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Hedge In A Profit?

Cattle feeders haven't had much to smile about in the past year or so, what with ethanol-fueled corn prices and persistently strong feeder cattle prices rewriting the rules in the cattle-marketing game. However, even after $130+/head average losses the first six months of the year, $7-$8/bu. corn doesn't look as bad if fed-cattle futures stay in the teens. Yes, corn prices are still fretful, but if

Cattle feeders haven't had much to smile about in the past year or so, what with ethanol-fueled corn prices and persistently strong feeder cattle prices rewriting the rules in the cattle-marketing game.

However, even after $130+/head average losses the first six months of the year, $7-$8/bu. corn doesn't look as bad if fed-cattle futures stay in the teens. Yes, corn prices are still fretful, but if feed and feeder cattle are bought right, a futures or options strategy could produce a tiny profit, or at least something near breakeven.

Of course, with feeder prices still high, there's never a guaranteed profit. Cattle feeders might only hope for a strategy that keeps losses to a minimum. And getting feed grains locked in before setting a cattle-marketing strategy is likely a must with the volatility seen in the craziest commodities market ever.

But it's doable, market analysts say. Cattle feeders might consider several strategies that could soften the blow of the year's steady losses. Cattle marketers favor buying puts and selling calls to cheapen the cost of protection to $1-$1.50/cwt. and work within a window of about $111-$118, or a combination of other futures and options programs or forward contracts.

“Producers should definitely think hard about price risk-management strategies — evaluating hedging as well as other forward-pricing strategies such as cash-forward contracting,” says John Anderson, Mississippi State University livestock marketing specialist. “Commodity prices in general will likely continue to be very volatile. And, with soaring production costs, cattle feeders will be putting more capital at risk than ever before.”

Mark Green, consultant at Schweiterman, Inc., a Garden City, KS commodity brokerage, says that “maybe we have some potential (for hedging cattle) as long as you have your input costs locked in. If feeder cattle are bought and corn has a ceiling, you can do it a number of different ways.

“You can spend money on puts, or buy puts and sell calls, or ‘sell the board’ (sell futures) and buy calls. Contracting with packers is another strategy, with basis in the $3-$6 under level.”

Opting for options

Elaine Johnson, a commodity consultant with DEVO Capital, Denver, CO, also likes the options angle. “Given today's volatile environment, especially in the corn market, I prefer cattle feeders use options, usually a combo such as buying puts and then selling out-of-the-money calls and/or puts,” she says. “My alternative is to use a straight hedge, but then to buy calls as well for upside protection.”

Even with late 2008 and early '09 live cattle futures in the $113-$116 area, cattle will have trouble breaking even. But at least feeders can avoid a further bashing on the bottom line, says Tyler Keeling, consultant with Amarillo Brokerage Co., Amarillo, TX.

“For many, it's no longer a situation of ‘how much weight can I put on?’ It's ‘what do I market at and at what price?’” says Keeling, whose family owns and operates a 17,000-head Hereford, TX feedyard.

“With the high prices for corn, you have to feed a bigger animal. Everything has to be below 180 days on feed. We're still seeing the 1,200- to 1,300-lb. finished animal, but feeder cattle are heavier when they arrive at the yard.”

He suggests cattle feeders look at the options strategy of buying puts, selling calls for cattle finishing out at year's end or early next year. Put options $2-$3 out of the money and a call $4-$5 over the futures price could provide a reasonable window of opportunity for marketing without costing a lot in premiums.

For example, if December '08 live-cattle futures are $113/cwt., then a $110 December put may cost about $4.80/cwt. That's pretty expensive price protection for an animal with a breakeven above $113.

But by selling a $116 December call for $5.30, the cost of protection is lowered to less than $1 ($5.30 - $4.80 = 50¢). Widening the spread with, say, a $118 call (sold for $4) can make the cost of protection at zero, or even in the money. The market window is $110-$116 for the first spread and $110-$118 for the second.

Anderson likes the spread strategy, especially since an at-the-money put option for a December contract might cost $6/cwt. “But producers must recognize this strategy introduces an element of risk not present in a straight hedge,” he says. “The seller of an option may be called on to take the opposite side of the market when an option is exercised. For that reason, margin money has to be posted when an option is sold, or written. Also, the sale of a call option will eliminate any upside gain above the call option's strike price.

“This strategy's advantage is that it leaves some upside open to the producer while reducing the cost of downside protection. Given the high price of options right now, there's likely to be quite a bit of interest in these strategies this year.”

Keeling says the volatile market can make the person using the $110-$118 spread vulnerable over $118. “If the price approaches that, then you can get out of the spread and just hedge the cattle by selling the board (selling futures),” Keeling says.

Anderson says the most straightforward strategy is to implement a short hedge by selling December futures to lock in a floor price of $113, or whatever the December price is on the transaction day. A similar approach could be used with the February and April '09 contracts.

“On the front end of this strategy, the producer should discuss the possibility of margin calls with his/her lender and ensure adequate financing to deal with that,” he says.

Price volatility must be taken seriously in a straight hedge or even an options strategy, Green says. “If you the sell board outright, understand we might even see markets go to $130 or higher,” he says. “You have to have a good banker (who understands marketing to establish a margin account).”

Alternative strategies

There's another strategy for “hedging” cattle, even though there's nothing artificial about trying to make a pen of cattle work. It's called a synthetic put and it involves selling the live cattle futures contract, then buying an out-of-the-money call.

“Holding the call option allows the producer to benefit from any price increase above the call option's strike price,” Anderson says. “Current option premiums are pretty high, though. You have to get so far out-of-the-money to get a reasonable-looking premium, that this strategy may not get much interest this year.”

That's also an alternative strategy for Johnson to help provide upside protection. She encourages feeders to also consider cash forward contracts, depending on the local basis offered.

“Record basis levels being offered in deferred futures contracts could provide effective hedge protection as well,” she says.

“Don't put cattle in the feedlot and hope that corn gets cheaper,” Anderson insists. “That wishful thinking has cost people a lot of money in the last 18 months. Price risk management on feed is just as important as price risk management on cattle.”

And don't look for a larger corn supply any time soon. “It will probably be another 15 months before we have a chance to see more corn in the pipeline,” says Chris Hurt, Purdue University grain marketing specialist, reacting to the worldwide corn demand even before the massive Corn Belt flooding likely reduced production for the year.

“The key to the whole thing is, what if we go to $10/bu.?” Green asks. “We'll probably have to ration 1.5 billion bu. of corn usage. When starting off with a tight situation anyway — the only way do it is to price it.”

Anderson says cattlemen should “carefully evaluate all pricing alternatives, such as live, rail and grids of various descriptions, and take advantage of any premium programs for which the cattle will qualify.”

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

TAGS: Feedlots