Cattle Risk Management

1
Cattle Risk Management

• GEOFF BENSON, PhD
• Extension Economist
• Dept of Agricultural and Resource Economics
• North Carolina State University

2
Agenda

• Introduction
• Price forecasting
• Price risk management
• Hedging with cattle futures
• USDA-RMA LRP Program
• Cattle futures options
• Setting price targets pulling the trigger
• Summary

3
Risk

• RISK -- the chance of loss or an unfavorable
  outcome or event
• Anticipated or unexpected
• Known probability or uncertain
• RISK EXPOSURE -- The amount of a loss, if it
  occurs
• The financial consequences for the business cash
  flow, profit, solvency

4
Sources of Risk

• Weather other natural phenomena
• Local variation in rain, temperature, etc.
• Regional, national, global weather
• Extreme (tornadoes, hurricanes, floods, etc.)
• Technology and competitiveness
• Changes in your customers ability or willingness
  to buy your product
• Societies attitudes preferences
• Government and other institutions rule changes
• Individual human behavior
• Random accidents

5
Managing Risk

• What are the most important risks your farm
  business is exposed to?
• How vulnerable is your farm business to these
  risks (exposure)?
• What cost-effective strategies are available to
  manage price risk?
• What is your attitude to risk?
• Do you have the time, knowledge and risk
  management skills?

6
Risk Management

• Management strategies include
• Reducing the chance of an event
• The management ability, knowledge and
  effectiveness of the producer is the key
• Reducing the impact if an event occurs
• Buying insurance
• Self-insurance, which comes in many forms
  including carrying inventories, diversification,
  maintaining financial reserves, borrowing,
  off-farm income

7
CostBenefit

• All risk management strategies involve costs, in
  money or time
• Effectiveness varies among alternatives
• Financial benefits costs
• Time, new knowledge and skills
• Evaluate trade-offs

8
Agenda

• Introduction?
• Price forecasting
• Price risk management
• Hedging with cattle futures
• USDA-RMA LRP Program
• Cattle futures options
• Setting price targets pulling the trigger
• Summary

9
Price Forecasting

• Helpful for making marketing and business
  decisions
• The futures market provides an industry consensus
  on prices as far as one year out
• Takes account of known information
• Changes daily as new information becomes
  available

10
Cattle Futures

• The CME Group trades two types of cattle futures
  data at www.cmegroup.com
• Live (or finished or fat) cattle futures --
  40,000 pound lots of 55 Choice, 45 Select,
  Yield Grade 3 steers, physically delivered Feb,
  Apr, Jun, Aug, Oct, Dec.
• Feeder cattle futures are for 50,000 pound lots
  of 650-849 pound LM 12 steers, cash settled
  Jan, Mar, Apr, May, Aug, Sept, Oct, Nov.

11
Price Forecasting

• Use nearby futures contract price for intended
  sale month
• BUT
• This is not the NC price
• Basis futures price local cash market price
  for similar cattle
• If basis is predictable, then we can use the
  futures market to project local North Carolina
  prices and use this to make business decisions

12
Price Forecasting, cont.

• The cattle futures contract may not match the
  cattle you have to sell need to adjust the
  futures price
• What market premiums discounts affect the value
  of your cattle?
• Weight
• Sex
• Frame
• Muscle
• Breed
• Other, e.g., market channel, truckload

13
Price Worksheet
14
Feeder Cattle Futures, /100 lb, 3/26/09
15
Historic Basis

• The most useful comparison is the published NC
  weekly auction (cash or spot) prices for a
  particular week or month relative to the cattle
  futures price for the nearby month
• Note
• NC Auction prices are reported weekly in 50 or
  100 lb./head increments for small lots
• CME feeder cattle futures contract is for 650-849
  lb. ML12 steers in truckload lots
• Contract months are Jan, Mar, Apr, May, Aug,
  Sept, Oct, Nov.

