“Users of corn should relax. This market has no big rally that is imminent unless…” That was a line in Virginia Tech University economist Wayne Purcell's marketing letter in late August. But it's words like “unless” that make Roy Heitschmidt a little nervous when it comes to holding down the cost of gain at a 40,000-head feedyard.
Heitschmidt is assistant manager of Cattlemen's Feedlot in Olton, TX. Many of the cattle are custom fed for ranchers, stocker operators and professional feeders. Many of the company-owned cattle arrive as lightweights that will consume a lot of corn and other feedstuffs while on feed for six to 10 months.
“We try to have all our company cattle hedged with either futures, options or other means,” Heitschmidt says. “To make sure we maintain a minimum cost of gain, we often use corn options to cover our grain costs.”
As a Southern Plains feeding operation, the feedyard faces corn prices with a basis much higher than northern yards closer to the Corn Belt. The tradeoff is often a milder feeding climate during the winter. Plus, there's a steady supply of feeder cattle from regional ranches and producers in the South and Southeast.
The corn basis for the Olton area, located about 50 miles north of Lubbock, is plus-40¢ to 50¢ over Chicago Board of Trade corn futures. In other words, December corn at $2.20/bu. means a local price over $2.60. A 50¢ increase in feed grain price can easily add $4-5/cwt. to the breakeven purchase price of feeder calves. So, costs of gain can often be better managed if corn costs can be managed.
Combining options spreads
Heitschmidt uses a combination of options spreads to protect against market spikes, up or down. For example, three-weight peewees were placed on feed in August. They won't finish out until late spring of 2005.
By then, his local corn prices could still be in the $2.60 range. They might also be far above $3 due to poor planting conditions, dry weather, a massive buy by China, etc. A price increase will push up feed costs for cattle hedged at a particular price based on feeding projections.
To prevent that scenario, Heitschmidt looked at potential strategies based on March '05 futures at about $2.50. The strategy selected involved buying a $2.60 March call for a premium cost of 9½¢/bu. He then sold a $2.20 March put for 3¼¢. He also sold a $3.20 March call for 1¢.
With that strategy, he's price protected for just over 5¢/bu. (9½¢ minus 3¼¢ minus 1¢). He could exercise the call options in the event of a wide range of price increases.
“I have my upside corn price protected up to $3.20,” he says. “Five cents is pretty cheap insurance, especially when there's always a chance prices can increase, even if they're not forecast to do so.”
In mid- to late-2003, when corn prices were projected to increase for '04 due to tight grain supplies, Heitschmidt used a different strategy.
“We bought corn outright pretty far out instead of using options,” he says. “We didn't have to get too sophisticated with that strategy. Our options strategies this year are also pretty straightforward. We're just looking for price protection should we get a sharp spike in futures.”
Options for flexibility
Steven Blank, University of California-Davis Extension economist, says the use of options for protecting feed costs provides more flexibility than straight futures or forward contracts.
“Hedging with options enables cattlemen to lock in feed costs to protect against market price increases, but with flexibility which may allow feeders to pay lower prices if the market prices decreases,” he says.
For example, if a feeder believes a corn price of $2.50 could go up to $3, he could lock in the lower price with a cash forward contract.
“This guarantees his feed cost, no matter what feed prices do in the future,” he says. “However, if prices fall after the forward contract was signed, the cattleman would still be obligated to pay the contract price of $2.50.
“If the cattleman uses a futures hedge, he would lock in the current $2.50 price, plus or minus any change in basis. The hedge could be placed with a delivery on or after the date he actually intended to take delivery of cash grain.”
If both cash and futures prices go to $3 before the hedge is liquidated, the cattleman would have a 50¢ profit from his futures position to compensate for the higher cash price paid. But if futures prices dropped by 50¢ to $2, he would still be obligated to the $2.50 price.
If the feeder had used options, he would have benefited from price decreases which occurred while the hedge was in place. Yet, he would have received the same protection against price increases.
“If he believes the price could rise from $2.50, he could hedge by using a simple strategy of buying a call option for a premium of about 10¢,” Blank says. “If market prices rise to $3, the hedger would profit by 50¢ by exercising the call option and selling for that price. He would net the difference as a profit to compensate for the rise in cash corn.”
If the corn price drops to $2, he is only out the 10¢ premium cost. He would pay 40¢ less for his options trade over a straight futures hedge.
Of course, any move to hedge feed costs depends on an operation's individual cattle pricing techniques. In late August, Virginia Tech's Purcell projected lower corn prices this fall due to strong chances for a record crop “unless we have very unusual and severe weather damage.” If at harvest, corn prices have not dropped below the $2.25 for the December level, he says, then perhaps the forecast for an 11-billion-bu. crop will not come true.
“Feeders may want to step up and get their long hedges in,” he says, noting that trades using March or even July contracts might be in order. “They may want to buy the board (with futures hedges) or buy calls.”
But for the most part, the economist felt the huge record crop would be there and that prices could approach $2.
“Probably the next big pressure on corn prices will come if there are weather problems with the South American crop, which is planted in early 2005,” he says.
If that happens, Heitschmidt's options strategy will have his corn — and his cost of gain covered.
Larry Stalcup is an agricultural journalist based in Amarillo, TX.