Transcript Do's and Don'ts of Dairy Risk Management

Do’s and Don’ts of Dairy Risk
Management
Dr. Marin Bozic
Alltech Workshops
October 23-24, 2013
A real problem…
U.S Dairy IOFC Margins, / cwt
25
20
15
10
5
0
IOFC Margins
Feed Prices
All-Milk Prices
Source: USDA, various reports and own calculations
But it hurts to leave money on the table…
$22.00
$21.00
$20.00
$19.00
$18.00
$17.00
$16.00
$15.00
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
Hedge early, hedge often
Hedge early, hedge often
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.
A simple hedging program with puts
Hedging
Horizon
What Can You Buy for 50 cents?
(Option Strike)
1 month
5 cents below futures
3 months
64 cents below futures
5 months
1.08 below futures
7 months
1.44 below futures
9 months
1.74 below futures
11 months
2.08 below futures
Hedging with Puts: 3-months Out
Hedging with Puts: 7-months Out
Hedging with Puts: 11-months Out
A simple hedging program with puts
Number of
Profitable
Trades
Net
Profit/Loss
2007-2012
Return on
Investment
2007-2012
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%
Hedging
Horizon
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/bu
Payout: 0.16/bu
6 months ahead:
Cost: 0.95/bu
Payout: 1.33/bu
3 months ahead:
Cost: 0.68/bu
Payout: 0.79
9 months ahead:
Cost: 1.13/bu
Payout: 1.59/bu
LGM-Dairy
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
Senate
Coveragebill Dairy
Farm
Margin
Level
House
4mil+
0.00
<4mil
4mil lbs+
4.00
<4mil
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
Subsidized Margin Insurance
Subsidized Margin Insurance
Subsidized Margin Insurance
DPMPP: What triggers it exactly?
Consecutive
Two-Month
Periods
2012
January
7.57
February
5.82
March
4.94
April
4.26
May
3.41
June
3.51
July
2.74
August
2.98
September
5.51
October
7.28
Two-month
Average
•
Calendar year is
divided into
consecutive twomonth periods
•
Average margin
must be below the
purchased
coverage level in
order for
indemnities to be
due.
6.70
4.60
3.44
2.86
6.39
DPMPP: What is the payment rate?
Consecutive
Two-Month
Average
Jan – Feb
6.72
Mar-Apr
4.59
May-Jun
3.44
Jul-Aug
2.86
Sep-Oct
5.90
• 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
• Example: Larry subscribed for basic margin
protection. For Jul-Aug, payment rate was $1.14
per cwt.
DPMPP: What is the payment base?
Consecutive
Two-Month
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 JulAug, the payment rate on supplemental was $6.50max($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
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
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
DMSP – what is the “penalty”?
• 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
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…
Year
Pounds
shipped
2005
2006
2007
30 mil
35 mil
40 mil
2008
2009
2010
43 mil
44 mil
45 mil
2011
2012
50 mil
55 mil
Information as of January 2008…
Information as of January 2008…
Information as of January 2008…
Coverage
Level
$4.00
$4.50
$5.00
$5.50
$6.00
$6.50
$7.00
$7.50
$8.00
Fees &
Premiums
1,000
6,273
13,692
28,973
54,112
79,580
158,787
215,503
336,206
Expected
Indemnity
7,515
14,201
24,620
39,989
62,276
93,393
135,560
190,772
260,142
DMSP
Penalty
14,097
14,097
14,097
14,097
14,097
14,097
14,097
14,097
14,097
Net
Revenue
-7,582
-6,169
-3,169
-3,081
-5,933
-283
-37,323
-38,828
-90,161
Actual Income Over Feed Cost Margin in 2008
This is how 2008 turned out for you…
Coverage
Level
$4.00
$4.50
$5.00
$5.50
$6.00
$6.50
$7.00
$7.50
$8.00
Fees &
Premiums
Realized
Indemnity
DMSP
Penalty
Realized
Net
Revenue
1,000
6,273
13,692
28,973
0
0
0
0
0
0
0
0
-1,000
-6,273
-13,692
-28,973
54,112
79,580
158,787
0
0
0
0
0
0
-54,112
-79,580
-158,787
215,503
0
0
-215,503
336,206
0
0
-336,206
Information as of January 2009…
Information as of January 2009…
Information as of January 2009…
Coverage
Level
$4.00
$4.50
$5.00
$5.50
$6.00
$6.50
$7.00
$7.50
$8.00
Fees &
Premiums
1,000
6,661
14,623
31,067
58,120
85,527
170,009
230,758
