Cattle markets have remained at record highs thanks to fewer numbers and high demand.
By: Kenny Burdine, Livestock Marketing Specialist, University of Kentucky
The unprecedented strength of the cattle markets has continued into early May. Tight feeder cattle supplies and an incredibly strong fed cattle market have continued to support feeder cattle prices. At the time of this writing, prices for 550 lb steer calves were above $2 per lb on a state average basis with larger groups selling in a range of $210-$220 per cwt. As strong as these price levels for calves are, they are largely the product of fall CME© Feeder Cattle futures trading above $190 per cwt. We seem to be trading in a new price range for feeder cattle.
Producers should continue to watch the grain markets as we learn more about corn planting progress this spring. While it is early, planting progress appears to be ahead of last year. We discussed last month that a significant decrease in corn acres was expected for 2014. Since early April, new crop corn futures have largely traded within ten cents per bushel of $5. Changes in corn price are a major driver of feeder cattle prices through the summer. Thus far, 2014 has been a true bull market for feeder cattle.
Many summer stocker operators have placed calves into summer grazing programs and this was largely the focus of a March article that Greg Halich and I wrote. In that article, an estimation of returns to a summer stocker program was made based on fall feeder cattle futures and estimated expenses for the stocker program. Many stocker operators undoubtedly took some type of price protection on the calves that were purchased in order to manage the downside price risk potential. I thought it would be appropriate to focus this month's article on two common price risk management strategies and how they would have applied to this 2014 market.
I get a lot of questions about the advantages and disadvantages of simply selling futures as a risk management strategy versus purchasing a put option. When a producer sells a futures contract for the month in which they plan to sell feeder cattle, this is often called a straight hedge. In a market like we have seen thus far in 2014, producers who sold futures contracts have been losing on those futures contracts as prices increased. As this happens, producers send margin money to cover the losses on those contracts. Those producers are losing on their short futures positions, but are making it up as the value of the cattle they will sell this fall increases. However, margin calls can be very frustrating as they require significant capital and the producer will not benefit from the strong feeder cattle market until the cattle are sold.
Conversely, when a producer purchases a put option, they pay a premium to buy the right to sell a futures contract at a predetermined price. If the market goes down while they own the cattle, they can make money on the option because they own the right to sell at a higher price. Of course if this happens, it means that the overall cattle market has dropped and they will likely sell their cattle on a weaker fall market. The producer is out the premium spent regardless of what the market does. A put option provides downside risk protection, but a producer is always better off if the market stays strong and their put option ends up expiring worthless. Put options are often thought of as "price insurance" in that it is great to have if the market drops, but one is better off if they don't collect on their "insurance".
I have often shared that my philosophy on risk management is to protect the downside first, then worry about the upside. Both of these strategies provide solid downside protection. The straight hedge provides the highest level of protection as no money is spent on premium and producers immediately gain on the futures market as prices decrease. While the put option sets a lower price floor, it does still provide significant downside risk protection. However, 2014 has clearly been a market where those who considered the upside have benefited and I wanted to briefly describe what is meant by this.
Producers who protected their prices by selling futures have made significant margin calls over the last couple months. Again, this will be largely offset when cattle are sold if the market holds. But, by selling futures they have not been able to benefit from the rising feeder cattle market on cattle that were protected by the straight hedge. A bull market such as the one we have enjoyed thus far in 2014 is the type of year when put options can be very advantageous. Producers who chose to purchase a put option, rather than sell a futures contract have been able to benefit from the rising market. Many of those producers may have spent $10-$25 per head on premium, but that has been more than offset by the increase in the market. The put option set a price floor, but not a ceiling on their sale prices.
While I wanted to describe how these two strategies would have worked in 2014, I think it is very important that I make two additional points. First, I want to stress that applying risk management strategies to a single year can be very misleading. The primary point of this article was to describe how purchasing put options may be more attractive than straight hedges in some cases. However, the reason why price risk management makes sense is because there is uncertainty about the direction of prices. There was no guarantee about where prices were headed earlier in the year. Had the feeder cattle market decreased this spring, producers who sold futures contracts would have been better off than those who purchases put options.
Secondly, it is also important to remember that it is still very early in the summer stocker season. There are still many factors that will affect feeder cattle prices between now and fall and producers who have risk management positions in place are protected from potential decreases in feeder cattle prices between now and sale time. So while it is useful to examine strategies today, there is still a great deal of uncertainty going forward and risk management strategies are taken to deal with that uncertainty. Stocker operators have a lot of money at stake this year, especially given the incredibly high prices paid for calves this spring. Hedging and options, as well as forward contracts, LRP insurance, and other risk management strategies provide an opportunity to manage that downside risk and limit the potential loss should markets move against producers while they own cattle.