LGM-Dairy: Respect the Tool, Beware the Fallacies

Published on: 12:26PM Mar 07, 2011

Continued high milk prices and feed costs demand the use of risk management tools. One of those, the Livestock Gross Margin-Dairy insurance program, has been subject to misinformation.

Excitement in the dairy markets continues to build as the weeks unfold. Nonfat dry milk prices were the leaders of the market for some months, pulling cheese prices higher. The wide spread between Class III and Class IV needed to be closer, demanding that the cheese prices increase in order to remain competitive. This was taking place while butter price remained stable and actually decreased for a time.
Recently, nonfat dry milk price decreased slightly and has remained stable. However, this has not yet had any impact on cheese prices. Cheese buyers have been purchasing what has come to the spot market and continue to look for more. It seems there is a shortage, but all indications suggest there is sufficient cheese to meet demand, with more going to storage. Each monthly cold storage report shows increased stocks, despite reports of good demand both in the U.S. and overseas.
All this means good milk prices for dairy farmers. The February Class III price was announced at $17.00 per cwt., an increase of $3.52 and a record for the month. Class IV was $18.40 per cwt., an increase of $1.98 for January. March prices look even better with Class III futures trading at near $19.60 per cwt. and Class IV futures at $19.75. You can see that the market is doing the job of getting Class III in line with Class IV again.
Even though milk prices are good and look to be good, they are not having fostering much improved profitability due to high grain prices. The February milk/feed ratio was unchanged from January at 1.96. This compares to 2.36 a year earlier. Corn price in February jumped 72 cents to an average of $5.66 per bushel, with soybeans up 50 cents to an average of $12.10. At the same time, the all-milk price increased $1.70 per cwt. So basically, we are trading dollars for dollars.
The milk/feed ratio has not changed much lately, continuing to keep things tight. This brings me to the need to bring up the LGM-Dairy (Livestock Gross Margin) insurance program. This program has been around since 2008, but it’s now subsidized by the government, making it more attractive as a risk management tool. There have been many meetings on this program, and Jim Dickrell wrote about it in his article, “Dairy Margin Insurance Making More Sense,”  posted online Jan. 16, 2011.
There has been a fair amount of misinformation being given out about this program. Brian Gould and Victor Cabrera from the University of Wisconsin have been doing a lot of meetings and webinars, which have been very informative and accurate. However, there are others doing seminars and are giving some misleading information.
Some have been indicating that LGM-Dairy is a replacement for forward contracting, or using futures and options to protect price. It is not a replacement. It is another tool. LGM-Dairy is just that. It protects a livestock gross margin or income over feed cost. It does not hedge milk prices nor does it hedge feed prices in and of themselves. It protects the margin between the two.
Another fallacy is that if you establish LGM-Dairy contracts you need to get out of already hedged milk and cannot use the markets to hedge any more. These are two separate things. LGM-Dairy has no bearing on whether you can use the markets. It is insurance similar to crop insurance. Those who have crop insurance regularly hedge their grain prices up to the level of coverage they have. It is a good marketing combination.
Another fallacy is that a payment will be made if any month falls below your gross margin guarantee. This may or may not happen. Your gross margin guarantee is calculated over the entire period chosen for your policy. If you choose six months, the entire period will be used to determine whether you will receive an indemnity or not. In essence, there could be two months during which the calculations would indicate a payment, but the other four months may indicate the income over feed costs was more favorable with the average of these months may resulting in no indemnity payment. Simply put, if milk prices and feed prices increase at the same ratio, there will not be a payment. If milk priced decrease and feed prices decrease at the same ratio, there may be no payment. If milk prices increase and feed prices decrease, there may be no payment. If milk prices decrease and feed prices increase, there will be a payment.
Makes sure you understand what you are doing and what you are trying to protect when initiating an LGM-Dairy contract. I promote using this as another tool that is available to protect an area of risk on your operation. Use it is conjunction with or an add-on to your marketing plan. Find an insurance agent who is well-informed about LGM-Dairy. We are licensed to write LGM-Dairy in Wisconsin and Michigan.
Upcoming reports:
- World Agricultural Supply and Demand report on March 10
- California Class I price on March 10
- Fluid milk sales on March 11
- Fonterra auction on March 15
- April Class I price on March 18
- February Milk Production report on March 18
- February Cold Storage report on March 22
Robin Schmahl is a commodity broker and owner of AgDairy LLC, a full-service commodity brokerage firm located in Elkhart Lake, Wisconsin. He can be reached at 877-256-3253 or through their website at www.agdairy.com.
The thoughts expressed and the data from which they are drawn are believed to be reliable but cannot be guaranteed. Any opinions expressed are subject to change without notice. There is risk of loss in trading and my not be suitable for everyone. Those acting on this information are responsible for their own actions.