Buckeye Dairy News : Volume 15 Issue 5

  1. Protecting Income Over Feed Cost Margin on U.S. Dairy Farms

    Dr. Cameron Thraen, State Extension Specialist, Dairy Markets and Policy, John Newton, Ph.D. candidate, The Ohio State University, and Dr. Marin Bozic, Assistant Professor, Department of Applied Economics, University of Minnesota

    Introduction

    The goal of this article is to provide a discussion on the recent developments in farm-level margins in the U.S. dairy sector and to provide some insight into the current risk management and U.S. dairy policy innovations designed to provide an effective dairy safety net in times of high and volatile livestock feed prices. Figure 1 presents milk and dairy feed prices, as well as income over feed costs (IOFC) dairy margins in the U.S. from 1980 through June 2013. This figure reveals three distinct price regimes. The first period, covering 1980 through 1989, was characterized by low feed prices and very stable milk prices supported through an active public stock-holding price stabilization role provided by U.S. Federal dairy policy. Once direct milk price intervention was scaled back, a period of increasing volatility of milk prices ensued, and from 1990 through 2006, the primary source of risk in the U.S. dairy sector originated on the milk revenue side. Since 2007, volatile milk prices were accompanied by rising and increasingly volatile feed prices. The coefficient of variation of IOFC margins increased from 0.12 in 1980 through 1989, to 0.19 in 1990 through 2006, and to 0.37 in the 2007 through 2013 period.

    Thraen Fig 1

    Figure 1. Dairy income over feed cost (IOFC) margins in the U.S., 1980 through 2013.

    The observed increase in volatility associated with milk price and production feed costs merits a discussion on several topics. First to be considered is the appropriate measurement for IOFC margins. Second, the role of private risk markets in providing effective margin risk management for U.S. milk producers is discussed. And third, we consider the likely policy response in face of these developments.

    U.S. Dairy IOFC Margin

    Historically, U.S. dairy farms were located in geographic areas where land quality presented obstacles to grain farming due to lower crop yields per acre. In times when grain prices were fairly low, family farms perceived dairying as a value-added activity that could increase net income per acre. However, since at least the 1970s, innovations in dairy technology and management practices have enabled a new business model to emerge, one focused not on adding value to the existing land base but in efficiently and profitably converting purchased livestock feed to milk. Figure 2 shows a map depicting the percentage of total feed costs attributed to purchased feed for 23 major dairy producing states in the U.S. A typical dairy business model in traditional dairy-producing states, such as Minnesota and Wisconsin, is characterized by owning agricultural land and growing most of the feed needs. For these 2 states, valuing homegrown crops at market prices, we find that the purchased feed costs amount to only a third of total feed costs. Ohio, Michigan, and New York are characterized by intermediate levels of 40 to 60%. In sharp contrast, purchased feed accounts for 74% of total feed costs in Texas and 79% in California, production locations in the U.S. which typify a feed purchase business model.

    Thraen Fig 2

    Figure 2. Purchased feed costs as percentage of total feed cost
    (Source: USDA Economic Research Service. Milk production costs and returns per hundredweight, by State, 2012).

    These market-feed oriented dairy farms generally are large, often at the technological cutting-edge, and tend to focus their capital and management efforts on milk production while either outsourcing livestock feed production to contracted grain farmers or buying commodity feed in the open market. Dairy farm financial record analysis shows that the return on assets is substantially higher for this feed purchase – milk production business model. However, this business model requires a commodity pricing regime characterized by low and stable feed prices. The U.S. Federal feed grain market policy over the period 1980 to 2006 can be characterized as ensuring low and stable feed grain prices. The post 2006 period can be characterized as one of rapidly escalating feed prices, accompanied by large market price shocks. This shift has eroded the financial advantage for the feed buying business model and shifted the financial advantage to land owning, feed grain producing business model.

    Managing IOFC Margin Risk

    The purpose of any proposed dairy margin risk management program is to effectively smooth IOFC margins across years. Using the existing private risk markets, such as the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade, margin smoothing can be achieved through a combination of dairy futures short positions or with put options to protect the milk revenue side, and forward contracts, long futures positions, or call options on livestock feed commodities such as corn and soybean meal. In the United States, the CME group offers a suite of dairy-focused derivatives, as well as very liquid grain contracts. However, in order to understand what would make a risk management program effective and why, some believe only a government sponsored program will be effective; you need to think about the dynamics of milk production, milk price behavior, and price risk management.

    In the long run, competitive markets do not allow for either extra or negative profits. If profit margins are beyond normal returns to capital and management, existing businesses will expand or new businesses would enter the market. Likewise, negative profits will lead to reduction in supply through contractions or exit of some sellers. The above implies that profit margins whenever too high or too low, relative to a long-term norm, will return to a more normal level.  Economists call this mean-reverting behavior. Research on the behavior over time for dairy IOFC margins in the U.S. has confirmed that indeed the IOFC margin is mean-reverting – whenever current margins are extraordinary high or low, forward margins implied from futures prices for milk, corn, and soybean meal always revert to the long-run average mean (Bozic et.al., 2012).

