execution services on futures, options, spot and forward markets. If you are interested in learning more, Katie offers monthly webinars on the basics of risk management. You can reach Katie at firstname.lastname@example.org.Visit www.ricedairy.com.