Will the New Dairy Margin Protection Program Reduce Risk for Dairies?

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1 Will the New Dairy Protection Program Reduce for Dairies? Tyler B. Mark University of Kentucky Agricultural Economics 417 Charles E. Barnhart Bldg. Lexington, KY Kenneth H. Burdine University of Kentucky Agricultural Economics 415 Charles E. Barnhart Bldg. Lexington, KY Selected Paper prepared for presentation at the Southern Agricultural Economics Association s 2015 Annual Meeting, Atlanta, Georgia, January 31-February 3, 2015 Study funded in part by a grant from ERS cooperative agreement # Copyright 2015 by Tyler Mark and Kenny Burdine. All rights reserved. Readers may make verbatim copies of this document for non-commercial purposes by any means, provided that this copyright notice appears on all such copies. i

2 Jan-1992 Oct-1992 July-1993 April-1994 Jan-1995 Oct-1995 July-1996 April-1997 Jan-1998 Oct-1998 July-1999 April-2000 Jan-2001 Oct-2001 July-2002 April-2003 Jan-2004 Oct-2004 July-2005 April-2006 Jan-2007 Oct-2007 July-2008 April-2009 Jan-2010 Oct-2010 July-2011 April-2012 Jan-2013 Oct-2013 July-2014 Introduction Dairy producers continue to face challenges stemming from highly variable milk prices and feed costs. Weather events, increased impacts from international trade, grain and dairy farm policy, and many others factors have resulted in increasingly variable dairy margins (milk price over feed costs). Figure 1 below shows this pattern since January 1992 by plotting US All Milk price and the feed cost index for a 16% protein dairy ration. Since 2008, the volatility of this margin has been one and half times greater than that seen from 1992 to It was also around 2008, that dairy policy tools started shifting towards becoming more margin orientated, as opposed to focusing solely on the price of milk. Figure 1: Average U.S. all-milk and feed costs Dollars per hundredweight $30 $25 $20 All Milk $15 $10 $5 16 percent dairy ration $0 Source: USDA, National Agricultural Statistics Service and Gould (2014) Numerous programs and policies have existed over the years that have impacted farm-level milk prices and dairy producer profitability. The Dairy Federal Milk Marketing Order s program goal is to stabilize market conditions, assure adequate supply, and establish minimum prices by milk class. 1 The Milk Income Loss Contract (MILC) program provided some support for declining milk prices, but no support for rising feed costs. A modification was later implemented that triggered a larger payment when the National Average Dairy Feed Ration Adjustment (NADFR) 1 For information about federal milk marketing orders, see: eftnav=commodityareas&page=federalmilkmarketingorders&description=federal+milk+marketing+orders 2

3 exceeded a specified level 2. The Livestock Gross (LGM)-Dairy insurance program, which was first made available in 2008, allowed producers to purchase a premium subsidized margin insurance product based on deferred futures prices for class III milk, corn, and soybean meal prices (Burdine et al., 2014a). The Dairy Protection Program (MPP-Dairy), established as part of the 2014 Farm Bill, is the most recent of these programs made available to dairy producers (see box: How does Dairy MPP Work?). Similar to LGM-Dairy, producers can insure a margin, however the feed cost index includes alfalfa hay, in addition to corn and soymeal and the quantities of the feeds per hundred pounds (cwt) of milk produced are fixed, rather than flexible, as in the case of LGM- Dairy. Further, the margins and premiums are also fixed for the life of the farm bill, unlike LGM-Dairy where they evolve with the futures market. The purpose of this research is to evaluate the MPP-Dairy program using a historical approach, as if the program has existed over the previous 12 years, and compare it to the LGM-Dairy program. In both cases margins will be evaluated for 13 regions to estimate the overall impact on profitability as well as the risk reduction by region (Figure 2). Figure 2: 13 Study Regions Background Safety nets are often a component of agricultural policy and the dairy sector is no exception. The MILC program was in existence from 2002 until the establishment of the MPP-Dairy Program in MILC provided countercyclical payment to milk producers when the Boston Class I milk price fell below $16.94 per hundred pounds (cwt). An adjustment was made to the MILC 2 NADFR is calculated each month using the price of feed ingredients needed to create a 16 percent protein dairy feed. For more information, see: &type=detail&item=pf_ _insup_en_milc.html 3

4 payment calculation in 2008 to raise the baseline price when the National Average Dairy Feed Ration exceeded certain levels (USDA, 2014; Newton and Kuethe, 2014). However, this payment is only made on a limited percentage of milk and is further constrained by a cap on the number of pounds covered (Wright, 2012). Futures and options markets also provide a market based system with which producers could manage risk and have been examined in the literature. In general, they have been found to be effective in reducing risk (Maynard et al., 2005), but have also been found to have challenges. First, the terms of futures contracts prevent the majority of dairy operations from using them because they are not well designed for use by smaller dairy farms (Maynard et al., 2005). Second, many producers do not view use of futures and options strategies as true risk management tools (Ibendahl et al., 2002). The creation of the LGM-Dairy program in 2008 represented a blend of government safety nets and market based risk management strategies. Through LGM Dairy, producers purchased an insurance policy that guaranteed a margin that was available through the futures prices for class III milk, corn, and soybean meal. It also provided flexibility on scale of pounds covered as well as the quantities of corn and soybean meal per hundred pounds ( cwt ) of milk production. The result was an insurance program very similar to a bundled option (see glossary), but premiums for LGM-Dairy were subsidized such that participation was made more attractive. Using a historical approach, it was estimated that LGM-Dairy could have potentially reduced downside margin risk by 24% to 41% over 13 US milk producing regions. The same study found limited impact on average margins, ranging from 0.7% to 1.0% across the 13 regions (Burdine et al., 2014b). 3 Despite the overall positive aspects of LGM-Dairy, it was not without challenges. The first was limited funding. Funding constraints resulted in LGM-Dairy availability only on occasion and once available, funds for the program would quickly become exhausted and offerings would end. For this reason, it did not become a regular part of many producers risk management programs (Wright, 2012). Secondly, in the same way that many producers struggled to view futures and options markets as risk management tools, many struggled to understand the complex LGM- Dairy program (Wright, 2012). And finally, due to the fact that margins and premiums evolved with the futures markets, it did not truly provide countercyclical support. It merely allowed producers a way to capitalize on the expectation of milk and feed prices and did not provide a floor to the milk producer s margin (Burdine et al., 2014a and 2014b). The details of LGM- Dairy program and its estimated risk reduction potential is the focus of research previously published by the Economic Research Service (Burdine et al., 2014a). The creation of the MPP-Dairy program represented the next step along this policy progression. The MPP-Dairy program maintains the margin protection concept that began with LGM-Dairy, but also provides this protection on a countercyclical basis by setting the available margins (coverage levels) that will stay in place through 2018, rather than allowing those margins to evolve with market conditions as in the LGM-Dairy program. The program is distinguished by the fact that premiums are also set for the life of the bill, despite the fact that the attractiveness of 3 Burdine et al. (2014a) covers the time period from January 2002 May 2010 and Burdine et al. (2014b) utilized the time period from January 2002 January This range is representative of the risk reduction for the time period from January 2002 January