    In face of a major shock to margins, such as that one experienced by the dairy farm sector in 2009, it takes 6 to 9 months for margins to recover or revert back to the long-term mean. It follows that in order for hedging in the futures markets to be consistently effective in smoothing dairy IOFC margins, the hedging horizon must be longer than the time needed for supply adjustments in face of a major shock to margins, i.e. futures and options positions must be initiated for a period that is at least 9 months into the future. This also means that a dairy farmer who waits for a crisis to begin before attempting to lock in margins will very likely be unable to avoid a significant margin decline. Even disciplined risk management programs which stipulate consistent hedging of production for the forthcoming quarter will have little effect on volatility of realized IOFC margins, as a hedging horizon of only 3 months is found to be inadequate.

    In order for long-run risk management to be practically implementable, deferred dairy futures and options contracts need to be liquid. Liquidity means that there is sufficient trading volume such that individual trades do not impact prices.  Grain contract markets are liquid, but dairy contract markets are not. After 20 years of trading dairy contracts at the U.S. commodity exchanges, this liquidity has not been achieved. It is fair to say that the use of dairy futures and options markets stands little chance of being a solution that can be implemented on a large scale. Time has demonstrated that the lack of speculative interest and a limited use of milk contracts by long hedgers jointly limit the milk hedging opportunity using the private risk markets. In light of this reality of the inadequacy of using commodity exchange derivative markets to effectively mitigate price risk, other price risk management tools have been developed or are proposed for use by the dairy industry in the United States.  These include a quasi-private-public insurance product and a currently debated Federal government sponsored margin insurance program.

    Livestock Gross Margin Insurance for Dairy Cattle

    Recognition of the difficulty faced by dairy farmers inherent in using derivative markets as an effective price risk management tool led to the development of alternatives designed to address these shortcomings. The first attempt to provide an insurance based safety net as part of the Federal dairy policy was the introduction of the Livestock Gross Margin Insurance for Dairy Cattle (LGM-Dairy) (Gould and Cabrera, 2011). With LGM-Dairy insurance product, first offered for sale in August 2008, expected milk and feed prices for up 10 months are based on information inferred from CME futures prices for milk, corn, and soybean meal; and producers can insure expected IOFC margins averaged over the duration of the insurance contract. The advantage of LGM-Dairy is that users can define their own quantities of milk, corn and soybean meal that they wish to protect, so the IOFC margin is customized to their particular situation. The risk transferred under LGM-Dairy insurance policies is born by participating private insurance companies and the U. S. Federal Crop Insurance Corporation as the reinsurance agent. The USDA manages LGM-Dairy through its Risk Management Agency and offers heavy subsidies covering administrative fees as well as up to 50% of the insurance premiums. While LGM-Dairy can be very effective in smoothing IOFC margins, it has in practice proven to be challenging for dairy producers due to its many choice variables and irregular contract offering.

    Dairy Producer Margin Protection Program

    As a result of the shortcomings of LGM-Dairy, insights from this program have been used in designing an alternative margin insurance program, serving as the basis of the dairy farm safety-net in the proposed U.S. 2013 Farm Bill. This dairy margin insurance, called Dairy Producer Margin Protection Program (DPMPP), is essentially a government sponsored and subsidized put option on a national IOFC margin index formula based on the dairy feed ration developed by the National Milk Producers Federation with the support of a number of prominent animal nutritionists (NMPF, 2010). It should be clear from the previous discussion that any attempt to construct a single nation-wide index for dairy feed costs and IOFC margins can at best be a rough approximation that is likely to capture only major turning points in average farm profitability. Nevertheless, should this legislation be enacted as part of the next U.S. farm bill, this IOFC formula is likely to be used by both government and private industry analysts as a main measure to summarize a complex issue of dairy profitability into a single number.

    As a government program, the DPMPP has a number of complexities associated with its implementation. To participate in DPMPP, producers must sign-up for the margin insurance for an entire calendar year and choose a per-hundredweight margin coverage level to protect. The program has been very carefully evaluated and is expected to be highly effective as a catastrophic risk management tool (Newton et al., 2013c). However, several long-term economic impacts may be anticipated. First as currently constructed, the DPMPP program may encourage producers to use the new margin insurance program strategically, transferring to the government losses that are imminent and underinsuring when risks seem remote (Newton et al., 2013a). The long term result may be a policy-induced increase in milk production and higher than projected government outlays. Second, a positive supply response may reduce the average long-run IOFC margin (Nicholson and Stephenson, 2011). Third, liquidity of private risk markets may decline if producers substitute this program for more expensive private risk management instruments. Fourth, while the DPMPP may reduce IOFC volatility experienced by participating dairy farmers, it is unclear what would be the effect on volatility of cash IOFC margins. If the new program shields producers from market shocks, they will have less incentive to cut back milk production in times when cash margins are low. As such, supply might take longer to adjust in face of adverse shocks to IOFC margins, and volatility of IOFC margins may actually increase. Finally, DPMPP, as currently configured, lacks any program participation or indemnity payment limitations. Without some limiting constraint, a disproportionately large share of DPMPP will net indemnities that will flow to the largest dairy producers (Newton et al., 2013b). These large scale producers consistently exhibit higher positive return on assets compared to their small scale competitors, and this added financial advantage may contribute to a faster consolidation of the U.S. dairy sector.

