With the unheard-of volatility in corn prices and a virtual guarantee that high-cost feed won't go away, cow-calf producers might be wise to consider some sort of price protection to ensure against a wreck waiting to happen.
USDA's Livestock Risk Protection (LRP) may be the safest form of price protection available. But forward contracting to lock in a price, or cross-hedging calves using feeder-cattle futures, may also work.
Ranchers have to admit they've had it pretty good price-wise for calves, at least until corn burst the bubble for all sectors. Now, they must worry about what those calves will be worth in the ethanol frenzy.
In early March, 400- to 450-lb. medium and large frame steers brought $124-130/cwt. in Amarillo, TX; $125-138 in West Plains, MO; and $132-137 in La Junta, CO. Those were still good prices for calves, but below the $140 or better of a year ago.
What will the market be for 4- and 5-weight calves this fall? How will even a normal corn crop that can't meet feed, biofuels and other demands impact grain prices -- prices that will directly impact fed cattle prices and what feedyards will pay for feeder cattle?
There are no sure answers to those questions. But the demand for corn for ethanol production can easily drive prices higher than cattlemen want to see, says Darrell Mark, University of Nebraska-Lincoln livestock marketing economist.
He and John Lawrence, Iowa State University livestock marketing economist, have promoted the LRP program as one form of calf price protection for ranchers.
"It works similar to a put option hedge by creating a floor selling price, plus it fits smaller-sized operations better than futures hedging in many cases," Mark says. "LRP is a prudent choice right now. All the markets are so volatile. When there's a good price offered, consider taking it."
LRP is administered through USDA's Risk Management Association (RMA) and is available to producers and feeders in 20 states. These include Colorado, Illinois, Indiana, Iowa, Kansas, Michigan, Minnesota, Missouri, Montana, Nebraska, Nevada, North Dakota, Ohio, Oklahoma, South Dakota, Texas, Utah, West Virginia, Wisconsin and Wyoming.
The price insurance is purchased through a local licensed crop insurance agent. Each set of cattle insured must be documented on a Specific Coverage Endorsement (SCE). There's no minimum number of livestock, but there are maximums that can be insured on a single SCE -- 1,000 feeder cattle or 2,000 fed cattle, Mark says. In a given crop year (July 1-June 30), that's up to 2,000 feeder cattle and 4,000 fed cattle.
The coverage price insured by LRP is from 70%-95% of the expected ending value of the cattle, which corresponds to deferred futures prices. LRP premium costs are higher for the higher coverage levels, but USDA provides a 13% subsidy on the total LRP premium. Coverage can be from 13-52 weeks in length.
Lawrence says the cost of an LRP is similar to the cost of a put option. "It behaves like a put," Lawrence says. "It has a fixed adjustment for lightweight calves under 600 lbs., heifers separate from steers, Holsteins, Brahman, and heavy 600- to 950-lb. animals."
Premium costs vary by the type of cattle and weight. For steer calves less than 600 lbs., there's a 110% price adjustment. The LRP coverage price, rates and expected ending values are available at www.rma.usda.gov/livestock/. Site users can enter their state and type of cattle to receive an on-screen report of LRP data to fit their cattle.
Here's an example of an LRP deal: Say you have 50 head of steers you plan to sell at 500 lbs. in the fall. First, they have a 110% price adjustment factor because they're less than 600 lbs. They have an expected end value of $120/cwt. in mid-September.
If the producer selects a coverage level of 94%, then 94% multiplied by $120 is about $113/cwt. For 50 head, or a total of 250 cwt., that comes to $28,250 (250 cwt. x $113).
If the premium price is about 3¢/insured dollar, the overall premium is about $850. With the 13% government subsidy of $110, the total premium is lowered to about $740, or about $2.95/cwt.
That's pretty expensive coverage for a relatively low level of coverage, but it protects against a wreck. A lower rate of price protection would cost less, a higher rate more.
"Producers need to strongly consider LRP for price protection (while the cattle market is hot)," Lawrence says. "Our prices are directly tied to corn, and the good markets (in early spring) give us an opportunity to do something."
He encourages cattlemen to change their thinking about markets. "A year ago, cattle or hog producers wouldn't have considered locking in $3 corn," says Lawrence. "But they would like to see it now. We have to adjust our thinking on cattle just like on corn.
"Ranchers who have seen $140 calf prices need to look at $125-130 as still a good price. We've had 7-8 good years for cow herds. Ranchers can assure yet another good year for prices using an LRP."
One would think cow-calf producers would welcome a calf-futures contract that works similar to the feeder-cattle contract. Apparently not, since a calf contract started by the Chicago Mercantile Exchange in the late '90s never built up any open interest and was discontinued.
Hedging calves using the feeder contract can be done, but a lot of factors can throw it for a loop. Possibly the biggest problems lie in the usually wide difference in prices and basis for a five-weight and seven-weight animal.
"It's a challenge given the size of the contract (50,000 lbs.), and that's for steers 700-800 lbs.," Lawrence says. "The calves may also be more susceptible than yearlings to changes in corn price."
Still, Iowa State has calculated typical basis levels for 500- to 600-lb. steers hedged on a 700- to 800-lb. contract. For the past three years, the average basis for five- to six-weight steers through the St. Joseph, MO, market is +$12.81 for cattle delivered in September on an average feeder futures price of $114.61.
Basis levels are higher for marketing periods January through July, ranging from $17.08 in July to $30.82 in March. Visit www.econ.iastate.edu/faculty/lawrence/Acrobat/CurrentFeederCattle%20Basis.pdf for a list of feeder-cattle basis values.
"A one-to-one position in the futures and cash market (for calves vs. yearling weights) may not be optimal," Mark says. "This could result in being over- or under-hedged. Research suggests this hedge ratio is closer to 1.4-1.5, meaning the 50,000-lb., feeder-cattle futures contract may be optimally hedging closer to 35,000 lbs. of feeder cattle.
"This relationship is seasonal as well, because the seasonal trend in lightweight calf prices doesn't exactly follow the seasonal trend for heavier feeders. Thus, hedging lighter weight calves into the feeder cattle futures market has shown to be riskier."
The use of feeder-cattle put options to protect lightweight calves is another strategy, but could be expensive.
"Normally, I like using options to create a floor price, or at least a window," Mark says. "Unfortunately, because of higher price volatility in recent years, option prices are relatively high. Further, for the cow-calf producer looking to sell calves this fall, the availability of those deferred options is limited. Still, these are about the same as for LRP insurance, and the cost is roughly the same."
Lawrence says options face the same challenge as the futures hedge due to size of contract and basis risk.
"If you don't match on contract size, you also pay more," he says. "A $2 put on 500 cwt. is $1,000. If you're using it to cover 30,000 lbs. of calves, the cost is $3.33/cwt.
"Feeder options are also thinly traded. On March 6, for example, there were a total of 205 feeder options traded, counting all strikes and puts and calls. Some had a volume of one."
Mark says fall price protection may not be needed if the expected huge corn crop comes in and the supply of feeder cattle remains tight, but being wrong about that could be very expensive.
"Corn prices could go either direction (with planned higher plantings)," Mark says. "With the LRP, sometimes you have to get pretty far out-of-the money, but it protects against a big disaster."
-- Larry Stalcup, BEEF magazine