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S TRATEGIES AND C ONSIDERATIONS W ITH M ARGIN P ROTECTION P ROGRAM (MPP-D AIRY ) John Newton University of Illinois jcnewt@illinois.edu 21 st Annual National Workshop for Dairy Economist and Policy Analysts May 1 & 2, 2014 Milwaukee,

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STRATEGIES AND CONSIDERATIONS WITH MARGIN PROTECTION PROGRAM (MPP-DAIRY)

John Newton

University of Illinois jcnewt@illinois.edu

21st Annual National Workshop for Dairy Economist and Policy Analysts May 1 & 2, 2014 Milwaukee, Wisconsin

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SLIDE 2

21st Annual National Workshop for Dairy Economists and Policy Analysts

Presentation Materials

Visit the ‘Outreach’ page at farmdoc.illinois.edu/newton

PDF of slides available today

Dashboard available today: www.farmdocdaily.illinois.edu

Contact Information

jcnewt@illinois.edu @New10_AgEcon

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SLIDE 3

21st Annual National Workshop for Dairy Economists and Policy Analysts

Disclaimer

  • Content based on my interpretations of the 2014

Dairy Title and may vary from final rules published by USDA Farm Service Agency (FSA)

  • Charts, and dashboards are for educational and

illustration purposes only

  • FSA Regulations on the 2014 Dairy Title are

expected on or before September 1, 2014

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21st Annual National Workshop for Dairy Economists and Policy Analysts

Based on USDA survey data the costs of producing milk have

  • utstripped the milk price

received.

5 10 15 20 25 30 2000 2002 2004 2006 2008 2010 2012 $/cwt

Total Costs Total, Gross Value of Production Source: USDA Economic Research Service Survey Data

Total costs include operating costs and over head costs such as labor, taxes, and insurance.

USDA Dairy Costs of Production

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21st Annual National Workshop for Dairy Economists and Policy Analysts

Consequences of Margin Variability

8,800 8,900 9,000 9,100 9,200 9,300 9,400

  • 5

10 15 20 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 1,000 Head $/cwt

2014 Farm Bill Dairy Production Margin

U.S. Milking Cows

3% Decline in U.S. Milking Herd (Herd buyouts)

Source: USDA National Agricultural Statistics Service and Agricultural Marketing Service

May 2011 Senate First Hearing on Farm Bill

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SLIDE 6

21st Annual National Workshop for Dairy Economists and Policy Analysts

What is Margin Protection Program (MPP-Dairy)?

  • Enacted with 2014 Farm Bill (Feb 2014)
  • Voluntary program based on income-over-feed-

cost margins

  • Designed to protect dairymen from single- or

multi-year downturns in the production margin

– Pays indemnity when the average difference between

the USDA national All-Milk price and a feed ration index falls below a user selected coverage level

  • Consecutive 2-month average margins determine

indemnity: Jan/Feb, …, Nov/Dec

  • No eligibility constraints or payment limitations
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21st Annual National Workshop for Dairy Economists and Policy Analysts

MPP-Dairy Does

  • Provide free coverage at $4 per cwt ($100

annual fee)

  • Provide a voluntary framework to protect

production margins up to $8 per cwt

MPP-Dairy Does Not

  • Guarantee a profit or minimum income for

dairy farmers

  • Include milk production quotas or prevent

dairy operations from expanding

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SLIDE 8

21st Annual National Workshop for Dairy Economists and Policy Analysts

Margin Protection Elements

  • Dairy Production Margin

– All-milk price minus feed ration value – National average formula, cannot be customized

  • Production History (“PH”)

– Max calendar year production 2011, 2012, 2013 – Revised annually by USDA based on U.S. growth in milk

production

– Payment made on production history – not based on

actual/current milk production (i.e. base acres for dairy)

IOFC Margin = U.S. All-Milk Price – NASS Corn Price x 1.0728 + AMS SBM x 0.00735 + NASS Alfalfa x 0.0137

