Aug 22, 2014
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Dairy trading experts offer strategies and practical perspectives to optimize market performance.

Making the Decision: Margin Protection vs. LGM-Dairy

Aug 18, 2014

While awaiting details on USDA’s Margin Protection Program, consider these examples and comparisons with the LGM-Dairy program.

ron mortensen photo 11 05   Copy

By Ron Mortensen, Dairy Gross Margin, LLC

As of this writing, we all are waiting for the Milk Protection Program (MPP) details and regulations from the USDA.

The biggest unknown surrounds the possible proration of premiums for producers of more than 4 million pounds of milk.

Another question that needs to be answered is when the MPP premium will be payable. Will it be at the beginning of each year or maybe quarterly or monthly?

The next question is if producers can use the Livestock Gross Margin for Dairy (LGM-Dairy) program one year and MPP the next. We already know if a producer has an LGM policy in place, the USDA will honor it. If a dairyman has signed up for the MPP, after the LGM coverage expires, the MPP starts automatically.

The USDA is required to get the MPP program in place in September. We will have to see if they are able to pull this off. As we wait, please understand LGM-Dairy is still available. There is subsidy money available and policies are being written.

MPP vs. LGM Research

We have spent a lot of time comparing MPP to LGM. We used a dairy producing 2 million pounds per month. For the MPP, we assumed the premium would be pro-rated (we do not know if this is correct). We did adjust the premium to reflect 100% coverage, even though the MPP will only cover 90% of a dairy’s historical production. For the LGM program, we also covered 100% of production.

We assumed we would buy the LGM policy in November and to cover January through October. In January, we would purchase coverage for November and December. Only once in 10 years did the LGM policy have an indemnity payment for November and December.

MPP

If you picked the $4.00 MPP for the last 10 years, your premium would have been $1,000, or $100 per year. The estimated payout for the 10 years was $166,142. The payout was $100,597 in 2009 and $65,545 in 2012. For the 10-year period, the net payout was $165,142 ($.068/cwt). The highest payout net was in 2009 for $100,497 ($.42/cwt).

If you picked $6.50 MPP for the last 10 years, your premium would have been $685,000, or $68,500 per year ($.285/cwt). The estimated payout for the 10 years was $943,945. Payouts occurred in 2009, 2012 and 2013. For the 10-year period, the net payout was $258,945 (.108/cwt). The highest payout net was in 2009 for $525,190 ($1.93/cwt).

LGM

For this research, we used LGM with feed coverage similar to the MPP program (please remember, LGM does not include hay). The premium for the last 10 years would have been $535,727, or $53,572 per year ($.22/cwt). The estimated payout for the 10 years was $958,467. Payouts occurred in 2006, 2008, 2009, 2010 and 2013. The net payout was $422,740 ($.176/cwt). The highest payout was in 2009 for $593,703 ($2.47/cwt).

The best value was to just buy LGM in November and just cover January to October. Only one small indemnity payment in November and December 2012 would have been missed. For this research, we used LGM with the lowest allowed feed coverage. The premium for the last 10 years would have been $280,168, or $28,016 per year ($.14/cwt). The estimated payout for the 10 years was $690,627. Payouts occurred in 2006, 2008, 2009, 2010 and 2013. The net payout was $410,459 ($.205/cwt). The highest net payout was in 2009 for $583,018 ($2.92/cwt).

Decision-Making Thoughts


What are the potential issues with this research? The LGM has a better risk/reward ratio than the MPP. In other words, you get more bang for your buck (premium paid). Because the MPP has a lot of corn, soybean meal and hay, the calculation may not reflect what you are doing on your farm. If you buy a lot of feed and hay, the MPP may be more appropriate.

Also, size does matter in the decision-making process. If you have less than 150 cows, the MPP may be your best choice because the premiums are highly subsidized. If you have more than 3,500 cows, you may be better off with the MPP because LGM has a limit of 240,000 cwt. If you are a larger producer, you may want to buy the LGM in November 2014. Then, if the subsidies run out, you can always move to the MPP program. It’s a process--step one and step two.

