Managing Price Risk
This is the fourth of five installments of the Marketing 101 series based on the university bulletin “Livestock Marketing and Risk Management.”
In this installment, we will look at utilizing marketing strategies to manage price risk. Regardless of the marketing method chosen by producers, there are opportunities for risk management strategies.
Cash sales are not often thought of as a risk management tool. However, there are some opportunities within cash sales to reduce risk.
One way to mitigate risk in the cash market is to be in the market often. By selling livestock at multiple times of the year producers may reduce some of the effects of seasonality in cash sales. This may also mitigate the risk of selling in a “bad market.”
On a practical level, a ranch may choose to market a portion of its calves in different time frames by utilizing production practices in a combination, such as early weaning, overwintering and summer yearling programs. Through utilization of multiple productions practices as mentioned, producers will be marketing calves multiple times throughout the year and utilizing multiple weight categories.
This spreading out of marketing over time and market class is a form of diversification that can reduce risk. Essentially, you are not “putting all your eggs in one basket,” or perhaps it would be better said that you are not putting all your calves in one market.
Often when it comes to price risk management, many producers will opt to arrange a forward contract with a buyer. Producers contract to provide the livestock at a future date at a certain average weight. The buyer agrees to accept delivery at that date, and a price is agreed upon at the time of the contract.
There are many forward contracts still agreed to with only a handshake between the two parties. Provided the market does not move drastically higher or lower and provided the livestock meet the agreed upon specifications, there are usually no problems with these handshake agreements. However, in the case of drastic market moves or livestock that end up being considerably different than what was agreed to, a written contract with specifications on remedies for breach of contract can help avoid costly litigation.
Most sales on satellite video auctions and many internet sales are actually forward contracts. Frequently the pricing transactions take place one to four months in advance of when the livestock will be delivered. Generally, these forward contracts are written, and often the video or internet auction company acts as a third party to help insure that the principal parties to the contract fulfill their obligations.
Futures and options markets
Sometimes you want to forward contract your cattle, but you can’t find anyone willing to write you a contract. Or perhaps you want to leave your livestock marketing decisions more open, but would still like to have some form of price protection.
There is a feeder cattle futures market that you can use to establish an expected price for your cattle. This is similar to forward contracting but also very different. Producers can establish a price prior to delivery by using the Chicago Mercantile Exchange (CME) feeder cattle futures.
A producer can hedge their calves by selling an October or November feeder cattle contract earlier in the spring or summer. Then, when the calves are sold at weaning in the local market, the producer buys back the October or November feeder cattle contract. If the market has declined from the time of the initial futures market sale, then the producer will make a positive return in the futures market. This will offset the lower cash price received.
However, as with a forward contract, producers cannot take advantage of higher prices. If prices increase after the initial sale of the October or November feeder cattle futures, then when the producer buys the contract back, they lose money in the futures market. This offsets the higher price received in the cash market and producers are left with about the same return regardless of whether the market moves higher or lower after the initial futures sale.
Hedging is designed to minimize price risk. It is not a method to consistently receive a higher price.
Historically, most cow/calf producers have not used the CME feeder cattle futures or options to hedge the sale price of their calves. University Extension specialists have conducted numerous workshops over many years to educate producers on the use of futures and options, and yet only a small percentage of producers use these risk management tools.
One explanation has always been that the feeder cattle contract specifications do not fit a weaned calf and that the basis variability for this cross hedge may be too large for an effective hedge.
Another reason is the fixed contract size – 50,000 pounds – does not work well for smaller producers.
In 2002 the USDA-Risk Management Agency (USDA-RMA) introduced Livestock Risk Protection (LRP) insurance for feeder cattle. It is now available in 37 states, including all of the largest cow/calf producing states.
This insurance product is very similar to purchasing a put option on feeder cattle futures in that a minimum price is established. If prices fall below this level, then an insurance indemnity is paid out to the producer. If the market is higher than the insured price, then the producer is out the insurance premium but receives the higher market price.
However, producers can insure as few as one head if they desire, thus overcoming the size of contract issue with the CME feeder cattle contract.
There is no one pricing strategy that will return the highest price every year. Nor is there one pricing strategy that is right for each producer. However, if producers know their cost of producing a calf and evaluate the various pricing alternatives, the “best” alternative can be selected for a particular year and situation. What is “best” for producers depends upon how much risk they are willing to tolerate and their overall financial position.
In the last article in this series, we will look at historical returns to alternative pricing and risk management. Remember if you are interested in looking at the full bulletin, go to uwyoextension.org/ranchtools then click on “Fact Sheets” and selecting “Livestock Marketing.”