5 those coverage levels will undoubtedly change over time. Participating producers are allowed to choose coverage levels for the margin, and the quantity of milk they wish to cover, on an annual basis. For this reason, previous work has shown that MPP-Dairy has the potential for both adverse selection and moral hazard (Newton, Thraen, and Bozic, 2013). Adverse selection is an issue as producers can choose to purchase higher coverage levels and cover a larger percentage of their productions history when margins are lower in order to capitalize on the existence of the program. Moral hazard would become an issue if producers increase their production as a result of enrolling in the MPP program (Newton, Thraen, and Bozic, 2013). In one sense, moral hazard is less of an issue with MPP-Dairy because production histories for existing dairies are established based on production levels in However, it is possible that coverage on a portion of their milk may induce increased production even if the production increase is not eligible for the program. Further, new production histories can be established for new dairies and moral hazard would also be present if the existence of MPP- Dairy attracted new dairy operations. A more detailed description of the MPP-Dairy programs appears in the following section. How does Dairy MPP-DAIRY work? The Dairy Producer Protection Program is designed to guarantee what is called the Actual Dairy Production (ADPM). The ADPM is a calculated margin using monthly prices for US All Milk, Corn, Soybean Meal, and Alfalfa Hay, collected by USDA. Specifically the formula is the US All Milk Price minus the sum of the average monthly corn price per bushel received by farmers multiplied by a factor of , the monthly soybean meal price per ton in Central Illinois multiplied by a factor of , and the average price received by farmers for alfalfa hay per ton multiplied by a factor of This is probably best explained by seeing the computation in the adjacent box (Figure 3, which assumes a US All Milk Price of $23.50 per hundred pounds (cwt), a corn price of $4.50 per bushel, a Soybean Meal Price of $500 per ton, and an Alfalfa Hay price of $200 per ton. Based on these assumed prices, actual margin for this hypothetical month would have been $12.25, as can be seen in Figure 3. Figure 3: Example Actual Calculation US All Milk Price $23.50 Corn: $4.50 x = $ Soybean Meal: $500 x = $3.675 Alfalfa Hay: $200 x = $2.74 Estimate Average Feed Cost $11.25 The MPP-Dairy would provide payments to participating dairy Actual Dairy Production $12.25 producers on covered milk production when this average margin falls below their chosen coverage level during the most recent two month periods. The two month periods are couplets: Jan-Feb, Mar-Apr, May-June, July-Aug, Sept-Oct, and Nov-Dec. For example, the average actual margin for January and February would have to be below the coverage level to trigger a payment (indemnity) for covered production during that two-month period. 4 The next trigger 4 January + February 2 < Coverage Level 5

6 would be based on the average of the March and April margins relative to the chosen coverage level. Producers make a series of choices with respect to participation in the MPP-Dairy. The first choice is simply to participate. Enrollment in the program costs $100 per year, which provides margin protection at the $4.00 level on 90% of their production history. At this level, producers receive a payment on two months of covered milk equal to the amount below the $4.00 threshold the actual margin was for that two month couplet. For example, if the actual margin for the couplet in question was $3.50, the participating producer would receive a payment of $0.50 per cwt on two months of their covered milk production. Secondly, producers must decide if they want to pay premium to purchase higher coverage levels. Available coverage levels range from $4.00 to $8.00 in $0.50 increments. Premium costs per cwt increase as producers choose higher coverage levels. Table 1 shows available coverage levels and associated premiums per cwt as set in the 2014 Farm Bill. For producers choosing to cover over 4 million pounds, they can cover up to 4 million pounds at the lower premium cost, but additional pounds over 4 million would be subject to the higher premium level. Table 1: Premiums by Coverage Level and Pounds Covered Coverage Level Premium per CWT* (First 4 million lbs) Premium per CWT (After 4 million lbs) $4.00 None None $4.50 $0.010 $0.020 $5.00 $0.025 $0.040 $5.50 $0.040 $0.100 $6.00 $0.055 $0.155 $6.50 $0.090 $0.290 $7.00 $0.217 $0.830 $7.50 $0.300 $1.060 $8.00 $0.475 $1.360 *Premiums are discounted by 25% for calendar years 2014 and 2015 for all coverage levels except $8.00 Finally, producers must choose the quantity of milk that they wish to cover through the MPP- Dairy. Each dairy operation has an established production history equal to the highest level of milk marketings in the years 2011, 2012, and There is also language that allows the secretary to adjust production history in subsequent years based on national average production as well as language that allows for production history to be established for new dairy operations. Participating dairy operations choose a percentage of coverage between 25% and 90%, in 5% increments (25%, 30%, 35%,, 90%) of their production history. Like the coverage level threshold, the percentage of coverage is also chosen on an annual basis. 6