Note the premiums for LGM were cheaper prior to 2006 because volatility was lower. I would expect premium costs to come down a little as the volatile markets subside (for example, corn prices are now under $4.00, versus $5.00-$7.00). Remember the MPP premiums are fixed. The LGM premiums more accurately reflect market risks.

Summary


The LGM program performed surprisingly well in this historical analysis and was equal to or even better than the MPP. The $4.00 MPP payments in 2009 would not have saved the family dairy with payouts of about $100 per cow. The $6.50 MPP program was more expensive than the LGM. LGM will be a good alternative to the MPP if your dairy has between 150 and 3,500 cows.

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. Reach him at ron@dairygrossmargin.com, or visit www.dairygrossmargin.com.

Feed and Cull Cow Prices Spell Opportunity Now

Aug 11, 2014

While negative scenarios color the early 2015 milk market, there are other places to look for revenue excitement.

By Warren Wagner, Stewart-Peterson

Dairy producers may be looking out to the early 2015 Class III Milk prices, which are down in the low $18 range and enjoying the current prices hovering around $21.00 per cwt. There isn’t a lot to get excited about right now in the milk market. In fact, early 2015 prices have many negative scenarios built into them, and so that is why they are trading significantly lower than today’s prices.

There are other places to look for excitement, however: the cull cattle market and the corn market.

The cull cattle market has been insanely high, and for many dairy producers, this spells great opportunity for an additional revenue stream. At the time of this writing, live cattle futures are at record highs, with August through December contracts trading as high as $160 per cwt. As of Aug. 5, live cattle contracts through April 2015 were trading at $156 per cwt. or higher. So, the pricing opportunity for cull cattle extends into the spring of 2015, whereas milk pricing opportunities do not.

On the feed side, note that corn prices are at relatively low levels. On Aug. 1, 2014, the corn price had declined 32% over a period of three months. That 32% selloff from the May 2014 high of $5.22-3/4 to the July 2014 low of $3.56-1/2 is right in line with other historical percentage moves that led to a long-term, bear-market bottom. So, from a cyclical perspective, there is a lot of evidence to suggest the corn price is very close to a cyclical bear market low.

Feed buyers need to realize that these low prices are not going to last forever. In fact, at past major lows, the corn price has rallied on average 18% within 60 days. Favorable feed prices can come and go fast, as historical statistics tell us. Remember this fact when all the headlines scream "record corn crop" this fall.

Chart 1 shows the forward curve for Class III Milk futures. It shows how the higher-priced opportunities for milk disappear quickly past the November contract. As a result, the opportunities to lock in near record high milk prices are now pretty limited. Producers will need to look to other markets like cull cows and feed to find opportunities to manage prices.

Chart 2 shows Live Cattle prices trading in record high territory out through spring of 2015.

Chart 3 shows the opportunity to secure corn at relatively low prices.

The message for business people who are using markets to protect a price advantage is to go where the opportunity is. Right now that opportunity is in cull cattle and in feed.

Warren Wagner is a dairy advisor with Stewart-Peterson Inc., a commodity price management firm based in West Bend, Wis. You may reach Warren at 800-334-9779, or email him at wwagner@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.

Are You a Speculator?

Aug 04, 2014

If you’re in business and haven’t utilized hedges to protect profit levels, you’re speculating.

Chris Robinson

By Chris Robinson, Top Third Marketing

Over the past 2½ years, dairy producers have watched the value of your out put on a very slow, determined rally. Glancing at a weekly price chart, the trend has definitely been in favor of the producers.

Class II milk on the August price board is bumping up against the $22.00 level. Back in November 2011, the price struggled at the $14.00 level. All of the experts and price gurus have had opinions over the last 2½ years as to when the trend will end.

At the end of the day, you need to ask yourself, as a producer and a business person, if you’re comfortable speculating on the direction of prices over the long term. You have to ask yourself if you would be either psychologically or financially stressed if, for some unforeseen reason, milk prices were to begin sliding back towards those 2011 levels.

