Dairy Programs in the 2012 Farm Bill. Who should sign up for subsidized margin insurance with supply management?

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1 Dairy Programs in the 2012 Farm Bill Who should sign up for subsidized margin insurance with supply management? Dr. Marin Bozic University of Minnesota Introduction Substantial increases in milk production costs experienced since 2006, due primarily to increases in grain prices, have brought about a consensus among dairy producers federal dairy policy should abandon supporting milk revenue only, and should focus on net income protection instead. Tools used in the past Milk Income Loss Contract (MILC) and Dairy Product Price Support Program (DPPSP) will not be re-authorized in the 2012 Farm Bill. Instead, a new dairy safety net is proposed that consists of the Dairy Producer Margin Protection Program (DPMPP) and the Dairy Market Stabilization Program (DMSP) a combination of heavily subsidized margin insurance with a mandatory participation in supply management for those farmers that elect to participate in the margin protection program. The purpose of this talk is twofold. First, to describe the proposed changes in dairy policy and what they mean in practice for dairy producers. And second, to propose a method that farmers can use to determine if they should participate in the new dairy safety net, once farm bill is signed into law. What is going on in D.C.? Early in the legislative process, in September 2011, a bipartisan stand-alone bill H.R. 3062, known as Dairy Security Act of 2011 (DSA) was introduced by Congressmen Colin Peterson (D- MN) and Mike Simpson (R-ID), offering for the first time in legislative language the dairy safety net founded on principles of margin insurance and cutbacks in production when income over feed costs margins are low. This approach has been adopted, with various modifications in three versions of the Farm bill dairy title: 1) The first version is contained within the Senate version of the Farm Bill, S 3240 Agricultural Reform, Food, and Jobs Act of 2012, passed on June 21. 2) Senate modifications to DSA were largely adopted in the House of Representatives bill HR 6083 Federal Agricultural Reform and Risk Management Act of This bill has passed the House Committee on Agriculture, but has not yet been allowed to proceed to the discussion in front of the full House membership. 3) A third proposal is the amendment to the House bill introduced by Congressmen Bob Goodlatte (R-VA) and David Scott (D-GA), popularly known as Goodlatte-Scott 1

2 Amendment (GSA). The key differentiating characteristic of GSA is that dairy safety net is envisioned as basing solely on subsidized margin insurance, with no supply management. No one really knows what will happen next. Minor differences between S 3240 and HR 6083 would seem easy enough to reconcile quickly. However, it is not at all clear that there exists enough support for DMSP in the House, and while GSA was defeated in the committee, another similar amendment may be re-introduced at the time bill is finally discussed on the floor. In the meantime, MILC program has already expired at the end of September 2012, and milk price support through DPPSP is about to expire at the end of December One of the reasons subsidized margin insurance was easy to promote in the House is the savings DPMPP achieves over projected outlays under MILC and DPPSP. However, if a new Farm Bill is not passed by March 2013, new projected trajectory of government expenditures will no longer account for programs that expired in 2012 (MILC, DPPSP). What that means is that subsidized margin insurance will no longer be consider a net savings, but rather a net cost to the federal government. That may necessitate further increases in margin premiums to make program costneutral to the government. What you should know about new dairy safety net I will explain here the programs that comprise the new dairy safety net, as envisioned in the House and Senate bills. Dairy Producer Margin Protection Program (DPMPP) starts by defining a specific income over feed cost margin, referred to as Actual Dairy Producer Margin and equal to the difference between the average price received, per hundredweight of milk, by dairy producers for all milk sold (popularly known as all-milk price) and the average cost of feed used by a dairy operation to produce a hundredweight of milk. The feed ration per cwt of milk consists of lbs of corn, 14.7 lbs of soybean meal and 27.4 lbs of alfalfa hay. This ration accounts not just for milking cows, but also replacement heifers, and hospital and dry cows. To calculate the cost of feed, national average price received for corn and alfalfa hay and central Illinois price for soybean meal are used. Final margin formula is: Actual Margin = All-milk $/cwt Corn $/bu Soybean Meal $/ton Alfalfa hay $/ton To understand what this formula implies, take a look at the Figure 1. below that illustrates the observed monthly margins from January 2000 through August Average margin for the past 13 years has been $8.42. Margins varied from the high of $14.65 in August 2007, to low of $2.25 in June