7 Methods Used to Estimate Impact on Levels and Average s This study addresses two key questions that producers face in the dairy industry, one related to income (or margin) support, and the other related the reduction of downside risks. First, how effective is MPP-Dairy as a risk management tool? This question is addressed by evaluating the historical gross margins and the impact this program would have had on those historical margins had it been available. Second, is how does the risk management of MPP-Dairy compare to LGM- Dairy over the same time periods and regions? This is evaluated by comparing the risk reduction potential between the two programs over the time period from January 2002 to December 2013, had each program been available during that time period. To evaluate the risk reduction potential of MPP-Dairy, risk is defined as the downside squared deviation from the median Actual Dairy Production (ADPM). ADPM is a calculated margin using monthly prices for US All Milk minus feed costs (corn, soybean meal, and alfalfa hay). Aggregate ADPM are estimated for 13 regions over 6 monthly couplets per year from January 2002-December 2013, both with and without MPP-Dairy. The Regional Actual Dairy Production (RADPM) is constructed for each region using regional mailbox milk price (net price received), regional corn price where available, regional soybean meal price where available, and regional alfalfa price where available. This RADPM represents the without MPP-Dairy margin insurance margin estimate. The estimates for the RADPM with MPP-Dairy is determined by subtracting MPP-Dairy premiums and adding indemnities to the RADPM estimated without the MPP-Dairy margin insurance, under different levels of assumed coverage. The analysis relies on two other key assumptions: (1) the $100 annual fee to participate in MPP- Dairy is not considered in the premium calculation, and (2) the 25% reduction in insurance premium for 2014 and 2015 is not accounted for in this analysis. The downside risk reduction associated with $4.00, $6.00, and $8.00 margin levels and 25%, 50%, 75% and 90% coverage levels are determined for each region. In order to make the work applicable to a wider range of dairy operations and examine the impact of the increased premium rates as covered milk production exceeds 4 million lbs, three representative dairy herds of various sizes were considered. To be consistent with the design of the MPP-Dairy program, these sizes were based on established production histories. A small dairy is assumed to have a production history such that they can cover up to 4 million lbs, a medium sized dairy is assumed to have a production history such that they can cover up to 20 million lbs, and a large dairy is assumed to have a production history such that they can cover up to 40 million lbs. The average premiums paid by these three representative dairies are impacted by their scale, however, the analysis assumes that they are identical in terms of cost structure and prices received. 7

8 Formulating the Model for MPP-Dairy Analysis The potential risk reduction impacts of MPP-Dairy were estimated through a historical margin analysis. Data for the analysis came from two sources. The first was the Understanding Dairy Markets Website (Gould, 2014), which provides monthly milk, corn and alfalfa hay prices from USDA s National Agricultural Statistics Service (NASS). The second was a dataset of historical soybean meal prices at seven locations provided by ERS (HOW DO WE CITE THIS DATASET?) Historical local margins were first constructed for 13 milk producing regions consisting of Florida, New England, California, Northwest, New Mexico, West TX, Minnesota, Wisconsin, Illinois, Southern, Michigan, Ohio, and the Appalachian region using the same formula used for the MPP-Dairy margin calculation described in the previous section. Mailbox milk prices were collected for each of the 13 regions. State level corn and Alfalfa hay prices were available in most regions, but when unavailable national level prices were used, which is consistent with the approach taken in Burdine et al., (2014b). In regions containing multiple states, the most representative and available state corn and alfalfa prices were collected. Soybean meal prices were available for seven locations including Decatur and Chicago, IL, Kansas City and St. Louis, MO, Memphis, TN, Minneapolis, MN, and Portland Oregon. For each region, the soybean meal price in the location closest to that region was used. Using this approach a monthly local margin (mailbox price minus estimated feed cost) was constructed for each region from January 2002 to December This is essentially a regional margin without participation in the MPP-Dairy program. Once constructed, these monthly regional margins were coupled into two-month periods as described in the previous section. In similar fashion, historical monthly MPP-Dairy margins were constructed using the same formula, but instead by using the actual prices relevant to the MPP-Dairy actual margin calculation. This includes the monthly US All Milk Price, US corn price, US Alfalfa price, and the Soybean meal price at Decatur, IL. Once monthly MPP-Dairy margins were constructed, they were coupled into two-month periods and indemnities were estimated for each potential MPP-Dairy coverage level during the same period. Premiums for each coverage level were subtracted from estimated indemnities to arrive at a net payout from hypothetical MPP-Dairy participation. This net payment was then added to, or subtracted from, each local margin couplet to construct a local margin with participation in MPP-Dairy had it been available during that time. It s important to note that we make the assumptions that production decisions and prices would have been unaffected by participation in MPP-Dairy. That is, even if their actual production margin was higher with MPP than without it, producers would not increase production (or reduce it less), as could be expected. A discussion of the potential for increased production will follow the results section. Results of Impact and Potential of MPP-Dairy The 2014 Farm Bill provided producers with a new risk management tool in MPP-Dairy and eliminated the MILC program. With the elimination of MILC, producers were given the opportunity to choose between MPP-Dairy and LGM-Dairy to provide a safety net for their dairy operations, but neither is required. Previous studies by Burdine et al. (2014a and 2014b) showed that LGM-Dairy could potentially reduce downside margin risk by 24% to 41% depending upon 8