If you are not hedging some or all of your price risk, you are speculating. As a producer, you are in effect making the same decision that an "investor" might be making by deciding to buy milk and hold it looking for higher prices. Make no mistake about it: If you are in business and you have not utilized hedges to protect profit levels, you are speculating.

Many hedgers resist adding a marketing budget to their business bottom line simply because there is a cost associated with any hedging program. If you are using futures markets to hedge, you are opening yourself up to margin calls, and you might need to be on a first-name basis with your banker to have them:
1) Understand, and
2) Be willing to finance a hedge for your milk.

The grain and livestock commodities were the original derivatives market. In 1851 the first "forward contracts" ever were created and began trading in Chicago. Farmers were given a way to protect themselves against uncertain price moves. That means for over 160 years, farmers and producers have had a method to hedge their business risk.

As we head into the second half of 2014, the farmer is faced with a lot of business risk. Record hog and beef prices are being enjoyed by producers. Milk is also sitting at contract highs. Domestic and worldwide demand for beef and pork as well as dairy has held up well. One can only hope that this demand continues strong. There is an old saying, however, among hedgers and producers: "Hope is not a marketing plan."

Is there a price associated with hedging? Absolutely. However, with prices near record highs, one could argue that there is an even greater level of risk. The higher the prices, the value of your product increases. As a producer, you have downside price risk up until the day you contract your milk. Prudent risk management would suggest having downside protection of some sort in place until that physical sale is booked. In essence, the hedge, either a futures contract or an options contract on the futures price, is a substitute sale. Your risk is on paper, as opposed to being completely unprotected in the cash market.

So what is a producer to do?

First, educate yourself about hedging. Secondly, find an advisor or group of advisors whom you trust to help you make hedging decisions. Finally, make sure you include a line item in your business budget for marketing. You have line items for your inputs, electricity, etc. You owe it to yourself to budget for your marketing. With prices at or near record levels, you have a lot riding on that marketing plan.

Chris brings over 23 years of experience to his Top Third clients. He began his career as a broker and analyst in 1991 with a Chicago firm which specialized in cash grain trading and hedging. In 1992, Chris became a member of the CBOT. He joined Top Third in January 2010, capping an 18 year career as a floor trader and broker. Today, in addition to his Top Third duties, Chris is a featured grain and livestock analyst for the CME. He is also featured on weekly video summaries with RFDTV. In January of 2013, Chris became the lead broker for the Pit bull division of Top Third. This is a separate branch of the company that is involved with traditional speculative trading and is separate from the hedging arm of Top Third. Chris is a 1988 graduate of Colgate University with a degree in Political Science and Economics. Contact him at crobinson@topthird.com.

This material has been prepared by a sales or trading employee or agent of Top Third Ag Marketing and is, or is in the nature of, a solicitation. This material is not a research report prepared by Top Third Ag Marketing. By accepting this communication, you agree that you are an experienced user of the futures markets, capable of making independent trading decisions, and agree that you are not, and will not, rely solely on this communication in making trading decisions.

DISTRIBUTION IN SOME JURISDICTIONS MAY BE PROHIBITED OR RESTRICTED BY LAW. PERSONS IN POSSESSION OF THIS COMMUNICATION INDIRECTLY SHOULD INFORM THEMSELVES ABOUT AND OBSERVE ANY SUCH PROHIBITION OR RESTRICTIONS. TO THE EXTENT THAT YOU HAVE RECEIVED THIS COMMUNICATION INDIRECTLY AND SOLICITATIONS ARE PROHIBITED IN YOUR JURISDICTION WITHOUT REGISTRATION, THE MARKET COMMENTARY IN THIS COMMUNICATION SHOULD NOT BE CONSIDERED A SOLICITATION.

The risk of loss in trading futures and/or options is substantial and each investor and/or trader must consider whether this is a suitable investment. Past performance, whether actual or indicated by simulated historical tests of strategies, is not indicative of future results. Trading advice is based on information taken from trades and statistical services and other sources that Top Third Ag Marketing believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades.

