Last month, several Cattle & Corn Comments articles on iGrow focused on backgrounding and finishing calves. Certainly, there has been a lot more interest in backgrounding programs amongst farmer/feeders and cow-calf producers due to cheaper corn prices and more plentiful hay supplies this year. Even in spite of near-record high feeder calf prices, there is some profit opportunity in backgrounding and finishing programs this winter.

One of the good questions posed in response to those articles is whether or not to hedge the calves in a winter backgrounding program. At the end of last week, March 2014 feeder cattle futures were near $167/cwt, which is less than $1/cwt below its life-of-contract high posted on October 14, 2013. In many respects, locking in near-record high prices for yearlings coming out of a backgrounding program seems like an easy decision. However, most of the fundamentals in the feeder cattle market remain fairly bullish, and more potential upside could exist. And, even if higher prices didn’t materialize, the risk of lower prices may not be sufficient to offset the risk management expenses for some producers.

A first step in evaluating the decision to hedge the yearlings, or any commodity, is to recognize that the objective is to reduce risk, in this case price variability. Research examining routine hedging programs confirms that, over time, price variability is reduced through futures hedging. That research also generally demonstrates that the returns are lower, on average over a long time period, in a routine hedging program compared to strictly cash sales. The typical risk-reward tradeoff exists in hedging: in order to reduce risk (i.e., price variability), the hedger has to “pay” for it through lower net prices.

Consider a specific example from some research on routinely hedging yearling steers (coming out of a backgrounding program) that I did a few years ago in Nebraska. In that program, I compared the prices and variability of prices received for selling a 750 lb steer on May 1 from 2002 to 2010 using three marketing alternatives: 1) cash market sale with no hedging, 2) short futures hedge established on December 1 and lifted on May 1, and 3) an at-the-money put option purchased on December 1 and lifted on May 1. As would be expected, the average cash market sale without hedging ($105.88/cwt) was higher than the futures hedge ($105.85/cwt) and the options hedge ($102.89/cwt) over the nine-year time period. However, the price variability was greatest when not hedging. In fact, the standard deviation from the futures hedging alternative was $10.27/cwt, $3.05/cwt less than the cash market sale without hedging and $1.13/cwt less than the options hedge.

With that background in mind, the management decision for producers considering hedging their calves needs to determine whether a potentially lower price – on average – is worth the risk reduction that a hedge could provide. The answer will depend on producers’ individual risk tolerance as well as their operations’ financial position. Businesses that are more highly leveraged and those with less working capital likely will need hedges in place to reduce risk.

A second important step to deciding whether to hedge is to know the breakeven cost of production. Being able to lock in a price through a hedge is easier to do when there is a profit to protect. While backgrounding costs vary widely amongst producers, it would appear that, on average, most producers can project a profit from backgrounding calves this winter. Thus, taking advantage of today’s high prices and hedging the selling price is likely attractive to many producers.

A third component to deciding whether and when to establish a hedge is your outlook on prices. At near record high feeder cattle prices, it can be hard to envision prices going substantially higher. From a chart perspective, a technical analyst would likely say that the feeder cattle futures market is oversold and due for a downside correction. However, from a fundamental standpoint, both the supply and demand side of the feeder cattle market looks fairly bullish. On the supply side, the feeder cattle supply from this fall’s calf crop is the smallest in decades. On the demand side, ample feedlot capacity, much cheaper corn, and positive feeding margins driven by high fed cattle prices suggest demand for feeders should remain solid.

After examining the price outlook and cost of production, a next step is to evaluate various hedging strategies. These may include cash forward contracting, futures hedging, options hedging, or a combination of these. For an typical producer, it would seem that futures hedging may be less desirable than usual this year with potential upside in the feeder cattle market. By selling futures now, a hedger would have to margin the futures position if the market rallies. Granted, the feeder cattle would be sold at a higher price in the cash market (assuming constant basis), but the futures hedger doesn’t participate in the rally. The same is true for cash forward contracting, which locks in both the price level and the basis. A minimum price hedge (i.e., put options or Livestock Risk Protection insurance) maybe more attractive because it would allow the hedger to realize higher prices should they materialize, but provide protection in case prices decline from their current highs.

As prices were trading near $167/cwt in March feeder cattle futures last Friday, an at-the-money put option ($167/cwt strike price) was trading for about $1.60/cwt. Thus, a floor price (before basis) of about $165.40/cwt can be hedged buy purchasing a put option. Although feed costs, cattle performance, and other expenses vary widely, on average this price level could protect about $15-$20/head of profit for backgrounding calves this winter.

Cattle producers should never turn down an opportunity to lock in a profit – they haven’t been available that frequently in recent years! However, at this time, the need for a fixed price hedge (i.e., futures hedge, cash forward contract) probably isn’t very strong for most producers. Still, for those desiring to take advantage of profitable prices and have protection from an unforeseen price drop, an options hedge that establishes a floor price and leaves some upside potential should be an attractive choice for backgrounders.

Source: Darrell Mark

The information in this report is believed to be reliable and correct. However, no guarantee or warranty is provided for its accuracy or completeness. This information is provided exclusively for educational purposes and any action or inaction or decisions made as the result of reading this material is solely the responsibility of readers. The author and South Dakota State University disclaim any responsibility for loss associated with the use of this information. There is substantial risk of loss in trading commodity futures contracts and traders should consult their brokers for a full disclosure of these risks to determine whether such trading is suitable for them in light of their circumstances and financial resources.