Mean-Reversion in Dairy Prices and Horizon-Specific Subsidies for Dairy Insurance Products

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1 Mean-Reversion in Dairy Prices and Horizon-Specific Subsidies for Dairy Insurance Products SCC Pensacola, FL Dr. Marin Bozic (co-authors: Josh Woodard, John Newton)

2 National Avg. Income Over Feed Cost Margin 2 $18.00 $16.00 $14.00 $12.00 $10.00 $8.00 $6.00 $4.00 $2.00 $0.00 MPP-Dairy Margin

3 Previous Research on Mean-Reversion/Hedging Horizon 3 Geppert, J.M. (1995), Malliaris and Urrutia (1991) find hedging horizon may be important because basis risk may be smaller at some horizons than other. Bessembinder et al. (1994) (Journal of Finance) suggests meanreverting coefficient of spot prices may be inferred from slope of the term structure of futures prices. Bozic, Newton, Thraen and Gould (2012, 2014) analyzed Livestock Gross Margin for Dairy Cattle and find that longer hedging horizon increases hedging effectiveness.

4 Can we use term structure of IOFC margins to make inferences about time series properties of spot margins? 4 Bessembinder et al. (1995): Uses term-structure of futures prices to make inferences on mean-reversion in spot prices. Results can be used to make statements on investors expectations on mean-reversion in commodity prices. For the commodity markets, including metals, crude oil, and agriculturals, the regression coefficients are uniformly negative and significant, implying that increases in the level of commodity prices tend to be accompanied by decreases in the slope of the commodity futures term structure, and vice versa. Our contribution: Extended Bessembinder et al. model to agricultural crush margins and sectors where storage arbitrage does not apply.

5 Term structures of synthetic IOFC futures 5

6 Evolution of synthetic IOFC futures contracts 6

7 Econometric Analysis 7 f IOFC,T+1,t f IOFC,T,t = α T + β T p IOFC,t p IOFC,5year ҧ + ε t f IOFC,T+1,t f IOFC,T,t is the slope of the term structure of dairy income over feed costs margins, i.e. difference between futures margins T+1 and T months to maturity, observed on date t. p IOFC,t p IOFC,5year ҧ is the difference between spot margins on date t and 5-year moving average of spot margins. α T, β T We estimate separate regression for each horizon T.

8 Econometric Analysis 8 f IOFC,t,t+k+1 f IOFC,t,t+k = α k + β k p IOFC,t p IOFC,5year ҧ + ε t Hypotheses: Mean reversion in spot margins is expected if β T < 0 and k 1 < k 2 β k1 < β k2

9 Econometric Analysis 9 k β k st.err p-value R < < < <

10 How can we estimate coefficient of mean-reversion? 10 Let stochastic process for spot prices be mean reverting: y t+1 = α y t തy + y t + ε t α 0,1, ε t ~ 0, σ ε i. i. d t

11 Deferred futures prices will converge to unconditional average 11 y t+1 = 1 α y t + α തy + ε t y t+2 = 1 α 2 y t α 2 തy+ 1 α ε t +ε t+1 y t+k = 1 α k y t α k തy + k i=1 1 α i 1 ε t+k i F t,t = E t y t+k ) = 1 1 α k തy + y t 1 α k lim k E t y t+k = തy

12 K-horizon unconditional variance of futures prices 12 y t+k = 1 α k y t α k തy + k i=1 1 α i 1 ε t+k i y t = N തy,σ F t,t+k = 1 1 α k തy + y t 1 α k Var F t,t+k = 1 α 2k σ 2

13 Estimating speed of mean reversion α 13 y t+1 = α y t തy + y t + ε t Var(y t ) = σ 2 Var F t,t+k = 1 α 2k σ 2 α = 1 Var F t,t+k Var(y t ) 1/2k

14 Term structures of synthetic IOFC futures 14

15 Formulating the optimal hedging horizon problem 15 Define minimum needed futures price as: y = തy δ A hedger chooses minimum hedging horizon T such that whenever it is time to initiate the next hedging round, futures price is higher than minimum needed futures price y in γ percent of cases. Pr F t,t+k y γ, t For example, setting γ=0.05 would insure that hedging results in desirable hedged price levels 95% of times.