    Summary

    Increased volatility in milk prices and feed costs in the United States has resulted in significant financial stress on dairy farmers over the past decade.  This has led to an increased focus on providing, whether private or public, more effective tools to manage this volatility.  This focus has been on the provision of risk management tools designed to smooth out the fluctuation in milk prices and feed costs separately or as an index of IOFC.  These instruments include a fully functional derivatives market for milk and dairy products at the U.S. CME group offering strictly private futures and options contracts to dairy farmers.  In addition to these market-based instruments, the United States Department of Agriculture, Risk Management Agency offers a private-public, subsidized insurance product designed to limit volatility in IOFC.  Lastly, as part of the current United States debate on the safety-net provisions of the 2013 farm bill, an income over feed cost insurance program is being proposed, and if made law, it will become a centerpiece of Federal government support of U.S. dairy farmers for the next 5 years.

    References

    Bozic, M., J. Newton, C.S. Thraen, and B.W. Gould. 2012. Mean-reversion in income over feed cost margins: Evidence and implications for managing margin risk by US dairy producers. Journal of Dairy Science 95:7417-7428.

    Gould, B.W., and V. Cabrera. 2011. USDA's Livestock Gross Margin Insurance for Dairy: What is it and how can it be used for risk management. Dept. Ag and App. Econ, University of Wisconsin-Madison.

    Newton, J., C.S. Thraen, and M. Bozic. 2013a. Actuarially fair or foul? Asymmetric information problems in dairy margin insurance. Paper presented at the annual meetings of NCCC-134, Applied Commodity and Price Analysis, Forecasting, and Market Risk Management, St. Louis, MO.

    Newton, J., C.S. Thraen, and M. Bozic. 2013b. “Whither dairy policy? Evaluating expected government outlays and distributional impacts of alternative 2013 Farm Bill dairy title proposals.” Paper presented at AAEA Annual Meeting, Washington, DC., August 4-6.

    Newton, J., C.S. Thraen, M. Bozic, M.W. Stephenson, C. Wolfe, and B.W. Gould. 2013c. Goodlatte-Scott vs. the Dairy Security Act: Shared potential, shared concerns and open questions. Briefing Paper 13-01, Midwest Program on Dairy Markets and Policy.

    Nicholson, C., and M.W. Stephenson. 2011. Market impacts of the Dairy Security Act of 2011 and the dairy provisions of the Rural Economic Farm and Ranch Sustainability and Hunger Act of 2011.  Dairy Markets and Policy Information Letter Series.
    ___________________________________________

    The DPMPP IOFC margin formula, introduced in proposed U.S. federal dairy policy legislation (S.954, H.R.2642), is defined as:

    Thraen footnote

    where U.S. All-Milk price means the average price received by dairy producers for all milk sold to plants and dealers in the U.S.; prices of corn and alfalfa hay are taken from monthly United State Department of Agriculture Agricultural Prices report; and the price of soybean meal is the central Illinois price for soybean meal as reported in the United States Department of Agriculture Market News-Monthly Soybean Meal Price Report. The ration is based on nutritional requirements of a cow producing 68.85 lb/day of milk during lactation.

  2. The Costs of Nutrients and Comparison of Feedstuffs Prices

    Dr. Normand St-Pierre, Extension Dairy Management Specialist, Department of Animal Sciences, The Ohio State University

    A good portion of the corn harvested for silage in Ohio has now been chopped and ensiled.  Early reports are that both yields and quality varied from good to excellent.  With December futures hovering around $4.50/bu, we will soon be feeding corn silage with a corn-based value at the mixer wagon in the $50 to 55/ton range as opposed to the mid to upper $70s experienced last year.  Cash corn grain and other energy feeds should be dropping substantially throughout the corn cropping season.  Although milk prices are not expected to remain at current levels, we still expect feed costs to drop more rapidly and extensively than milk prices, at least until Christmas.  On the feed side, commodities will be jockeying for a place at the “cow table”.  Expect much movement in all markets, which means that there should be some good bargains to be found and bought.

    For now, feeding balanced diets based on economically priced feed ingredients can help in maintaining positive margins.  The idea is to maximize the use of underpriced feeds and to minimize the use of overpriced ones.