Hedging: Would I Be Better Off Doing Nothing?

Jul 28, 2014

If doing nothing means achieving an average price return over the long run, a good question to ask may be, "Do I strive to be average?"

chip whalen thumbBy Chip Whalen, CIH

In discussing margin management and proactively hedging forward opportunities, some questions that get asked a lot are: "Is there really any long-term advantage to doing this?" and "Wouldn’t I be better off doing nothing at all?"

Perhaps some of this stems from concern that hedges may lose money, result in margin calls, and the effort and capital necessary to devote to the process just aren’t worth it in the long run. Moreover, there are many stories out there about bad experiences using the futures market, and this likely scares people into thinking they are actually taking on more risk to their operation by trying to hedge forward margins.

While an introduction to hedging with the futures market and an overview of proper hedging mechanics are probably best left for a different article, the main question is pretty straightforward to address.

Below is a graph showing historical profit margins for the dairy industry. It examines a rolling average of four calendar quarters worth of profit margins at a given time within a long-term historical context. Given that we are currently in Q3 of 2014, the last observation would be averaging the profit margin in spot Q3 with the margins of Q4 as well as Q1 and Q2 of 2015. This allows us to see where a group of margins average out looking forward a year in time at any given point, and compare that value against a long-term historical average.

Two things should be immediately clear when analyzing the graph. First, current margins are well above the long-term historical average when considering the opportunity looking out over the next year. Second, with the exception of only a few years within this history, the four-quarter rolling margin was above the long-term average at some point in almost every year.

Whalen graph 7 29 14

Getting back to the original question, what if you actually did nothing over time? If I am a dairy producer, this essentially means buying my feed on a hand-to-mouth basis as I need it and getting a milk check from my co-op as I ship product in the cash market.

In doing so, I basically will realize an average margin over a long-term time horizon. There will be periods such as the current year where I will make a lot of money, but there will also be times such as in 2009 when I will be losing a great deal of money. I will ultimately catch every high as well as every low, and thus achieve an average return over the long run. Many producers can likely identify with this and are familiar with the ebbs and flows of profitability in this cyclical industry. Some might even be wise in realizing they should save and build equity from the strong returns they are currently realizing to help cushion the eventual drawdown they will endure when the cycle turns the other way.

In addition to the average margin on the graph, you will notice that there are a few other lines drawn in as well. These depict the 70th, 80th, and 90th percentiles of where those profit margins have been over that range of history. While there are only a few years within the history in which dairy margins reached or exceeded the 90th percentile of profitability, the occurrences of margins above the 80th and especially above the 70th percentiles are much more common.

As an example, dairy margins attained the 70th percentile in eight out of the past 10 years. If I am trying to achieve better results than doing nothing, and doing nothing means receiving an average margin over a long-term time horizon, it doesn’t appear very difficult, based on looking at this chart to beat an average return over a long period of time.

While in any given year (such as the current one) I might be better off staying open to the market, my results will average out over a long period of time. Just as you wouldn’t judge a ball player or sports team based upon a single game or series but rather over an entire season, the same thing holds true with judging the merits of hedging and proactive margin management.

While it may be true that in the current year a dairy producer can argue they would have been better off doing nothing, it may be more difficult to make this claim when considering that strategy over a longer time horizon. A question one might ask at this juncture is, "How can I manage margins successfully so that I would in fact be better off than doing nothing?" This is where a carefully crafted plan comes into play.

Knowing that forward margins typically achieve above-average historical percentiles in almost every single year, implementing a plan that spells out how to capture those margins when they are achieved can put you in an advantageous position to be better than average. While hedging a 70th, 80th or 90th percentile historical margin is, of course, no guarantee that the margin won’t continue to strengthen, it does help assure you won’t sustain extreme financial hardship should margins subsequently drop to very unprofitable levels.

