Price Risk Management Basics
Cost of Production
• The first and most important first step in developing a risk
• Calculates each and every one of your individual costs
• Determines your real breakeven
• Helps you establish a realistic target price for your cattle
The basis is the difference between the cash market and the
futures at the time of delivery.
Forward contracts are written with a specific packing plant for
• Provides a guaranteed basis
• Sets guaranteed final price
• Gives premiums for exceeding contract specifications
• Packer has the ability to pull cattle when they need
them rather than when the producer wants to deliver them.
• Contracted cattle are a captive supply to the packer
Contracts are sold directly off the Chicago Mercantile Exchange
and are not committed to a specific packing plant.
• Deliver to the packer of your choice
• Prevents captive supply situation
• Final price is not determined until the time of delivery
• No basis guarantee is given; basis is at risk
Puts and calls each offer an opportunity to take advantage of
futures price movements without actually having a futures
• The buyer of an option has the right, but not the obligation, to
buy or sell a futures contract, at a specific price on or before a
certain expiration date
• The seller of an option has the obligation to buy or sell a futures
contract, at a specific price on or before a certain expiration date
Today’s American beef producer operates in an environment with unprecedented outside influences.
Seemingly external factors can bring risks that can send the cattle markets downward in minutes, but others can offer long-term opportunities. Consider food perceptions in the European Union today versus the demand China could bring to the export table in the future.
To make that happen, it’s multi-billion dollar, international companies who need to purchase your beef as cheaply as possible on one side of commodity transactions, and local ag producers on the other side. Each party needs the other, but they have entirely opposite goals in the money variable of the equation.
The vast majority of producers aren’t large enough to leverage scale to their advantage. Further, markets simply become too volatile and uncontrollable for many. In today’s cattle business, and agriculture in general, we see higher market highs, and lower market lows. That’s simply what ag commodities are today.
The challenges and questions in the cattle business are difficult and broad. It’s high volume and it can be low margin. Product differentiation, capitalizing on distinct qualities of beef and developing new markets help the whole industry.
But sometimes that isn’t enough. And it’s not everything you can do to profit in this setting. Marketing and risk management matter more today than ever. Nexus can assist in securing prices — and your operation.
The Proper Mindset
Producers have a range of opinions and feelings about price risk and how to deal with it in their operations. But how should the individual producer think about risk management?
Consider open markets overseas, consumer perceptions, and market swings - up or down - that go with those circumstances. Think of the power in managing input costs well and how that pays off. A solid cattle pricing strategy increases the odds of marketing at a profit.
A solid strategy includes cattle futures or options that open the door to forward pricing opportunities. Often, it’s easier for producers to see the positive price effects at an operational level, than for some of the broader industry changes. At Nexus Ag Marketing, we see using these price risk management tools as critical.
Using these tools as part of a cattle marketing plan helps producers capture profits and manage risk. And typically the sales program still also encompasses capitalizing on the open market for a portion of the beef production.
When the marketing plan includes forward pricing opportunities, producers often enjoy a much more clear picture of where they stand financially. That, in turn, allows them to plan more comprehensively on the whole operation, and eases the process of securing financing.
Price Risk Tools
We refer a lot to risk management tools, and they’re just as handy as vice grips or your GPS when it comes to staying in the black.
Of course, these tools come in the form of contracts. But this process is about a lot more than shuffling papers.
The contracts come in four basic forms. Think of them as written ways to get specific about three topics.
Topics Contracts Cover
* What the marketing opportunities really are
* What you as a producer need to do
* How the buyer must perform
With Nexus Ag Marketing, one of the advantages we provide is, you don’t need to work directly with a broker or exchange, or an ag industry buyer. We’re here to help you interpret what the opportunities mean for you and your operation.
Forward Contracts: The Basics
Typically, this refers to a processor-created contract made with a producer, and has a fixed base price. It will also designate a specific delivery timeframe for a defined commodity. It comes with price adjustments for commodity quality, size, weight and possibly other conditions.
