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Part II: Time to re-think and re-calculate
What margins? How will ‘basis’ affect the two programs?

Special for Farmshine

BROWNSTOWN, Pa. – In Part I, we wrote about how the “milk margin” is a way of measuring dairy profitability by calculating the amount of milk income remaining after subtracting the cost of feed, which is the largest cost on a dairy farm.

We also covered some of the differences in the way the Farm Bill Dairy Title’s Margin Protection Program through USDA’s Farm Service Agency (FSA) calculates “margin” compared with the way “margin” can be calculated for the LGM Dairy Insurance program, still in effect on a limited funding basis through USDA’s Risk Management Agency (RMA).

The FSA margin uses the historic USDA-announced “all-milk”, corn, soybeans, and alfalfa prices. The milk margin is compared to set thresholds for which producers can purchase coverage at 50-cent increments.

LGM-Dairy, on the other hand, uses closing prices on the futures markets for Class III milk, corn and soybeans. LGM insures the difference between expected closing prices at the point when purchased to future contract closing prices at the end of a month -- or if multiple months are purchased as a group, the average of those months. Producers can insure one month or up to 10 months into the future and the sales period occurs every month.

With the Farm Bill MMP program through FSA, average margins are calculated for set 2-month periods (Jan-Feb, Mar-Apr, May-June, July-Aug, Sept-Oct, Nov-Dec). Producers can sign up for the free or reduced cost $4 margin and then buy coverage on margins of $4.50 to $8 in 50-cent increments. Indemnities are paid only when the average two-month actual margins fall below the level of insurance purchased by the producer for that year.

Even though the margins are calculated differently, they track similarly when looked at historically. That is, except for certain times in 2009 and 2013-14 when the “basis” varied.

Why does the “basis” vary at times? It varies because the LGM-Dairy margin is based on Class III milk, while the Farm Bill FSA/MPP margin is based on the announced “all-milk” price.

When Class IV is higher than Class III, this puts Class II and Class I also at a higher base value; so the basis becomes a more negative difference between the “all-milk” price and the Class III price. This is a significant factor in regions where Class III is a smaller percentage of the milk utilization for the producer’s milk check.

Another difference is that the Farm Bill FSA/MPP margin is reflective of a national industry average, whereas, producers can adjust the margin they insure under LGM-Dairy to insure feed and milk or to max-out insuring just the milk risk.

“Sometimes the futures markets prove more economical and producers can insure or protect a higher margin at a better value using LGM-Dairy and other commercial tools than with the new Farm Bill MPP,” observed Alan Zepp, risk management coordinator for the Center for Dairy Excellence during a meeting with Farmshine at the Center’s office in Harrisburg last month.

For example, in the Center’s recent “protecting your profits” call with dairy producers, Zepp noted the current milk margin is 20% higher than the 5-year average. In fact, it is at record highs, and far above even the highest margin threshold that will eventually be available for purchase under the Farm Bill’s new FSA/MPP program.

Thus, the only way to “lock in” some of that profit potential being offered right now by current futures markets is to use the LGM-Dairy program through private insurers and RMA, or to work with a broker and/or the milk cooperative -- or a little of all three -- in developing a marketing plan.

On the other hand, Zepp notes that during a prolonged downturn, like in 2009, the length of the downturn may leave producers without those other tools in a market plan. This occurs when the futures markets do not offer profitable future margins to protect in the first place.

“That is when the Farm Bill’s FSA/MPP would provide the best protection,” he explains. The MPP uses set margin thresholds for purchasing protection instead of relying on the futures markets to provide those positive margins to insure or protect. It is a form of catastrophic loss insurance.

Dairy farmers will not be allowed to use both LGM through RMA and MPP through FSA, so each year they will have to choose between the MPP and the LGM -- according to most interpretations of the new law.

USDA official guidance is still forthcoming on how the new FSA/MPP will be implemented come September.

According to Zepp, producers will have to look at what provides the opportunity to protect a profitable margin going forward in the most cost-effective way.

“The $4 / cwt base margin has become the standard,” Zepp says. That is where the MPP starts providing no-cost protection for 90% of a producer’s historical production base and up to 4 million pounds annually. The cost at the $4 / cwt base margin is very low for the additional pounds on larger farms above 4 million pounds annually.

“It is important for producers to become familiar with the tools that are available to them so that when the time comes for them to make a choice, they understand the tools well enough to make a good decision,” Zepp relates.

He also observes that one of the biggest, lowest cost tools a producer can use to manage price risk is to work on reducing the farm’s cost of production. That can be achieved by benchmarking the operation to numbers on top dairies, increasing milk production, and/or improving the quality of forages since that usually lowers the cost of production by reducing purchased feed costs while improving herd production and health.

As for expansion, the jury is out on whether the provisions of the Farm Bill’s MPP will encourage or deter expansion. “Producers can cover 25 to 90% of their historical production,” Zepp explains.

If a producer is looking to expand and protects the margin on 90% of his milk; he can expand 10% and still be protected at 80% of his actual milk marketings. “That is still manageable,” says Zepp.

It also fits the typical scenario in parts of the country – like the Northeast – where producers are going to maximize their resources with incremental growth.

Another thing to remember when looking at available tools through USDA, cooperatives, proprietary plants, or brokers, is that they all tend to use national pricing. “That’s just the way it is,” Zepp acknowledges. “When regional markets differ, the ‘basis’ can distort the best laid plans, but at the end of the day, some protection may be better than no protection.”

Stay tuned for more about margins once USDA releases the rules for the new Margin Protection Program.

Visit www.centerfordairyexcellence.org for information about risk management and to learn how to participate in “protect your profits” phone discussions that occur monthly. Farmshine readers can also keep track of changing margins every week in the Markets and Management Update -- a joint production by Farmshine, Center for Dairy Excellence and RMA found in the markets and classifieds section of Farmshine every week.