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BEEF Magazine is the source for beef production, management and market news.
August 1, 2011
<b>Jeff Smith, a stocker operator</b> and corn/wheat/sorghum producer from Happy, TX, knows he isn't smart enough to outguess the market so he uses risk management to lock in profit.
With a near-guaranteed profit of $15-$20/cwt. and the grass or preconditioning pens to assure stocker gains, Jeff Smith feels he’s safe in hedging spring- and summer-bought cattle for fall sales.
“I’m not smart enough to outguess the market. But when the profit’s there, I think you need to take part of it,” contends the stocker operator and corn/wheat/sorghum producer from Happy, TX.
Smith’s philosophy echoes the old saying that “you can’t go broke by making a profit.” He’s willing to make those early-on hedges, even if there’s a chance profit margins will grow even wider as the squeeze on feeder-cattle supplies tightens.
Such risk management has forever been one of the most overlooked parts of this business. Many producers fear making a big mistake, facing margin calls or aren’t familiar enough with the marketing tools available. However, huge financial requirements for buying stockers or feeder cattle, coupled with high volatility in feed and cattle prices, make risk management essential.
“If not now, then when?” asks Stephen Koontz, Colorado State University livestock marketing economist. “I’ve taught risk management for years and it is always – understandably – a tough sell. Why? There were not good margins or profits to lock-in. That is not the case today.”
Smith runs several thousand stockers almost year ’round to take advantage of both summer grass and irrigated wheat pasture. He buys them at 350-500 lbs. and takes them to 750-850 lbs. “We usually cut back a lot in July and August when it’s dry and hot,” he says.
Along with growing wheat and grass in several Texas Panhandle locations and in southwestern Oklahoma, he runs a backgrounding yard to help promote early gain and/or straighten out the calves. “About half the cattle we buy are ‘good’ cattle that have been through a VAC program, and half are more sale-barn type that need help in getting started,” he says. “We normally go with our own wheat hay and starter-corn ration with Sweet Bran to produce early gains. Cattle are preconditioned 30-45 days before going on wheat pasture or grass.”
Smith takes different approaches, depending on the weather and demand for feeder cattle. Both are playing a part in his 2011 marketing plan. “I’ll often hedge a third of the cattle, forward contract a third and leave a third open close to the day they’re sold,” he says.
“Since we’ve seen severe drought much of the past year, you can’t be sure if there’ll be enough grass for summer grazing. It’s more difficult to find a price to hedge in cattle.”
Still, with October feeder-cattle futures trading in the $135/cwt. range in early spring, Smith seized the opportunity to sell October futures to hedge 50% of a crossbred group of stockers.
“Those cattle weighed about 450 lbs. when we brought them in,” he says. “We figured the breakeven in the low-teens. When futures were in the $130s, we hedged them. They’ll be forward contracted when we know we’ll have the rain to produce the grass.”
With those hedges, cattle with a $115-$118 breakeven would see a solid $15-$20/cwt. profit. And if October futures climb above the hedged price and margin calls are required, that added expense will be countered by the additional profit from selling the cattle at the higher price.
He used the same strategy to hedge 350- to 450-lb. cattle with a $115 breakeven. “Those cattle and the other set were bought for $145 to $150 cwt.,” says Smith, noting that the additional 400 lbs. will make them attractive to feedyards eager to buy heavier cattle due to high corn prices.
When feeder cattle futures rose into the $140s in July after plunging into the $120s in late spring, Smith was considering rolling up some of his hedges.
“Also, now that we received some rain in Oklahoma, we’re getting close to contracting cattle as we get closer to the finish line,” Smith says.
Risk management could increase profit
Derrell Peel, Oklahoma State University Extension livestock marketing economist, says most stocker programs should generate some profit this year, due mainly to the continuing shortage of feeder cattle. Risk management could increase profit margins.
“About the only stocker program that doesn’t work well is to buy a lightweight animal and sell them too soon, at relatively light weights,” Peel says. “Starting with a lightweight animal and selling them at heavy feeder weights, or buying cattle at a heavier beginning weight and selling them at heavy weights, both work well.”
