Earlier this year, Industry At A Glance ran a series of columns on risk management that covered a variety of topics. The first column in the series (June 5) highlighted an example of how a straight hedge, from a selling perspective, would work for fed cattle.Â
The column, using an example of marketing fed cattle in May, explained the expectation would be as follows, assuming a $114.50 hedge by shorting the June live cattle contract and $9.75 basis:Â Â Â
…at the time of placing the hedge, the feedyard’s expected selling price would be $124.25 ($114.50 + $9.75). The feedyard is now indifferent to what occurs in the futures market – they are protected against downside market risk. The only remaining price risk revolves around basis.
Now fast-forward to the first week of May and the cattle are ready to be marketed. The cash market averaged $123.75 while the futures had drifted back to $114 (basis was right in line with the five-year average). The feedyard markets the cattle at $123.75 while simultaneously negating the short position in the futures market by purchasing June contracts at $114 – thereby facilitating a 50¢ profit. The net selling price is $124.25 ($123.75 + $.50).Â
All of that can seem somewhat irrelevant when talking hypothetically. Â
However, 2019 provides a very real-life case study regarding the benefit of futures markets and risk management. To that end, this week’s graph highlights the advantage of using hedges in a consistent manner; it contrasts the benefit for those feedyards which stay hedged regardless of market conditions versus those which simply operate in the cash markets. Â
Placements purchased in 2019 began to be marketed in June, based on a ~160-day feeding period. The illustration features the selling price of closeouts on a hedged basis versus a cash basis since that time (through the week ending Oct. 4). It highlights the value of risk management when unexpected, black-swan events occur (e.g. plant fires) – the hedged cattle aren’t affected by sharp downturns in the market.
Thus far, the value of hedging 2019 purchases is equivalent to $11.50 per cwt. The average slaughter weight during the respective marketing window is 1,330 pounds, based on USDA data, thereby providing the disciplined hedgers a $150+ per head advantage versus selling in the cash market only. Â
Clearly, that has huge implications for the entire feeding sector. And that value difference will ultimately translate back upstream to backgrounders and cow-calf operators. In other words, risk management is an invaluable tool that possesses implications for the entire industry. Â
Speer serves as an industry consultant and is based in Bowling Green, Ky. Contact him at [email protected]
