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An alternative milk pricing plan using margins

Randy Pepin

Published in Dairy Star October 16, 2009

We often hear that we should be actively marketing our milk to help lessen the blows of the low-income times. We also hear that we need to consider profit margin rather than merely price. A milk-marketing tool has been available since August of 2008 that could give the dairy industry the flexibility it may be looking for. The Risk Management Agency (RMA) of USDA has a program called Livestock Gross Margin for Dairy. Minnesota and all of its bordering states are among the thirty-six states where the program is available.

The Livestock Gross Margin for Dairy is all about the margin between the milk price and feed inputs, not the actual price of milk or actual cost of feed inputs. A rough description of this margin might be the term, Income Over Feed Costs. It is essentially equivalent to obtaining a Put Option on Class III milk and Call Options on corn grain and soybean meal but doing it all in one transaction. Typically, to accomplish this, one would need to enter into three separate option contracts; and minimum options size requirements eliminate smaller farms from participating. The Livestock Gross Margin for Dairy has no minimum size requirements; however, the maximum milk volume a farm can purchase insurance for is twenty-four million pounds of milk per year. Just like an option contract, if the actual margin is better than the insured amount, the dairy farm can take advantage of the actual prices.

The Livestock Gross Margin for Dairy program is an insurance policy designed for milk producers and is not available to speculators. The dairy farm must work with an insurance agent certified to handle the program, which is a separate certification through the RMA Federal Crop Insurance Program. Livestock Gross Margin for Dairy only considers the futures market settlements for the month under consideration, not actual feed costs, actual milk price, or milk contracts a dairy farm may have. When a dairy farm makes an insurance claim for a given month's margin, that farm must bring in that month's milk receipts to justify the insurance payment.

Prior to signing an insurance contract, the dairy farm must examine its grain and protein usage, use formulas created by RMA to convert various commodities to corn and soybean meal, and then determine the appropriate amount of corn and soybean meal to use. The farm then evaluates the margins on the board for the next eleven months, not including the next month, for a net of ten months. In other words, if the dairy farm is considering this at the end of December, the farm can buy insurance on the margins for the months of February through November. At 3:30 p.m. on the last business Friday of each month, RMA posts the average futures settlements based on the last three trading days. The dairy farm has until 8:00 p.m. the next day, Saturday, to purchase the desired insurance. If the farmer likes the margin for a given month, the farm can lock in any amount of milk volume up to the expected milk sales for that month and buy an insurance policy on that margin. The last decision to be made is how much of a deductible to take. Like all insurance deductibles, the higher the deductible, the lower the premium. Deductibles can range from $0 to $1.50/cwt of milk.

The amount of the insurance premium for the Livestock Gross Margin for Dairy program cannot be determined until all the calculations for a given month are completed. The premium amount will vary with the milk $/cwt deductible, number of months in the contract, the present market volatility, and the amount of corn and soybean meal included in the policy. Insurance premiums have usually ranged from $0.10 to $0.85/cwt of milk. RMA requires advance payment of insurance premiums. Presently, few insurance agents have taken the measures necessary for certification to handle the Livestock Gross Margin for Dairy program.

One thing the dairy industry may have learned over the last couple of years is the need to do more than just lock in a "good" milk price; dairy producers must also protect themselves on the input side. The Livestock Gross Margin for Dairy program is not a perfect system and cannot always place a farm in a profitable position; however, it may allow a producer to lock in some higher margins that periodically appear on the futures market. In the end, it is really the profit margin and not the actual prices that count.

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