Strategies for livestock futures hedging
Mar 24, 2004 11:27 AM, By Rob Hogan, Scott Stiles, Kelly Bryant, and James Marshall
Managing price risk using futures contracts.
FAYETTEVILLE, Ark. -- Livestock producers face many potential risks in their quest for profitable operation. These risks may fall into either marketing or production categories.
Marketing risks may be either price or basis risk. All producers face them. Price risks contribute as a major source of revenue and cost variability and as such may be a factor in whether an operation is financially viable or not.
This article presents strategies for managing price risk using futures contracts.
Price risk may be defined as risk that market price may decline before or during a producer’s normal marketing time frame. In other words, after all production decisions influencing quantities of livestock to be produced are made, price risk would be that risk associated with a lower livestock sales price than what was expected.
In addition to price risk affecting livestock sales, there is also price risk involving feed costs. Increased grain or supplemental protein prices will result in reduced net revenue just as surely as decreased livestock price.
Finally the producer may experience price risk from some combination of both sales price and feed cost risk.
Before marketing strategies may be evaluated, a producer must know:
• breakeven prices for his operation
• sales price objective for feeder cattle
• least-acceptable sales price for feeder cattle
• greatest acceptable cost of feed
• feeder cattle and feed prices the market is currently offering
• producer’s ability to stand risk.
Sales price risk strategy:
Scenario—falling feeder cattle prices. March 1 — spring calving is coming to an end or is already over. Cash prices in Arkansas for large to medium frame No. 1 600- to 700-pound steers are $94 to $104 per hundredweight. As a producer you are concerned prices might fall between now and Oct. 1, when you plan to market your calves.
Marketing alternative— sell October feeder cattle contract(s) at the current market price of $88.05. This price, corrected for basis and differences in contract specifications, will become the minimum sales price at your farm. In October offset the hedge, buying the futures contract(s) and selling calves in cash market.
Feed price risk strategy:
Scenario—rising corn and soybean prices. March 1—current cash corn at $3.03 per bushel; soybean prices at $9.55 per bushel. The producer may wish to “creep” feed their calves when larger and are concerned higher corn and soybean prices may result in a cost of feed that is greater than budgeted amounts.
Marketing alternative — buy September corn and soybean contract(s) at current market price $3.015 and $8.32 per bushel respectively. These prices must be corrected for basis, difference in contract specifications, and transportation. In September offset the hedge, selling the futures contract(s), having bought “creep” feed along to supplement the calves.
Cattle and Feed Price Risk Strategy:
Scenario—falling feeder cattle prices and rising corn and soybean prices. This scenario is the worst of all worlds. Falling feeder cattle prices will result in reduced revenue while rising feed costs will result in increased costs.
Marketing alternative — sell October feeder cattle contract(s) and buy September corn and soybean contract(s). As stated before, feeder cattle and grain prices must be corrected for basis, difference in contract specifications, and transportation. In September offset the grain hedge and in October offset the feeder cattle hedge, selling the calves in the cash market.
Advantages of the strategies include:
• Provides price risk management against lower prices of feeder cattle and higher feed costs.
• Establishes a range for feeder cattle prices and feed costs.
• Helps with the planning and budgeting process.
Disadvantages include:
• Futures positions require a margin account with a commodity futures broker.
• There is a risk of financial loss in the futures market.
The strategies presented here deal with using futures contracts instead of options. Although there is increased financial exposure resulting from the use of futures, these strategies would outperform similar options strategies by the amount of the option premium if, in fact, market prices moved in the predicted direction.
However, care must be used to balance increased exposure, acceptable levels of risk, and projected returns.
If options are purchased instead of futures contracts, price risk is reduced without the disadvantages listed above.
For further information, contact your local Extension personnel, state Extension specialists, or the authors of this article.
Rob Hogan, Scott Stiles, Kelly Bryant, and James Marshall are University of Arkansas Extension economists. Comments or questions? Call 870-460-1091 or e-mail bryantk@uamont.edu.
