LGM-Dairy 101: What You Need to Know about this Risk Management Program
Feb 01, 2013
An LGM-Dairy expert explains the basics, including why you would -- and would not -- want to use the program.
By Ron Mortensen, Dairy Gross Margin, LLC and Advantage Ag Strategies, Ltd.
Q. What should you and your lender know about LGM-Dairy?
LGM-Dairy is an insurance policy that guarantees the difference between the milk price (Class III on CME) and corn and soybean meal prices (CBOT). It is designed and underwritten by the USDA’s Risk Management Agency (RMA). Essentially, it is backed by the full faith of the government, just like crop insurance is for corn and other crops.
Buying a policy is a way to guarantee cash flow for up to 10 months. It is a floor price for revenue but does not put a cap on revenues. Therefore, the LGM policy can help you and your banker plan a minimum cash flow for your operation. In a volatile marketplace, this is a big "win-win" situation.
LGM-Dairy is available until the government subsidy money runs out. As of this month, $8.5 in subsidy is available. LGM-Dairy will be able to be purchased on Feb. 22 and, if subsidy money is available, again on March 22, 2013.
LGM-Dairy does not insure or guarantee milk production. It insures the potential 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.
The milk price is based on the CME price, not your mailbox price. Likewise, the feed prices are based on the CBOT price, not your local price. Please note LGM-Dairy has a limit of 240,000 cwts. (or 24,000,000 pounds) per producer per year.
LGM-Dairy is very similar to using options. LGM-Dairy is like buying a milk put, a corn call and a soybean meal call. If you compare buying these options to LGM-Dairy, the insurance policy can be as much as $.60/cwt cheaper (zero deductible). The difference is LGM-Dairy is subsidized if you purchase a policy covering two or more months. The subsidies range from 18% for the zero deductible to 50% for the $1.10 deductible. If you purchase a policy that includes all 10 months at a zero deductible, generally it will be significantly cheaper than purchasing options over that same 10 month period.
LGM-Dairy averages the indemnities for each month, unlike the options. Said another way, the policy averages each of the months’ gains and losses when determining if an indemnity is paid and how much is paid. Be sure to understand how the premium and coverage changes based on the duration of the policy and the deductible.
Besides choosing the deductible and the months covered, you can design your own feed plan. For every 1,000 cwt’s of milk, LGM-Dairy allows you to manage the risk of 130 to 1,361 bushels of corn. For the same 1,000 cwt’s of milk, you can include between .805 to 13 tons of soybean meal.
Q. Why would I use LGM-Dairy?
You can manage your risks for up to 10 months. That means you can cover the first six months, the last three months or any months you need protection. This flexibility allows you to manage short term or long term. It is easier to buy LGM than to buy options, especially in the far out months. Sometimes the lack of liquidity at the CME makes it difficult to buy options in the deferred months. If you look at buying options, the bid/ask spread can be a little wide.
Your banker would have no worries about borrowing to meet margin calls in a hedge account. The premium for an LGM policy is a known expense and is due at the end of the coverage period. For example, a policy purchased on Feb. 22, 2013, will have the premium due in February 2014. This due date is even for policies that only have a few months covered.
You can monitor the policy after the purchase and you can share this information with your lender.
Simply go to Dr. Brian Gould’s website, or our website and click on premium estimator. Enter your existing policy—month(s) purchased, amount of milk covered and amount of corn and meal covered. As the policy progresses, the site will tell you the potential for an indemnity.
Q. When would I not use LGM-Dairy?
When you develop a marketing plan, it may make sense to sell milk a portion of your milk on a cash contract or futures contract because the profit margin is attractive. One of the marketing ideas I like is to sell one-third of your milk with contracts or futures and use LGM-Dairy or options on one-third of your production. If the market goes up, you only have one-third of your milk sold. If the milk goes down, you have two-thirds of your milk protected.
Possible outcomes for Indemnity Payments (subject to deductible):
Ron Mortensen is principal of Dairy Gross Margin, LLC, an agency that specializes in LGM-Dairy products, and owner of Advantage Strategies, Ltd., a commodity trading advisor. Contact him at
firstname.lastname@example.org or visit www.dairygrossmargin.com.