Feed Ration

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SLIDE 9

21st Annual National Workshop for Dairy Economists and Policy Analysts

Premium Rates Are Fixed for 5-Year Life of Farm Bill

Coverage Level ≤ 4 Mil Lbs ≤ 4 Mil Lbs (Discount)* > 4 Mil Lbs

$/cwt $4.00

Free Free Free

$4.50 $0.010 $0.008 $0.020 $5.00 $0.025 $0.019 $0.040 $5.50 $0.040 $0.030 $0.100 $6.00 $0.055 $0.041 $0.155 $6.50 $0.090 $0.070 $0.290 $7.00 $0.217 $0.163 $0.830 $7.50 $0.300 $0.225 $1.060 $8.00 $0.475 $0.475 $1.360 * Premium discount of 25% for 2014 and 2015 calendar year protection

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21st Annual National Workshop for Dairy Economists and Policy Analysts

Premium Rates May Alter Participation Incentives

$0.00 $0.20 $0.40 $0.60 $0.80 $1.00 $1.20 $1.40 $1.60 $4.00 $4.50 $5.00 $5.50 $6.00 $6.50 $7.00 $7.50 $8.00

Premium Rates

First 4 M lbs PH After 4 M lbs PH

$6.50 to $7.00 Coverage has $0.54 Increase in Premium Rate

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21st Annual National Workshop for Dairy Economists and Policy Analysts

Key Farmer Decisions

Each year a farm must choose:

  • Coverage Percentage

– 25% to 90% of production history in

5% increments

– Insurable pounds = (Cov %) x (PH)

  • Coverage Level

– $4 to $8 per hundredweight in $0.50

increments

  • 126 coverage choice combinations
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21st Annual National Workshop for Dairy Economists and Policy Analysts

8.00 $ 7.50 $ 7.00 $ 6.50 $ 6.00 $ 5.50 $ 5.00 $ 4.50 $ 4.00 $ 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% Coverage Level Coverage Percentage

Coverage Options*

*126 Possible Coverage Choice Combinations

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21st Annual National Workshop for Dairy Economists and Policy Analysts

Potential MPP-Dairy Strategies

1) Passive MPP-Dairy strategy

– Keep the coverage options fixed for life

  • f farm bill

2) Dynamic MPP-Dairy decision

– Change coverage levels annually based

  • n anticipated risk in milk and feed

markets

3) Integrate MPP-Dairy into existing risk management activities

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21st Annual National Workshop for Dairy Economists and Policy Analysts

“Passive” Observations

  • No “sweet spot” rule for passive coverage

– Passive coverage may not work the same for

all operations

  • For large dairies “passive” strategy may be

net IOFC reducing

– Due to significantly higher premium rates – Strategy more important due to participation

costs

– “Dynamic” Strategy or – “Anchored Flexibility” –Bozic 2014

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21st Annual National Workshop for Dairy Economists and Policy Analysts

“Dynamic” Observations

$4.00 $8.00 $6.00 25% 90% 60%

Coverage Quantity Coverage Level

Anticipate Good Margins: Free Coverage Anticipate Bad Margins: Buy-Up Coverage

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21st Annual National Workshop for Dairy Economists and Policy Analysts

Integrating MPP-Dairy at Farm-Level

  • MPP-Dairy can provide revenue

support during margin declines

  • How well does MPP-Dairy relate to

farm level margins?

– Jan/Feb payment is April (final prices) – No cross 2-month triggers (Dec/Jan) – Timing of benefits relative to local margin

levels

– Regional and component basis

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21st Annual National Workshop for Dairy Economists and Policy Analysts

State-Level “Representative” Margins Correlated w/ National

  • 2

2 4 6 8 10 12 14 16 18 2007 2008 2009 2010 2011 2012 2013 $/cwt U.S. IOFC Margin

Includes: CA, IL, IN, IA, KY, MI, MN, MO, NY, OH, PA, TX & WI

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21st Annual National Workshop for Dairy Economists and Policy Analysts

  • 4
  • 2

2 4 6 8 10 12 14 16 2007 2008 2009 2010 2011 2012 2013 $/cwt

IOFC Margin Estimate

“Representative” California Margin

U.S.

$- $2.22 $4.51 $5.60 $4.40 $4.19 $1.74 $4.25 $6.11 $7.47 $6.72 $6.93

NOV/DEC SEP/OCT JUL/SUG MAY/JUN MAR/APR JAN/FEB

2009 2-Month Indemnity

California Basis Adj. Indemnity MPP Indemnity

California

What amount of margin support is needed?

