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

The Portfolio Approach to Risk Management

Oct 14, 2013

With this strategy, the idea is to make smaller, more frequent decisions regarding marketing. LGM for Dairy can be a part of that.

ron mortensen photo 11 05   CopyBy Ron Mortensen, Dairy Gross Margin, LLC and Advantage Agricultural Strategies, Ltd.

The problem with managing risk is that, almost by definition, one cannot predict anything about the next risk. One cannot predict when it will occur or how large it will be. For example, it’s hard to predict the timing of rainfall and heat in the summer—factors that affect pollination. Many farmers will buy a package of seed corn varieties with different maturities. Most would not plant the same corn hybrid maturity across all their fields. Farmers spread out maturities and pollination times to spread out risks. They plant a corn portfolio--something similar to a financial portfolio at a bank or other financial institution.

For dairymen, the portfolio approach speaks to marketing strategy. The idea is to make smaller, more frequent decisions regarding marketing. This certainly is better than trying to hit the year’s high in milk prices (where, of course, everyone says they will sell 100% of their production) and the lows in prices for any feed purchased. It’s a nice goal but not a practical goal.

Ever since USDA’s Livestock Gross Margin for Dairy (LGM-Dairy) program started six years ago, we thought it would make sense to buy multiple policies. For example, purchase three to six months of coverage on 10% to 25% of your milk production every month. This way you would be building a portfolio of coverage. You are reducing risk by spreading your risk.

If you look back, you can see buying multiple polices with three to six months coverage would have given you better risk management than just buying one long-term policy.
Mortensen graph 10 14 13

Guide to the chart

The chart above represents potential LGM-Dairy policies that could have been purchased starting in January 2012 and ending December 2012. The chart shows a zero-deductible policy. The coverage would have started in March 2012 and ended in November 2013. In the spirit of full disclosure, policies were not available in 2012 until October (the government subsidy money had run out). Currently, there is subsidy money available and policies have been purchased every month so far in 2013.

The green line is the CME Class III milk price. The black line is the Actual Gross Margin (AGM). This is a combination of the actual settlement prices of milk, corn and meal used in calculating possible LGM indemnities. Please note the AGM tracks with the CME class III milk. This highlights the most important factor in LGM calculations—the milk price.

Each of the other colored lines represents a policy’s Estimated Gross Margin (EGM) that could have been written. EGM is the guarantee for that month.

When the black line (AGM) is below the colored line of the policy, an indemnity for the month would have been calculated.

For example, the bright blue line shows a policy that was purchased in October 2012. The first month of coverage would be December 2012. For this period, every month had an indemnity except May 2013.

LGM-Dairy Review

LGM-Dairy is an insurance policy which guarantees the difference between milk prices (Class III on CME) and feed prices (CBOT corn and soybean meal prices). It is designed and underwritten by the USDA/RMA. Essentially, it is backed by the government, just like crop insurance is for corn, soybeans, wheat and other crops. This is a way to guarantee cash flow for up to 10 months.

Simply, LGM-Dairy manages the risk of rising feed costs and falling milk prices. LGM-Dairy does not guarantee milk production. It guarantees a level of protection from changes in milk prices and feed prices.

For example, if the price of milk (Class III) goes up and feed goes down, you will not get an indemnity payment. If milk prices go down and feed prices go up, you will get a payment depending on how big a deductible you used. LGM-Dairy manages the price changes or the margin. Remember, the milk price is based on the CME price, not your mailbox price.

LGM-Dairy is very similar to using options. The difference is that LGM-Dairy is subsidized if you buy protection covering two or more months. The subsidies range from 18% for a zero-deductible policy to 50% for the $1.10 deductible. LGM-Dairy is like buying a milk put, a corn call and a soybean meal call. Policies are cheaper when they last for more months and/or if their deductibles are increased. If you compare milk, corn and meal options to LGM-Dairy, the insurance product can be as much as $.60 per cwt. cheaper.

Ron Mortensen is principal of Dairy Gross Margin, LLC, an agency that specializes in LGM-Dairy products, and owner of Advantage Agricultural Strategies, Ltd., a commodity trading advisor. Contact him at ron@dairygrossmargin.com or visit www.dairygrossmargin.com.

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