do’s and don’ts of dairy risk management dr. marin bozic alltech workshops october 23-24, 2013

Do’s and Don’ts of Dairy Risk Management

Dr. Marin Bozic

Alltech WorkshopsOctober 23-24, 2013

A real problem…

1 21 41 61 81101

121141

161181

201221

241261

281301

321341

361381

4010

5

10

15

20

25

IOFC Margins Feed Prices All-Milk Prices

U.S

Dai

ry IO

FC M

argi

ns,

/ cw

t

Source: USDA, various reports and own calculations

But it hurts to leave money on the table…

1/3/

2012

1/22

/201

2

2/10

/201

2

2/29

/201

2

3/19

/201

2

4/7/

2012

4/26

/201

2

5/15

/201

2

6/3/

2012

6/22

/201

2

7/11

/201

2

7/30

/201

2

8/18

/201

2

9/6/

2012

9/25

/201

2

10/1

4/20

12$15.00

$17.00

$19.00

$21.00 Class III Milk Futures: Oct 2012

Agenda for Today

1. Goals and Principles of Dairy Risk Management

2. Hedging with Futures and Options

3. Using LGM-Dairy

4. New Farm Bill Dairy Programs

Start with the end in mind.

• Retirement without debt?• Prevent catastrophic losses?• Gives me headaches, but necessary evil?• Chase the highs, beat the market? • Grow faster?

Hedge early, hedge often

A simple hedging program with puts

• Buy puts consistently, do not try to guess what the price will do next

• Never spend more than 50 cents on a put

Let us evaluate three strategies:1) Always buy puts for milk produced THREE months from now

E.g. in January 2013 hedge April milk, in February hedge May milk, etc.2) Always buy puts for milk produced SEVEN months from now

E.g. in January 2013 hedge August milk, in February hedge September milk, etc.3) Always buy puts for milk produced ELEVEN months from now

E.g. in January 2013 hedge November milk, in February hedge December milk, etc.


Hedging Horizon

What Can You Buy for 50 cents? (Option Strike)

1 month 5 cents below futures 3 months 64 cents below futures5 months 1.08 below futures7 months 1.44 below futures9 months 1.74 below futures

11 months 2.08 below futures

Hedging with Puts: 3-months Out


Hedging Horizon

Number of Profitable

Trades

Net Profit/Loss 2007-2012

Return on Investment2007-2012

1 month 16/74 -0.14 -41%

3 months 21/74 0.06 13%

5 months 19/74 0.21 46%

7 months 15/74 0.24 52%

9 months 09/74 0.26 57%

11 months 10/74 0.33 73%

Lessons Learned?

• Either hedge consistently or not at all.

• Plan for hedging far ahead. When prices decline, they tend to stay low for a while. If you wait for too long, the opportunity to lock in good prices may be gone.

• You are likely to lose money on most of your trades. That’s OK. That does not mean that the market is full of crooks. It means that bad times come around infrequently, but when they do come, you will get back plentifully.

2006-2012 returns to at-the-money put options

1 month ahead:Cost: 0.19/buPayout: 0.16/bu

3 months ahead:Cost: 0.68/buPayout: 0.79

6 months ahead:Cost: 0.95/buPayout: 1.33/bu

9 months ahead:Cost: 1.13/buPayout: 1.59/bu

LGM-Dairy

Farm bill

Two alternatives:

Senate Bill No. 954 “Dairy Security Act”

House Bill. 2642“Goodlatte-Scott Amendment”

Farm bill Dairy Margin

• All-Milk (/cwt)

- 1.0728 x Corn (/bu)

- 0.0735 x Soybean meal (/ton)

- 0.0137 x Alfalfa hay (/ton)

• Feed ration per cwt of milk: • 30 pounds of shell corn, • 106.4 pounds of corn silage, • 14.7 pounds of soybean meal• 27.4 lbs of alfalfa hay

Farm bill Dairy MarginCoverage Level

Senate House

<4mil 4mil+ <4mil 4mil lbs+

4.00 0.00 0.00 0.00 0.03 4.50 0.01 0.02 0.01 0.045 5.00 0.02 0.04 0.02 0.066 5.50 0.035 0.10 0.035 0.11 6.00 0.045 0.15 0.045 0.185 6.50 0.09 0.29 0.09 0.29 7.00 0.40 0.62 0.18 0.38 7.50 0.60 0.83 0.60 0.83 8.00 0.95 1.06 0.95 1.06

Subsidized Margin Insurance

• Official name: Dairy Producer Margin Protection Program (PDMPP)

• Two layers: • Basic Margin Protection – No-cost protection

at 4.00 margin• Supplemental Margin Protection – Can buy up

from 4.50 to 8.00 margin in 50 cents increments (called “Coverage Level”)

Subsidized Margin Insurance

Consecutive Two-Month

Periods 2012Two-month

Average

January 7.57

February 5.82 6.70

March 4.94

April 4.26 4.60

May 3.41

June 3.51 3.44

July 2.74

August 2.98 2.86

September 5.51

October 7.28 6.39

• Calendar year is divided into consecutive two-month periods

• Average margin must be below the purchased coverage level in order for indemnities to be due.

