Protection site

Income and Cost Components of Margin Protection

Current high commodity prices and the current high cost environment in 2023 are driving renewed interest in the Margin Protection (MP) crop insurance product ahead of the 2023 MP decision deadline of September 30, 2022. MP is a crop insurance risk management tool, providing protection at the area level. In this article, we explain and discuss the input costs used in the calculation of PM.

Background

MP is a regional insurance plan that provides protection against variations in operating margins, including revenue and cost measures (see daily farmdoc August 30, 2022 and a more detailed explanation in daily farmdoc, September 8, 2017). Although MP provides a hedge against unexpected declines in operating margins, it is an area plan and the input prices used to calculate the margin are not agricultural prices. For these reasons, MP does not provide margin risk protection at the farm level.

The policy pays based on a change from an expected margin to a harvest margin, with the margin for both being based on revenue minus fixed costs over a specified period for each.

Components of income

The revenue side of the margin calculation includes yield and commodity price components.

Yield is based on county yields published by the United States Department of Agriculture (USDA) Risk Management Agency (RMA). The forecast yield is the same county forecast yield used for area risk protection crop insurance plans and is released in September for the next crop year. Crop yield is calculated by county based on crop insurance records and is released in June following harvest (see Table 1).

Commodity prices are set using the Chicago Mercantile Exchange (CME) December crop year futures contract for corn and the November crop year futures contract for soybeans. For MP 2023 policies, these are the December 2023 corn futures and the November 2023 soybean futures (see Table 1).

Corn – based on CME Corn (ZCZ2) with a contract unit of 5,000 bushels. Over the past 30 trading days, open interest for ZCZ2 has fluctuated between 1.2 million and 1.4 million contracts with daily trading volume ranging from 144,000 to over 453,000 trades. To give a better picture of market liquidity, corn options currently have an open interest of over 500,000 contracts and over 20,000 trades per day over the past 30 trading days.

Soy – based on CME Soybeans (ZSX2) with a contract unit of 5,000 bushels. Over the past 30 trading days, open interest for ZSX2 has ranged between 570,000 and 620,000 contracts with daily trading volume ranging from 97,000 to 225,000 trades. To give a better picture of market liquidity, soybean options currently have an open interest of over 550,000 contracts and over 20,000 trades per day over the past 30 trading days.

Cost components

The cost side includes the input components that are subject to price changes and those that are not subject to price changes. Fixed price inputs that are not subject to price variations for MP are seed, machinery operating costs (in addition to fuel) and similar expenses. Inputs subject to maize price variations are diesel, diammonium phosphate of interest (DAP), urea and potash. Apart from urea, soy has the same set of inputs subject to price changes.

For diesel, DAP and urea input pricing, the CME May crop year futures contract is used. For 2023 MP, this is the May 2023 contract. The forecast price is set using the average value of the futures contract during the price discovery period from August 15 to September 14. For 2023 MP, this is the value of the May 2023 futures contract between August 15 and September 14, 2022. The harvest price is set using the average value of the futures contract in April. For 2023 MP, this is the value of the May 2023 futures contract between April 1 and April 30, 2023 (see Table 1).

For interest rate pricing, the CME November crop year futures contract is used. For 2023 MP, this is the November 2023 contract. The expected price is set during the same price discovery period as the other inputs, but the harvest price is set based on the average value of the futures contract in October. For 2023 MP, this is the value of the November 2023 futures contract between October 1 and October 31, 2023 (see Table 1).

Diesel – based on CME NY Harbor Ultra Low Sulfur Diesel (HOV2) with a 42,000 gallon contract unit. Over the past 30 trading days, open interest for HOV2 has varied between 260,000 and 300,000 contracts with daily trading volume exceeding 100,000. To give a better picture of market liquidity, options currently have open interest of over 17,000 contracts, and daily trading volume ranges from 40 to over 1,100 trades per day over the past 30 trading days.

DPA – based on CME DAP Freight-on-Board New Orleans (DFN) with a contract unit of 100 tons. Over the past 30 trading days, open interest for DFN has ranged between 195 and 270 contracts with trades over just 9 days and the highest volume traded on any of those days at 45. There is no options trading for DAP.

Urea – based on CME Granular Urea Freight-on-Board at US Gulf (UVF) with a contract unit of 100 tons. Over the past 30 days of trading, open interest for UVF has fluctuated between 1,500 and 1,900 contracts, with trades taking place on most days, but not all. On the days traded, the trading volume ranged from 2 to nearly 300. There is no options trading for urea.

Interest – based on CME’s 30-day federal funds (ZQG3). Over the past 30 trading days, open interest in ZQG3 has fluctuated between 1.5 and 2.0 million contracts. Daily trading volume ranged from 100,000 to over 500,000. Although available for trading, options for the 30-Day Federal Fund are virtually unused (open interest is currently 1).

Potash – based on USDA’s Agricultural Marketing Service (AMS). For MP 2023, the MP website is currently using the AMS Cost of Production report value as of 8/11/22, which is $856.50. The price is captured once during the price discovery period. This value is used for both the expected price and the harvest price in the calculation of the PM.

During the price discovery period, the costs are published daily on www.marginprotection.com.

Discussion

While corn and soybean futures were heavily traded, futures were used to set input prices for DAP and urea and were lightly traded (see Figure 1). There are a small number of contract holders and a low volume of transactions. A single move can cause noticeable changes in the market price. Although not a concern, it is possible for a single market player to have a big influence on the price.

Although potash is included as an input subject to price change, the price of potash does not change. The potash price is set once and the value is used for both the forecast price and the harvest price in the MP calculation. For farmers, the price of potash changes throughout the season. For example, for MP 2022 policies, the price was set during the price discovery period from August 15 to September 14, 2021 at $629.10. In April 2022, when the crop price is set for other inputs, the average USDA AMS cost of production value for potash was $861. Although farmers were paying over $200 more per ton, the influence of this impact on farm margins was not factored into the calculation of PM.

Urea is the form of nitrogen used as an input component in PM, but anhydrous ammonia is the form of nitrogen most widely used by farmers for corn and soybeans. Although the prices of urea and anhydrous ammonia have been highly correlated over the past 15 years, there is statistically greater variance in the price of anhydrous ammonia. This means that the price changes that farmers are subject to can be much larger than what MP captures. Using values ​​from the USDA AMS Cost of Production report to provide a comparison, the price of anhydrous ammonia increased approximately 110% between August/September 2021 and April 2022, while the price of urea has increased by about 70% over the same period.

Summary

There are serious constraints on the usefulness of PM for risk management, especially when input prices are volatile, which is probably when farmers are most interested in buying PM. Farmers are advised that the MP is an area plan and is not intended to reflect the situation of an individual farm. But given the way inputs are set, actual farm costs may deviate from the margin changes captured by the PM program. It is important to understand these differences and the implications this could have on margin changes on the cost side of the payout calculation. Despite these differences, MP allows the projected price of the product to be set earlier than other insurances. Farmers may find this option valuable in 2023, as commodity prices during the current price discovery period from August 15 to September 14 are relatively high to price the revenue side of the equation. margin.