9 the dairy producing region with little impact on average margins. By comparison, this work suggested greater risk reduction impact from MPP-Dairy when utilized to cover 90% of production history 5, while having a greater impact on the average realized margin. In evaluating the impacts of MPP-Dairy, this study examined three different margin levels ($4.00, $6.00, and $8.00) and four different coverage levels (25%, 50%, 75%, and 90%) for three different dairy sizes (4, 20, and 40 million pounds of potentially coverable production ) 6. Figure 4 shows the percentage of dairy cows held by dairy size and depicts increased concentration in the dairy sector over time. From 1998 to 2012, the percentage share of dairy cows held by small dairies (less than 4 million pounds of production per year) has been shrinking at an average of 5% per year. Conversely, large dairies (over 40 million pounds of production annually) have been growing at almost 11% per year on average. It is likely that different sized dairies will enroll in the MPP-Dairy program differently given the two-tiered premium structure that exists. Producers that cover 4,000,000 lbs or less face constant premium costs for all milk they choose to cover. 7 However, dairies with production histories that exceed that level will actually see their average premium cost per cwt increase as they choose to cover more pounds of milk as additional covered pounds are associated with greater premiums. This decision will impact the expected margin with MPP-Dairy and the potential for the MPP-Dairy to reduce margin risk. The remainder of the results section will discuss: 1) how average margin changes by the coverage selections of the operations and 2) how risk levels are impacted by the coverage selections of the operations. Figure 4: Percentage of Cattle Inventory by Dairy Size* 5 reduction levels will remain unchanged by region no matter the size of the dairy. This is a result of the way we define risk as downside squared deviation from the median. As the margin and coverage level increase the median will increase. 6 The selections of these dairy sizes were done at the authors discretion and are used as representative dairy sizes to evaluate the MPP-Dairy premium schedule. Additionally, the authors assumed an average of 20,000 pounds per cow milk production per year. Therefore this analysis covers approximately 65% of the dairy cattle inventory in the US for 2012 (USDA,??). 7 For simplification we have rounded this down to 4 million pounds, but in reality, a dairy operation that can potentially cover 4 million pounds would have an actual production history of 4,444,444 pounds as 90% is the maximum coverage percentage. 9

10 Small Medium Large *Small is 200 cows and less; Medium is 200 cows to 2000 cows; Large is 2000 cows and up Figures 5-7 show average margin level from 2002 to 2013 for the 13 different regions based on hypothetical utilization of a program like MPP-Dairy. Average margins are shown for operations that do not enroll in MPP-Dairy. These margins differ by region primarily due to different pricing structures in each region (based on class I differential and class utilization 8 ). Additionally, average margins are shown for each region for operations that choose the $4 coverage level, operations that choose the $8 coverage level and cover 25% of their production history, and operations that choose the $8 coverage level and cover 90% of their production history. During the time period of this study, small dairy producers enrolling in MPP-Dairy would have seen increases in average margins for every region examined. Further, these increases in margin would have increased as they chose higher coverage levels and as they chose to cover greater percentages of their production history (Figure 5). This occurs because indemnities (payments from the government) exceed premiums on average, which raises the average margin for smaller dairies paying the lower premium rates. Maximum utilization of the MPP-Dairy (90% coverage level, $8 margin) would have resulted in an average margin increase of 0.35 per cwt from January 2002 to 2013 for a small dairy (see tables 2-5). The impact on average margin is less clear for medium and large size dairies. Since no cost efficiencies are assumed based on size, changes in average margin are due solely to the increased premiums paid on higher levels of covered milk production. Because of this two-tiered premium structure, producers have an additional decision to make with regards to the margin and coverage level tradeoff. Unlike the smaller dairies discussed previously, larger dairies may choose a lower percentage of coverage to avoid the higher premiums associated with covering milk beyond the 4 million pound per year level. The key question they will have to answer is Should I select a 8 Class I differential refers to the premium paid per cwt of milk above class I mover. Class utilization refers to the percentage of milk that is sold as Class I (fluid) milk. 10

11 higher margin level and lower coverage level or a lower margin level and higher coverage level? Table 1 showed the premium schedule for each margin level. Medium and large dairies can cover up to 4 million pounds at the lower level, but pay the higher premium level on any lbs above 4 million. Figures 6 and 7 demonstrate this tradeoff by showing the average margin for producers not enrolling in MPP-Dairy, those choosing only the $4 catastrophic level, those choosing the $8 level at 25% coverage, and those choosing the $8 level at 90% coverage. As can be seen in the figures, average margin increases for both large and medium-sized dairies when the $4 level is chosen. This is not a surprising result given the extremely low cost of the catastrophic coverage level. In both cases, average margins decrease at the $8 level when higher levels of coverage are chosen for medium and large farms. At the $8 level, average margins are lower for higher coverage percentages as more milk is covered at the higher premiums. Maximum utilization of the MPP-Dairy (90% coverage level, $8 margin) would have resulted in a margin decrease of 0.27 (medium) to 0.35 (large) per cwt from January 2002 to However, although not shown in the figures, medium and large dairies would have earned progressively higher margins at progressively higher coverage levels (25%, 50%, 75%, and 90%) when protecting intermediate (i.e., $6.00) margins (see tables 6-13). Figure 5: Level by Region for Small Dairy $12.00 $11.50 $11.00 $10.50 $10.00 $9.50 $9.00 $8.50 $8.00 $7.50 $7.00 $6.50 $6.00 $5.50 $5.00 No MPP 90% 25% 90% Figure 6: Level by Region for Medium Dairy 11

12 $11.50 $11.00 $10.50 $10.00 $9.50 $9.00 $8.50 $8.00 $7.50 $7.00 $6.50 $6.00 $5.50 $5.00 No MPP 90% 25% 90% Figure 7: Level by Region for Large Dairy $11.50 $11.00 $10.50 $10.00 $9.50 $9.00 $8.50 $8.00 $7.50 $7.00 $6.50 $6.00 $5.50 $5.00 No MPP 90% 25% 90% 12

