June 15, 2023
Swine Margin Management
Swine producers have historically focused on managing the risk of profitability through a price-centric approach. In this way, margin deterioration through eroding sales values on hog prices or input price increases from rising feed costs were treated independent from one another and managed separately. While there is not necessarily anything wrong with this approach and the price movements for both hogs and feed prices like corn and soybean meal are generally separate, there is a different way of thinking about managing profitability risk in commodity hedging.
Hog margin management is the process of analyzing financial risk from the perspective of an overall profit margin approach, considering costs and revenues together as a single unit of risk. A margin management process involves modeling forward projected costs and revenues using the futures market as a price discovery mechanism. The futures market is an unbiased estimate of forward value based on a dynamic, daily auction of buyers and sellers discovering hog price and feed price on an organized, regulated exchange of futures contracts. Because there is a strong correlation between futures prices and the cash prices swine producers pay and receive for their feed and hogs, the futures market can effectively be used to discover forward margins through futures contracts.
Building a Risk Management Strategy
Building an accurate representation of a swine producer’s operation by accounting for all costs and revenues is the first step in being able to estimate future profitability using swine margin management. Corn and soybean meal would be the main input costs of producing hogs, along with other feed and non-feed expenses. While there is a strong correlation between cash corn and soybean meal prices with corresponding futures values, the other feed and non-feed expenses do not correlate with a futures price, and thus certain fixed estimated values for these would need to be assumed in the model. On the revenue side, the hog futures market can be used to estimate forward hog sale prices for the swine operation’s hog margin management.
Holding certain fixed cost assumptions static and using futures market prices to represent both input costs and revenue values together, forward profit margin opportunities can be identified in deferred time periods to indicate how profitability is projected to change from one period to the next. This is beneficial by itself in providing greater visibility to a swine producer on how the market projects forward profitability. In addition to this though, because the futures market also provides a risk transfer function, a swine producer can contract both input costs and revenue values simultaneously using exchange-traded derivatives to lock-in or protect a profit margin level in a forward time period.
This can significantly add value to an operation by improving planning and budgeting, assisting with lender discussions, and smoothing out volatility in returns over time. Moreover, it may sometimes be the case that a projected forward profit margin opportunity identified in advance may turn into an actual loss in the spot marketing period as market conditions change over time. In other words, should input costs increase from what is projected today and/or revenue values decline it may be beneficial to capture or protect the opportunity in advance.
Once an accurate model of the swine operation is built, the next step would be to evaluate the forward profit margins being represented to determine whether the operation is projecting a profit or a loss in any given period. Assuming the model is projecting a profitable margin opportunity, the producer would want to know how good of an opportunity is being presented. One way to objectively determine the opportunity is to rank the projected margin over a historical period, comparing that profit margin to previous profit margin opportunities in that same period of the calendar year. For example, if one was evaluating a forward profit margin opportunity in upcoming Q4, they could compare that projected margin to the previous ten Q4’s to rank that opportunity within the context of the past decade.
Where this objectivity becomes powerful is in helping to guide contracting decisions to protect margin opportunities. As an example, if the current projection for forward margin ranks in the 90th percentile of historical profitability, that means that only 10% of the time have historical margins for that period been better than what is being projected today. It also suggests that there is a much higher probability of the margin deteriorating over time moving into that marketing period than for a further improvement. If by contrast the margin projection ranks at the 50th percentile of historical profitability, that means it’s about a coin flip as to whether the margin will be stronger or weaker once we get into that marketing period.
The previous two examples suggest much different approaches to commodity price risk management, which may not be as obvious with a more traditional price-centric approach. With a 90th percentile margin opportunity, a swine producer might be more inclined to secure their profitability with contracting choices that offer a higher degree of protection against potential margin deterioration. They may also choose to execute these strategies on a larger share of their production for that period. By contrast, if the margin opportunity ranks at only the 50th percentile of historical profitability, the producer may choose a more flexible approach to managing their risk on less production if they choose to do anything at all.
There are a variety of different marketing tools at a producer’s disposal to manage profit margin opportunities. The cash market is one outlet where the swine operation can contract with local counterparties to secure feed input costs, and/or hog sales prices in advance of a given marketing period. In addition to protecting price risk, these alternatives also allow for physical supply to be secured which can be an important consideration in certain situations. They may also address local basis risk if a delivered price can be established in advance.
Another alternative to protect feed input costs and hog sales revenue around forward margin opportunities is to use exchange-traded derivative contracts. Futures and options allow a swine operation to lock in or protect price levels in a forward period, ahead of realizing actual cash revenues and expenses in that period. 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 (LRP Insurance) and Livestock Gross Margin Insurance (LGM Insurance), is another alternative available to swine 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 cash contracts. Swaps are also another financial risk management alternative that can be an effective addition to the swine producer’s risk management toolbox under certain scenarios.
Swine margin management may offer significant benefits to a swine operation in helping to create an objective way to evaluate risk and navigate the various contracting tools available in the marketplace today. Learning more about this approach with a commodity price risk consulting service could be well worth the time invested to manage your operation’s profitability and help secure it for future generations of hog margin management.