DPMPP: What triggers it exactly?

DPMPP: What is the payment rate?


Average

Jan – Feb 6.72

Mar-Apr 4.59

May-Jun 3.44

Jul-Aug 2.86

Sep-Oct 5.90

• Example: Larry subscribed for basic margin protection. For Jul-Aug, payment rate was $1.14 per cwt.

• Basic Margin Protection

The difference between the actual margin and $4.00, except that, if the difference is more than $4.00, the Secretary shall use $4.00

DPMPP: What is the payment base?


Average

Jan – Feb 6.72

Mar-Apr 4.59

May-Jun 3.44

Jul-Aug 2.86

Sep-Oct 5.90

• Supplemental Margin Protection:

The difference between coverage level and the greater of actual margin and $4.00.

Example: Larry also subscribed for supplemental margin protection at $6.50 coverage level. For Jul-Aug, the payment rate on supplemental was $6.50- max($4.00, $2.86) = $2.50

DPMPP: What is the payment base?

Basic Production History- Highest annual milk marketings in any 1 of the

3 calendar years before program sign-up- Used in Basic Margin Protection

Annual Production History:- Actual milk marketings of the participating dairy

during the previous year- Used in Supplemental Margin Protection

Trigger:- Actual margins of $6.00

or less for each of the immediately preceding two months

- Actual margin of $4.00 or less for the immediately preceding month

Dairy Market Stabilization Program

Month 2012

January 7.57

February 5.82

March 4.96

April 4.26

May 3.41

June 3.51

July 2.74

August 2.98

September 5.51

October 7.28

• Producer is not going to be paid for more than the greater of… – If margins were $5.00-$6.00:

• 98 percent of stabilization base• 94 percent of the marketings of milk

– If margins were $4.00-$5.00• 97 percent of stabilization base• 93 percent of the marketings of milk

– If margins were less than $4.00• 96 percent of stabilization base• 92 percent of the marketings of milk

DMSP – what is the “penalty”?

Let’s play a game…

Imagine that it is January 15, 2008. Dairy Security Act has just become a law. You are the owner of ‘North Star Dairy’ a fictional large dairy operation in Minnesota that had grown to about 2000 cows at the end of 2012. You have made a decision to participate in the DPMPP/DMSP in 2008.

Let’s see how did the program work for you over 2008-2012 period.

Please take a look at this device… (forget everything from 2008+)

North Star Dairy has been growing…

YearPounds shipped

2005 30 mil2006 35 mil2007 40 mil2008 43 mil2009 44 mil2010 45 mil2011 50 mil2012 55 mil

Information as of January 2008…


Coverage Level

Fees & Premiums

Expected Indemnity

DMSP Penalty

Net Revenue

$4.00 1,000 7,515 14,097 -7,582$4.50 6,273 14,201 14,097 -6,169$5.00 13,692 24,620 14,097 -3,169$5.50 28,973 39,989 14,097 -3,081$6.00 54,112 62,276 14,097 -5,933$6.50 79,580 93,393 14,097 -283$7.00 158,787 135,560 14,097 -37,323$7.50 215,503 190,772 14,097 -38,828$8.00 336,206 260,142 14,097 -90,161

Actual Income Over Feed Cost Margin in 2008

This is how 2008 turned out for you…

Coverage Level

Fees & Premiums

Realized Indemnity

DMSP Penalty

Realized Net Revenue

$4.00 1,000 0 0 -1,000$4.50 6,273 0 0 -6,273$5.00 13,692 0 0 -13,692$5.50 28,973 0 0 -28,973$6.00 54,112 0 0 -54,112$6.50 79,580 0 0 -79,580$7.00 158,787 0 0 -158,787$7.50 215,503 0 0 -215,503$8.00 336,206 0 0 -336,206


Coverage Level

Fees & Premiums

Expected Indemnity

DMSP Penalty

Net Revenue

$4.00 1,000 78,471 129,704 -52,232$4.50 6,661 141,674 129,704 5,308$5.00 14,623 230,757 129,704 86,430$5.50 31,067 340,466 129,704 179,695$6.00 58,120 464,086 129,704 276,261$6.50 85,527 599,567 129,704 384,336$7.00 170,009 745,680 129,704 445,968$7.50 230,758 901,491 129,704 541,029$8.00 360,046 1,066,022 129,704 576,272


Coverage Level

Fees & Premiums

Realized Indemnity

DMSP Penalty


$4.00 1,000 145,191 191,360 -47,169$4.50 6,661 274,168 191,360 76,147$5.00 14,623 403,145 191,360 197,162$5.50 31,067 532,122 191,360 309,695$6.00 58,120 675,425 191,360 425,944$6.50 85,527 836,657 191,360 559,770$7.00 170,009 997,889 191,360 636,520$7.50 230,758 1,159,120 191,360 737,002$8.00 360,046 1,337,377 191,360 785,971


