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Who Wants to Think About Risk Management, Now?

Geoff Vanden Heuvel

Director of Regulatory and Economic Affairs

It’s always a bit tricky as a dairyman trying to figure out how to manage risk – particularly on the milk income side. The current market situation is unique. We have seen a rapid rise in feed costs and operating costs. Milk prices have finally responded and risen to levels unseen in the past. How long will these milk prices stay high? The futures prices are projecting a decline in prices later in the year. Our experience tells us that eventually they will come down, unless of course the dairy paradigm has permanently shifted.

USDA extended the signup period for the Dairy Margin Coverage (DMC) program by one week and I strongly recommend that every dairy sign up for the full 5 million pounds of $9.50 coverage at your local FSA office. The DMC mechanism has been continually sweetened in producers’ favor by USDA over the past couple of years. It is now, by far, the most generous dairy safety net program ever created for producers. The problem is 5 million pounds is the limit and that covers the production from about 250 cows. So, the question is what to do about the rest of your milk?

The market situation is full of factors to consider. Typically, once milk production becomes profitable, milk production increases to meet demand. To increase production, we need feed and animals. Feed is very expensive and the growth of beef from dairy animals may have a significant impact on how many dairy heifers might be available. Labor is an issue in most major dairy areas of the country. Many milk handlers have activated production limits on their producers. Long-term environmental challenges and costs create a significant risk profile to new or expanded dairy construction. Meanwhile, milk production in Europe is flat as is production in New Zealand and Australia. Maybe this milk price runup will last longer than we expect. But maybe not.

I sell Dairy Revenue Protection (DRP) crop insurance and get to talk to producers about their thinking on a regular basis. What DRP does is provide a revenue guarantee based on a floor price that is directly tied to daily closing prices for milk futures. Right now, a producer can purchase revenue coverage for Quarter 2 of 2022 (April, May and June) and Quarter 3 (July, August and September) and Quarter 4 (October, November and December). Coverage for Quarter 1 of 2023 and Quarter 2 of 2023 are also available.

The floor prices are historically high for these future quarters, but so are the premiums. The way this program works is a producer purchases coverage for a fix volume of milk that will be produced in a future quarter of time. The floor price establishes the minimum revenue that will be obtained for this volume of milk. If the actual price of milk in that future quarter generates less revenue than the revenue guaranteed by the policy, the insurance company pays the difference.

The DRP program has a lot of flexibility. The highest floor prices that can be obtained are based on a floor price that is 95% of the closing futures price in force for each day. For example, a $20 Class III futures price would dictate an available floor price for purchase of $19 per cwt. ($20 x 95%=$19). 95% is the level at which most DRP purchases have been made until recently. The DRP program also offers revenue guarantees at the 90% level and the 85% level for much lower premiums.

Some producers I am talking to are looking at these options as a lower cost way to put in a revenue floor. Another idea that is being considered by some folks is to buy DRP coverage and then sell calls in the futures market to earn money to help offset the cost of the DRP premiums. This type of move puts a floor under your price, but also a ceiling. Selling calls must be done through a licensed broker and does require money up front and an exposure to margin calls if futures prices move higher. There are some cooperatives who offer the opportunity to sell calls and the program takes the risk of the margin calls. If you are interested in this approach you can check with your cooperative to see if they have a program.

The bottom line is the dairy industry is in uncharted waters. There are many different options and opinions about what might happen and what can be done to prepare. In the three years I have been talking to producers about DRP I have discovered that there are as many opinions as there are dairymen. Everyone has a different perspective, and no one is right all the time. Other than signing up for the full 5 million pounds of coverage in the DMC, the path each individual producer takes will be different. It has been a wild ride for a while now and it seems that uncertainty and risk will be the reality for some time to come.

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