16
NC Basis, Avg. 1990-2000
17
NC Basis, 1990-2000

• Negative (transportation cost)
• Varies by market, west to east
• Seasonal
• Smaller discount in spring, high demand for
  cattle for summer grazing
• Larger negative differences in fall as cattle are
  sold as grass runs out
• Historic data on line at
• http//www2.ncsu.edu/unity/lockers/
• project/arepublication/AREno32.pdf

18
Quality Differences

• What are the characteristics of your cattle and
  how do they affect the price (value)?
• Weight
• Sex
• Frame
• Muscle
• Breed
• Other, e.g., market channel, truckload

19
Price Differences, NC Graded Sales, M1 Steers,
1991-2001
.
20
Price Differences, Graded Sales, M1 Heifers v.
Steers, 1990-2001
21
Price Differences, Graded Sales, 500-599 lb.
Steers, 1990-2001
22
Selected Breeds

• Angus
• Braford
• Brahman
• Brangus
• Braunveih
• Charolais
• Chianina
• Devon
• Galloway
• Gelbveih

• Hereford
• Holstein (dairy)
• Jersey (dairy)
• Limousin
• Longhorn
• Maine Anjou
• Nellore
• Piedmontese
• Pinzgaur
• Polled Hereford

• Red Poll
• Sahiwal
• Salers
• Santa Gertrudis
• Shorthorn (dual)
• Simmental
• South Devon
• Tarentais
• Zebu
• Crosses
• Composites

23
Price Differences, Graded Sales, 500-599 lb. M1
Steers, 1991-2001
24
Marketing Options

• Regular auction Base
• Graded sale
• Special programs, e.g., Southeast Pride,
  pre-conditioned sales
• Direct farm sale (several options)
• Retained ownership

25
Marketing Options

• Farm situation determines opportunities and cost
• Size of herd
• Number of cattle for sale
• Uniformity of cattle
• Market Premium offered
• Marketing Cost
• Risk

26
Price Worksheet
27
QUESTIONS OR COMMENTS ON PRICE FORECASTING?
28
Hedging Price Risk

• Basics of futures options
• Hedging with futures examples
• USDAs Livestock Risk Protection (LRP) Program
• Hedging with Options
• Is hedging for you?
• How much do you have at risk?
• Risk management strategies

29
Futures Contracts

• Sell a Feeder Cattle contract for a specific
  month at a specific price -- Locks in a price!
• Off-set your position in the futures market
• By letting the contract expire
• By buying back an identical contract (at or near
  the expiry date)
• At the expiry date the futures price the cash
  market (spot) price

30
Futures Contracts

• Set up a trading account with a brokerage
• Pay a small commission to the broker for the
  transaction
• You may get margin calls to ensure you can cover
  your position -- Deposit cash in your trading
  account when the futures price moves above the
  price you locked in

31
Hedging Example 1
32
Hedging Example 2, Part 1
33
Hedging Ex 2, Part 2
34
Hedging Example 3
35
USDAs LRP Program

• Price risk insurance, pay a premium
• Can cover each year up to
• 2,000 head of feeder cattle of up to 900 lb.
  two weight categories, steers or heifers, 3
  breeds Brahman, Dairy, all other
• 4,000 head of 1,000 to 1,400 lb fed cattle
• Coverage can range from 70 to 100 of estimated
  ending value
• More flexible and more direct pricing than
  hedging with futures

36
Example 1, Nash Co, 3/30/09
37
Example 2, Nash Co, 3/30/09
38
Information on LRP

• Fact Sheets are available on line at
  http//www.rma.usda.gov/livestock/
• Examples of contracts are at http//www3.rma.usda.
  gov/apps/livestock_reports/main.aspx
• A premium calculator is available at
  http//www.rma.usda.gov/tools/premcalc.html
• A list of LRP insurance providers is at
  http//www3.rma.usda.gov/tools/agents/companies/20
  08/north_carolinaLPI.cfm. All are from
  out-of-state

39
Options

• The right (but not the obligation) to buy or sell
  a futures contract.
• Puts a floor under the price but not a ceiling
  you get the upside
• A put right to sell allows the producer to
  hedge
• A call right to buy allows the buyer (e.g.,
  the feedlot operator) to hedge