13 In addition to evaluating the potential impact on margins, another focus of this paper was to evaluate the risk reduction potential of the MPP-Dairy program had it been available in the past. Tables 2-13 show regional breakdowns of the margin and risk reduction potential for three different margin levels ($4.00, $6.00, and $8.00) and four different coverage levels (25%, 50%, 75%, and 90%) for the time period from 2002 to These levels were evaluated for the same three dairy sizes. reduction impacts for small, medium, and large sized dairies were the same across the three sized dairies evaluated in this study, which was a function of the risk measure employed. As increasingly larger dairies enrolled in MPP-Dairy, they received payments (indemnities) and paid premiums on the share of their production history that was covered. The result was a shift in the median margin with MPP-Dairy and a like shift in the various bi-monthly margins, but no change in the deviation between the two. Therefore, risk reduction was the same, regardless of the size of the dairies. reduction impacts across regions were substantial and became greater as higher coverage levels and larger percentages of production history were covered. This occurs because choosing higher coverage levels and greater percentages of coverage remove increasingly more of the extremely low bi-monthly margins, resulting in lower risk levels. At the $4 coverage level, covering 90% of production history resulted in a risk reduction of 7-10% across the regions evaluated. At the $6 coverage level, the same percentage of coverage resulted in risk reduction of 18-38% across the 13 regions. Finally, at the $8 coverage level, risk reduction levels range from 46% to 80%. Full risk reduction estimates can be seen in tables Table 2: by Region for 4 million lbs. Dairies at 25% Coverage Level w/o Region MPP- at $4.00 at $6.00 at $8.00 DAIRY Appalachian $8.66 $8.67 2% $ % $ % California $6.01 $6.03 3% $ % $ % Florida $10.98 $ % $ % $ % Illinois $8.29 $8.30 2% $ % $ % Michigan $7.93 $7.94 2% $ % $ % Minnesota $8.76 $8.78 2% $8.82 9% $ % New $7.76 $7.77 2% $7.81 8% $ % England New Mexico $5.60 $5.61 2% $ % $ % Northwest $7.16 $7.17 3% $ % $ % Ohio $7.83 $7.84 2% $7.88 9% $ % Southern $7.78 $7.80 2% $7.83 8% $ % Western Texas $6.38 $6.40 3% $ % $ % Wisconsin $8.74 $8.75 2% $8.79 9% $ % 13

14 Table 3: by Region for 4 million lbs. Dairies at 50% Coverage Level Region w/o MPP- at $4.00 at $6.00 at $8.00 DAIRY Appalachian $8.66 $8.68 5% $ % $ % California $6.01 $6.04 5% $ % $ % Florida $10.98 $ % $ % $ % Illinois $8.29 $8.32 5% $ % $ % Michigan $7.93 $7.96 5% $ % $ % Minnesota $8.76 $8.79 4% $ % $ % New $7.76 $7.79 4% $ % $ % England New Mexico $5.60 $5.63 5% $ % $ % Northwest $7.16 $7.19 5% $ % $ % Ohio $7.83 $7.85 4% $ % $ % Southern $7.78 $7.81 4% $ % $ % Western Texas $6.38 $6.41 6% $ % $ % Wisconsin $8.74 $8.77 4% $ % $ % Table 4: by Region for 4 million lbs. Dairies at 75% Coverage Level Region w/o MPP- at $4.00 at $6.00 at $8.00 DAIRY Appalachian $8.66 $8.70 7% $ % $ % California $6.01 $6.06 8% $ % $ % Florida $10.98 $ % $ % $ % Illinois $8.29 $8.33 7% $ % $ % Michigan $7.93 $7.97 7% $ % $ % Minnesota $8.76 $8.81 6% $ % $ % New $7.76 $7.80 6% $ % $ % England New Mexico $5.60 $5.64 7% $ % $ % Northwest $7.16 $7.20 8% $ % $ % Ohio $7.83 $7.87 6% $ % $ % Southern $7.78 $7.82 6% $ % $ % Western Texas $6.38 $6.42 8% $ % $ % Wisconsin $8.74 $8.78 6% $ % $ % 14

15 Table 5: by Region for 4 million lbs. Dairies at 90% Coverage Level Region w/o MPP- at $4.00 at $6.00 at $8.00 DAIRY Appalachian $8.66 $8.71 8% $ % $ % California $6.01 $6.06 9% $ % $ % Florida $10.98 $ % $ % $ % Illinois $8.29 $8.34 9% $ % $ % Michigan $7.93 $7.98 9% $ % $ % Minnesota $8.76 $8.82 7% $ % $ % New $7.76 $7.81 8% $ % $ % England New Mexico $5.60 $5.65 9% $ % $ % Northwest $7.16 $ % $ % $ % Ohio $7.83 $7.88 8% $ % $ % Southern $7.78 $7.83 7% $ % $ % Western Texas $6.38 $ % $ % $ % Wisconsin $8.74 $8.79 7% $ % $ % Table 6: by Region for 20 million lbs. Dairies at 25% Coverage Level Region w/o MPP- DAIRY at $4.00 at $6.00 at $8.00 Appalachian $8.66 $8.67 2% $ % $ % California $6.01 $6.03 3% $ % $ % Florida $10.98 $ % $ % $ % Illinois $8.29 $8.30 2% $ % $ % Michigan $7.93 $7.94 2% $ % $ % Minnesota $8.76 $8.78 2% $8.81 9% $ % New $7.76 $7.77 2% $7.81 8% $ % England New Mexico $5.60 $5.61 2% $ % $ % Northwest $7.16 $7.17 3% $ % $ % Ohio $7.83 $7.84 2% $7.87 9% $ % Southern $7.78 $7.80 2% $7.83 8% $ % Western $6.38 $6.40 3% $ % $ % Texas Wisconsin $8.74 $8.75 2% $8.79 9% $ % 15