3 Figure 1. Actual Dairy Producer Margins: January August 2012 $16.00 $14.00 $12.00 $10.00 $8.00 $6.00 $4.00 $2.00 $0.00 Figure 2. explores in further depth all-milk price vs. feed costs. Feed costs were remarkably stable at $5 per cwt until the end of summer Feed costs have more than doubled between 2006 and 2008, reduced somewhat in 2009, and reached all-time high in summer 2012, with maximum of $15.11 per cwt in August Average margin for the high-feed cost period is $8.04. High feed costs have reduced average margin for the first eight months of 2012 to $ Feed Costs All-milk Price 3

4 While declines in margins in the first part of the past decade have been mostly due to oscillations in milk prices, rising and increasingly unpredictable feed costs reinforce the need for margin protection program that would focus on income over feed costs margin, rather than milk prices. That is precisely what DPMPP does. First of all, this program is voluntary, and producers must elect to participate. If they do, they automatically get protection at $4.00 margin, called Basic Margin Protection. They may buy additional protection, called Supplemental Margin Protection, for any level between $4.50 and $8.00 margins, in 50 cent increments. This program works similar to option contracts one can buy at the commodity exchange when margins fall below the set protected level, indemnities are paid to those producers that have the bought the protection. Here are the important details of DPMPP: 1) Producers may elect to participate in the Basic Margin Protection program, or forgo the opportunity to subscribe. Once subscribed, producer must stay in the program for the duration of the Farm Bill. Likewise, if a producer does not subscribe during the initial sign-up period, he will forgo the opportunity to participate for the entire duration of the Farm bill. If a choice is made to participate in the margin protection program, that producer is automatically enrolled in the Dairy Market Stabilization Program, which mandates occasional reductions in payments for milk marketings in order to incentivize production cutbacks in periods when margins are low. This program is explained in detail in the next section. 2) Producers participating in the Basic Margin Protection may choose to participate in the Supplemental Margin Protection by choosing a coverage level between $4.50 and $8.00, in 50 cent increments. Although participation in Basic Margin Protection is a one-time decision, producers may change the coverage level annually. Senate and House bills differ when it comes to premiums for these coverage levels. In addition, the premiums are lower for the first 4 million lbs. See Table 1. below for full details. 3) Participating producers must elect a percentage of coverage to not more than 90 percent, nor less than 25 percent of the annual production history (i.e. amount of milk produced in the previous year). Percentage of coverage can also be changed once a year. 4) A calendar year is split into six bimonthly periods: Jan-Feb, Mar-Apr, May-Jun, Jul-Aug, Sep-Oct, and Nov-Dec. These are referred to in the bill as consecutive two-month periods. 5) Indemnity is due whenever average actual dairy producer margin for a consecutive twomonth period is less than the coverage level threshold selected by the dairy producer. 6) Indemnity per cwt is calculated as difference between chosen coverage level and actual margin, but cannot exceed $4.00. That amount is then multiplied with the lesser of one sixth of annual production history and actual milk marketings in the preceding bimonthly period. 4