    Nutrient Prices

    As usual in this column, I used the software SESAME™ that we developed at Ohio State to price the important nutrients in dairy rations to estimate break-even prices of all major commodities traded in Ohio and to identify feedstuffs that currently are significantly underpriced as of September 22, 2013.  Price estimates of net energy lactation (NEL, $/Mcal), metabolizable protein (MP, $/lb – MP is the sum of the digestible microbial protein and digestible rumen-undegradable protein of a feed), non-effective NDF (ne-NDF, $/lb), and effective NDF (e-NDF, $/lb) are reported in Table 1. Compared to its historical 6-year average of about 10¢/Mcal, NEL is still a highly priced nutrient at 17.9¢/Mcal.  This is important because a cow producing 70 lb/day of milk requires in the neighborhood of 33 Mcal/day of NEL.  For MP, its current price (42.8¢/lb) is also greater than its 6-year average (28¢/lb).  Whereas the dietary energy price should drop substantially throughout the fall, I am very uncertain as to what to expect for the protein.  In short, we are still in a period of very high dietary energy and protein prices.  The cost of ne-NDF is currently discounted by the markets (i.e., feeds with a significant content of non effective NDF are price discounted), and the discount of 16.5¢/lb is significantly better than its 6-year average (-9¢/lb).  Meanwhile, unit costs of e-NDF are about at their historical average, being priced at 1.5¢/lb compared to the 6-year average (3.3¢/lb).  So, rumen-effective dietary fiber is currently not a significant cost factor from a historical standpoint. 

    Table 1.  Prices of dairy nutrients for Ohio dairy farms, September 21, 2013.
    Table 1

    Economic Value of Feeds

    Results of the Sesame analysis for central Ohio on September 21 are presented in Table 2. Detailed results for all 27 feed commodities are reported.  The lower and upper limits mark the 75% confidence range for the predicted (break-even) prices.  Feeds in the “Appraisal Set” were deemed outliers (completely out of price).  One must remember that Sesame compares all commodities at one point in time, early fall in this case.  Thus, the results do not imply that the bargain feeds are cheap on a historical basis.

    Table 2.  Actual, breakeven (predicted) and 75% confidence limits of 27 feed commodities used on Ohio dairy farms, September 21, 2013.
    Table 2

    For convenience, Table 3 summarizes the economic classification of feeds according to their outcome in the Sesame analysis.

    Table 3. Partitioning of feedstuffs, Ohio, September 21, 2013.

    Bargains

    At Breakeven

    Overpriced

    Bakery byproducts
    Corn, ground, shelled
    Corn silage
    Distillers dried grains
    Gluten feed
    Gluten meal
    Hominy
    Molasses
    Wheat middlings

    Alfalfa hay – 40% NDF
    Brewers grains, wet
    41% Cottonseed meal
    Whole cottonseed
    Feather meal
    Soybean meal – expeller
    Roasted soybeans
    Tallow
    Wheat bran

    Beet pulp
    Blood meal
    Canola meal
    Citrus pulp
    Fish meal
    Soybean hulls
    44% soybean meal
    48% soybean meal

     

  3. Glyphosate-Resistant Palmer Amaranth Problems Developing in Ohio – What Dairy Producers Need to Know

    Dr. Mark Loux, Extension Specialist, Department of Horticulture and Crop Science, The Ohio State University

    We have plenty of glyphosate-resistant weed populations in Ohio.  Resistance currently is known to occur in four weed species here – marestail (horseweed), giant ragweed, common ragweed, and waterhemp - and many of these populations are also resistant to acetolactate synthase (ALS) inhibitors (Classic, FirsRate, etc.).  The good news is that our resistance problems are overall less severe than in the southern United States, where the now widespread occurrence of Palmer amaranth has had a substantial impact on crop yields and profitability of cotton and soybean growers and forced a semi-permanent change in the amount of herbicide that has to be used.  As we expected though, glyphosate-resistant Palmer amaranth populations are starting to show up here in Ohio.  We are already working hard to educate grain producers and their advisors and suppliers about this weed in hopes of curtailing the spread.  The purpose of this article is to inform dairy producers about the problem, that they may be inadvertently facilitating the spread of this weed, and the actions that can be taken to avoid doing so.

    Palmer amaranth is in the Amaranthus or pigweed family.  The most abundant pigweed species in Ohio are redroot and smooth pigweed, which are essentially identical to each other with regard to identification.  Most preemergence herbicides have substantial activity on these pigweed species, and they are usually well controlled by a combination of preemergence and postemergence herbicides.  We have screened a few redroot and smooth pigweed populations for resistance to herbicides, and so far, we have not observed  glyphosate resistance.  Palmer amaranth (aka Palmer pigweed) has been fairly accurately characterized as “pigweed on steroids”.  In addition to the glyphosate resistance, this weed’s rapid growth, large size, extended duration of emergence, prolific seed production, and general tolerance of many POST herbicides makes it a much more formidable weed to deal with than the other pigweeds.  The POST herbicides that have activity on Palmer amaranth must be applied when the weed is less than 3 inches tall.  Palmer amaranth has overall more potential to reduce yield if not controlled well, compared with the other pigweeds.  It’s probably not possible for us to overestimate how severe a problem this weed can be based on these characteristics and the problems that have occurred in the south, where some growers finally resorted to hiring crews of laborers to remove plants from fields at great expense.

