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.