Cattle Risk Management GEOFF BENSON, PhD Extension Economist Dept of Agricultural and Resource Economics North Carolina State University

Cattle Risk Cattle Risk ManagementManagement

GEOFF BENSON, PhDExtension Economist

Dept of Agricultural and Resource EconomicsNorth Carolina State

University

GEOFF BENSON, ARE, NCSU 2

AgendaAgenda Introduction Price forecasting Price risk management

Hedging with cattle futures USDA-RMA LRP ProgramCattle futures optionsSetting price targets & pulling the

trigger Summary


RiskRisk 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

Sources of RiskSources 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


Managing RiskManaging 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?


Risk ManagementRisk 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


Cost:BenefitCost:Benefit All risk management strategies

involve costs, in money or time Effectiveness varies among

alternativesFinancial benefits & costs Time, new knowledge and skills

Evaluate trade-offs



AgendaAgenda Introduction Price forecasting Price risk management

Hedging with cattle futures USDA-RMA LRP ProgramCattle futures optionsSetting price targets & pulling the

trigger Summary


Price ForecastingPrice 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


Cattle FuturesCattle 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 L&M 1&2 steers, cash settled: Jan, Mar, Apr, May, Aug, Sept, Oct, Nov.


Price ForecastingPrice 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 cattleIf basis is predictable, then we can

use the futures market to project local North Carolina prices and use this to make business decisions


Price Forecasting, cont.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?WeightSexFrameMuscleBreedOther, e.g., market channel, truckload

Price WorksheetPrice WorksheetITEM $

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



Feeder Cattle Futures, Feeder Cattle Futures, $/100 lb, 3/26/09$/100 lb, 3/26/09


Historic BasisHistoric 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

NoteNC Auction prices are reported weekly in 50

or 100 lb./head increments for small lotsCME feeder cattle futures contract is for

650-849 lb. M&L1&2 steers in truckload lots Contract months are Jan, Mar, Apr, May,

Aug, Sept, Oct, & Nov.


NC Basis, Avg. 1990-2000NC Basis, Avg. 1990-2000

-14

-12

-10

-8

-6

-4

-2

0

J F M A M J J A S O N D

$ p

er c

wt.

AshevilleSiler CitySmithfield


NC Basis, 1990-2000NC 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


““Quality” DifferencesQuality” Differences What are the characteristics of your

cattle and how do they affect the price (value)? WeightSexFrameMuscleBreedOther, e.g., market channel, truckload


Price Differences, NC Graded Price Differences, NC Graded Sales, M1 Steers, 1991-2001Sales, M1 Steers, 1991-2001

.

Weight, lb. Fall Calf

Spring Stocker

400-499 + 11.5¢/lb. + 22¢/lb.

500-599 + 7¢ + 19¢

600-699 + 4¢ + 8¢

700-799 Base Base


Price Differences, Graded Sales, Price Differences, Graded Sales, M1 Heifers v. Steers, 1990-2001M1 Heifers v. Steers, 1990-2001

Weight, lb. Fall Spring

400-499 -12¢/lb. -15¢/lb.

500-599 -8.5¢ -14¢

600-699 -8¢ -12¢

700-799 -6.5¢ -6¢


Price Differences, Graded Sales, Price Differences, Graded Sales, 500-599 lb. Steers, 1990-2001500-599 lb. Steers, 1990-2001

Grade Fall Spring

M1 Base Base

S1 -11¢/lb. -16.5¢/lb.

LMS2 -6¢ -9.5¢


Selected BreedsSelected 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


Price Differences, Graded Sales, Price Differences, Graded Sales, 500-599 lb. M1 Steers, 1991-2001500-599 lb. M1 Steers, 1991-2001

Breed Fall Spring

Black Base Base B&W + 0.5¢/lb. + 0.5¢/lb. Exotic X - 6¢ - 6¢ Hereford - 10¢ - 2.5¢ Str. Cont. - 12¢ - 13.5¢

Brahman -13.5¢ -7.5¢


Marketing OptionsMarketing Options Regular auction = Base Graded sale Special programs, e.g.,

Southeast Pride, pre-conditioned sales

Direct farm sale (several options)

Retained ownership


Marketing OptionsMarketing Options

Farm situation determines opportunities and cost:Size of herd

Number of cattle for sale Uniformity of cattle

Market Premium offeredMarketing CostRisk

Price WorksheetPrice WorksheetITEM $

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



QUESTIONS OR COMMENTS ON PRICE FORECASTING?


Hedging Price RiskHedging 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


Futures ContractsFutures 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 expireBy buying back an identical contract (at

or near the expiry date) At the expiry date the futures price =

the cash market (spot) price


Futures ContractsFutures 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


Hedging: Example 1Hedging: 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


Hedging: Example 2, Part 1Hedging: Example 2, Part 1

ItemMarketFalls

MarketRises

1. Sell October contract in April $100 $1002. Local basis -$5 -$53. Expected local cash price $95 $95


Hedging: Ex 2, Part 2Hedging: 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


9. Actual Basis $5 $5


Hedging: Example 3Hedging: Example 3

ItemMarketFalls

MarketRises

Sold Oct. futures $100 $1005.Future price in Oct $85 $1106.Gain or Loss $15 -$10

7. NC Oct. Cash Price $82 $101


9. Actual Basis $3 $9

USDA’s LRP ProgramUSDA’s 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


Example 1, Nash Co, 3/30/09Example 1, Nash Co, 3/30/09ITEM 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


Example 2, Nash Co, 3/30/09Example 2, Nash Co, 3/30/09ITEM 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


Information on LRPInformation 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/2008/north_carolinaLPI.cfm. All are from out-of-state



OptionsOptions

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


OptionsOptions 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


OptionsOptions 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


OptionsOptions 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

Feeder Cattle Options Premiums, Feeder Cattle Options Premiums, May Contract, $/cwt., 3/25/09May 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


QUESTIONS OR COMMENTS ON HEDGING?


