Futures, contracting alleviate risks
Powell – “Variability in market prices is a cost of doing business, and we’ve got to ask the question, do we want to reduce that variability or not,” states Gary Brewster, agricultural economist at Montana State University. “Variability in market prices is great when it is going up when selling calves but not so great when going downward and selling calves.”
Some price risk management tools that are available to help producers manage their risk and the market price variability are forward contracts, future markets and short hedging.
Brewster mentions that one of the problems with forward contracting is that a producer has to find a willing partner to purchase their crop or calves. When a buyer of a contract walks away, the producer really hasn’t managed for any price risk.
Brewster warns, “Forward contracts are only as good as the partner a producer is working with.”
“It’s really important to think about a sufficient down payment, or earnest money, if a buyer is going to commit to a producer’s production,” adds Brewster. “Producers should have some amount of money to offset the possibility that buyers might walk.”
Brewster continues, “Buyers are most likely to walk away if market prices end up falling, even though that’s exactly what producers are trying to avoid with contracts.”
“With cattle, the price producers receive is not necessarily the stated contract price,” says Brett Crosby, president of Custom Ag Solutions, “especially with feeder cattle and price slides.”
Price slides generally apply to forward contracts when cattle weigh above their stated contract weight. They generally only affect the higher price per pound a buyer has to pay a producer.
As an example, a $10 slide is applied for every 100 pounds the cattle weigh above their contracted weight, resulting in a price reduction of 10 cents per pound of the contracted price.
It is very rare to a have a slide that moves both ways in the market, so with cattle weighing 100 pounds under the contract weight, the buyer will still have to pay the same contract price. The price slide is only implemented when the cattle weigh over the contract weight.
“That is why it is very important that before a producer contracts their calves they have a pretty good estimate of what they are going to weigh,” says Crosby.
Future markets can also be used as a potential way to manage price risk, and Brewster comments that there are ways for producers to transfer their price risk.
“Risk is a commodity and can be traded,” explains Brewster. “Futures markets are a place where people who want more risk can get it from someone who wants less risk. The key is to move risk to someone else and compensate someone for taking that risk.”
Brewster mentions that forward contracts have a lot of similarity to futures market. The difference between them is dealing with standardized contracts with futures market.
Knowing the basis of a commodity can be very important to a producer. The basis is the difference between a specific futures contract price and the local cash price at the time the contract is settled.
The basis of a commodity is never constant and is usually the difference between transportation costs and local market conditions.
“Basis can have movements, but it is not nearly as much as the movement in overall cattle prices,” says Brewster.
The expected cash price is the best-forecasted method for futures prices in the futures market, explains Brewster. It also tells the difference between what the futures market is telling a producer for prices and what prices have been historically.
“No one can predict future price better than the futures market adjusted for its basis,” states Brewster.
For a producer to take part in short hedging and trade futures, they need a margin account with a broker.
Producers have to put some money into that account but not the entire value of their cattle under contract. Typically, 10 percent of the total value of a contract is required for the account.
“Margin accounts ensure that a contract can be settled with cash between a buyer and seller,” says Brewster. “If we didn’t have margins, this would be like giving someone on an unsecure loan and not knowing their name.”
Concerns with hedging are not locking in a sure price because changes in basis can improve or reduce a final price. However, forward contracts don’t lock in a sure price either, but they can reduce a lot of the variability.
“The absolute worst thing producers can do is leave money in their margin account, because so many times when they leave money in their hedge accounts, they are tempted to try and make money with it,” warns Crosby. “When producers make money in their hedge account, they need to tell their broker to write them a check.”
Brewster and Crosby spoke at the Northwest College in Powell for a five part series Comprehensive Marketing Planning. The series is also an archived webinar, which began on Jan. 30 and ended on Feb. 27.
Act of God clause
Sometimes forward contracts have an Act of God clause incorporated into them stating if a weather event or other uncontrollable act affects the production of a crop the producer is forgiven for the contract and does not have to purchase the required amount of commodity to fulfill the contract.
For some commodities, like spring wheat, an Act of God clause doesn’t work mainly because similar varieties of the crop can be found readily in the area, and the producer will have to purchase the crop to fulfill their contract or pay their way out of the contract.
Brett Crosby, president of Custom Ag Solutions, mentions, producers understand if a buyer sorts off some of the producer’s animals and doesn’t buy them as part of the forward contract.
However, when the market price is higher than the contracted price, buyers are typically going to purchase every animal a producer has under contract, and when the price is lower than the contracted price, the buyer is going to become very picky.
The animals with frozen ears are the most susceptible of being cut out of the herd, due to the probability of their feet being frozen, as well, when they were young. Calves that had frozen feet have a high probability of foundering in the feedlot and/or breaking down when a lot of weight is put on them.
Crosby mentions that if a producer has some cutbacks made to their herd, they can take those cutbacks and either run them on grass or feed them out themselves.
“When those cutback cattle are on the kill floor, the slaughter plant doesn’t care if they had both ears or not or if their tail was frozen off,” stated Crosby. “It’s implicated a buyer can pick and choose which cattle they want and if they want to deal with defects of the cattle.”
“No one has ever gone broke making a profit. That’s an important thing to keep in mind,” commented Montana State University Agriculture Economist Gary Brewster.