    So why are we trying to get information to dairy producers about this weed?  At this point, we know of several major infestations of Palmer amaranth in Ohio, and it is starting to be found in additional fields.  As far as we can tell, the source of the first major infestation may have been a Conservation Reserve Enhancement Program (CREP)/wildlife type seeding, where the seed of the desirable species was apparently contaminated with Palmer amaranth seed.  However, for the newer infestations that are occurring, the source appears to be contaminated cottonseed brought in from the southern US for use as animal feed here.  Manure from these animal operations is being spread on crop fields, where the Palmer amaranth can then became established.  For example, there appears to be somewhat of an epicenter of new Palmer amaranth infestations in an area southwest of Columbus, bordered roughly by Midway on the north and Washington CH on the south.  There is a dairy in the area that has been using cottonseed products for feed and a local grower has been transporting these products to the dairy from somewhere in the south.  There are Palmer amaranth plants in a number of fields in the area and also on the grounds of the dairy.  Cottonseed feed products also have been the source for major infestations of Palmer amaranth in Michigan and Indiana. 

    A primary goal over the next decade for Ohio agribusiness and growers, and OSU weed scientists, has to be the prevention of additional infestations of Palmer amaranth.  This weed has more potential to impact the profitability of our corn and soybean production than our other resistance problems.  Some things for dairy producers to consider relative to this developing problem include:

    1. Take a few minutes to familiarize yourself with the problem.  The OSU weed science website (http://agcrops.osu.edu/specialists/weeds) has information on Palmer amaranth, including a short video on identification and an 11-minute video that explains the risk from this weed. 
    2. If you are feeding cottonseed feed products, be aware that there is at least some likelihood that they are contaminated with Palmer amaranth seed.  Make your feed supplier aware of this and ask what steps are being taken to ensure that these products are not contaminated.  Scout areas where manure is stored or spread for the presence of Palmer amaranth plants. 
    3. Early identification and management are keys to preventing major infestations.  The OSU weed scientists can help with identification, either via digital photos emailed to us or with visits to fields.  We would appreciate being informed (loux.1@osu.edu) of any new infestations of Palmer amaranth as soon as possible. 
    4. Where Palmer amaranth plants are found, it is essential that growers take all steps possible to prevent weed seed production.  This can include tillage, mowing, and also removal of surviving plants by hand.  The result of not doing so could be substantial increases in weed management costs and loss of income in future years. 
  4. The Land of “MILC and Honey” - Dairy Policy Watch 2013

    John Newton, Ph.D. Candidate, The Ohio State University, and Dr. Cameron Thraen, State Extension Specialist, Dairy Markets and Policy

    Key Finding:

    • The choice for dairy safety-net can be a win-win for all.
    • Offering farmers a choice between an expanded Milk Income Loss Contract (MILC) program and a limited income over feed cost (IOFC) margin insurance program would double the support of existing programs yet cost 40 to 60% less than the proposed stand-alone margin insurance programs.
    • The IOFC support capped at $6.50/cwt would allow farmers to receive market signals attributable to low IOFC margins. In response, though reductions in output but not whole herd liquidations as was the case in 2009, milk supply would naturally adjust to return margins to average levels.
    • Farms would no longer have an incentive to opt-out of the margin insurance and would instead opt for the no-cost MILC program when margins appear favorable. This would allow all farms to participate in a government sponsored safety net program and may prevent ad-hoc disaster payments in the future.

    Background

    The hardships experienced across the dairy sector in 2009, where U.S. dairy farmers rapidly liquidated more than 250,000 dairy cows from the national herd (Figure 1), brought about a consensus among dairy industry participants that a new risk management solution was needed. As an alternative to price and revenue support, several new safety net programs with an emphasis on government sponsored IOFC margin insurance have been proposed. Dairy subtitles in both House and Senate 2013 Farm bills discontinue the MILC and Dairy Producer Price Support Program (DPPSP) and institute a Dairy Producer Margin Protection Program (DPMPP). The DPMPP is a highly subsidized IOFC margin insurance program designed to pay an indemnity to a participating farm when the difference between the national average all-milk price and the formula-derived estimate of feed costs falls below a farmer-selected margin trigger. The House bill (Dairy Freedom Act) includes only the DPMPP. If enacted into law, the Senate bill (Dairy Security Act; DSA) would require farms enrolling in DPMPP to also participate in a Dairy Market Stabilization Program (DMSP). The DMSP is a supply management-type program designed to enhance milk prices by reducing the rate of growth in U.S. milk production when IOFC margins fall below a specified threshold. Farms must either reduce the quantity of milk sent to market or face milk revenue penalties on milk shipped over their assigned production base.

    Figure 1

    The solid black line represents monthly IOFC margin, the dotted line represents the average IOFC margin over the sample period (both in $/cwt on the left axis), and the solid blue line represents the size of the U.S. milking herd as reported by USDA NASS (1,000 head on the right axis).

    Figure 1. Income-over-feed-cost (IOFC) margin and size of the U.S. milking herd, 2000-2013.

    Why Dairy Market Stabilization?