5 Table 1. Premiums for Supplemental Margin Protection H.R (House bill) S (Senate bill) Coverage level First 4 mil lbs Above 4 mil lbs First 4 mil lbs Above 4 mil lbs $ $ $ $ $ $ $ $ In summary, there are three decisions a dairy producer must make: 1) Do I want to subscribe to the Dairy Producer Margin Protection Program, and thus be automatically enrolled in the Dairy Market Stabilization Program? 2) If yes, do I want to buy Supplemental Margin Protection? 3) If yes, at which coverage level and coverage percentage do I want to buy the Supplemental Margin Protection? The answers to these questions should not be made until you understand the workings and consequences of the Dairy Market Stabilization Program. Hence, I explain that program next, and only then describe the decision-support tool. Dairy Market Stabilization Program In times of low margins, it is in collective interest of dairy producers to reduce production to boost margins quickly to long-run average, sustainable levels. However, even in absence of collective action, periods of low margins are always just a temporary phenomena. Through herd liquidations, milk supply will naturally adjust to return margins to average levels. The downside of relying exclusively on markets to govern supply correction is that recovery may be slow for as long as milk production covers variable costs (feed, fuel, labor, etc.), it is in the best interest of any individual producer to continue to produce as much as possible in the short run, despite insufficient milk revenue to cover costs of capital and management. That is the reasoning behind complementing DPMPP with a supply management-type program such as DMSP. Dairy Market Stabilization Program stipulates that when margins fall below a critical threshold, all producers that are benefactors of subsidized margin insurance must accept incentives to reduce milk production. In particular, this is how the program works: 1) All dairy producers that have subscribed for Basic Margin Insurance are automatically enrolled in Dairy Market Stabilization Program. 5

6 2) Enrolled producers must choose their stabilization program base calculation method. What that means is that there is more than one way to determine the production base to which penalty will be imposed, in case stabilization program is activated. Two methods are available: a. The volume of the average monthly milk marketings for the three months immediately preceding the announcement that stabilization program is effective. b. The volume of the monthly milk marketings of the dairy producer for the same month in the preceding year as the month for which stabilization program is announced to be effective. 3) For stabilization program to be triggered, either of the following two conditions must be satisfied: a. Actual dairy producer margin is equal to or lower than $6.00 for each of the immediately preceding two months b. Actual dairy margin has been equal to or lower than $4.00 for the immediately preceding month Notice that this method introduces a lag between onset of low margins and engagement of stabilization program. For example, if margins have been below $6.00 (but above $4.00) for January and February, USDA would announce in March that stabilization program would be effective in April. The first milk check effected would be for April production. 4) Reduction in dairy producer payments: The principle method of fostering quicker margin recovery is to incentivize producers to cut back their production. DMSP does this by taxing at 100% milk revenue in excess of the greater of A. If margins were lower than $6.00 but higher than $5.00 for preceding two months: - 98% percent of the stabilization program base - 94% of the marketings of milk for the month B. If margins were lower than $5.00 but higher than $4.00 for preceding two months: - 97% of the stabilization program base - 93% of the marketings of milk for the month C. If margins were lower than $4.00 for preceding two months: - 96% of the stabilization program base - 92% of the marketings of milk for the month Bottom line, if margins fall below $6.00 for two months in a row, to avoid penalty you would need to cut back to 98% of your stabilization base. You may decide to continue to produce milk in higher amount than that, but you will not get paid for it. And the lower the margins were, the bigger must the cutback be to avoid penalties. 5) Suspension of stabilization program. 6