Forward Contracting Negatives
* Contract sizes can be difficult to manage
* Buyer specifications can be harder than open market
* Captive supply
* Not always able to price at profit
Forward Contracting Positives
* Fixed base price
* Known basis
* Market access assured
* Can assure profit
The Futures Markets
Trading futures contracts dates back to the mid-1800s. The Chicago Board of Trade was the first exchange formed. Its purpose was to alleviate issues Illinois grain dealers were experiencing receiving financial backing from their lenders for grain inventories. The Kansas City Board of Trade opened in 1876, and the Chicago Product Exchange came along, trading butter, in 1874.
The futures market serves two foundational purposes. One involves price discovery. Participation is global. Buyers and sellers in a futures market engage in transactions, and those determine prices. It’s a fluid process.
The second purpose? Transferring price risk. Looking at buyers’ and sellers’ transactions through the price risk management lens, futures allow the participants to determine prices for future delivery. Transferring this risk is known as hedging.
How can the futures market work for cattlemen?
The fact is, the futures markets make tricks of the trade work for producers. When you manage price risk, you use what you already have, time, history, knowledge of your operation and preferences.
Maybe think of the futures market as a pinch hitter. It can substitute, temporarily, for a cash sale or cash purchase planned for a later date. And it offers a way to hedge, or offset, the price risk seen, or anticipated, in the cash market.
Livestock Futures Contracts Key Points
A livestock futures contract is a standard agreement to buy or sell livestock at a date in the future. An exchange-traded contract, it includes a base price.
Typically, it’s offset on paper in conjunction with a sale to a processor. A publicly traded contract, pricing is transparent, or known each business day, and making a trade requires a licensed broker.
The commodity’s final price varies as floor brokers at the exchange make buy and sell orders happen. Remember, the electronic marketplace, which operates simultaneously with the floor market, must be figured into the equation, as well. And electronic trading has eclipsed floor trading.
The Contract Parties
Market speculators enter bids and offers that reflect their opinion of the supply and demand picture for the commodity, and their expectations about if the price will increase, decrease or remain stable. Commercial hedgers and traders are you as producers. Your cost of production ranks as your biggest factor when it comes to contract prices and participation.
Futures Contracting Negatives
•Contract size can make delivery for some difficult
•No assured market access
•Not always able to price at profit
Futures Contracting Positives
•Provides fixed base price
•Allows producers to deliver anywhere, anytime, where commodity value is maximized. nNo processor pre-set specs
•Sets price discovery time at futures sale time and at commodity sale time
•Eliminates captive supply issue
What is Hedging?
Hedging is buying or selling futures contracts as protection against the risk of loss caused by changing prices in the cash markets. A hedge is a risk-management tool for a producer who is feeding livestock to market and wants protection from falling prices in the cash markets. Hedging provides that protection. It’s the use of any of the futures contract tools to protect, in your case, a cattle operation.
Hedging includes forward contracts such as the live cattle contract, the feeder cattle contract and put and call options. All of these are available on the Chicago Mercantile Exchange, and for those working with National Farmers and Nexus Ag Marketing, our service providers handle the contact with the exchange on your behalf.
Producers use short hedges, or sell, for protection against falling prices. They sell futures contracts. When they are ready to market their livestock, they buy back the futures contracts and sell the livestock in the cash markets simultaneously. Usually, that offsets falling cash market prices with a gain in the futures transaction.
A futures product for hedgers that typically pools producers commodity sales together so that contract delivery sizes are smaller, and combines a futures contract with margin financing so producers don’t have margin calls.
1. Basis and other futures related factors remain present.
2. Delivery is usually required in order to prove that the sale was a bona fide hedge (not speculation in futures)
3. The commodity sale is cash negotiated at delivery time.
4. Can provide the advantages of a futures hedge, without the disadvantages of margin calls and size demands.
Hedge Contract Positives
•Fixed base price
•No margin calls
•No processor captive supply issue
Hedge Contract Negatives
•Like futures contract, has basis uncertainty
•No assured market access
•Not always able to price at a profit
•May have to deliver to co-op
Short Hedge – Your Strategy
How is the short hedge done?
Livestock producers who are feeding cattle for market can use a short hedge to offset their risks of prices falling by the time they’re ready to sell.