Coverage Level

Fees & Premiums

Expected Indemnity

DMSP Penalty

Net Revenue

$4.00 1,000 195 1,453 -2,258$4.50 6,763 633 1,453 -7,583$5.00 14,867 1,511 1,453 -14,809$5.50 31,616 3,274 1,453 -29,795$6.00 59,171 6,932 1,453 -53,691$6.50 87,086 13,740 1,453 -74,799$7.00 172,950 26,249 1,453 -148,153$7.50 234,757 47,807 1,453 -188,403$8.00 366,295 85,034 1,453 -282,714


Coverage Level

Fees & Premiums

Realized Indemnity

DMSP Penalty


$4.00 1,000 0 0 -1,000$4.50 6,763 0 0 -6,763$5.00 14,867 0 0 -14,867$5.50 31,616 0 0 -31,616$6.00 59,171 0 0 -59,171$6.50 87,086 0 0 -87,086$7.00 172,950 0 0 -172,950$7.50 234,757 10,442 0 -224,314$8.00 366,295 58,078 0 -308,217


Coverage Level

Fees & Premiums

Expected Indemnity

DMSP Penalty

Net Revenue

$4.00 1,000 56,708 75,364 (19,656)$4.50 6,909 86,061 75,364 3,788 $5.00 15,219 125,352 75,364 34,769 $5.50 32,407 177,189 75,364 69,418 $6.00 60,684 245,898 75,364 109,850 $6.50 89,331 338,082 75,364 173,387 $7.00 177,188 458,393 75,364 205,841 $7.50 240,518 601,849 75,364 285,967 $8.00 375,298 761,759 75,364 311,097


Coverage Level

Fees & Premiums

Realized Indemnity

DMSP Penalty


$4.00 1,000 0 0 (1,000)$4.50 6,909 0 0 (6,909)$5.00 15,219 0 0 (15,219)$5.50 32,407 0 0 (32,407)$6.00 60,684 0 0 (60,684)$6.50 89,331 0 0 (89,331)$7.00 177,188 0 0 (177,188)$7.50 240,518 0 0 (240,518)$8.00 375,298 9,886 0 (365,412)


Coverage Level

Fees & Premiums

Expected Indemnity

DMSP Penalty

Net Revenue

$4.00 1,000 14,908 43,764 (29,856)$4.50 7,605 28,329 43,764 (23,041)$5.00 16,888 48,455 43,764 (12,197)$5.50 36,163 77,637 43,764 (2,291)$6.00 67,871 119,094 43,764 7,458 $6.50 99,996 175,689 43,764 31,929 $7.00 197,312 250,372 43,764 9,296 $7.50 267,875 349,725 43,764 38,085 $8.00 418,049 481,176 43,764 19,363

Actual Income Over Feed Cost Margin


Coverage Level

Fees & Premiums

Realized Indemnity

DMSP Penalty


$4.00 1,000 90,541 271,253 -181,712$4.50 7,605 165,929 271,253 -112,929$5.00 16,888 271,141 271,253 -16,999$5.50 36,163 384,224 271,253 76,808$6.00 67,871 497,307 271,253 158,183$6.50 99,996 610,390 271,253 239,141$7.00 197,312 774,434 271,253 305,870$7.50 267,875 962,905 271,253 423,777$8.00 418,049 1,178,465 271,253 489,163

Historical and Forecasted Income Over Feed Costs Margins

• Forecasted IOFC Margins for 2014 are higher than 75% of historical IOFC margins since 2000.

Source: USDA, CME Group, Own Forecasting Model Developed together with John Newton, the Ohio State University

Sep

Oct NovDec

Jan '1

4Fe

bMar Apr

May Jun JulAug

Sep

13.00

15.00

17.00

19.00

21.00

23.00

25.00

U.S. All-Milk Price 2014 Outlook (80% Confidence Interval)

Source: CME Group, Own Forecasting Model Developed together with John Newton, the Ohio State University

Do’s and Don’t‘s of Dairy Risk Management

Alltech WorkshopsOctober 23-24, 2013

Dr. Marin [email protected] of Applied EconomicsUniversity of Minnesota-Twin Cities317c Ruttan Hall1994 Buford AvenueSt Paul, MN 55108

Acknowledgements:Fanda Yang, PhD Student UMNLou Kuhlmann, Advance Trading, Inc.John Newton, PhD Student, OSU

mailto:[email protected]

do’s and don’ts of dairy risk management dr. marin bozic alltech workshops october 23-24, 2013

Documents

cwt of milk

bu lgmdairy

dairy security acthouse

simple hedging program

senate bill

corn bu

month5 cents

months64 cents