7 For DMSP to be suspended, either margins must recover to over $6.00 for two months in a row, of domestic prices of leading dairy commodities - cheddar cheese and nonfat dry milk - must be found to be sufficiently higher than world prices. For example, if margins are between $5.00 and $6.00, the stabilization program will nevertheless be suspended if either U.S. price for cheddar cheese is found to be higher than world price for cheddar cheese, or U.S. price for nonfat dry milk is found to be higher than the world price for skim milk powder. In summary, there are two decisions producers must make in regard to DMSP: 1) What method should be used for determining stabilization base? 2) How should production decisions be adjusted to minimize the adverse impact of penalty? Available options may include drying some cows a bit earlier, more aggressive culling of underperforming cows, increase of on-farm use of milk, or changing the feed ration for some cows to reduce production. What should you do? Previous analyses done by Dr. Mark Stephenson, Dr. Charles Nicholson and Dr. Andrew Novaković indicate that about the worst thing you could do is sign up for these programs, but take only Basic Margin Protection. If you choose $4.00 margin protection, there will be no upfront cash outlays, but what is likely to happen is that lost revenue due to stabilization program will more than offset any indemnities from free margin insurance. The current tool I am working on with several dairy economists 1 indicates the following: 1) If you are planning significant expansion of your operation, it might be the best to stay out of these programs altogether. 2) Probability that indemnities from Basic Margin Protection alone will suffice to compensate for lost milk revenue due to DMSP penalty is only 13-14%. This reinforces conclusions from earlier studies if you are going to participate, it is smart to buy Supplemental Margin Protection 3) For 2013, subsidy for coverage offered through the Supplemental Margin Protection is generally the highest at $6.00-$7.50 levels, and the best level actually depends on the size of your operation, which version of the bill is analyzed, and your risk preferences. Let me illustrate this further for a small and a large farm, assuming supplemental coverage percentage of 90%. For both representative farms I will assume 21,000 lbs annual per cow milk yield. Small farm is taken to have 150 cows in milk, while the large farm is modeled as having 1,200 cows in milk. Results are in the tables below 1 Our group is comprised of John Newton and Dr. Cam Thraen at the Ohio State University, Dr. Mark Stephenson and Dr. Brian W. Gould at University of Wisconsin-Madison, Dr. Chris Wolf at the Michigan State University and Dr. Marin Bozic at the University of Minnesota. 7

8 Table 2. Expected farm-level impacts of participating in DPMPP/DMSP in 2013: 150 cow operation. 8

9 Table 3. Expected farm-level impacts of participating in DPMPP/DMSP in 2013: 1,400 cow operation. 9

10 For a small farm (150 cows), the best option for 2013 would be to buy supplemental insurance at $6.50 coverage level. At that level, insurance would cost you $18.57 per cow for the year, and the expected net revenue (indemnity minus the DMSP penalties and premiums/fees) is $ Notice that this is expected, not guaranteed profit, and there is in fact 39% chance that you will lose money by participating, i.e. that you would get less back in indemnities than you would pay in for premiums, administrative fees and would likely lose in revenue because of production cutbacks. For a large farm (1,400 cows), the best option in terms of net revenue is $7.50 under the House bill, and $6.50 under the Senate bill. In terms of return to investment, House and Senate bill differ but the recommendation is the same for both farm sizes: while $6.50 is the best option under the House bill, but $6.00 is the best dollar-for-dollar under Senate bill. As you contemplate these results, please take into account that no model is perfect reflection of reality. We had to make a lot of assumptions to produce these numbers. For example, there is no futures market for alfalfa hay, so we need to use corn and soybean meal futures markets to guess what market expects hay prices will be like next year. That relationship may change. In addition, while I am proud to be able to say that North Dakota dairy farmers are the first in the country to see results of this tool, that also means you are looking at the numbers from a product still being developed. One piece still under development, for example, is the ability to analyze which strategy is likely to work the best over the entire duration of the Farm bill, not just for the first year. Another thing to keep in mind is that while participation in these programs can be viewed as yet another profit center (and that is the approach I took above), it is more than that it is in fact risk management program, as the title of it says. The program will pay back the most when you need it the most. And if you get back in indemnities less than you paid in premiums, that is most likely going to happen when milk prices are better than average. If you do choose to participate, you should not just blindly choose a single level of supplemental margin protection, and leave it at that level year after year. Because you are allowed to adjust supplemental margin protection coverage level at the beginning of each calendar year, you should use our tool (soon to be available online at to check which margin protection level has the best chance of maximizing your net revenue. A simple example would be if futures markets at the beginning of the year indicate that margins are extremely low, and are likely to remain at very depressed levels for several quarters. That is the situation where you probably want to buy supplemental margin insurance at a very high level. Alternatively, if it is clear that forthcoming year is expected to be a stellar year in terms of margins (think 2007), then you should probably buy margin insurance at a very low level, if not leave it at Basic Margin Protection level. Finally, you should make effort to examine which stabilization base method works the best for you, and this may change from year to year. Our tool, now being developed, will enable you to enter your production history and see which method for calculating stabilization base is better for you. 10