Will the Farm Bill Replace Risk Management?

November 13, 2014 12:12 PM
 
Will the Farm Bill Replace Risk Management?

Three experts explain the new Margin Protection Program and how it fits into conventional risk management plans. 

AgDairy Market’s Robin Schmahl, Dairy Farmers of America’s Ed Gallagher and Stewart-Peterson’s Bob Devenport discuss why the Margin Protection Program (MPP) and Livestock Gross Margin for Dairy (LGM-Dairy) Program may--or may not--be important to you. 

Dec. 5 is the deadline for sign-up in the MPP. Contact your Farm Service Agency office to participate.

Why should I sign up for the MPP?

Gallagher: Recent history has shown that events beyond any dairy farmers’ control can cause significant harm to milk prices or push livestock feed prices higher. Just remember the global financial crisis and the U.S. drought in just the past five years. During these occurrences, the Milk-feed margin fell below the $4 level and times were tough on most US dairy farms. Unfortunately, we will likely again see margins fall below $4, but for reasons none of us can imagine today. For a mere $100 annual investment, you can protect you dairy from the harshest points of these unprofitable parts of the “margin cycle”. Participating also allows you to “buy-up” to a better level of protection, if you so choose.

Why bother with the MPP for $4?

Schmahl: Dairy producers certainly are not going to make money at a $4 margin. Signing up requires the payment of $100 fee and automatically establishes a margin protection at the $4 level. The reason that it is a good idea to sign up, even if the intention is not to buy up to a higher level, is that it allows a producer to receive the first “bump” of 0.87% to the individual’s farm milk production history next year. If sign-up is first done next year, the advantage of the first bump will not available. Each subsequent year, the production bump will be raised by another percentage based on national milk production. 

If I buy MPP insurance in the $6 range, can I replace a risk management program with the MPP?

Devenport: No, I would not recommend it. Historically, it has not been very often that income over feed cost--as defined by the MPP-–has dropped below the $6 level. Given where current Class III futures prices and feed futures prices are for 2015, margins are still projected over the highest levels of coverage offered by the MPP. 

That means that producers can utilize the many different hedging tools available to them to take control now, and preserve the higher margins that the market is offering through hedging their milk price as well as their feed costs. This way, producers don’t have to sit back and watch the price of milk fall significantly or the price of feed rise significantly before their coverage kicks in. This doesn’t mean that producers need to stick with one strategy or the other, though. 

Consider $6 margin coverage, for example, as an added layer of coverage, and, if things get particularly bad, producers will be that much better off if they are also employing their current risk management strategy. 

In its margin calculation, the MPP uses the U.S. All-Milk price and national feed prices. How does that affect my decision if I’m in California, for example, where milk prices are typically lower and feed prices are typically higher? Or in the case of the Southeast, where milk prices typically are higher than the U.S. all-milk price?

Gallagher: Federal dairy support programs have been based on a single, national index. Some of us can remember the 1980’s and earlier when the Federal price support, for all intents and purposes, set the manufacturing milk price. Although a single national “base” price, those in the eastern U.S. had a gross milk price that was better than those dairies in the Western US – so it has always been this way. The MPP program is a significant improvement, for everyone, over the old combination of the price support and MILC programs. Changing age-old Federal policy is a major breakthrough. It likely would not have occurred if it were not a simple, national program.

Will the MPP be triggered during high or low milk prices?

Devenport: Possibly both-–it all depends on where feed prices are. One common misconception of the MPP is that it protects against low milk prices. That’s not necessarily true, because if feed prices are also depressed when milk prices are low, it may not trigger an indemnity payment. 

On the other hand, milk prices can be high, and an indemnity payment could be triggered if feed prices are high as well and squeezing margins. One perfect example: During the 2012 drought, when feed prices soared and milk prices were also relatively high. For many levels of coverage offered by the MPP, indemnity payments would have been triggered because of the high feed prices eating in to the margins. Another example: 2006, when the Class III price dipped below $12 per cwt. and a payment would not have been triggered due to low feed prices. Remember, the MPP is covering your margin, not just the milk price. 

