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Livestock Gross Margin for Dairy: Pros and Cons

Sep 24, 2012

While this insurance program benefits producers because it helps protect against both milk and feed price volatility, its availability and inflexibility can be problems.

Katie Krupa photoBy Katie Krupa, Rice Dairy

October will start a new year for the government’s Livestock Gross Margin Insurance Program for Dairy (LGM). With the reoffering of the program, many producers want to know if they should purchase LGM, how much coverage they should obtain, and for what timeline. Every producer and business is different, so there is no simple answer, but here are some things to consider.

What is LGM? Simply put, LGM insures producers against a decline in the margin between the Class III milk price and the feed costs (which are corn and soybean meal). The program calculates the margin based on the trading prices of those three commodities on the Chicago Mercantile Exchange, and the actual USDA settlement prices. So, in other words, the insurance is not based on your actual feed costs or milk price. This program is beneficial to producers because it helps protect against both milk and feed price volatility.

Some pros of the program:

• Premium payment due at end. Since this program is insurance, there is a premium payment that producers have to pay to get the coverage. But unlike most insurance, the premium payment is due at the end of the coverage period. That means the premium amount is not tied up but is free to be used on the business until the insurance period has ended.

• Contract size. Producers can insure as little as one cwt. of milk, and the corresponding feed per month. That makes this program a great risk management strategy for smaller producers.

• Doesn’t limit upside potential. Because this is insurance against the margin decreasing, if the margin should increase, you will benefit from that higher margin. The program does not limit upside potential, but you will always have to pay the insurance premium.

Some cons of the program:

• Availability. This has been a big problem in the past year. Firstly, the program is only offered one day per month. Secondly, when the government’s funding runs out (which it did last year), the program is not offered until the new insurance year begins, or they allocate more funds to the program. It is important to note that with a new farm bill and possibly new dairy policies on the horizon, the future availability of LGM is uncertain.

• Not flexible. Unlike hedging on the exchange, once you purchase LGM coverage, you cannot adjust the insurance you already purchased or exit the program.

• Payments made at the end of the insured period. Any possible payments are made at the end of the insured period. So if you insured January–June, and a payment was due, you would not receive any payment until all prices settle for the month of June.

• Settlement based on all months, not each month insured. Unlike hedging on the exchange or with your cooperative or milk plant, possible payments are calculated from the average of all insured months, not each month individually. So if you insure January–June, the payment due is calculated by taking the insured margin and subtracting the January–June average margin. For example, if the margin is low for the first three months, but then recovers so that the average is above the insured margin, no payment would be due. That means your business can experience a cash flow crunch but no payment would be received.

Some thoughts for purchasing LGM:

Think about your cash availability and use this to help insure some of your production for further out months. That enables you to protect your margin without tying up funds. You can then use those funds for shorter-term hedges with a broker.

Since payment is based on the average of all insured months, think about breaking up your coverage to about three months at a time. For example, insure April–June, then later you can purchase another policy for July–September, if you desire.

Risk management does not, and usually should not, need to be a one-size-fits-all solution. LGM should be analyzed as part of your diversified risk management strategy that benefits and protects your business.

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. You can reach Katie at klk@ricedairy.com.Visitwww.ricedairy.com. There is risk of loss trading commodity futures and options. Past results are not indicative of future results.

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