    During times of low margins, it is in the collective interest of dairy producers to reduce production to boost margins quickly to sustainable levels. However, even in absence of coordinated collective action, periods of low margins are generally a temporary phenomenon. Through herd liquidations, milk supply naturally adjusts to return margins to average levels, as evidenced by historic IOFC margin patterns and the term structure of forward IOFC margins (Bozic et al., 2012). The downside of relying exclusively on markets to govern the supply correction is that the recovery may be delayed for as long as revenue from milk production covers at least variable costs. Thus, to expedite IOFC recovery the DSA couples DPMPP with a supply management-type program.

    Additionally, supporters of the DSA argue that a highly subsidized stand-alone margin insurance program offering coverage of only $0.30/cwt less than the historical average of $8.30/cwt will make the milk supply less responsive to negative price signals, and in the long run it will result in lower average milk prices and higher indemnity payments from the taxpayer to the dairy farmer. Such a scenario may be undesired but would not be unforeseen.

    Opposition to a Dairy Market Stabilization Program

    The DMSP portion of the DSA package has wide-spread support within the dairy farming community and its cooperative leadership, but this support is not nearly unanimous. Significant resistance with regard to the DMSP has been registered by dairy cooperatives, restaurant and food marketers, consumer groups, dairy food manufacturers, and their trade associations. These groups are concerned that artificial enhancement of milk prices through DMSP milk supply reductions will have detrimental effects on procurement costs, throughput efficiency, retail prices, consumer demand, and dairy export opportunities. In addition, opponents fear that once DMSP becomes part of legislation, it could be easily amended by Congress to be non-voluntary or more severe in the financial penalties, a slippery slope opposition groups seek to avoid.

    A MILC and Honey Compromise

    With both sides in the dairy policy debate set in their positions, it is difficult to see a path to compromise. How can we offer a retooled dairy farm safety net that: (i) works for small and large-scale dairy farm managers; (ii) is fiscally responsible; (iii) does not mute market supply and demand signals, and (iv) does not require a market supply program? We propose a new policy alternative, one we decorously label “MILC and Honey”. This program would accomplish all of these goals by increasing eligibility of MILC to 4 million pounds per year and allowing farms an option to choose annually between: 1) MILC participation, or 2) a stand-alone margin insurance program as their elected safety net.  Specifically, our proposal is for a combined program that we call MILC-Insurance.  This program will provide for:

    • Continuing to offer the MILC program and increase the MILC eligibility to 4 million pounds per fiscal/calendar year,
    • Farms not wishing to participate in MILC would be able to participate in a program that offers margin insurance from $4.00 to 6.50/cwt, and
    • The choice of either MILC or Insurance can be made each calendar or fiscal year.

    In order to determine how this new policy option would perform, the margin insurance and MILC benefits were modeled for 5000 representative farms and 4 IOFC margin scenarios. Milk production data for 48 months were simulated for the representative farms. The data were structured to include consolidation trends, herd demographics, seasonal production patterns, and farm growth rates common to U.S. farms. In all of the analyses, we use the milk marketings in months 1 to 36 to construct the production history and months 37 to 48 are used to analyze the performance of the margin insurance program and MILC benefits.

    Four beginning-of-the-year expected margin scenarios are identified that should well cover the space of likely expected margin environments:

    • Catastrophic Margins. Expected margins are well below long-run average but revert to mean by the end of the year.
    • Mean-Reverting Margins. Expected margins for the first quarter of the year are well above historical average but revert to long-run average.
    • Above-Average Margins. Expected annual average margin is almost $1/cwt above average.
    • January 15, 2013. Expected margins derived using January 15, 2013 futures and options prices.

    These scenarios, depicted in Figure 2, are based on actual expected margins, as observed on January 15 in one of the previous 7 years. The simulation techniques used for this analysis are similar to those employed by Newton et al. (2013).

    Figure 2

    The solid black line represents the mean first-stage IOFC margin, the shaded region represents to middle 50% of first-stage IOFC observations, and the dashed line represents the actual IOFC margin calculated using announced USDA prices for all-milk, corn, soybean meal, and alfalfa hay.  Catastrophic scenario corresponds to 01/15/2009, Mean Reverting to 01/15/2008, and Above Average to 01/15/2010.

    Figure 2. Simulated beginning-of-the-year income over feed cost (IOFC) margin scenarios.

    MILC-Insurance Simulation

    Consider first the benefits of the Dairy Freedom Act (DFA) (Table 1) when anticipated IOFC margins are catastrophic; the net benefits of DFA are up to 3 times greater than payments under a counter-cyclical payment program for the 5000 farms in this analysis. For example, given 2013 margins, DFA would provide $76 million dollars in revenue support, while the MILC program would provide only $23 million dollars (Note: Financial outlays reflect only the simulation results and are not indicative of total dairy farm safety net outlays by the government). During favorable margin outcomes, such as a mean-reverting margin or an above-average margin, the support from DFA is less than the support received from MILC. In fact, during an above-average margin outcome, MILC would still provide a marginal amount of income support while the margin insurance program support is near zero. This disparity is due to the fact that during times of low milk and low feed prices, an IOFC program may not pay an indemnity, while the MILC program may still trigger a payment if the feed adjusted Boston class I price of milk is below $16.94/cwt.