Is Hedging for You?Is Hedging for You?

Things to considerSize of your cattle operationFinancial importance of your

cattle operationAbility to handle price riskAttitude to risk & expectations

about hedging


Farm Structure, 2007 CensusFarm Structure, 2007 Census US NC

All farms with beef cattle

963,669 19,229

Farms with beef cows

818,992 14,895

-- 1-49 cows 626,775 13,178

-- 50-99 cows 102,217 1,169

-- 100-499 cows 80,816 525

-- 500+ cows 9,184 23


Why Do You Have Cattle?Why Do You Have Cattle?

OR

FUN OR MONEY?


HedgingHedging It is not for everyone

Very small producersBusy 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 skillsEvaluate trade-offs in your situation


HedgingHedging How much do you have at risk?

Number of headPossible change in priceTotal financial lossesImpact 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


Price Risk Management StrategiesPrice Risk Management Strategies Ride it out – “self-insure”

Draw on savings or borrowRestructure debt paymentsAdjust expenses, especially

maintenance & new investmentsAdd off-farm income or cut family

living expenses Prevent unacceptably low prices

with futures contracts, options, LRP – “buy insurance”


HedgingHedging 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!


Attitude to RiskAttitude to Risk Attitude to risk affects an

individual’s decision in a given risk situationAre 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


Setting Hedging Price TargetsSetting Hedging Price Targets A minimum profit

Full cost of production + marginBreak even

Cash flow protection Stocker purchase price+ or - debt service+ or - cash production costs + or - $$ for family living


Do you know your cost of production Do you know your cost of production & profit margin?& profit margin? Operating cost - Out of pocket

expenses, e.g. forage, other feed, fertilizer, vet, repairs,

Investment (fixed) costs—Depreciation, interest, property taxes & insurance (DITI)

Opportunity cost – charge for your time and equity capital invested


MN Cow-calf Cost & Returns, 2007MN Cow-calf Cost & Returns, 2007

LowProfit

Avg.Profit

HighProfit

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

GEOFF BENSON, ARE, NCSU56

MN Stocker Cost & Returns, 2007MN Stocker Cost & Returns, 2007

LowProfit

Avg.Profit

HighProfit

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


NCSU beef & forage budgetsNCSU 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


Costs in the BudgetsCosts 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


Cash FlowCash Flow Budgets include full economic costs For cash flow price targets, evaluate

the revenue needed to coverOut 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


Pulling the TriggerPulling 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


Demand & Supply FactorsDemand & Supply Factors Consumer Demand

General economy – income, unemployment, exchange rates

Competition from other meatsDemographic changes – age, race, pop.

SupplyAvailability of cattle – stage of cycleFeedlot costsTransportation costsTrade


..

US BEEF PRODUCTION & PRICES, 1976-2006

15,000

17,000

19,000

21,000

23,000

25,000

27,000

29,000

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

Pro

du

ctio

n, m

il. lb

.

$20

$30

$40

$50

$60

$70

$80

$90

$100

Pri

ce, $/1

00 lb

.

BEEF PROD.

FED CATTLE PRICE

TREND IN FED CATTLE PRICE


Cattle cyclesCattle 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

LagsDecision making takes time15 months to raise a heifer to breeding ageSeasonality in breeding & 9-month gestation 14-18 month production period


Beef Product & $$ FlowsBeef Product & $$ Flows

$ CONSUMER $ RETAILER

WHOLESALER

PACKER FEEDLOT

STOCKERCOW-CALF

PROCESSOR


Price VolatilityPrice 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., BSEEconomic crises

Feeder Cattle October Contract Feeder Cattle October Contract Price HistoryPrice History


HedgingHedging Takes time to learn to follow

market conditionsMarketing club?Paper tradingFinding a market adviser and/or

broker you trust Takes confidence to learn when

to “pull the trigger”



SummarySummary All producers can use futures and

other price information to project prices for their cattle as part of marketing and business decisions

Benefits of hedgingProtecting 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


SummarySummary 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


SummarySummary For Stockers, key factors:

Purchase priceSelling priceFeed costsAverage 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


SummarySummary 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 $imple or ea$y an$wer$!!


“If it’s easy, fun or can be done from the seat of a tractor, there ain’t no money in it”

Anonymous Cowboy


What Next?What Next? What more assistance do you want or

need, if any? Topics

Price forecastingHedging with futuresUSDA’s Livestock Risk Protection Program

How would you like this help delivered?One-on-one with an adviser & brokerGroup meetingsMaterials, publications, etc.


Geoff BensonGeoff Benson Phone: (919) 515-5184 Fax: (919) 515-6268 E-mail: [email protected] Web page:

http://www.ag-econ.ncsu.edu/ faculty/benson/benson.html

Documents

Cattle Risk Management GEOFF BENSON, PhD Extension Economist Dept of Agricultural and Resource Economics North Carolina State University