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Hedged Against Disaster

Price protection blunted the effect for these operations of the market plunge that followed the Dec. 23 BSE announcement.

Riding up last fall's sharp increase in cattle prices with hedges and put options helped a major feeding operation prevent huge losses when bovine spongiform encephalopathy (BSE) struck the U.S. and sent markets tumbling some 20% in just a few days.

In others words, Friona Industries (FI) used the market's reaction to the Canadian BSE scare, coupled with tight supplies, to secure a profit and protect itself against a similar psychological impact on U.S. futures and live cattle prices. Thanks to marketing moves in October on cattle sent to slaughter in December, prices were covered at $90/cwt., while the live price sunk to $75/cwt.

Market-wrecking catastrophes have been part of the cattle business since the first herds were driven over land to market. The past 30 years have seen consumer beef boycotts in the 1970s and the dairy herd buyout followed by mini-stock market crash in the '80s.

Then, three or four days of limit-down markets just happened to follow anti-burger comments by a certain talk show superstar in 1997.

Most recently came the still-stinging Christmastime Washington state BSE stunner. Four days of limit-down, with the limit sometimes extended to $5/day, brought in the new year. Futures prices dropped 20%. So did cash markets — from $95 to $75 — or more than $200/head.

But FI had a disaster plan. The Amarillo, TX-based company was hurricane-ready. Some damage occurred, but the sea wall kept out the brunt of the storm.

James Herring, FI president and CEO, attributes the company's policy of maintaining either straight futures hedges or options positions on virtually all of its four-feedyard inventory as the savior against a BSE meltdown.

“Our policy centers around the concept of price protection for our current and future livestock inventory,” says Herring, whose company has a feeding capacity of about 235,000 head.

“Depending on the time of the year, the state of the production cycle and seasonality, we use all kinds of marketing strategies. We make sure we're not left out on a limb if a market disaster happens.”

Northern Exposure

Ironically, it was the Canadian BSE scare that led FI to establish extra price protection.

“Unfortunately, another country's trauma meant the U.S. would be counted on more to supply the world's beef,” Herring says, noting that cattle prices were already in the $80s due to tight beef supplies. The U.S. market then started its climb to record prices that first topped $100 cwt., then $110.

Wayne Purcell, livestock marketing economist at Virginia Tech University in Blacksburg, says the Canadian misfortune opened doors to big profits for U.S. cash sales, as well as wide windows for price protection.

“Before BSE hit [in the U.S.], we had all the uncertainly surrounding the Canadian border,” Purcell says.“I suggested producers and feeders keep their short hedges even before BSE hit the U.S. That probably made a lot of people a ton of money.”

In developing the FI marketing strategy, Herring says high consumer prices created by the price run-up were weighed against a potential drop in consumer demand.

“During the fall when prices got to $110, we felt like that price was unsustainable for cattle. We didn't believe the consumer would continually absorb that price level,” he says.

“That was a pretty high price for us and we did not think the marketplace could handle that kind of price load. We wanted to protect against a major loss. We made sure we were 100%-hedged on our current and future inventory,” he adds.

FI established positions in October on cattle placed in July and August. The cattle had a breakeven range at about $75.

“When the market peaked in October, we protected those cattle at about $90 with 2004 live cattle options and futures,” Herring says.“There were plenty of chances that month to pull huge money out of the market, at least $180 per head.”

When the price plunged, the value of the futures and options positions made up for much of the downfall. Cattle sold at $75 were protected at about $90. In addition, cattle slated for February delivery, with breakevens also in the $75 range, were also hedged.

“We took out $85 to $90 futures on those cattle,” Herring says, noting similar positions were also in place for cattle headed to market in the spring.

Insurance Policy

Scott Keeling, owner of Keeling Cattle Feeders outside Hereford, TX, isn't one to keep the yard's inventory hedged all the time. The philosophy of year-round feeding and year-round price averaging on company cattle normally suits him best. But $100+ cattle aren't the norm. So he took out “catastrophic” protection for December- and February-finished cattle.

Keeling operates a 17,000-head yard. When cash markets skyrocketed to $110 and the price of replacements hit $1/lb., it was time to pull the trigger.