Just as a batter is much more likely to reach base by only swinging at pitches in the strike zone, by implementing hedges when returns are historically attractive, a producer is much more likely to achieve stable, attractive returns over the long run. Because some years may be more challenging, a plan should also spell out contingencies for potentially protecting breakeven levels should margins never achieve targets in which hedges would be implemented. This can help protect against losses that could be more significant without protection in place.

In the end, if doing nothing means achieving an average return over the long run, a good question to ask may be, "Do I strive to be average?" Most producers look to excel in their production practices, incorporating improvements in technology, genetics and other factors to constantly improve upon what they are doing. Should their approach to managing the risk associated with forward profit margins be any different?

As Vice President of Education & Research at CIH, Chip Whalen is responsible for developing and conducting all of CIH’s Margin Management seminars. He is also the editor of CIH’s popular Margin Watch newsletters. Whalen can be reached at (312) 596-7755 or cwhalen@cihedging.com.

A Rising Tide Lifts All Boats – Until It Collapses

Jul 24, 2014

Dairy prices, exports and the stock market have surged, but a ‘Black Swan’ event could change all that. Have you developed a way to protect your milk price from a sudden downturn?

Katie Krupa photo

By Katie Krupa, Rice Dairy

The old saying goes, ‘A rising tide lifts all boats,’ and in many ways this statement can be applied to the recent surge in the dairy market.

In recent years, the strength of the dairy market has been heavily reliant on the world economy with a significant amount of our domestic dairy production meeting the demands of the international market. While this rising tide is helping push domestic dairy prices higher, a growing world economy is not a guarantee for higher prices.

The first chart (below) shows the USDA announced the Class III milk price and the Dow Jones Industrial Average. Prior to 2008, there doesn’t seem to be much correlation between the Class III milk price and the Dow Jones average, but that changes in 2008. The rise in both the milk price and the Dow Jones in 2008 followed by the crash in 2009 start a trend of prices moving closer together. Starting in 2010, the trend is the same for both Class III milk and the Dow Jones Industrial Average, but the statistical correlation is not very high – it is around 0.70 (the closer to 1.0 the higher the correlation).

You can look at various charts for different economic indicators compared to the Class III milk price, and you will find the same pattern for many of those charts. The economic crisis of 2008 had a noticeable impact on many industries and the dairy industry was certainly one of those industries.



The underlying issue for much of the dairy industry’s troubles in 2008 and strength in recent years has been the strength of the export market. The second chart shows the annual dairy exports. As you can see, the exports drastically decreased in 2009 and then have been at historic high levels in recent years. The export market chart and the Dow Jones Industrial Average charts both have the same trend – decreased in 2008 and then increasing since 2009.


While both of these charts show the same trend, these charts are not a guarantee of the future weakness or strength of the dairy industry. Unfortunately, our dairy industry is dependent on various factors that are both domestic and international issues. And worst off, there are many issues that can occur that have nothing to do with milk production, cows or the feed situation, but still have an impact on your milk price.

For example, several things that can turn the industry around are a geopolitical issue (here or abroad), a significant weather or world event, such as an earthquake or tsunami, or continued economic growth in developing countries. These are what I call Black Swan events, and there are many more that could potentially occur. The trouble with these Black Swan events is that you can in no way predict them. Unlike a change in the milk supply due to cold weather, poor feed quality or a change in cow numbers, a Black Swan event happens fast and the impact is nearly immediate. While there are many benefits of being in the international market, there are also some negatives. It is important to remember that although the stock market may be strong, that is no guarantee that the dairy industry will be strong.

As dairy producers, you have many Black Swan events that can happen on a daily basis in your business. These on-farm events you can personally manage, and you probably have developed ways to work around these more frequent issues. The international Black Swan events may be harder to work around, but luckily there are multiple risk management strategies available to help you protect your milk price for the future months. Just as you have developed ways to manage around on-farm weather issues, cow death or employee issues, you can also develop a way to protect your farm milk price from changes in the world that would negatively impact the milk price.

Katie Krupa is a broker 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.Visit www.ricedairy.com. There is risk of loss trading commodity futures and options. Past results are not indicative of future results.
 

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