Risk management 101: Basics to know when making marketing plansRisk management 101: Basics to know when making marketing plans
Futures and options have been around for a long time as a way for producers to manage their market risk. Here’s a look at how it works. Part 1 on a 2-part series.
October 5, 2017
By Jason Bradley
If we step all the way back and look at cattle production, we see there are two types of risks. We call them risks because they are things you can't control. The first is production risk. This deals with factors influencing desirable reproduction levels, such as conception and birthing percentages, and keeping your cattle healthy, which ensures calves reach their desired levels of gain. The second is market risk, which is the focus of this article.
So, what about market risk? To borrow from Shakespeare: To hedge or not to hedge, that is the question: Whether 'tis nobler in the mind to maybe just go ahead and use forward contracting? But what about using options? You always hear about that being a great tool.
Then, you start hearing about all the ways you could combine all of these. Your mouth goes dry, hands begin to sweat and the room starts to spin. You can see how this can get very complicated, very fast. Without a firm understanding of what these strategies and tools are, it's almost impossible to understand what benefits they potentially hold for you. So let’s talk basics from here on out so your prepared to prepare your ranch for the opportunities that come up in the months ahead.
As a producer, you are a price taker. The price you receive for your goods is set by the consumers buying your product. Retail markets are price setters in that the consumers buying their goods pay the price set by the retailers.
A cow-calf producer's consumer is usually a stocker producer or feedyard operation. So, how do these buyers determine the price they are willing to pay for your cattle? They've done the math and figured out their breakeven. This breakeven is the maximum price they are willing to pay based on what they are expecting to receive for the cattle, less the costs expected to incur during their production phase.
What does this mean for you as a producer? You also need to know your breakeven price, not as a maximum price you're willing to pay but as the minimum price you can receive without taking a loss. This is where having a history of income and expense statements comes in handy. By looking back at your statement history, you can determine your production cost and the minimum amount you can receive for your calves.
What’s your willingness to accept risk?
Everyone has a different level of risk that they are willing to accept. We're going to talk about three levels of risk: high, medium and low.
High risk: Cash market
The method with the highest market risk level is strictly using the cash market. With all the discussion about the volatility of today's cattle markets, someone who is willing to take their chances and sell cattle on the cash market without any risk management plan in place would be considered a risk-seeker or risk-taker. If this is you, it is perfectly fine.
The reason this is considered the most risky method is that you are at the mercy of the market. If the market goes up, you picked the best method. You didn't have any extra costs from broker fees or margin calls. On the flip side, if the markets go down, you stand to take the biggest losses, making this the worst method.
Low risk: Forward contracting
For those who don't want to leave anything to chance, there's forward contracting. With your breakeven price in mind, you find a buyer who is willing to pay you an agreed price above your breakeven price on a set date that the cattle will be delivered. Just remember, while a handshake is good, it's better to get it in writing.
So, how does this work out? If the market price were to drop after your deal, you've made the best choice. No broker fees and no lost profit. But, if the market price were to go up, you've given up the chance to capture that extra profit.
Let's imagine this is your preferred level of risk. You want to lock in a price now, but you don't have a buyer lined up to buy your cattle. This is where we turn to the futures markets.
Low risk: Futures
The futures markets are just that: market price projections for future dates. People from all over the world gather to buy and sell contracts for different commodities based on these projected prices.
Each contract is different depending on the commodity. Since we're talking about cattle, we're going to use the feeder cattle futures. Because of the price variation between different sizes of cattle, the quoted prices are for Medium and Large #1, and Medium and Large #1-2 feeder steers weighing 700 to 899 pounds. The total volume for one of these contracts is 50,000 pounds. This means one feeder cattle contract will cover about 62 feeder steers weighing 800 pounds.
As the contract date gets closer, the futures price and cash price start to converge. When the contract closes, the difference between those prices is the basis (Basis = Cash Value – Futures Value). Basis accounts for the form, location and time aspect of the commodity. The cattle's weight or gender can affect the basis in the way of form, while the distance the sale is happening accounts for the location.
Next week, we’ll look at how the futures market works and work through some examples of how hedging and options can work on the ranch.
Bradley is an agricultural economics consultant with the Noble Research Institutre in Ardmore, Okla.
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