Feeder cattle Managing marketing risk
“Do you have the opportunity to capture the higher feeder cattle prices seen in May or July versus those seen November?” asks Dillon Feuz of Utah State University. “The answer is that if you don’t separate your pricing and delivery decisions on feeder cattle, then you don’t have that opportunity. You have a one-time deal of weaning and selling, and take the price at that time.
“But, if you consider separating when you price your calves versus when you might wean and deliver them, then you can consider pricing alternatives,” explains Feuz.
He suggests looking at forward contracts, hedging and/or put options or Livestock Risk Protection (LRP) Insurance as additional marketing options on feeder cattle.
“If we stay in the cash market, we are subject to the whole range of price risk, and the uncertainty of not knowing where prices will go,” notes Feuz. “However, I can lock in a forward contract, based off a video auction, or by going directly to a feedlot and writing one.”
He explains that a forward contract is a legal agreement between a buyer and seller, and is a way to separate calf pricing and delivery decisions. Ranchers can use forward contracts to price calves in July, then wean and deliver them in October. He can also utilize this method to purchase inputs, such as hay, at a specific price. Such a contract on inputs would protect the producer from higher prices, but in the case prices fall, the producer is still required to pay the contracted price.
“With a forward contract on cattle, we have essentially eliminated any downside risk. But, we have also removed ourselves from taking those higher prices in the cash market. That forward contract will likely end up a little below the cash price, because if someone is taking that risk away from you, on average they’re probably going to make you pay a little to assume that risk. You have to decide if that slightly lower price, with less associated risk, will work for you,” notes Feuz.
“While forward contracts eliminate market risk, they do nothing to protect against production risk, and producers are required to deliver the agreed upon commodity, in the agreed upon condition, on a specific date. It’s important to consider production related risks when drawing up forward contracts to ensure the producer can meet all terms of the contract,” adds Feuz.
“A futures hedge is essentially the same as forward contracting, only we have basis risk associated with a hedge,” explains Feuz. “A producer would purchase a commodity futures contract, and by doing so is obligated to purchase the contract amount of the input commodity at the expiration date of the contract. Before the contract expires and purchase is required, the rancher would resell the contract and purchase the input commodity on the cash market. If input prices had risen over the course of the contract, the producer would pay a higher price for his inputs on the cash market, but would also receive a higher price on his futures contract that would largely offset his increased input costs.”
“We end up getting our cash price relative to the market, and that will vary from year to year. But, we typically find that the variability between a local, cash price, and the futures price is much less than overall market price variability,” adds Feuz.
The third option, LRP insurance, which is very similar to buying a put option, is another way to put a base floor price on feeder cattle.
“LRP insurance tries to take advantage of both forward contracting and hedging. It creates a floor, and eliminates the downside of the market. Producers can choose the number of head they want to insure, and are not locked into a fixed contract size.
“However, you’re never going to get that high price. LRP insurance eliminates the downside, and in some cases allows you to still take advantage of most of the upside. It’s something to think about, depending on where the market is. Sometimes the floor gets fairly low, at which point an LRP may not be very attractive. But, if you can get that floor set up in the mid-range of the market, then it become a more attractive alternative,” says Feuz.
He adds that when dealing with feeder marketing options, futures and contracts are based on 650 to 800 weight calves, and the lighter the calves are, the wilder the base can get.
“When you move away from that target weight range, things outside the live cattle and corn markets will have even more influence on feeder prices, and result in a much wilder basis,” says Feuz.
“When markets stay where they’re expected and are somewhere in the middle of the range, all three options are fairly equal. If the market takes off and goes higher, we would be best off in the cash market. But, if it goes lower, then we would be best to take advantage of a forward contract or hedge. The LRP option is never the best alternative, but perhaps being consistently second in all cases may be better than being first or worst in any given scenario, as the first two often are,” notes Feuz.