For Demonstration Only

Pays on national index, not farm-level margins

CA: Economies of scale 1,000 head vs. 200 head

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21st Annual National Workshop for Dairy Economists and Policy Analysts $0.36 $1.37 $5.14 $4.54 $3.40 $1.30 $- $- $3.58 $3.19 $1.79 $-

NOV/DEC SEP/OCT JUL/SUG MAY/JUN MAR/APR JAN/FEB

2012 2-Month Indemnity

Jersey Basis Adj. MPP Indemnity

  • 4
  • 2

2 4 6 8 10 12 14 2011 2012 2013 $/cwt

IOFC Margin Estimate

“Representative” Jersey Herd Margin*

U.S. Jersey Herd

* 4.7% Fat / 3.5% Protein Premiums for high components

For Demonstration Only

Pays on national index, not farm-level margins

What amount of margin support is needed?

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21st Annual National Workshop for Dairy Economists and Policy Analysts

Integrating MPP-Dairy at Farm-Level

  • Margins across U.S. are correlated

– Correlation is not slope: CA IOFC ≠ ρCORREL x U.S.

IOFC

– Does not tell you how much MPP-Dairy to use

  • When will MPP-Dairy payments occur relative

to farm-level margin requirements?

– Determine farm-level margin requirements first

  • Farm Level Margins & MPP-Dairy Index

– Futures/forward contract customization – Balance MPP-Dairy lag with use of futures and

forwards which pay immediately upon liquidation/settlement

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21st Annual National Workshop for Dairy Economists and Policy Analysts

Example of Hedging With MPP- Dairy

  • Hedge ratio with and without MPP-

Dairy estimated for Wisconsin

– Modeled Class III futures only – Six-month hedging horizon – MPP-Dairy at 90%

  • Illustrative Purposes Only

– Historical futures and cash market

prices may have been different with MPP-Dairy

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21st Annual National Workshop for Dairy Economists and Policy Analysts

Wisconsin Mailbox Milk Price Hedge Ratio With Class III Futures

80% 52% 50% 55% 60% 65% 70% 75% 80% 85%

Optimal Hedge Ratio (Hedge 6-Months Out)

35% Decline in Class III Hedge Ratio

Estimated using 2001-2013 data

For Demonstration Only

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21st Annual National Workshop for Dairy Economists and Policy Analysts

$0 $5 $10 $15 $20 $25 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Base Wisconsin Mailbox MPP-Dairy Net Premium MPP-Dairy Net Indemnity

Protecting With MPP-Dairy (2001-2013)

Protecting Wisconsin Mailbox Milk Price with MPP-Dairy (4M PH/$8/90%)

Less Variability

  • Avg. No MPP $16.07
  • Avg. W/ MPP $16.41

For Demonstration Only

Support during price declines

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21st Annual National Workshop for Dairy Economists and Policy Analysts

$0 $5 $10 $15 $20 $25 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Base Wisconsin Mailbox Loss from Futures Gain from Futures MPP-Dairy Net Premium MPP-Dairy Net Indemnity

Using Both Futures and MPP-Dairy (2001-2013)

Protecting Wisconsin Mailbox Milk Price at 180 days with Class III and MPP-Dairy (4M PH/$8/90%) Double support during price declines

Variability lower than MPP Alone

  • Avg. No Double $16.07
  • Avg. W/ Double $16.25

For Demonstration Only

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21st Annual National Workshop for Dairy Economists and Policy Analysts

Farm-Level Integration

  • MPP-Dairy may be a substitute to futures

and forward contracts

– Observed reduction in hedge ratio – What about impact on feed risk management?

  • Farmers may “double dip” when

combining MPP-Dairy and forward/futures

– Observed overlap in indemnity & positive

futures return

– Costly if Texas hedged (HR > 100%) – Consider alternating among risk management

tools

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21st Annual National Workshop for Dairy Economists and Policy Analysts

Alternating Among MPP-Dairy and Futures/Forward

When anticipated margins are above MPP-Dairy strike prices

– Buy less MPP-Dairy – Increase use of CME futures/options/forwards

  • r LGM-D if allowed

When anticipated margins are below MPP-Dairy strike prices

– Buy more MPP-Dairy – Roll back use of CME futures/options and

forwards

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21st Annual National Workshop for Dairy Economists and Policy Analysts