16 Table 7: by Region for 20 million lbs. Dairies at 50% Coverage Level Region w/o MPP- DAIRY at $4.00 at $6.00 at $8.00 Appalachian $8.66 $8.68 5% $ % $ % California $6.01 $6.04 5% $ % $ % Florida $10.98 $ % $ % $ % Illinois $8.29 $8.32 5% $ % $ % Michigan $7.93 $7.96 5% $ % $ % Minnesota $8.76 $8.79 4% $ % $ % New $7.76 $7.79 4% $ % $ % England New Mexico $5.60 $5.63 5% $ % $ % Northwest $7.16 $7.19 5% $ % $ % Ohio $7.83 $7.85 4% $ % $ % Southern $7.78 $7.81 4% $ % $ % Western $6.38 $6.41 6% $ % $ % Texas Wisconsin $8.74 $8.77 4% $ % $ % Table 8: by Region for 20 million lbs. Dairies at 75% Coverage Level Region w/o MPP- DAIRY at $4.00 at $6.00 at $8.00 Appalachian $8.66 $8.70 7% $ % $ % California $6.01 $6.06 8% $ % $ % Florida $10.98 $ % $ % $ % Illinois $8.29 $8.33 7% $ % $ % Michigan $7.93 $7.97 7% $ % $ % Minnesota $8.76 $8.81 6% $ % $ % New $7.76 $7.80 6% $ % $ % England New Mexico $5.60 $5.64 7% $ % $ % Northwest $7.16 $7.20 8% $ % $ % Ohio $7.83 $7.87 6% $ % $ % Southern $7.78 $7.82 6% $ % $ % Western $6.38 $6.42 8% $ % $ % Texas Wisconsin $8.74 $8.78 6% $ % $ % 16

17 Table 9: by Region for 20 million lbs. Dairies at 90% Coverage Level Region w/o MPP- DAIRY at $4.00 at $6.00 at $8.00 Appalachian $8.66 $8.71 8% $ % $ % California $6.01 $6.06 9% $ % $ % Florida $10.98 $ % $ % $ % Illinois $8.29 $8.34 9% $ % $ % Michigan $7.93 $7.98 9% $ % $ % Minnesota $8.76 $8.82 7% $ % $ % New $7.76 $7.81 8% $ % $ % England New Mexico $5.60 $5.65 9% $ % $ % Northwest $7.16 $ % $ % $ % Ohio $7.83 $7.88 8% $ % $ % Southern $7.78 $7.83 7% $ % $ % Western $6.38 $ % $ % $ % Texas Wisconsin $8.74 $8.79 7% $ % $ % Table 10: by Region for 40 million lbs. Dairies at 25% Coverage Level Region w/o MPP- at $4.00 at $6.00 at $8.00 DAIRY Appalachian $8.66 $8.67 2% $ % $ % California $6.01 $6.03 3% $ % $ % Florida $10.98 $ % $ % $ % Illinois $8.29 $8.30 2% $ % $ % Michigan $7.93 $7.94 2% $ % $ % Minnesota $8.76 $8.78 2% $8.80 9% $ % New $7.76 $7.77 2% $7.80 8% $ % England New Mexico $5.60 $5.61 2% $ % $ % Northwest $7.16 $7.17 3% $ % $ % Ohio $7.83 $7.84 2% $7.86 9% $ % Southern $7.78 $7.80 2% $7.82 8% $ % Western Texas $6.38 $6.40 3% $ % $ % Wisconsin $8.74 $8.75 2% $8.78 9% $ % 17

18 Table 11: by Region for 40 million lbs. Dairies at 50% Coverage Level Region w/o MPP- at $4.00 at $6.00 at $8.00 DAIRY Appalachian $8.66 $8.68 5% $ % $ % California $6.01 $6.04 5% $ % $ % Florida $10.98 $ % $ % $ % Illinois $8.29 $8.32 5% $ % $ % Michigan $7.93 $7.96 5% $ % $ % Minnesota $8.76 $8.79 4% $ % $ % New $7.76 $7.79 4% $ % $ % England New Mexico $5.60 $5.63 5% $ % $ % Northwest $7.16 $7.19 5% $ % $ % Ohio $7.83 $7.85 4% $ % $ % Southern $7.78 $7.81 4% $ % $ % Western Texas $6.38 $6.41 6% $ % $ % Wisconsin $8.74 $8.77 4% $ % $ % Table 12: by Region for 40 million lbs. Dairies at 75% Coverage Level Region w/o MPP- at $4.00 at $6.00 at $8.00 DAIRY Appalachian $8.66 $8.70 7% $ % $ % California $6.01 $6.06 8% $ % $ % Florida $10.98 $ % $ % $ % Illinois $8.29 $8.33 7% $ % $ % Michigan $7.93 $7.97 7% $ % $ % Minnesota $8.76 $8.81 6% $ % $ % New $7.76 $7.80 6% $ % $ % England New Mexico $5.60 $5.64 7% $ % $ % Northwest $7.16 $7.20 8% $ % $ % Ohio $7.83 $7.87 6% $ % $ % Southern $7.78 $7.82 6% $ % $ % Western Texas $6.38 $6.42 8% $ % $ % Wisconsin $8.74 $8.78 6% $ % $ % 18

19 Table 13: by Region for 40 million lbs. Dairies at 90% Coverage Level Region w/o MPP- at $4.00 at $6.00 at $8.00 DAIRY Appalachian $8.66 $8.71 8% $ % $ % California $6.01 $6.06 9% $ % $ % Florida $10.98 $ % $ % $ % Illinois $8.29 $8.34 9% $ % $ % Michigan $7.93 $7.98 9% $ % $ % Minnesota $8.76 $8.82 7% $ % $ % New $7.76 $7.81 8% $ % $ % England New Mexico $5.60 $5.65 9% $ % $ % Northwest $7.16 $ % $ % $ % Ohio $7.83 $7.88 8% $ % $ % Southern $7.78 $7.83 7% $ % $ % Western Texas $6.38 $ % $ % $ % Wisconsin $8.74 $8.79 7% $ % $ % Comparison of MPP-Dairy to LGM-Dairy Since producers are given the choice between LGM-Dairy and MPP-Dairy through 2018, a comparison of the two programs seems in order. Both programs aim to provide downside margin risk protection to producers, but take very different approaches to do so. First, differences in margin calculation exist, which producers should keep in mind. Where MPP- Dairy utilizes US All Milk Price and national and regional prices for feeds, LGM-Dairy utilizes the futures prices for Class III Milk, Corn, and Soybean Meal. The use of different price series in the margin calculation means that producers must adjust expectations for the difference between those prices and the relevant milk and feed prices for their area. LGM-Dairy is also a bit more flexible in terms of feed costs and the amount of production that can be covered. On the feed side, producers can adjust the quantities of corn and soybean meal they want included in the margin calculation within an accepted range. This effectively allows producers to scale milk output and feed inputs appropriately to their operations, which allows producers to tailor LGM-Diary towards their individual feeding programs. LGM dairy is also more flexible in the sense that producers can cover all of their production, unlike MPP-Dairy where the maximum amount that operations can cover is 90% of the established production history. 19