How do I know when I’ll get a payment?

Schmahl: Payment will be announced by the government through some channel similar to how the MILC payments were announced. Of course, the income-over-feed cost can be easily calculated using the monthly “Dairy Products” report and the Central Illinois rail soybean meal price. However, the income-over-feed costs will be calculated using the average over each two-month period (January-February, March-April, etc.) Payments will be announced a month after each two-month period is calculated as the following “Ag Prices” report establishes the final prices for each feed component. 

Will the MPP cause changes to LGM-Dairy? How will the two programs play out against each other?

Schmahl: It is not anticipated that the MPP will cause any changes to LGM-Dairy. There are advantages and disadvantages to each program. The MPP uses national average feed prices and the All-Milk price to calculate income over feed costs. LGM-Dairy uses a three-day average of futures prices for each month for feed and milk and allows a producer to choose a weighted feed or milk price, allowing for more flexibility. The MPP makes a calculation for every two-month interval, whereas LGM-Dairy can choose a margin interval of two to 10 months. MPP buy-up levels for margin protection on the first 4 million pounds of milk are less expensive than LGM at a $0 deductible level but less costly than MPP at the $8 level. 

Expanding dairies can increase coverage for extra milk under LGM-Dairy, while expanding herds under MPP cannot take advantage of increased production due to the calculation of the highest average of 2011, 2012 or 2013. Farmers are required to pay for any buy-up of margin earlier in the year for MPP, while LGM payments are due near the end of the year. If sign-up is done for the MPP, then the producer is ineligible to participate in LGM-Dairy unless contracts are already established into 2015, at which time the MPP would kick in once LGM contracts are finished. 

If the MPP guarantees at least $4/cwt., how will the market respond to over-supply?

Gallagher: The MPP was designed as a catastrophic “disaster insurance” program. If the insurance pays off, it will not generate profits, unless paired with private sector risk management transactions that were executed at profitable levels. The MPP was designed to soften the financial blow to dairy farmers when adverse margins exist – either due to too much surplus milk and/or too high feed prices. The program’s impact should help to keep dairies in business in the short term, thereby supporting a more stable milk supply, which in the long run benefits everyone from dairies to consumers.

Are there potential consequences to the MPP, such as affecting market liquidity?

Devenport: The risk of affecting market liquidity is there, but it is not something we are overly concerned with. The large dairy producers in the country make up a good chunk of open interest in the milk market because many of them already use risk management strategies in which they are utilizing futures and options. I would think that these same producers are going to continue with their current risk management strategies because they can often times protect greater margins with the use of futures and options. 

The MPP also becomes very expensive for larger producers, and that premium is due in two, large lump sums, resulting in a large capital outflow at one time. I would think that many of these producers may sign up for the program, but I do not think that it will replace their current risk management strategies, and thus shouldn’t have much of an impact on market liquidity. In fact, open interest in both the Class III and cheese futures markets has grown since USDA released the final details of the MPP. If producers were leaning toward the MPP as a replacement for their current risk management strategies, I would imagine that we would already see the impact, as many wouldn’t be hedging 2015 milk production, and open interest would already be shrinking. 

Does the MPP have a cap?

Devenport: There is no cap as to the monetary value of indemnity payments the MPP will pay.
USDA has built the Dairy Product Donation Program (DPDP) into the 2014 Farm Bill, however. The DPDP is intended to support dairy producer margins by triggering the obligation to purchase dairy products when the margin falls below certain levels. The dairy products will then be provided to individuals in low-income groups through public and private non-profit organizations. 

The DPDP specifies that purchases of dairy products will be made whenever the dairy production margin--as defined by the 2014 farm bill--falls below $4 per cwt. for two consecutive months. This purchasing program would end if purchases have occurred for three consecutive months, the margin rises above $4 per cwt. again, or U.S. prices exceed world prices by certain levels. Although there is no cap on the MPP, the DPDP could effectively help to support margins if they dip below the $4 level and could therefore limit the duration of indemnity payments to a certain extent. 

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