40
Options

• An option is for a specific futures contract and
  a specific price
• The agreed upon futures contract price is called
  the strike price
• The cost of an option is called a premium
• Premiums are established by public outcry pit
  trading and by electronic trading, similar to the
  way futures prices are established

41
Options

• There is a range of strike prices for each
  futures contract
• Premiums have 2 components
• Time value -- pay more for options on far off
  contracts, shrinks as the expiry date approaches
• Intrinsic value -- related to the relationship
  between the strike and current price of the
  futures contract

42
Options

• In-the-money -- Underlying futures price is
  favorable compared to the strike price
• Out-of-the-money -- Futures price is unfavorable
  vs. strike price
• At the money
• Options automatically settle for cash at the time
  the underlying futures contract expires

43
Feeder Cattle Options Premiums, May Contract,
/cwt., 3/25/09
No brokers fee or cost of margin calls included
44
QUESTIONS OR COMMENTS ON HEDGING?
45
Is Hedging for You?

• Things to consider
• Size of your cattle operation
• Financial importance of your cattle operation
• Ability to handle price risk
• Attitude to risk expectations about hedging

46
Farm Structure, 2007 Census
47
Why Do You Have Cattle?
OR
FUN OR MONEY?
48
Hedging

• It is not for everyone
• Very small producers
• Busy producers
• Producers for whom beef cattle are a sideline
• All risk management strategies involve costs and
  effectiveness varies among alternatives
• Financial benefits costs
• Time, new knowledge and skills
• Evaluate trade-offs in your situation

49
Hedging

• How much do you have at risk?
• Number of head
• Possible change in price
• Total financial losses
• Impact of those losses on farm and family
  finances
• Example,
• I truckload of feeder cattle 50,000 pounds (65
  head)
• A 10 per cwt. price drop - 5,000

50
Price Risk Management Strategies

• Ride it out self-insure
• Draw on savings or borrow
• Restructure debt payments
• Adjust expenses, especially maintenance new
  investments
• Add off-farm income or cut family living expenses
• Prevent unacceptably low prices with futures
  contracts, options, LRP buy insurance

51
Hedging

• Attitude Expectations
• Futures, options LRP are tools to manage
  downside price risk and prevent or moderate the
  financial problems lower prices would cause
• It is unrealistic to expect that using futures
  and options will increase your average or long
  run profit but using them may help keep you in
  business!
• Using them may help you sleep better!

52
Attitude to Risk

• Attitude to risk affects an individuals decision
  in a given risk situation
• Are you risk averse?
• Willing pay to reduce risk (insurance)
• Willing to accept a somewhat lower expected
  profit to avoid downside risk
• Are you a risk preferer NOT willing to pay
  for risk reduction and possibly accept lower
  average profit

53
Setting Hedging Price Targets

• A minimum profit
• Full cost of production margin
• Break even
• Cash flow protection
• Stocker purchase price
• or - debt service
• or - cash production costs
• or - for family living

54
Do you know your cost of production profit
margin?

• Operating cost - Out of pocket expenses, e.g.
  forage, other feed, fertilizer, vet, repairs,
• Investment (fixed) costsDepreciation, interest,
  property taxes insurance (DITI)
• Opportunity cost charge for your time and
  equity capital invested

55
MN Cow-calf Cost Returns, 2007
Source MN Farm Business Management database
55
56
MN Stocker Cost Returns, 2007
Source MN Farm Business Management database
57
NCSU beef forage budgets

• Beef cow-calf, backgrounding, summer grazing,
  pasture finishing, conventional finishing,
  pre-conditioning
• Forages perennials, annuals, hay making, silages
  
• Available on line at
• http//www.ag-econ.ncsu.edu/
  extension/Ag_budgets.html

58
Costs in the Budgets

• Operating inputs -- fuel, fertilizer, chemicals,
  labor, seed, interest
• Fixed costs -- depreciation, interest, taxes,
  insurance on machinery and buildings
• Full labor and interest costs and charges
• Forage budgets
• Do not include storage, feeding or pasture
  management costs
• Some include harvesting costs
• Include yield estimates and unit costs
• NO farm overhead cost
• NO land charges