16 Futures Price Term Structure of Futures Prices Under Alternative Speeds of Mean Reversion 16 $16.00 $15.00 $14.00 $13.00 $12.00 $11.00 $10.00 $9.00 $8.00 $7.00 Mean: $15.27, St.Dev: $3.62, Spot: $ Contract Month (Time To Maturity) alpha = 0.9 alpha = 0.6 alpha = 0.3 alpha = 0.2 alpha = 0.1 alpha = 0.01

17 Spot N/A Estimating speed of mean reversion α 17 k Var F t,t+k α k

18 Optimal Hedging Horizon as a Function of the Speed of Mean Reversion Mean: $15.27, St.Dev: $3.62 Probability Above Threshold: 95% $14.00 $13.00 $

19 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Short-term hedging carries availability risk 19 $16.00 $15.00 $14.00 $13.00 $12.00 $11.00 $10.00 $9.00 $8.00 Dairy Cost of Production vs. Class III Milk Futures on January 2, Class III Milk Futures Prices Cost of Production

20 Current Utilization of Dairy Risk Management Tools: Is There A Problem To Solve? 20 Futures and options 6 active futures contracts, 24 calendar months listed Open interest growing over years, currently at 180, ,000 contracts. Margin Protection Program for Dairy Producers For 2016: Used by more than 50% of U.S. milk producers producing more than 70% of milk. Less than 10% of U.S. milk at coverage levels higher than catastrophic ($4.00/cwt). Less than 2% of milk in $6.00/cwt or higher. LGM-Dairy High interest by dairy producers, but too complex, $20Mil cap makes it unreliable as a risk mgmt. tool OTC contracts Revenue-over-feed, cost-plus direct ship agreements, coop Economies of scale and balance sheet risk management High working capital, high assets per cow, keeping COP below competition

21 May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr Class III Milk Futures Open Interest on May 16, contract = 200,000 lbs Feb 2017 production > 17 billion lbs. To hedge the entire February 2017 milk production we would need 88,000 Class III Milk futures contracts!

22 Feb-01 Dec-01 Oct-02 Aug-03 Jun-04 Apr-05 Feb-06 Dec-06 Oct-07 Aug-08 Jun-09 Apr-10 Feb-11 Dec-11 Oct-12 Aug-13 Jun-14 Apr-15 Feb-16 Basis Risk is High Outside Upper Midwest 22 $10.00 Florida Mailbox Milk Price Minus Class III Milk Price $8.00 $6.00 $4.00 $2.00 $0.00 -$2.00 -$4.00

23 Principles for effective risk management in dairy 23 1) Design insurance policy with quarter-long contract period 2) Focus on basis risk 3) Focus on long-horizons. Short-term horizons expose hedgers to availability risk. Nudge producers to consider long-horizons with horizon-specific subsidy levels

24 Horizon-Specific Subsidies 24 CL Q1 Q2 Q3 Q4 Q5 60% 20% 25% 30% 40% 50% 65% 20% 25% 30% 40% 50% 70% 20% 25% 30% 40% 50% 75% 20% 25% 30% 40% 50% 80% 20% 25% 30% 40% 50% 85% 10% 15% 20% 40% 40% 90% 10% 15% 20% 40% 40% 95% 10% 10% 10% 15% 15% 100% 5% 5% 5% 5% 5%

25 Mean-Reversion in Dairy Prices and Horizon-Specific Subsidies for Dairy Insurance Products SCC-76 Pensacola, FL March 31, 2017 Dr. Marin Bozic Dept. of Applied Economics University of Minnesota 317c Ruttan Hall 1994 Buford Avenue St Paul, MN 55108

26 Does hedging work? 26 Maynard, Wolf, Gearhardt (2005): Hedging appears capable of reducing price variance by 50-60% in most regions, and favors large, sophisticated producers in heavy cheese manufacturing regions. Neyard, Tauer and Gloy (2013): Compared with the reference scenario of selling milk and procuring inputs on a monthly cash basis, the risk management activities did not result in a significant change in either the level or variance of net farm income.