1. Producers sell futures contracts to cover the livestock they will market
2. When the cattle are ready for market, they buy back the futures contracts and sell in the cash market at the exact same time
The short hedge allows them to lock in a price for the cattle — to the extent that the basis turns out as expected.
Short Hedge Scenario
We represent a cattleman in Iowa, Jerry, with 80 head of steers that will be ready to go into the cash market in October. Right now, it’s April, and our producer isn’t sure what to think about the future for cattle prices in the delivery month of October.
The futures price is $125. Based on the circumstances in the area of his operation, we project a basis at $2 under. So, the beef owner-operator sells an October Live Cattle futures contract at $125.
What Happens if Cattle Prices Fall?
By October, suppose the futures price has fallen to $120, and the cash price is $118. The basis turned out to be -$2, which is what was anticipated. The hedger buys back the futures contract and realizes a gain of $5 per cwt. ($125-$120). Then the hedger sells the cattle in the cash market at $118, but because of the $5 gain, receives $123, which is the net price.
Net Price Received Example
$118 cash market price
+ $5 gain
$123 net price
What Happens if Cattle Prices Rise?
Let’s put Jerry in a different situation this time. Suppose the cash price in October turns out to be 127 per cwt. and the October Live cattle futures price turns out to be $129 per cwt.
Again, the basis is $2 under, as expected. The cattleman buys back the futures contract at $129 per cwt. And experiences a loss of $4 ($125/cwt. - $129/cwt.).
Then the producer sells the cattle in the cash market at $127 per cwt. This time the net price received is the cash price of $127/cwt. plus -$4, the loss in the futures market, or $123.
Fortunately, in this scenario, the loss Jerry faced in the futures market is still offset by the higher price in the cash market. The net price received is the same as in the previous market circumstance.
What if the basis is stronger?
Sometimes the basis has to be adjusted. Notice previously, the difference between the price where the futures were sold for Jerry, and the net price received equaled the actual basis. That actual basis in the previous examples was $2 under.
So, in each of the previous two scenarios
Net price received = Futures selling price $125/cwt. + -$2 Basis.
That doesn’t always happen. Imagine that in October, the futures price is $120/cwt. and the cash price is $119/cwt., so the basis turns out to be $1 under. The net price received is the cash price of $119 plus the futures gain of $5, or $124/cwt. Comparing this stronger basis scenario to the previous examples, the stronger basis causes Jerry to improve his net price received.
All About Basis
The relationship of the local cash market price to the futures price at marketing time is called basis. When a producer knows the probable basis, he can then look at a futures price for delivery at a later date, and find the anticipated cash price that a particular hedge offers.
OK, let’s make this easier. To figure basis, simply subtract the price of the appropriate futures contract from the local cash market price.
Short hedgers – cattlemen – gain from a strong basis. The short hedger experiences a cash price increase related to the futures price, and might gain more from his position taken. So if we’re working with you, and we say as we evaluate contract performance, “There was a nice strong basis on the last six contracts,” that’s good news for you to hear.
The Live Cattle contract is a deliverable contract. (See glossary for information about deliverable vs. cash-settled contracts.)
Cattle meeting contract specifications can be delivered to any of several stockyard locations or, at the request of the buyer, directly to the packing house for slaughter on a grade and yield basis. At National Farmers and Nexus Ag Marketing, we focus on selling on a grade and yield basis. We find producers are better served selling cattle in this manner.
The delivery costs for the cattle include transportation and marketing costs, yardage and weight shrinkage.
The possibility of delivery on the futures contract generally causes the futures price during the delivery month to align with the cash price at the futures delivery locations. Basis differs from one location to another.
Depending on the circumstances of the local market and its distance and direction from the futures delivery points, the basis may be consistently positive (over) or negative (under). The quality of the cattle delivered in relation to contract specifications also can vary your basis.
Five Common Risk Management Approaches
Below we’ve described five approaches or outlooks for risk management. If you’ve used risk management enough, you may see yourself in one or all of them. At National Farmers and Nexus Ag Marketing, we urge producers to look at every expected cattle sale and use the right approach for that circumstance and timeframe.