20 While these details are important, distinctions between the two programs, the primary differences lie in the design. Since LGM-Dairy is based on futures prices, margins and premiums will change as the expectations of milk and feed prices change. Producers utilize LGM-Dairy to capitalize on the current expectation of prices (Burdine et al., 2014b). As those expectations change, so will futures prices and hence the opportunity to use them for margin protection. In contrast, available MPP-Dairy margins and the premiums associated with them are fixed for the life of the farm bill and will not evolve with market conditions. Generally speaking, this is likely to make LGM-Dairy more attractive when overall market conditions are more attractive (higher margins) and MPP-Dairy more attractive when they are not (lower margins). Specific to the impacts of the two programs on the operations that enroll, ERS Research Report 163 (Burdine et al., 2014a) outlined the impact of LGM-Dairy from a historical perspective in the same way this publication outlines the impact of MPP-Dairy. Results from this study suggest that risk reduction impacts from full utilization of the MPP-Dairy program would have had greater potential to reduce downside margin risk than LGM-Dairy during the time period from For operations choosing 90% coverage at the $8 level, risk reduction estimates from MPP-Dairy ranged from 46% to 80% across regions as compared to 28% to 39% from LGM Dairy. However, risk reduction from MPP-Dairy got progressively lower as lower margins and lower coverage levels were selected, being as low as 2% for $4.00 coverage at 25%. Comparison of the impact of the two programs on average margin is more complex due to the two-tiered premium structure of MPP-Dairy. For LGM Dairy, both Burdine et al., (2014a) and Burdine et al., (2014b), which used slightly different time frames, found little impact on overall margins across regions with a range of -1% to 2%. This work suggested greater impact on margins, although those differences varied across the three sizes of operations considered. For small dairies, full utilization of MPP-Dairy resulted in an increase in margins across regions from 3.22% to 6.31%. Although the minimum $4.00 margin coverage resulted in small margin gains for medium and large daires, fuller utilization of MPP-Dairy resulted in reductions in average margin of -2.43% to -4.76% for medium sized dairies and -3.23% to -6.34% for large dairies, by region, when the highest level of coverage was selected ($8.00 at 90% coverage). Recall that these results assume continuous coverage at these levels throughout the entire time span. The estimated margin impacts discussed here are not directly comparable to likely impacts given that producers under MPP-Dairy have the opportunity to annually elect coverage levels and may have been more strategic in their approach by purchasing higher coverage levels when the likelihood of payment appeared greater. Also note that margins for medium and large dairies were progressively better than the no-mpp case with higher percentage levels of coverage for intermediate margins (i.e., $6.00). 20

21 Any program that has the potential to increase margin or decrease risk has the potential to induce supply expansion as producers respond to the higher margins and decreased risk levels. The newly established MPP-Dairy program is no different as this study has demonstrated that both factors can be impacted. Burdine et al., 2014b attempted to make an upper bound estimate of potential supply impacts from LGM-Dairy by utilizing price and risk elasticities with study results. This same approach can be taken to estimate an upper bound supply response from the MPP-Dairy. In the case of MPP-Dairy, a couple key points should be made when considering supply impacts. First, while the margin impacts of LGM-Dairy were relatively small (1-2%), the potential margin impacts from MPP-Dairy were more substantial, at least for smaller operations when estimated for the time period from Had the medium and large dairies also selected the minimum ($4.00) or intermediate ($6.00) levels of coverage, the impact of higher margins on potential supply would also be expected to positive under the MPP. Secondly, while risk reduction impacts are likely to have much less impact on production than margin impacts, full utilization of MPP-Dairy resulted in considerably greater reduction in margin risk levels than was estimated for LGM-Dairy. Both of these factors would combine to yield a greater upper bound estimate of production impacts from MPP-Dairy. The term upper bound is used because several factors are likely to mitigate the impact of MPP- Dairy on production. First, since existing dairies can only cover 90% of their production history, the impact of MPP-Dairy on expansion of existing operations is somewhat lessened. While it is likely that lower risk on a large portion of existing production would impact the expansion decision, it is also likely to have much less impact than it would if the increased production could have been covered as well. Another piece of this discussion involves the likelihood of the existence of the MPP-Dairy program attracting new operations into the dairy sector as production histories can be established for new dairies. However, previous work has suggested that elasticities of supply from new operations are likely very small compared to yield and herd size (Adelaja, 1991). Secondly, the varying impacts on dairies by size are also likely to limit the production impacts. While small dairies analyzed benefited from full utilization of MPP-Dairy through both increased margins and decreased risk, large and medium sized dairies saw average margins decrease when margin coverage levels were at the full $8 coverage. At intermediate levels of protected margins (i.e., $6.00), actual margins exceeded the no-mpp outcomes. So, while one could argue that the greater risk reduction associated with full utilization of MPP-Dairy for these two larger size categories might encourage expansion, it could be offset by the reduction in average margin that resulted under some scenarios. 21