    Table 1. Net benefits and benefits per cwt of Milk Income Loss Contract (MILC) program, Dairy Freedom Act (DFA), and MILC-Insurance by farm size for 5000 representative farms (~1/10th of US milk supply).

    Program/Herd Size

    Catastrophic Margin

    Mean Reverting Margin

    Above Average Margin

    January 15, 2013

     

    Million $

    $/cwt

    Million $

    $/cwt

    Million $

    $/cwt

    Million $

    $/cwt

    Milk Income Loss Contract

     

     

     

     

     

     

     

     

    1-49 head

     16.0

    1.06

    1.4

    0.09

    0.7

    0.04

      4.0

    0.27

    50-99 head

     22.0

    1.06

    1.9

    0.09

    0.9

    0.04

      5.5

    0.27

    100-499 head

     40.5

    0.75

    3.7

    0.07

    1.8

    0.03

      9.8

    0.18

    500-999 head

       6.4

    0.33

    0.6

    0.03

    0.3

    0.02

      1.6

    0.08

    1000+ head

       5.8

    0.08

    0.7

    0.01

    0.4

    0.01

      1.7

    0.02

    Total

     90.7

     

    8.2

     

    4.1

     

    22.6

     

    Dairy Freedom Act

     

     

     

     

     

     

     

     

    1-49 head

      24.2

    1.59

    1.3

    0.08

    >0

    >0

      7.2

    0.47

    50-99 head

      33.1

    1.60

    1.7

    0.08

    >0

    >0

      9.8

    0.47

    100-499 head

      92.8

    1.56

    1.4

    0.04

    >0

    >0

    24.3

    0.41

    500-999 head

      30.5

    1.53

    Opt-Out

     

    Opt-Out

     

      7.1

    0.35

    1000+ head

    127.5

    1.51

    Opt-Out

     

    Opt-Out

     

    27.1

    0.32

    Total

    308.1

     

    4.4

     

    >0

     

    75.5

     

    “MILC-Insurance $6.50/cwt Cap”

     

     

     

     

     

     

     

    1-49 head

      19.4

    1.28

    1.4

    #0.09

    0.6

    #0.04

      5.0

    0.33

    50-99 head

      26.6

    1.28

    1.9

    #0.09

    0.9

    #0.04

      6.9

    0.33

    100-499 head

      72.4

    1.22

    4.1

    #0.07

    2.0

    #0.04

    16.0

    0.27

    500-999 head

      23.2

    1.16

    0.7

    #0.04

    0.4

    #0.02

      4.3

    0.21

    1000+ head

      95.3

    1.13

    0.9

    #0.01

    0.6

    #0.01

    15.3

    0.18

    Total

    236.9

     

    9.0

     

    4.5

     

    47.5

     

    “MILC-Insurance $6.00/cwt Cap”

     

     

     

     

     

     

     

    1-49 head

      16.0

    #1.06

    1.4

    #0.09

    0.6

    #0.04

      4.0

    #0.27

    50-99 head

      22.0

    #1.06

    1.9

    #0.09

    0.9

    #0.04

      5.5

    #0.27

    100-499 head

      58.3

     0.98

    4.1

    #0.07

    2.0

    #0.04

    11.6

    #0.21

    500-999 head

      18.7

     0.94

    0.7

    #0.04

    0.4

    #0.02

      2.5

    0.13

    1000+ head

      77.2

     0.92

    0.9

    #0.01

    0.6

    #0.01

      8.7

    0.10

    Total

    192.2

     

    9.0

     

    4.5

     

    32.3

     

    Notes: DFA Supplemental Coverage Percentage: 80%;  #Maximum net benefits were from expanded MILC program.

    As a joint program, MILC-Insurance, combines the benefits of both programs and ensures a safety net on either the milk price or the IOFC margin. As a result during favorable margin outcomes, the combined program does not reduce the expected benefits compared to a MILC only program. In fact based on the simulation results, all farms (large and small) would benefit more from a counter-cyclical MILC program when margins are favorable. It is only when IOFC margins fall to low levels would an IOFC program be preferred to MILC.

    When IOFC margins are poor, the combined program would provide 2 times the support of MILC for the 5000 farms in this analysis. For example, given 2013 margins, this joint program would provide $32 to 48 million dollars, while MILC would only provide $23 million dollars. The difference in MILC and Honey payments is due to the $6.00 and $6.50/cwt supplemental insurance cap, with $6.50 coverage providing an additional $16 million in revenue support to dairy farmers.

    During the catastrophic margin outcome, the average payment from a counter-cyclical payment program is approximately $1.06/cwt for herds under 99 head. The effective support price declines rather sharply for farms that produce more than 2.985 million pounds annually. For farms with 100 to 499 head the revenue support was $0.75/cwt, for farms with 500 to 999 head the revenue support was $0.33/cwt, and for farms with 1000+ dairy cows, the expected MILC benefit is only $0.08/cwt. This pattern, albeit not as extreme, is also observed in other price scenarios, and in each example, the largest farms receive the smallest share of total benefits. Given these results, it is evident why some argue that coverage provided via MILC is inadequate and outdated (Thraen, 2007; D’Antoni and Mishra, 2011).

