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
ITEM
FUTURES PRICE, SALE MONTH
Basis
Weight adjustment ( or -)
Sex (heifer) adjustment ( or -)
Frame adjustment , if not M or L (-)
Muscling, if not 1 or 2 (-)
Breed or color adjustment ( or -)
Other, e.g., special sale, lot size ( or -)
Estimated price for your cattle
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
ITEM
FUTURES PRICE, SALE MONTH
Basis
Weight adjustment ( or -)
Sex (heifer) adjustment ( or -)
Frame adjustment , if not M or L (-)
Muscling, if not 1 or 2 (-)
Breed or color adjustment ( or -)
Other, e.g., special sale, lot size ( or -)
Estimated price for your cattle
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
Item Market Falls Market Rises
1.Sell an October contract in April 100 100
2.Future price in Oct 85 110
3. Your Gain or Loss 15 -10
4.Cash Price in Oct 85 110
5.Net Proceeds 100 100
32
Hedging Example 2, Part 1
Item Market Falls Market Rises
1. Sell October contract in April 100 100
2. Local basis -5 -5
3. Expected local cash price 95 95
33
Hedging Ex 2, Part 2
Item Market Falls Market Rises
5. Future price in Oct 85 110
6. Gain or Loss 15 -10
7. NC Oct Cash Price 80 105
8.Net Proceeds 95 95
9. Actual Basis 5 5
34
Hedging Example 3
Item Market Falls Market Rises
Sold Oct. futures 100 100
5.Future price in Oct 85 110
6.Gain or Loss 15 -10
7. NC Oct. Cash Price 82 101
8.Net Proceeds 97 91
9. Actual Basis 3 9
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
ITEM STEERS STEERS
Number of head 20 20
Sale weight, cwt. 5.5 5.5
Coverage price per cwt. 92.39 94.59
Coverage level .8669 .8875
Insured value 10,163 10,405
Premium rate 0.014252 0.018142
Premium cost 126 164
37
Example 2, Nash Co, 3/30/09
ITEM HEIFERS HEIFERS
Number of head 20 20
Sale weight, cwt. 5.5 5.5
Coverage price per cwt. 83.99 85.99
Coverage level .8669 .8875
Insured value 9,239 9,455
Premium rate 0.014252 0.018142
Premium cost 115 150
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
ITEM PRICE NET
Futures contract price 95.375 95.375
Put Option at 92.00 1.80 90.20
Put Option at 94.00 2.50 91.50
Put Option at 96.00 3.35 92.65
Put Option at 98.00 4.425 93.575
Put Option at 100.00 5.95 94.05
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
Low Profit Avg. Profit High Profit
Revenue 394 524 710
Operating cost 481 437 376
Margin over op. cost -87 87 334
Fixed O/H cost 149 115 79
Labor Mgt charge 83 84 102
Total cost 713 836 556
Net Return -319 -112 154
Source MN Farm Business Management database
55
56
MN Stocker Cost Returns, 2007
Low Profit Avg. Profit High Profit
Revenue, net 110 207 252
Operating cost 200 179 149
Margin over op. cost -90 28 103
Fixed O/H cost 59 25 21
Labor Mgt charge 75 19 16
Total cost 333 223 187
Net Return -223 -16 65
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