Which Risk Management Tool is Best?

As dairy farmers try to manage risk moving into 2019, about the only thing you can say is that there is uncertainty as to which risk management tools is best. ( iStock )

Ron Mortensen, with Dairy Gross Margin LLCcompared Dairy Revenue Protection (DRP) insurance premiums against the cost of pur-chasing put options on the Chicago Mercantile Exchange (CME). They are listed in the table below and based on Oct. 24, 2018 prices. DRP coverage ranges from 70% to 95%. Mortensen assumed 95%, so a $15.03 average Class III price is equal to $14.28 option price.

For Wisconsin, the DRP premium on Oct. 24 for Class III was 9¢ per cwt versus an 18¢ per cwt premium for a $14.25 put option. The Class IV DRP premium was 11¢ per cwt versus 16¢ per cwt for a comparable put. The difference is USDA subsidizes DRP premiums.

Mortensen notes, however, DRP includes state milk yields. So if your state milk production per cow increases over year-earlier levels, your final payout will decrease. DRP premiums also vary by state because it’s an insurance product and actuarially based. Premiums in the Midwest are typically cheaper than in California, for example.

There are also differences in mechanics. DRP is based on three-month quarters, with premiums and indemnities due and paid after the quarter ends. Put options are monthly, with premiums due immediately and potential gains paid as contracts close monthly.

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“Right now, LGM-Dairy is running a little cheaper than DRP, depending on the state,” he says. But he notes LGM-Dairy, because it is margin insurance between milk and feed prices, is sensitive to corn and soybean meal markets. That’s a factor DRP or CME options don’t have. If feed prices go up, potential payouts are improved with LGM-Dairy.

Then there’s the farm bill. If the current bill gets approved, it could be a viable option for some dairy producers, says Mark Stephenson, director of dairy policy analysis at the University of Wisconsin. Revisions to the Margin Protection Program (MPP) could offer producers a 4:1 return.

The estimate is based on what returns would be if feed and milk margins are similar over the next five years to what they were between 2014 and 2018. Better returns are based on lower premium costs and raising the top margin to $9.

MPP premiums would be 17¢ per cwt for $9 coverage for Tier 1 production under the House bill and 18¢ per cwt under the Senate bill. If margins are similar to the past five years, MPP payments would average 73¢ per cwt under the new farm bill, Stephenson says.

“I think producers will need to look at this remodeled MPP,” he says. “An 18¢ investment for a 73¢ return looks good. This should be basic risk management.”

Bottom line: Work with a risk adviser to find a program that fits your farm, market and state.

 

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