Anticipate Low Margin

2 4 6 8 10 12 2 3 4 5 6 7 8 $8.00

Month $/Cwt

Estimated IOFC Mean IOFC 25% Boundary 75% Boundary

Forecast IOFC margin well below $8 cwt

Possible Strategy: MPP-Dairy / Pick $8 Coverage

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21st Annual National Workshop for Dairy Economists and Policy Analysts

Anticipate High Margin

2 4 6 8 10 12 8 8.5 9 9.5 10 10.5 11 11.5 12 $8.00

Month $/Cwt

Estimated IOFC Mean IOFC 25% Boundary 75% Boundary

Forecast IOFC margin well above $8 cwt

Possible Strategy: Use Futures/Forward & $4 MPP

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21st Annual National Workshop for Dairy Economists and Policy Analysts

$0 $5 $10 $15 $20 $25 2008 2009 2010 2011 2012 2013 Base Wisconsin Mailbox Loss from Futures Gain from Futures MPP-Dairy Net Premium MPP-Dairy Net Indemnity

Risk Management “Switching” (2008-2013)

Protecting Wisconsin Mailbox Milk Price at 180 days by Switching Futures & MPP-Dairy (4M PH/$8/90%)

Best of Both Worlds

  • Avg. No Protection $17.67
  • Avg. Double Dip $18.68
  • Avg. Switching $18.83

For Demonstration Only

Reduces Downside Risk

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21st Annual National Workshop for Dairy Economists and Policy Analysts

Summary: “Skin in the Game”

  • MPP-Dairy can provide revenue support during

single- or multi-year losses in farm equity

– Passive strategy may not work for all dairymen – Dynamic strategies can be creative (may involve

alternating coverage choices annually)

  • Can be integrated with futures/options and

forward to improve risk management at farm

– What level of integration is best?

  • Goal to shift dairymen into new era (“Skin in the

Game”)

– Not actuarially fair as premiums do not reflect risk in

milk and feed market prices

– Potential to revise/improve in next farm bill

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21st Annual National Workshop for Dairy Economists and Policy Analysts

Some Unanswered Questions

  • Sign-up deadline compared to coverage start date

– Report 3/25/2014 of 90-120 day gap – http://farmdocdaily.illinois.edu/authors/john_newton/

  • Five year or annual participation
  • How will premiums be calculated?
  • How will premiums be paid (annually, bi-

monthly,…,at end of year)

  • Treatment of new operations versus expansion of

existing dairy FSA Regulations Will Provide Additional Clarity

September 1, 2014 Deadline

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21st Annual National Workshop for Dairy Economists and Policy Analysts

D-MaP Ongoing Research Projects

  • Final development stages of MPP-Dairy decision tool

–

Will utilize real time market information to help farmers make annual coverage decisions

  • Improved LGM-D decision aid

–

  • Dr. Gould’s “Dairy Risk Analyzer”
  • Will MPP-Dairy interfere with private risk management?

–

  • Dr. Bozic research project with USDA ERS examining VaR Hedge

Ratios/ “Crowding Out”

–

  • Drs. Stephenson, Bozic and Wolf recent survey of interaction of MPP-

Dairy and futures market

  • Crowd Sourcing as a forecasting technique

–

  • Drs. Novakovic and Newton investigating if crowd sourcing may
  • utperform futures as a forecasting tool

www.dairymarkets.org

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21st Annual National Workshop for Dairy Economists and Policy Analysts

Coming Soon: Web-Based Decision Tool

www.dairymarkets.org

Decision tool based on CME futures price for milk and feed, updated daily

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21st Annual National Workshop for Dairy Economists and Policy Analysts

6 7 8 9 10 11 12 13 14 15 April May June July August September October November December January February March April May June July August 2014 2015 $/cwt

Decision Tool Forecast 17 Month U.S. Dairy Production Margin

2015 Forecast

Potential for Indemnity?

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21st Annual National Workshop for Dairy Economists and Policy Analysts

Interactive Dashboard from Presentation Released Online at www.farmdocdaily.illinois.edu

Questions?

Follow me on Twitter: @New10_AgEcon

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SLIDE 38

THANK YOU

John Newton

University of Illinois jcnewt@illinois.edu

21st Annual National Workshop for Dairy Economist and Policy Analysts May 1 & 2, 2014 Milwaukee, Wisconsin