360,046
Expected
Indemnity
78,471
141,674
230,757
340,466
464,086
599,567
745,680
901,491
1,066,022
DMSP
Penalty
129,704
129,704
129,704
129,704
129,704
129,704
129,704
129,704
129,704
Net
Revenue
-52,232
5,308
86,430
179,695
276,261
384,336
445,968
541,029
576,272
Actual Income Over Feed Cost Margin in 2009
This is how 2009 turned out for you…
Coverage
Level
$4.00
$4.50
$5.00
$5.50
$6.00
$6.50
$7.00
$7.50
$8.00
Fees &
Premiums
Realized
Indemnity
DMSP
Penalty
Realized
Net
Revenue
1,000
6,661
14,623
31,067
145,191
274,168
403,145
532,122
191,360
191,360
191,360
191,360
-47,169
76,147
197,162
309,695
58,120
85,527
170,009
675,425
836,657
997,889
191,360
191,360
191,360
425,944
559,770
636,520
230,758
1,159,120
191,360
737,002
360,046
1,337,377
191,360
785,971
Information as of January 2010…
Information as of January 2010…
Information as of January 2010…
Coverage
Level
$4.00
$4.50
$5.00
$5.50
$6.00
$6.50
$7.00
$7.50
$8.00
Fees &
Premiums
Expected
Indemnity
1,000
6,763
14,867
31,616
59,171
87,086
172,950
234,757
366,295
195
633
1,511
3,274
6,932
13,740
26,249
47,807
85,034
DMSP
Penalty
1,453
1,453
1,453
1,453
1,453
1,453
1,453
1,453
1,453
Net
Revenue
-2,258
-7,583
-14,809
-29,795
-53,691
-74,799
-148,153
-188,403
-282,714
Actual Income Over Feed Cost Margin in 2010
This is how 2010 turned out for you…
Coverage
Level
$4.00
$4.50
$5.00
$5.50
$6.00
$6.50
$7.00
$7.50
$8.00
Fees &
Premiums
Realized
Indemnity
DMSP
Penalty
Realized
Net
Revenue
1,000
6,763
14,867
31,616
0
0
0
0
0
0
0
0
-1,000
-6,763
-14,867
-31,616
59,171
87,086
172,950
0
0
0
0
0
0
-59,171
-87,086
-172,950
234,757
10,442
0
-224,314
366,295
58,078
0
-308,217
Information as of January 2011…
Information as of January 2011…
Information as of January 2011…
Coverage
Level
$4.00
$4.50
$5.00
$5.50
$6.00
$6.50
$7.00
$7.50
$8.00
Fees &
Premiums
1,000
6,909
15,219
32,407
60,684
89,331
177,188
240,518
375,298
Expected
Indemnity
56,708
86,061
125,352
177,189
245,898
338,082
458,393
601,849
761,759
DMSP
Penalty
75,364
75,364
75,364
75,364
75,364
75,364
75,364
75,364
75,364
Net
Revenue
(19,656)
3,788
34,769
69,418
109,850
173,387
205,841
285,967
311,097
Actual Income Over Feed Cost Margin in 2011
This is how 2011 turned out for you…
Coverage
Level
$4.00
$4.50
$5.00
$5.50
$6.00
$6.50
$7.00
$7.50
$8.00
Fees &
Premiums
Realized
Indemnity
DMSP
Penalty
Realized
Net
Revenue
1,000
6,909
15,219
32,407
0
0
0
0
0
0
0
0
(1,000)
(6,909)
(15,219)
(32,407)
60,684
89,331
177,188
0
0
0
0
0
0
(60,684)
(89,331)
(177,188)
240,518
0
0
(240,518)
375,298
9,886
0
(365,412)
Information as of January 2012…
Information as of January 2012…
Information as of January 2012…
Coverage
Level
$4.00
$4.50
$5.00
$5.50
$6.00
$6.50
$7.00
$7.50
$8.00
Fees &
Premiums
1,000
7,605
16,888
36,163
67,871
99,996
197,312
267,875
418,049
Expected
Indemnity
14,908
28,329
48,455
77,637
119,094
175,689
250,372
349,725
481,176
DMSP
Penalty
Net
Revenue
43,764 (29,856)
43,764 (23,041)
43,764 (12,197)
43,764 (2,291)
43,764
7,458
43,764 31,929
43,764
9,296
43,764 38,085
43,764 19,363
Actual Income Over Feed Cost Margin
This is how 2012 turned out for you…
Coverage
Level
$4.00
$4.50
$5.00
$5.50
$6.00
$6.50
$7.00
$7.50
$8.00
Fees &
Premiums
Realized
Indemnity
DMSP
Penalty
Realized
Net
Revenue
1,000
7,605
16,888
36,163
90,541
165,929
271,141
384,224
271,253
271,253
271,253
271,253
-181,712
-112,929
-16,999
76,808
67,871
99,996
197,312
497,307
610,390
774,434
271,253
271,253
271,253
158,183
239,141
305,870
267,875
962,905
271,253
423,777
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
U.S. All-Milk Price 2014 Outlook
(80% Confidence Interval)
25.00
23.00
21.00
19.00
17.00
15.00
13.00
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 Workshops
October 23-24, 2013
Dr. Marin Bozic
[email protected]
Department of Applied Economics
University of Minnesota-Twin
Cities
317c Ruttan Hall
1994 Buford Avenue
St Paul, MN 55108
Acknowledgements:
Fanda Yang, PhD Student UMN
Lou Kuhlmann, Advance Trading,
Inc.
John Newton, PhD Student, OSU