22 In order to provide an estimate of an upper bound supply response to MPP-Dairy, assumptions were made about coverage levels, percentage of coverage, as well as both price and risk elasticities. In the case of small dairies, $8 coverage on 90% of production history was chosen as this would have been a logical choice for a typical producer. For medium and large dairies, $6 coverage on 90% of production history was chosen as this avoided he negative margin impact of the $8 coverage level. To be consistent with previous work (Burdine et al., 2014b), price elasticity was assumed to be -0.5 and risk elasticies were considered at -0.1, -.05, and , however this range is greater than recent risk elasticities estimated for the dairy industry (Burdine et al., 2014a). Specific estimates for supply impact for each size operation can be found in tables Estimates suggest more impact on production on small dairies as estimates exceed 10% in some regions at the highest risk elasticity assumptions. This is logical as smaller operations are those most impacted by increases in average margin and decreases in risk levels. However, even large operations could respond to the program with production growth in the 1% to 8% range given the assumed risk elasticities. Table 14: Estimated Supply Impact for Small Dairies by Region Change Supply Impact Supply Impact Region Elast: 0.1 Elast: Supply Impact Elast: Appalachian 63% 4.08% 8.37% 5.21% 3.62% California 58% 5.87% 8.73% 5.83% 4.39% Florida 67% 3.22% 8.27% 4.94% 3.27% Illinois 71% 4.26% 9.19% 5.66% 3.90% Michigan 71% 4.45% 9.32% 5.77% 4.00% Minnesota 61% 4.03% 8.13% 5.07% 3.54% New England 46% 4.55% 6.86% 4.57% 3.42% New Mexico 71% 6.31% 10.21% 6.68% 4.92% Northwest 80% 4.93% 10.44% 6.45% 4.46% Ohio 64% 4.51% 8.65% 5.45% 3.85% Southern 69% 4.54% 9.18% 5.73% 4.00% Western Texas 66% 5.53% 9.34% 6.05% 4.41% Wisconsin 56% 4.04% 7.65% 4.84% 3.43% Note: Based on $8 coverage on 90% of production 22

23 Table 15: Estimated Supply Impact for Medium Sized Dairies by Region Change Supply Impact Supply Impact Supply Impact Region Elast: Elast: 0.05 Elast: Appalachian 32% 1.38% 3.89% 2.29% 1.49% California 38% 1.99% 4.77% 2.88% 1.94% Florida 32% 1.09% 3.79% 2.17% 1.36% Illinois 33% 1.45% 4.04% 2.38% 1.55% Michigan 33% 1.51% 4.02% 2.39% 1.57% Minnesota 28% 1.37% 3.46% 2.07% 1.38% New England 27% 1.54% 3.47% 2.12% 1.45% New Mexico 34% 2.14% 4.49% 2.78% 1.92% Northwest 38% 1.67% 4.60% 2.72% 1.78% Ohio 29% 1.53% 3.68% 2.23% 1.50% Southern 28% 1.54% 3.55% 2.16% 1.46% Western Texas 17% 1.88% 2.65% 1.80% 1.37% Wisconsin 28% 1.37% 3.52% 2.10% 1.39% Note: Based on $6 coverage on 90% of production Table 16: Estimated Supply Impact for Large Dairies by Region Change Supply Impact Supply Impact Supply Impact Region Elast: 0.1 Elast: 0.05 Elast: Appalachian 32% 1.27% 3.83% 2.23% 1.43% California 38% 1.83% 4.68% 2.80% 1.86% Florida 32% 1.00% 3.75% 2.12% 1.31% Illinois 33% 1.32% 3.98% 2.32% 1.49% Michigan 33% 1.38% 3.96% 2.33% 1.51% Minnesota 28% 1.25% 3.41% 2.02% 1.32% New England 27% 1.41% 3.40% 2.05% 1.38% New Mexico 34% 1.96% 4.40% 2.69% 1.84% Northwest 38% 1.53% 4.53% 2.65% 1.71% Ohio 29% 1.40% 3.62% 2.16% 1.43% Southern 28% 1.41% 3.48% 2.09% 1.40% Western Texas 17% 1.72% 2.56% 1.71% 1.29% Wisconsin 28% 1.26% 3.46% 2.04% 1.34% Note: Based on $6 coverage on 90% of production 23

24 Conclusions In general, a program like MPP-Dairy would have been successful in reducing risk, had it been in place for the 12 years from January 2002 to December However, the level to which it would have reduced margin risk would depend heavily on the region and the choice of coverage level and percent of coverage selected by the individual producers. In general, the western regions have much lower margins, which results in greater risk reduction estimates from MPP- Dairy participation.. Given the lower actual regional margins that exist, changes to those margins from indemnities are greater on a percentage basis. This results in a greater percentage change in average margin and a greater reduction in downside margin risk. For the western regions of the country risk reduction could go as high as 80%. Dairies that fall into the small category as described in this paper would have benefited from full participation in the MPP-Dairy-like program. At the lower premium structure, payments exceeded premiums for all coverage levels. So, the more milk that was covered and the higher level at which it were covered, average margins increased for the small producers. Additionally, the elimination of low margin periods also worked to reduce the downside margin risk. So, this size of operation would have benefitted from a program like MPP-Dairy as average margins increase across the board and risk would have been reduced. The optimal strategy would have been full participation. Once production histories move beyond levels where 4,000,000 lbs can be covered, the decision becomes less obvious from a historical perspective. This work examined $4 coverage, $6 coverage, and $8 coverage. At the $4 level, participation costs are fixed at $100, so average cost per cwt covered is extremely small, and decreases as production history increases. However, premiums at higher coverage levels increase as more milk falls into the higher premium structure. For the medium (20 million lbs) and large (40 million lbs) dairy operations examined in this work, payments continued to exceed premiums at the $6 level, while risk levels continued to be reduced. However, while risk reduction benefits continue to increase when the $8 coverage level is chosen, average margins began to decrease. So, larger operations are faced with a classic risk question. Am I willing to trade some level of expected margin for some level of margin risk reduction? If the answer is yes, individual operations must decide what makes the most sense for them and may find themselves examining coverage levels that exceed $6. As for the question of production impacts, increases in average margins and decreases in margin risk level both have potential to impact production. While existing producers are unable cover increased production, there are methods by which production histories can be established for new dairy operations. Further, it is likely that the existence of the program could impact expansion even if additional production is not eligible as overall risk levels are reduced. While supply impacts estimated in table should be treated as upper bound estimates, moderate supply impacts are possible given the potential for MPP-Dairy to impact both margins and risk levels. 24