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Cattle Market Risk Will Only Increase

If you’re feeding cattle, you’re managing risk. And with no end in sight to market volatility, market risk will only increase.

June 1, 2011

7 Min Read
Cattle Market Risk Will Only Increase

Kyle Williams doesn’t expect to hedge in a super profit for cattle going on feed this spring and summer. With record corn costs, the numbers aren’t there. Yet, he doesn’t place a set of company cattle without at least managing that risk to cover his breakeven.

“We’ve always been staunch hedgers,” says Williams, manager of Lubbock Feeders LP, Lubbock, TX. “If the cattle don’t at least break even through a hedge, we don’t buy them.”

With corn prices anywhere from $6.50-7.50/bu., and feeder-cattle prices at $130-140/cwt. for a 750-lb. steer, cost of gain for putting on 500 lbs. by late 2011 will swell by $1/lb. and more. That puts the breakeven price for the finished steer at $120/cwt. or higher.

A $120+ breakeven and the ability to manage that risk through futures? Yep. And industry analysts believe bullish markets may look even stronger as the year progresses.

“But even though all the fundamental signs point to higher prices, there’s no guarantee in today’s market if you’re not using some sort of risk management,” says John Michael Riley, Mississippi State University Extension livestock marketing economist. “You’re leaving yourself open to take a pretty big hit.”

Fewer ranchers are retaining ownership of calves through the feedyard because high calf prices are too tempting.

“It just makes more sense to them not to deal with $7 corn and the chance that cattle prices will go down,” Riley says. “But for those who ask about feeding cattle, I tell them to put it on paper, look at the futures market and see if they can pencil out to breakeven or better. You then lock it in and ‘shut your eyes.’”

Williams has managed the Lubbock Feeders for a decade. About half the cattle are company owned and half are custom fed for others. All company cattle are covered.

“We’re not gamblers. We work to cover the projected breakeven,” he says. “We buy them, hedge them and try to get our profit out of production. It’s not very sophisticated.”

Basically, he sells futures contracts that equal the approximate number of cattle that will finish in the subsequent month. He also buys corn futures for the closest month to where they’ll finish.

As an example, this spring, he bought 525-lb. steers for $135/cwt. to finish in December. The projected breakeven was about $120/cwt. To protect that price, he sold December live-cattle futures at about $122. To cover his feed cost, he bought December corn futures at about $6.40/bu. With a corn basis that’s 30¢-60¢ above futures, actual feed costs are close to $7/bu.

“We buy enough corn contracts for every 200 head of cattle and keep those futures all the way to the end,” Williams says. “If corn prices go up, or we lose money on the futures, it all goes toward a particular lot of cattle. If corn prices go down and we make money off the futures, that’s also applied to the cattle. Each lot of cattle stands on its own.”

Volatility here to stay

When the USDA report on prospective plantings came out March 31, corn markets reacted by heading limit-up the first day, with steady rises well into April. Record prices for old-crop corn surged past $7.70. Some of the shift in prices was likely already figured into feeder and fed-cattle prices. But Williams was among those who was happy he’d locked in some corn for summer and fall feeding after the big swing upward.

Glynn Tonsor, Kansas State University Extension livestock marketing economist, says that even with high prices for corn, tight feeder-cattle supplies and little movement in herd build-up, “a virtual floor” may remain under feeder-cattle prices. “With feeders at $130-140/cwt., it’s hard to see the floor falling out of those prices going forward through 2011,” he says.

However, he adds, “There is definitely a lot of risk locking in only one leg (live-cattle futures) of a three-legged monster. I generally caution against locking in only one, or even only two, of the legs.”

Locking in all three will raise transaction hedging costs, he says. “But at the same time, with more volatile markets than we’re used to, the risk goes up on all cattle-feeding ventures.”

He notes that some feedyards may have more control over supplies of feeder cattle to go on feed and possibly manage that price easier than managing corn prices. “They need to look at their margins and make risk-management decisions around that margin,” he says.

Options strategies

Cattle and corn options on futures are often cursed as being a “too expensive” means of risk management. An at-the-money $124 December live-cattle put option had a premium cost of $6/cwt. in early April. That’s a cost of about $2,400 for the 40,000-lb. contract. Depending on time value, it means live cattle would have to trade at $130 to break even on the transaction excluding basis and commission.

Steve Amosson, Texas AgriLife Extension economist in Amarillo, says an out-of-the-money put option could provide risk protection against a wreck, but not guarantee a profit. For example, a $116 December put cost about $3 in early April, or half the cost of the at-the-money put, but a cattle feeder would be protected against a major price crash and still be open to the upside.

“A new, more complex strategy that is gaining popularity is a three-way window, or a ‘collar,’” Amosson says. “You would buy an at-the-money put, then sell an out-of-the-money call and sell an out-of-the-money put.”

Prices can change by the minute. For an example of a collar spread, a feeder could have bought an at-the-money $124 fed-cattle December put in early April at a cost of about $6/cwt., then sold a $134 call for about $3.70 and sold a $114 put for about $2.40. The sale of the call and put options provided a premium gain of $6.10, offsetting the $6 cost for buying the at-the-money put.

“In this example, the cost of the strategy is basically nothing with the exception of the commission,” Amosson says. “However, it’s important that feeders understand that, to accomplish this, they have given up some upside price potential and downside price protection. But here, there is no chance for a margin call if the price goes down, but you can get a margin call if prices rise.

“The nice thing about a collar is you can pick the levels of price protection to coincide with your risk tolerance, outlook and what you want to spend.”

Amosson, Riley and Tonsor advise cattle feeders to have advanced knowledge of such options strategies before using them, or use a reputable commodity consultant or broker to help develop a sound risk management strategy.

For feeders with a smaller number of cattle, the USDA Risk Management Agency’s Livestock Risk Protection (LRP) program can be a useful risk management tool. Coverage levels range from 70% to 100% of total price protection. There is a calendar limit of 4,000 head and a specific coverage endorsement.

Riley likes the program because it enables southern producers to insure Brahman-influenced cattle, which includes many herds in the warm-climate regions. Premiums for LRP price protection are higher for maximum coverage and work down as the level of coverage decreases (for more on LRP programs, click here.

Don’t forget fuel

Along with cattle and feed, managing risk on volatile fuel prices may help prevent cattle-feeding margins from being blindsided even more. When it costs a cattle hauler more than $1,200 to fill up his truck, someone has to pay for that fuel to ship cattle. It’s probably the cattle feeder.

“Feedyards can look at forward contracting for diesel or gasoline through a local co-op grain elevator or other source of fuel,” Tonsor says. “My guess tells me the energy price is worth watching, but prices for corn, feeder cattle and fed cattle are certainly more important. We should also be concerned about the consumer demand for meat with higher gas prices they’re seeing.”

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