    By design, the disparity in per cwt benefits is eliminated when analyzing the DFA and the combined MILC-Insurance programs. Under the DFA margin insurance program, farms electing similar coverage options have similar net benefits per cwt.  Under MILC-Insurance, the benefits per cwt are similar when farms participate in the IOFC program and are only $0.20 to 0.50/cwt less than those under a margin insurance only program.  The key benefit of MILC-Insurance is found during favorable margin years; for example, during the above-average scenario, the expected benefits per cwt were near zero for farms who elected to remain in the program.  Meanwhile under a MILC-Insurance, not only did the farms not opt-out of a government safety net, but they received benefits up to $0.04/cwt.

    Relative to program preference, we find that with a $6.00/cwt MILC-Insurance program, smaller farmers would elect to remain in the MILC program compared to the IOFC program. The reason small farms may elect MILC over margin insurance is the MILC is a no cost to participate program; thus, even if margin indemnities are higher than MILC payments after paying premiums, MILC benefits are actually higher than IOFC insurance indemnities. When $6.50/cwt coverage is offered, the expected benefits of IOFC exceed those of a MILC program ($4 million pounds cap).  This pattern of preferring MILC to IOFC insurance does not continue as the herd size grows. The reason large farms would prefer the margin insurance over the MILC during poor margin outcomes is the 4 million pound benefit constraint results in the effective revenue support per cwt, dropping as farm size increases.

    Results indicate that the MILC-Insurance program would provide benefits to both small and large dairy farm operators by allowing them to annually choose their safety net. This new alternative would provide greater support to small farmers compared to the existing MILC program by expanding eligible pounds.  For farmers growing a majority of their feed, the target price MILC program provides a safety net to their primary revenue risk – milk prices.  For larger dairy farms (and farms who purchase feed), the IOFC program provides the ability to mitigate both milk and feed price variability.  Thus the opportunity to participate in one or the other provides a continuous safety net program in any IOFC environment for all dairy farmers.

    From a fiscal perspective, this program would also reduce the costs by as much as 60% compared to the DFA if IOFC coverage from $4.00 to 6.00/cwt is offered. These cost savings fall to just under 40% when $4.00 to 6.50/cwt coverage is offered. Finally, by offering insurance coverage only up to $6.50/cwt, a stand-alone margin insurance program may not mute market signals implicit during IOFC margin events compared to an $8.00/cwt insurance option. By directing market signals to the dairy farmers, they can respond to negative price signals not by liquidating their herd completely, but by reducing output. A slight reduction in output, while supporting dairy farm revenue with $6.50/cwt insurance coverage, would provide dairy farm stability and serve to prevent rapid declines in the U.S. milking herd similar to those witnessed in 2009.

    Summary

    As means to end the stalemate between supporters of the House and Senate dairy titles, we propose serious consideration on a new dairy safety-net program.  This program will: (i) work for small and large-scale dairy farm managers alike; (ii) is fiscally responsible, providing more support than the current MILC yet costing significantly less than the currently debated programs; and (iii) does not mute market supply and demand signals. This new policy alternative, which we title MILC-Insurance, would accomplish all of these goals by increasing eligibility of MILC to 4 million pounds per fiscal or calendar year and by allowing farms an option to choose annually between MILC and a stand-alone margin insurance program as their elected safety net.

    The MILC-Insurance saves money relative to the stand-alone margin insurance program by capping insurance at $6.00 to 6.50/cwt. With the savings, the revenue can be redirected to an expansion of the MILC program, effectively offering the best of both programs (counter-cyclical revenue support or catastrophic margin insurance).  Farms would no longer have an incentive to opt-out of the margin insurance and would instead opt for the no-cost MILC program when anticipated margins are favorable. This would allow all farms, regardless of size or management style, to participate in a government sponsored safety net program.  Such a program, which offers continuous support, may prevent ad-hoc disaster payments in the future.

    References

    Bozic, M., J. Newton, C.S. Thraen, and B.W. Gould. 2012. Mean-reversion in income over feed cost margins: Evidence and implications for managing margin risk by US dairy producers. Journal of Dairy Science 95:7417-7428.

    D’Antoni, J.M., and A.K. Mishra. 2011. Assessing participation in the Milk Income Loss Contract Program and its impact on milk production. Paper presented at the Agricultural and Applied Economics Association’s 2011AAEA and NAREA annual meeting, Pittsburgh, PA.

    Newton, J., C. Thraen, and M. Bozic. 2013. Whither dairy policy? Evaluating expected government outlays and distributional impacts of alternative 2013 farm bill dairy title proposals.  Paper presented at the Agricultural and Applied Economics Association’s 2013 annual meeting, Washington, DC.

    Thraen, C.S. 2007. Dairy Policy – How MILC changes the Dairy Support Price. OSUE Dairy Policy and Markets Briefing Paper, Department of Agricultural, Environmental and Development Economics, The Ohio State University.