June 06, 2023
Cattle Risk Management: Commodity Hedging
Cattle producers face many challenges. Chief among these headwinds is managing financial risk with an objective, measured approach as markets change. Historically, beef cattle producers have been at the mercy of the ebbs and flows of commodity price risks and their fluctuations. Every operation is different, but generally cattle finishers face upside corn and feeder risk and downside fat cattle price exposure. Weather, geopolitical events, inventory levels, trade disputes, and regulatory uncertainty impact both sides of this margin equation. It is now more critical than ever to think about managing risk in the cattle industry through the implementation of a comprehensive margin management policy.
A customized margin management policy typically involves analyzing the financial risk of a business via modeling forward projected costs and revenues by using the futures market as a price discovery mechanism. The futures market power is often described as an unbiased estimate of forward value because it brings together stakeholders in a daily auction in a regulated, organized marketplace. The eventual cash prices paid or received for products tend to be highly correlated with these futures prices, thus the futures market can be used as a benchmark for future expected cash values. Having confidence in the validity of these prices (even though they can and will change between today and expiration) allows market participants to begin the planning, budgeting, and risk management processes.
Evaluating Risk and Opportunity
Every beef cattle operation is unique in their business model, input cost structures, and profitability targets. Stockers and backgrounders vary but generally can rely on the feeder cattle futures contract to inform them on expected revenues down the road. They tend to evaluate profitability relative to a breakeven that involves the purchase price of calves, the cost of feed, and other costs such as vet, debt, and labor expenses. If the price of feeder calves is higher than their breakeven, it could make sense to protect this opportunity via cash or exchange-traded contracts or government-sponsored insurance: LRP insurance and LGM insurance.
Cattle finishers often view the profitability of their business through the lens of a crush equation. Put simply, a finisher’s crush examines sales revenue from live cattle sales less the purchase price of the feeder cattle and the cost of corn. The difference between the expected revenue and costs aids in determining whether profitability levels are worth protecting or not. Because each of these legs of the equation has an active futures contract trading not only for nearby delivery but also for deferred months, the futures market can help inform cattle feeders on the expected profitability of their placements. Once a customized model of the cash flows of a cattle operation is built, potential profitability relative to the producer’s breakeven can be evaluated. It is important for a producer to maintain a disciplined, objective approach to analyzing how good of an opportunity is being presented.
One method to evaluate this decision is to use historical percentiles to understand how the current situation ranks over a historical period. This aids in determining if and how a producer may want to protect these margins. For example, if December live cattle futures are trading at the 90th percentile of the past decade, that implies that the December live cattle contract has traded lower than current levels 90 percent of the time over the past decade and higher 10 percent of the time. As such, the producer may wish to “lock in” this price level by using a fixed price contract. At lower percentiles (when upside opportunity may be perceived to outweigh downside risk), a producer may wish to retain protection against lower prices while maintaining opportunity to higher prices by using more flexible strategies, such as livestock insurance or exchange-traded options.
Similarly, looking at the seasonality of commodity price movements can inform the producer whether there tends to be more opportunity for margin improvement or more risk to margin deterioration. Depending on which leg of the crush margin calculation we are examining, there tends to be seasonal price movements over time due to a variety of factors including stages of the growing season, inventory swings, or high demand periods of the year. While cattle producers face risk at all times of the year, there are periods when that risk to lower cattle prices or higher input costs may be greater than others.
At the end of the day, all beef producers, whether they are a cow/calf operation, backgrounder, or finisher, are running a business. A common ratio to determine the effectiveness and profitability of an endeavor is to look at the return on investment (ROI). Many producers are continually looking to expand or bring additional generations into the fold. No matter the goals of the operation, ROI can be used to set targets to help identify a gameplan and develop a risk management model. If ROI targets are met, it should serve as a trigger to begin implementing coverage according to the agreed upon, customized hedge plan.
Understanding Tools Available
There is a suite of marketing tools at a producer’s disposal to create risk management strategies. It is often prudent to implement a mix of the tools depending on the factors discussed above. When used together, the following tools create a comprehensive risk management approach that provides a competitive advantage, aids in discussions with lenders, and allows the producer to better navigate the market power of inherent volatility involved in commodity markets.
The cash market (market livestock prices) is often the easiest to understand tool and the most widely used wherein the producer can contract with local counterparties to secure feed input costs and/or cattle sales prices in advance of a given marketing period. In addition to possibly protecting price and/or basis risk, cash contracts also allow for physical supply to be secured, which can be advantageous in certain situations. The cash market has traditionally been the preferred method of choice to offset both futures and basis risk. The proliferation of cash market alternatives has offered some beef producers the ability to manage risk through a more proactive approach.
One such alternative to protect forward margin opportunities is to use exchange-traded derivative contracts. Futures and options allow a cattle operation to lock in or protect price levels in a forward period, ahead of realizing actual cash revenues and expenses in that period. The exact mix of protection and opportunity can be tailored to a producer’s personal bias based on the metrics described above. While these contracting alternatives do not address physical delivery or local basis risk, they do offer added flexibility in being able to trade in and out of different structures over time.
Government-sponsored insurance, including Livestock Risk Protection Insurance and Livestock Gross Margin Insurance, is another alternative available to producers to protect forward profit margins. These tools offer their own benefits in being subsidized by the government and are cash-flow friendly, as well as offering potential basis applications that may not be as effectively addressed using exchange-traded derivatives or some cash contracts. Swaps are also another financial risk management alternative that can be an effective addition to the cattle producer’s risk management toolbox under certain scenarios.
Use the Right Strategies for Your Operation
A comprehensive hedge plan using tailored analytics and the entire suite of tools available can offer significant benefits to a cattle operation. With so many moving parts, it is equally as important to have access to a platform to track and manage placements, inputs costs, projected out weights, and gains or losses on positions to have a top-line view of the business. We believe such a strategy allows operators to gain an information edge by removing emotion from the decision making process and to take advantage of profitable opportunities out in time. Customized commodity risk management software and relying on risk management experts to help guide your operation through the inevitable lean times could help secure your operation for future generations.
Please contact us to learn more about how to optimize the use of these valuable risk management strategies and insurance tools as part of a comprehensive risk management plan for your cattle operation.