When do profits occur on dairy farms?
We are through the first quarter of the new USDA dairy margin protection program (MPP). Minnesota has one of the highest participation rates of any state with 2,600 farmers or about 69% signed up for some level of coverage. Of the 69% who signed up, 73% bought up coverage above the minimum $4.00 coverage level. The memory of 2008 and 2009 must have been on the minds of many producers because at the time of sign up we were enjoying the highest margin year in memory.
The first potential MPP pay period (January and February 2015) is now in the books. The Jan/Feb income over feed cost calculation was $7.9955 per cwt. The February margin was potentially high enough to trigger a payment at a $7.66 margin but when averaged with January's margin of $8.33, it was not high enough to trigger payments–even at the highest coverage level.
It won't be long before the July 1 to September sign up period for 2016 coverage will be here. Based on current information, the online model is predicting that payments are unlikely except for coverage above the $6.50 level (http://dairymarkets.org/MPP/Tool/).
It may be obvious that the right decision for 2016 will be to take either none or choose the catastrophic coverage level of $4.00 because premiums are going up and possibly no payments were received in 2015 . However, if you evaluate when dairy farmers made and lost money over the past decade, the use of this program could have protected against extremely low margins; therefore, potentially improving overall long term profitability . Figure 1 shows income over feed cost margins from 2003 to 2013. This graph uses a level of $8.00 per cwt as the income over feed cost margin required to cover all other production costs for the farm. All numbers in Figure 1 to the left of the vertical black line are below $8.00 per cwt and are periods of negative margins. All areas to the right of the vertical line are periods of profit. FINBIN (the University of Minnesota Farm Financial Database) averages from the same period of time show that to cover all costs except labor and management, Minnesota and Wisconsin producers needed $7.73 per cwt; to cover all family labor and management charges, the margin needed to be $8.68 per cwt. Therefore, the $8.00 per cwt looks like an accurate number for the average Upper Midwest farm.
Figure 1 shows that the percent of time that margins are within any one of the $1.00 margin increments (dark bars) is somewhat consistent–ranging between a low of 6% for the months that the margin is between $5 to $6 per cwt and a high of 19% for the months that the margin is between $8 to $9 per cwt. The real message of the graph is that the majority of the profits and total losses occur at the extreme margin levels, even though margins are not at those levels for a large percentage of the time. Margins were only below $5.00 per cwt for 13% of the months but 63% of all losses occur at that margin level. Profits were similar. Margins were over $11.00 per cwt only 13% of the months but 53% of the entire profit over the 10-year period came when margins were at that level.
Figure 1. Margin protection program margin distribution from 2004 to 2013 (Bethard, 2014).
A couple of thoughts come to mind when considering this information. Even though time spent at each of the margin levels is somewhat consistent, total profit and loss is driven by the extremes. Intuitively this makes sense since margins are so extreme at low and high ends . It seems a good strategy is to protect your margins at the low end while leaving the upside potential open in order to capture the profits during high margin periods. Fortunately, the margin protection program allows producers to protect against the extremely low margins for a reasonable cost, especially for the first four million pounds of production. Another item to consider... if you are going to use future markets, it might be best to use them consistently because it is difficult to predict the extremely high or low margin periods. They usually occur because of unusual events. Think back to 2009 when the U.S. economy collapsed, and in 2014 when we had high exports, rapidly decreasing feed costs and slowly increasing production . It could create extreme financial stress to miss out on the highest margin periods without protecting against the lowest margin periods. Of course another option is to do nothing and just average out all the high and low periods.