USDA’s June Cattle on Feed report illustrated the demand for heavyweights and all weights of feeder cattle. There were 1.81 million cattle placed in May, compared to 2.03 million in 2010. Placements of cattle 800 lbs. and above totaled 580,000, compared to 635,000 last year; 700-799 lbs., 480,000 compared to 535,000 last year; 600-699 lbs., 365,000 compared to 410,000 last year; and under 600 lbs., 415,000 compared to 450,000 last year.
What about options?
Smith normally doesn’t use options. “The premiums have gotten too high,” he says. “I’d rather go with straight futures hedges.”
Even though options are often expensive in premiums, they can help manage price risk, Koontz says.
“Normally, I hate options because the premiums are so high,” he says. “They are still really high – but not as high as margin calls will very likely be.”
Koontz says one strategy to consider is to buy “a cheap, but not too-cheap, out-of-the-money put, then roll it up if the market climbs.”
With October feeder futures trading at about $144 in early July, an at-the-money put option cost about $5/cwt. For one 50,000-lb. contract (equal to about 60, heavier 8-weight yearlings), that put the cost at about $2,500, plus brokerage commission.
For that, any settlement of the futures price below $144 would be covered. If the price closed above $144, the option would expire worthless. However, the higher price would help make up for the cost of price protection, or risk management.
The $2,500 price and other “expensive” options premiums immediately turn off a lot of cattlemen. But an out-of-the-money put to protect against a wreck may be more attractive, although it still won’t come very cheap.
For example, in July, a $138 October put had about a $3/cwt. price, or about $1,500. A producer would be protected against prices below $138. So, if you figure a breakeven in the $115 range or even $120, there could be opportunities to protect that price in the event of a sharp drop in prices.
On the other hand, with the bullish outlook for cattle prices, perhaps forward contracting stockers, then using call options to take advantage of price increases over and above your contract price may be in order.
No matter which options or futures strategy you use, make sure you understand these marketing tools, Koontz stresses.
Consider Livestock Risk Protection
He adds that most livestock-producing states also offer federal Livestock Risk Protection (LRP) from USDA’s Risk Manage-ment Agency (RMA). “University Extension livestock specialists have a lot of LRP information available on the Internet,” Koontz says.
According to RMA, the annual limitation of the number of feeder cattle that may be covered during the crop year (July 1-June 30) is 2,000 head. It’s a program that can work for many stocker operators for all or part of their cattle. (For more on LRP rules, see your regional Extension office or visit www.rma.usda.gov/livestock/).
Koontz urges stocker operators and others to consider this or some other form of risk management. “At some point, the excitement in the corn market is going to overtake the excitement in the beef and fed markets – and feeders are going to weaken. Get ready and have some price protection before that.
“Sell some through the video auctions (or special sales for higher-quality cattle). A number of successful producers I’ve talked to sell on the video over the summer. The market tends to be strong then and they diversify sales then and in the fall.”
Koontz points out some buyers have walked away from forward contracts when cattle prices took steep declines in the past. So it’s essential to know your buyer’s financial situation and have an ironclad contract (see “Fallout From the Eastern Livestock Marketing Scam” in the April issue of BEEF).
Going beyond hedging and forward contracts
Smith’s risk management doesn’t stop with hedging and forward contracting. His irrigated corn, which averages about 225 bu./acre, eventually helps support the cattle. “We market corn early, usually before planting, when prices are seasonally better,” he says. “We can then use that profit to buy corn for the yard when it’s normally cheaper (at harvest).”
Silage produced from his corn and sorghum crops are worked into the backgrounding rations. “Silage is also a good backup if you run out of wheat and grass,” he says.
He fears corn will approach $7/bu. once more. And like other cattlemen, he was annoyed that even though corn prices dropped sharply in early July, the corn basis increased.
“The basis went up as much as corn went down,” he says. “Our basis was in the $1.18 range (in the southern High Plains).”
So, hopefully he can at least cover some of the added feed costs by making his own corn sales at higher prices.
Such indirect-hedge thinking is what helps keep Smith in the cattle business. “Knowing you can have corn and silage for backgrounding at a better price helps hold down your breakeven,” he concludes. “There are so many variables to consider; short cattle supplies, drought and corn prices. So, when the profit’s there, you need to take it.”
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