1. Expand Opportunity Window Approach
2. Major Medical Approach
3. Even the Odds-50/50 Approach
4. Scale Up Selling Approach
5. Beat the Averages Approach
These approaches can be used individually, or in combination if desired.
Expand Opportunity Window Approach
Look at current future month prices and trends; as well as historic prices and trends. Use this knowledge to sell for specific months at or above past averages when futures provide the opportunity. Or, take other price protection and strategy. Put time on your side by looking ahead and taking action before it’s time to transfer ownership of your commodity to a buyer (similar to Beat the Averages but less intensive).
Negatives of Expand Opportunity Window Approach
•May not be profitable
•May be too broad
•Subject to error
•Needs more dedication
Positives of Expand Opportunity Window Approach
•Can involve the best of numerous tools
•May increase overall odds of profitability
Major Medical Approach
Typically this means buying a put option and creating a floor price on your commodity. Usually it employs an out-of-the-money option, like a deductible on an insurance policy, which tends to be less expensive, and you will probably lose money if the market falls below the level of protection; but loss is limited. You retain complete up side profit potential - with no ceiling.
Negatives of Major Medical Approach
•May lose money
•Premium may be expensive
Positives of Major Medical Approach
•Will not lose farm
•Losses are limited
•Profit is unlimited
Even The Odds – 50/50
Sell 50% of production forward at a profit as a hedge while the remaining 50% is in the open market. Locked in profit offsets some of the risk of loss in the remaining 50%. The remaining 50% has complete upside profit potential. Profit of $1 on 50% means loss of $1 on remaining is still break-even. Gain of $1 on 50% not forward sold, is gain of 50 cents on all production.
Negatives of Even the Odds Approach
•Miss market high with 50%
•May hit market bottom with 50%
•No assured market access
•If forward contract, then access assured, but captive supply issue
•If futures, then basis issue
Positives of Even the Odds Approach
•Miss market bottom with 50%
•Retain opportunity to sell 50% at market high
Scale Up Selling
Systematically sell forward in increments of 10% to 25% when profit is available and each time a higher market level is achieved.
Negatives of Scale Up Selling Approach
•May not be able to scale up
•May involve captive supply - forward contract
•May not secure market access - futures, options
•Requires watching your plan and following through
Positives of Scale Up Selling Approach
•Often increases overall price average
•Keeps you active in the market and paying attention
•Focuses on locking in profit systematically without waiting for the proverbial top
Beat The Average
If you market daily, weekly or monthly with some consistency, then average the past years market price history and compare to the future 12 months price potential Be sure to take basis and processor premiums into consideration. (See glossary for explanations of basis and processor premiums.)
Sell portions of your commodities for each delivery month forward at the same time in the same size increments when you can lock in a price average at or above history.
Risk of downturn can be reduced by combining with Major Medical concept if desired. Also, you can select only the series of months with historically low prices and target those averages to sell above.
Combination with Scale Up selling is desirable. And 50/50 can work. Consistency is important for overall performance of strategy; must always be tracking future price averages day-to-day and have active price targets.
Positives of Beat The Average Approach
•Beat historic cash market averages consistently over time
Negatives of Beat The Average Approach
•May lose money
•Market access assurance uncertain - futures, options
•Can involve some level of captive supply - fwd contracts
•Must continue strategy for the long term for greatest effect
Words of Caution
Starting the process of using price risk management teaches many producers a lot about themselves. So, be prepared to face your Achilles’ heel. We’re not psychologists, but everybody’s heard the term market psychology. That’s because the market is driven by human activity, emotions and opinion.
Using futures to hedge and create a way to alleviate price risk can be very helpful. Still, it’s not the one silver bullet.
However, some producers have major difficulties in response to hedging. Being honest with themselves, continuing to remember to think business and strategy, and not going to extremes in either fear or in over-confidence, can help people avoid falling into some ways of thinking, and using risk management tools, that cause problems.
Cost of Production Uncertainty
Hedging sounds like a great idea to many producers, including many who do not keep tabs on their production costs. Imagine a game of darts. But in this game, you’re told, you can’t be sure if you get more points when you hit the bull’s eye, or the inner or outer circles. So do you throw for the bull eye’s eye or the red section near the outside? You have no idea what you’re supposed to do.
