Lots of Uncertainty Over Which Risk Management Tool Is Best
As dairy farmers try to manage risk moving into 2019, about the only thing you can say is that there is uncertainty about which risk management tool is best.
Ron Mortensen, with Dairy Gross Margin, LLC, ran a comparison of Dairy Revenue Protection (DRP) insurance premiums against the cost of simply purchasing put options on the Chicago Mercantile Exchange. They are listed in the table below for 2019, based on Oct. 24, 2018 prices. Note that you can opt for a range of DRP coverage from 70% to 95%. Mortensen assumed 95%, so a $15.03 quarterly average Class III price is equal to $14.28 option price.
For Wisconsin, the DRP premium on Oct. 24 was for Class III was 9¢/cwt versus an 18¢/cwt premium for a $14.25 put option. The Class IV DRP premium was 11¢/cwt versus 16¢/cwt for a comparable put. The difference is that USDA is subsidizing the DRP premiums.
Mortensen notes, however, that DRP also includes state milk yields. So if your state milk production per cow increases over year-earlier levels, that will decrease you final payout. (If production per cow decreases, that would increase your final payout.) DRP premiums also vary by state because it is an insurance product and actuarily based. Premiums in the Midwest are typically cheaper than in California, for example.
There are also differences in mechanics. For example, DRP is based on three-month quarters, with premiums and indemnities due and paid after the quarter ends. Put options are monthly, with premiums due immediately and potential gains paid as the contracts close each month.
Mortensen’s group also offers Livestock Gross Margin-Dairy insurance. “Right now, LGM-Dairy is running a little cheaper than DRP, depending on the state,” he says. But he notes that LGM-Dairy, because it is margin insurance between milk and feed prices, is also sensitive to corn and soybean meal markets. So that’s an additional factor that DRP or CME options don’t have. If feed prices go up, potential payouts are improved with LGM-Dairy.
And then there’s the farm bill. If the current bill stalled in Congress does get approved, it could also be a viable option for some dairy farmers, says Mark Stephenson, director of Dairy Policy Analysis at the University of Wisconsin. Revisions to the Margin Protection Program (MPP) could offer dairy farmers a 4:1 return.
The estimate is based on what returns would be if feed and milk margins are similar over the next five years to what they were between 2014 and 2018. The better returns are based on lower premium costs and raising the top margin to $9.
Under proposals passed by the U.S. House and Senate, MPP premiums would be just 17¢/cwt for $9 coverage for Tier 1 production under the House bill and 18¢/cwt under the Senate bill. If margins are similar to what they had been over the past five years, the MPP payments would average 73¢/cwt under the new farm bill, says Stephenson.
“The margin has been below $9 about half the time since the program was begun in March 2014,” says Stephenson. “I think producers will need to look at this remodeled MPP,” says Stephenson. “An 18¢ investment for a 73¢ return looks pretty good. This should be basic risk management.”
Bottomline: It’s important you work with a dairy risk adviser who is familiar with all these tools to select the risk management program that best fits your farm, your market and your state.
Dairy Revenue Protection versus CME Options, Oct 24, 2018
Note: Used CME strike price approximately $.80 lower than market.
DRP 95% (Price below X .95) 100% protection factor for the state of Wisconsin
The price to the right is the same for each state. Note: DRP premiums differ by state.
1st Quarter Jan, Feb, Mar 2019 DRP Quarterly Average Price
Class III DRP $.09 Price $15.03/cwt
CME Option Feb 14.25 put $.18
Class IV DRP $.11 Price $14.87/cwt
CME Option Feb 14.00 put $.16
2nd Quarter April, May, June 2019
Class III DRP $.173 Price $15.65/cwt
CME Option May 15.00 put $.35
Class IV DRP $.198 Price $15.44/cwt
CME Option May 14.75 put $.36
3rd Quarter July, Aug, Sept 2019
Class III DRP $.22 Price $16.28/cwt
CME Option Aug 15.50 put $.40
Class IV DRP $.27 Price $15.98/cwt
CME Option Aug 15.25 put $.49
4th Quarter Oct, Nov, Dec 2019
Class III DRP $.24 Price $16.30/cwt
CME Option Nov 15.50 put $.46
Class IV DRP $.294 Price $16.05/cwt
CME Option Nov 15.50 put $.62
Table Source: Dairy Gross Margin, LLC