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.
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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.