Attempting to achieve financial stability without a clear objective – a price above costs – simply won’t work if the total costs are an unknown. But to use the futures markets successfully, it is essential that producers accurately know their costs for producing quality beef. Otherwise, they cannot know what their target price needs to be.
Arrogance about Futures and Market Prices
Another one of our greatest concerns for producers is when they execute their cattle business marketing plan backward. We strongly urge producers to figure their breakeven level prior to purchasing calves or feeder cattle.
But sometimes cattlemen with a great deal of experience raising high-quality beef, and running a top-notch operation, mistakenly believe they know what direction the cattle market will go, and how far in that direction. Except they don’t know for certain. Especially not when snags in transportation, weather, or news or rumors of disease, result in overseas market closures.
But because they think they know, they buy live cattle or feeder cattle contracts after they already own cattle. That’s called a Texas hedge, and it increases risk instead of managing it. We urge our producers to know their purchase price before securing contracts.
Nexus Ag Marketing offer a reverse breakeven calculator app for smartphones and iPhones, to help make the proper decisions about contracting in the proper order.
Speculator or Beef Producer?
Watching the markets can get exciting. It can get the adrenaline flowing. Commodity markets can be enticing. And some producers get in trouble because of it. As they’re hedging, sometimes a cattle grower may experience a subtle shift in thinking about how to use the futures markets.
Unfortunately, some producers move into speculating from hedging. They’re just certain some good price momentum is happening with a commodity that they don’t even raise, and they’re equally certain that good price momentum will keep on happening. And, of course, they’ll sell at just the right time.
That’s financially dangerous, and we at National Farmers and Nexus Ag Marketing strongly caution against this. We urge producers to remember the side of the futures transaction where they need to remain. The short hedging side.
Futures Stage Fright
Imagine a cattleman who has locked in a profit. Now he’s part of the futures market stage. And he knows it. He watches the ups and downs of the market – a lot. He’s constantly checking market prices, and running disaster scenarios in his head - ones that won’t even happen because the price is locked in – and his operation has proper insurance coverage. And he has his margin account covered.
But he’s still nervous — even with that profit level price assured. Some producers are simply tortured by market volatility. Worries about margin calls are just too much. His operation is a very important enterprise, with more money riding on it than he ever imagined, so the tension is entirely understandable.
For this producer, the National Farmers and Nexus Ag Marketing Freedom Hedge is perfect, because we cover the margin calls. A producer struggling with this might also be better served using cash forward contracting, or put and call options.
Getting Out of the Market Too Early
Falling market prices don’t make cattle producers happy. When the market drops and they’ve had a short hedge, some producers want to offset that loss and see if they can profit before they market their cattle. But if the market continues its downhill slide, they are left with no protection.
But sometimes good news is bad news, too. Shawn in Minnesota owns an 1,800-head colored cattle feedlot. Let’s say Shawn puts in some hedges at reasonable levels. But then the markets experience a noteworthy uptick. That triggers margin calls beyond what Shawn and his local ag lender want him to carry.
So Shawn gets out, offsets his hedges at a loss, and to make matters worse, can only stand like a bystander when the market drops and he adds cash market losses onto it all.
Based on how Shawn reacts to market situations, he would be more comfortable with hedging just a portion of his beef production. Or using cash forward contracts. Or securing prices with futures options.
Situation, Strategy and Next Steps
At Nexus Ag Marketing, we suggest ongoing evaluations of your risk management and marketing plan for your cattle operation, considering new factors that can crop up from time to time in the cattle business. Or changing goals.
Plan and Strategize
1. Lay out your marketing plan and tools you’ll use to accomplish it
2. Determine pricing and price targets
3. Choose who pulls the trigger
4. Decide when to evaluate
5. Write it all down
7. Modify plan if facts change (avoid emotional changes)
8. Continue to take action and look farther forward
Yes, risk management calls for many steps to be taken. But it’s worth it. And at Nexus Ag Marketing, we can help. We’re in production agriculture. We understand the landscape. We take time to get to know each and every operation.
Nexus Marketing 877.207.1051
P.O. Box 1767
Ames, Iowa 50010-1767