59
Cash Flow

• Budgets include full economic costs
• For cash flow price targets, evaluate the revenue
  needed to cover
• Out of pocket production expenses, including
  cattle purchases
• or - Debt payments
• or - Family living
• Remember, the purpose is to lock in or set a
  floor price at an acceptable level to insure
  against a financial disaster

60
Pulling the Trigger

• Futures price volatility means pricing
  opportunities come and go
• Futures prices respond to
• Market fundamentals, so track key economic
  factors and understand their impact on prices
• Supply factors
• Demand factors
• Technical trading driven by market psychology, so
  following price moves and interpreting trading
  patterns can help

61
Demand Supply Factors

• Consumer Demand
• General economy income, unemployment, exchange
  rates
• Competition from other meats
• Demographic changes age, race, pop.
• Supply
• Availability of cattle stage of cycle
• Feedlot costs
• Transportation costs
• Trade

62
.
63
Cattle cycles

• Low prices force liquidation of breeding stock,
  adding to beef supplies and reducing prices
  further
• Reduced production leads to higher prices
  encouraging heifer retention for breeding,
  reducing beef supplies and raising prices further
  
• Lags
• Decision making takes time
• 15 months to raise a heifer to breeding age
• Seasonality in breeding 9-month gestation
• 14-18 month production period

64
Beef Product Flows

• CONSUMER

RETAILER
WHOLESALER
PROCESSOR
FEEDLOT
PACKER
STOCKER
COW-CALF
65
Price Volatility

• Unexpected changes in significant supply demand
  factors
• Known unknowns
• Weather
• Crop prices feed costs
• Forage supplies quality
• Cattle supplies
• Unknown unknowns
• Disease outbreaks, e.g., BSE
• Economic crises

66
Feeder Cattle October Contract Price History
67
Hedging

• Takes time to learn to follow market conditions
• Marketing club?
• Paper trading
• Finding a market adviser and/or broker you trust
• Takes confidence to learn when to pull the
  trigger

68
Summary

• All producers can use futures and other price
  information to project prices for their cattle as
  part of marketing and business decisions
• Benefits of hedging
• Protecting yourself from unfavorable price
  movements that would cause you serious financial
  problems
• For the seller -- protection from price drops
• For the buyer protection from price increases

69
Summary

• Several factors affect profits
• For cow-calf
• Prices premiums related to selling weight,
  frame, breed/color, season, choice of market etc.
• Animal performance
• Cost of production
• Base hedging decisions on feeder cattle futures
  prices, adjusted for basis, weight, other cattle
  characteristics, and market choice

70
Summary

• For Stockers, key factors
• Purchase price
• Selling price
• Feed costs
• Average daily gain change in body condition
• Use feeder cattle futures prices as the basis for
  profit projections
• Base hedging decisions on feeder cattle futures
  prices, adjusted for basis, weight, other cattle
  characteristics, and market choice

71
Summary

• Price risk management tools include futures,
  options and LRP
• Set price targets based on your own cost of
  production or cash flow needs
• Track market conditions to time your actions
• Producers need good financial records to set
  price targets, and monitor performance, costs
  profit margins
• No imple or eay anwer!!

72

• If its easy, fun or can be done from the seat
  of a tractor, there aint no money in it
• Anonymous Cowboy

73
What Next?

• What more assistance do you want or need, if any?
  
• Topics
• Price forecasting
• Hedging with futures
• USDAs Livestock Risk Protection Program
• How would you like this help delivered?
• One-on-one with an adviser broker
• Group meetings
• Materials, publications, etc.

74
Geoff Benson

• Phone [phone]
• Fax [phone]
• E-mail geoff_benson_at_ncsu.edu
• Web page
• http//www.ag-econ.ncsu.edu/ faculty/benson/bens
  on.html