Optimize Your Capital

For most agriculture producers, capital is an asset in limited supply. Hedging strategies, such as trading futures and options, require maintaining performance bonds, and these positions can become quite capital intensive. Moreover, longer-term positions can tie up capital for an extended period of time. Even strategies that are less capital intensive require producers to deposit and maintain funds in a brokerage account until the positions are closed out and converted to purchases and sales in the local cash market. That’s why successful, competitive agriculture operations make it a priority to ensure they are using their capital efficiently. With that in mind, we examine how producers can optimize their capital and take these considerations into account as part of their risk management plans.

Consider Your Credit Choices
Some producers may avoid futures and options altogether out of fear that margin calls could drain capital reserves, relying exclusively on the cash market for their risk management. But the futures and options market offers valuable tools for capturing attractive forward margins, and most lenders are willing to extend capital to fund a client’s hedging activities, particularly when they know it is part of a thoughtful plan aimed at securing an operation’s profitability. In some cases, these lines of credit can be in addition to – and distinct from – operational lines of credit, so they don’t inhibit the operation’s ability to address basic expenses like salaries and input costs.

But regardless of how your credit lines are structured, if you rely on a lender to gain access to the liquidity you need to fund your hedging activities, it is important that both of you understand the impact of those hedges on your net profitability. For example, a beef producer might be short on cattle in the futures market, while simultaneously long on corn as a way to secure an attractive feeding margin. As a borrower, you should be able to demonstrate to your lender the value of those positions as the market moves, by connecting them to the resulting change in your projected forward margins relative to the open market.

Make the Connection to Hedge Value
We can illustrate this connection by looking at hypothetical scenarios using a capital stress testing tool, such as CIH’s capital monitor. Figure 1 shows a hypothetical cattle feedyard that has a 10,000 head annual, one-time capacity. They are projecting and actively managing profit margins for their current on-feed inventory as well as forward crush opportunities. About 47% of their risk exposure is currently offset through hedge strategies made up of a combination of futures and options positions. The operation currently has $549,849 of capital tied up in performance bond requirements.

Figure 1
Fig1_Original_position_for_web

As the market moves over time, the projected profitability, as well as performance bond requirements, will change. Let’s say cattle prices rise 10% across all contracts that are currently hedged. This scenario is illustrated in Figure 2. While the cattle inventory value increases by $1,351,760, the value of the open hedges drops $686,757 so the net improvement is only $665,003. At the same time, the performance bond requirement increases by $1,140,315 to $1,690,164.

Figure 2

Fig2_Up10_for_web

If prices remain at current levels, the feedyard will secure $665,003 of additional value on cattle inventory over the following year. Although the hedge position loses value as cattle prices rise, the operation participates in 49% of those increases. This improvement can be seen by measuring the change in the total profit/loss, which increased by $665,003 as the inventory profit/loss rose by $1,351,760.

But, of course, price changes can go either way. Figure 3 illustrates the scenario where cattle prices go down 10%. In this case, the short cattle hedge position gains in value by $622,913, and performance bond requirements also go down, resulting in a $470,812 surplus in the brokerage account. However, the inventory value deteriorates by $1,351,760 as 51% of the total cattle inventory was unhedged and exposed to the lower prices.

Figure 3
Fig3_Down10_for_web

As the market moves, a lot of capital can be tied up in unrealized hedge losses and performance bond requirements. But producers can mitigate the cost of capital while still protecting margins. For example let’s look again at the scenario shown in figure 2 where cattle prices increase 10%, and the position became capital intensive. The feedyard could have purchased call options against some of the upside exposure on the short cattle futures.

Figure 4 illustrates this adjustment. Comparing the performance bond requirements and profit/loss figures to those of Figure 2, we see that while the cattle position will still lose money from the higher open market prices, the loss with the calls is smaller than without. $407,055 of negative equity accrues to the adjusted position value compared to the loss of $686,757 without the purchase of the calls. Also, because the purchased call options offset much of the risk on the short futures positions, the added performance bond requirement is significantly smaller: $493,461 versus $1,140,315.

Figure 4
Fig4_with_adj_for_web

Consider Alternative Contracts
Some producers may not be comfortable with the performance bond exposure on hedging positions, or would rather allocate their limited capital elsewhere – such as investing in upgrades to their facilities or expanding their operations. These producers might want to consider forward contracts with packers or swap contracts with a financial intermediary, which might allow them to protect profitable margins without tying up capital. By contracting directly with a counterparty, the feedyard doesn’t need to address performance bond requirements to initiate the contracts or maintain capital in an account to address daily settlement procedures as prices fluctuate.

While these contracting methods can free up capital to allocate elsewhere, they are not without other costs and risks. Forward contracts with a packer make the cattle feeder captive to that packer’s basis upon delivery, which may or may not be competitive with other alternatives in their local market. Swap contracts typically cost more to execute than similar strategies on the exchange through the feedyard’s own brokerage account. Also, depending on the intermediary, there might be additional costs or limits on adjustments that can be made to an initial strategy at a later date. Moreover, with either forward contracts or swaps, there is a counterparty risk associated with the single settlement procedure upon delivery or expiration.
Despite their limitations, swaps and forward contracts can be valuable contracting tools, especially when used in conjunction with exchange-traded alternatives to create a more flexible strategy. As an example, a feedyard might lock in a sale through a forward contract or swap agreement, and subsequently add price flexibility by purchasing call options in his own brokerage account. In this way, he need allocate only a limited amount of capital to address the opportunity cost of higher prices in a rising market.

Weigh All the Factors
As with any hedging strategy, there’s no one right way to allocate your capital. Determining the best solution for your needs will be a function of your operation’s margins and debt level, as well as a number of other considerations. But being able to quantify the impact of hedges on net forward margins can help facilitate communication with your lender and is a critical part of an effective risk management strategy.

If you have questions or would like more information about how to use your hedging capital most efficiently, please contact CIH at 1.866.299.9333.

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