“I'm usually not a hedge yard,” Keeling says.“But when we got to the $90s and $100s cash prices, that was a long way to drop. When feeders hit $1, we decided it was time to look at some catastrophic protection, mostly in the near months.”

Keeling looked at keeping that price protection at no more than $20/head. So, in October he bought $85 December '03 put options at a cost of $1.50/cwt. For February cattle, he bought $80 puts and sold $90 March calls for a combined price of about $2. That gave him an $80-$90 window and he was covered against anything below $80.

The December options expired worthless because the cattle were sold before the BSE sting. Fortunately, prices had started back up before Keeling had cattle for delivery. And he was hoping that the February positions would also expire worthless, even though that insurance cost him $20/head.

“That means the prices are higher than your options positions,” he says.“And insurance is what you are after in a strategy like that.”

George Enloe is co-owner of Amarillo Brokerage Co., a major commodity futures brokerage and consulting firm for feedyards and stocker operators. He says he encouraged the options-oriented strategy prior to the U.S. BSE hit.

“Because of the tremendous increase in prices, we encouraged customers to have coverage on everything in some form,” he says. “But with futures below cash (by $15 or more at times), we encouraged them to buy puts. If futures had been above cash prices, we would have felt more aggressive and would likely have sold futures.”

That was still the stance he took in late January when the February, March and April contracts were between $74 and $79, while live markets were in the mid-$80s. Cautiously, Enloe uttered what many in the industry were also thinking:“We may not be out of the woods on BSE. If they find an animal that is domestically raised, we are in the same boat again.”

He suggested put-buying strategies for cattle going on feed in late January and early February.

“But with breakevens in the high $70s to low $80s, and futures at huge discounts (to cash), risk management is next to impossible,” he says.“Before I would buy an $80 breakeven to go to feed, I'd buy a June $82 call for $1 or less and wait for the relationship between feeder cattle, live cattle and corn to become more favorable.”

Purcell says owners of cattle on feed with an $80 breakeven and summer delivery should consider June options, in the $66 to $68 range.

“Sometimes it makes sense to get some sort of disaster insurance,” he says. “There's a possibility of a worse situation in the market, especially if someone gets sick. The problem is those options might cost $2.50 or more, but that's sometimes the cost of insurance.”

Purcell notes that in less than a month, from late to December to late January, the market rebounded remarkably.

“In cases, it has made up about a 50% correction after the BSE break,” he says.“If you look at April, it broke from a high of $84.50 all the way down to $68.50 (before returning to the mid-$70s).

“It's hard to count on much more than a 38% correction. When the market shows signs of pressure to go below that amount, it may be time to get short the market,” he adds.

Hedges Can Hurt

Just as those with price protection prospered when the market plunged, many who were hedged with futures when the market took off were losers. Cattle hedged at $75 when futures close at $90 take a big hit.

“It was easy to understand why so many people were not hedged when the market broke,” Herring says.“Our policy of covering all our inventory meant we left a lot of money on the table when the Canadian situation hit. But we've seen this happen many times. You give up some of the upside to make sure you're still in business [in event of a wreck]. That's part of the game in our industry.”

Purcell notes that when margin calls are made on futures, there is still a positive sign. “If you're hedged and price goes up, the cash cattle cover you,” he says. “It's actually not a loss.”

What about more use of the Chicago Mercantile Exchange marketing tools down the road? Keeling is one who will consider it.

“We're going to look at having more price protection in place because of the increased volatility we're likely to see in the market,” Keeling says. “Every time they kill a BSE-infected cow, there's a chance it will impact the market. And we don't want to think about the worst possibilities that could severely damage our markets.”

He adds, “I figure I can stand a $50 per head loss and still come out and play.”

Herring sees lenders possibly requiring greater price protection before making cattle loans.

“Bankers are becoming more cautious with the overall risk level of cattle feeding and prices,” Herring says.“They wonder if we can continue to raise $85 or $90 cattle and have the consumer pay for it. There may be more requirements for options or futures protection, or a greater equity requirement.”

In other words, this isn't your grandfather's cattle business anymore. With scares like BSE, it is not even what it was last Thanksgiving.

Larry Stalcup is a freelance writer based in Amarillo, TX.

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