Click here to read part one of the series: Skating on thin ice.
A well-stocked toolbox comes in handy when you’re ready to make repairs around the farm. Having a hammer, screwdriver and pliers when you need it helps the task at hand run smoothly so you can get the job done efficiently. The same is true with marketing stockers. Having the right tools to manage risk helps your operation run smoothly without taking too many hits that can put you in the red.
Overall, stocker prices are strong, and that trend should continue for the near term. The problem arises when negative news impacts the market when you’re ready to sell. Fortunately, those shocks, such as BSE announcements and political trade issues, are short-lived.
Right now, on the buying side, calves probably won’t get any cheaper anytime soon, unless the feeder market comes under very severe pressure. But those high purchase prices increase your risk. Fortunately, many analysts see feeder prices holding fairly strong, but the feedyards may be less likely to buy those higher yearlings at these record prices later in the year.
“I think it will be the 7-weights and higher that will see pressure in October, November and December,” says Derrell Peel, Oklahoma State University agriculture economist. “It’s almost the same situation as last fall, but this time we had expensive feeder cattle earlier this year, which will likely cause losses on fed cattle in the second half of the year, and eventually that will limit the feedyard’s ability, if not their willingness, to pay higher prices for feeder cattle in that last part of the year.” However, he sees the feeder market bouncing back next spring and summer.
That’s good news for stocker operators selling off summer cattle and those with the ability to hold winter stockers long enough to hit the market in the spring and summer. Even if optimism remains in the feeding sector, there are still a number of uncertainties the market faces that put those high-priced calf purchases at greater risk when it comes time to sell.
“When the market is offering some unbelievably high prices, my recommendation is to look at all the options and do something, especially if you’re highly leveraged or can’t afford to take the risk,” says Rodney Jones, Kansas State University agriculture economist. Fortunately, there are a number of ways that you can reduce risks in marketing stockers — insurance, futures market, forward contracting and production flexibility.
Those experienced with using put options consider this rule one: buy a put to protect yourself and place a floor on your animals. An option is the right, but not the obligation, to buy or sell a particular futures contract at a specific price on or before a certain expiration date, according to the Chicago Mercantile Exchange’s “Introductory Guide to Options on Futures.”
With a put option, you have the right to sell a futures contract at a specific price on or before the expiration date. The CME uses this example: an October 70 Live Cattle put gives the put buyer the right to sell October Live Cattle futures at 70 cents per pound. Should Live Cattle futures decline to 64 cents per pound, the put holder (buyer) still retains the right to go short Live Cattle at 70 cents per pound.
For stocker operators running lightweight calves, however, using feeder options may be limited. “Right now for stocker and feeder cattle, futures and options don’t offer a lot if you’re dealing with lightweight cattle,” Dr. Peel says. “They can offer you some real bottom-line disaster coverage from an options standpoint if the market lost 40 to 50 percent of the value of cattle to some catastrophe. But they really aren’t going to do much to help you cover profits in any given set of cattle because they’re so discounted now because of where we’re at in the cattle cycle.”
This is an option that some producers may want to consider, especially if they can’t lock into the 50,000-pound increments that put options are sold at.
“Basically, you can buy any denomination you want within reasonable limits,” Dr. Jones says. Beyond that, it’s similar to buying a put option and locking in your price by paying a premium to do that. Unlike a put option, however, you can’t bail out of it before you’re ready to sell the cattle. “In other words, you can’t turn it into a spec position,” he adds. And there are restrictions on how you can get into and out of the contract.
To get started, you contact a licensed insurance agent to fill out the paperwork ahead of time so that at a future date when you want to buy insurance, your paperwork is ready and you can get in line to buy the insurance. When you think the price is right, you contact your insurance agent and say you want to lock in today’s price, which is based on the futures market, not the cash market. “Some producers feel more comfortable with the insurance product rather than using futures and options.”
Art Barnaby at Kansas State University summarizes LRP in this way. First it does not guarantee a cash price; instead, it protects against a negative change in the CME Cash Index Price. LRP does not guarantee the basis, does not cover any other peril and is limited to 2,000 feeders.
There are a number of intricacies associated with this form of risk management. You can find out more by contacting your state extension economist. Also, you can find out more information at USDA’s Risk Management Agency’s Web site at www.rma.usda.gov.
Forward contracting essentially locks in a price at a given time for future delivery. Forward contracting can be done directly with the buyer or though Internet or satellite auction.
Forward contracting offers producers with grass and forage resources the ability to keep cattle longer. “Let’s say you have ample grass or wheat supplies now, but you like the current price,” Dr. Jones explains. “Using a forward contract option is attractive because it allows you to lock in today’s price, but still use your resources.”
In addition, you build negotiating power with this method. “If you’re looking to forward-price cattle in a direct cash contract, you have more latitude to negotiate,” Dr. Peel says. Buyers will complain, but you can get a bigger down payment or get a better slide on the cattle. “I encourage producers to not assume that whatever tradition states you get, say $30 a head. At today’s price, that just isn’t enough down to cover you for anything. Put it on at least a percent of the value basis. That’s just good business practice.”
For instance, negotiate 10 percent of the value at a minimum as a down payment from the buyer. Also, consider doing that contracting sooner rather than later. That way you’re covered should cattle prices turn negative.
“You get your most risk-management protection from production flexibility,” Dr. Peel says. “This is especially true for stocker operators.” For instance, when prices are high, like they are now, there’s an incentive to purchase younger, lighter calves and turn them over sooner.
“When you look at the buy/sell margin and calculate value of gain, it makes sense to buy them lighter than normal from wherever you normally operate,” Dr. Peel says. Not necessarily 200 pounds lighter, but only 50 to 75 pounds lighter. By doing that, you’re able to maintain a value of gain for cattle up to about 650 pounds.
“My advice to producers is not to fight that,” Dr. Peel says. “Buy them sooner, sell them sooner. You don’t want to fight those kinds of trends in the market too much — go with it.”
Quick turnover is one way to limit risk, since the less time you have the cattle, the less risk of prices changing drastically. Also, spreading that risk by marketing different groups of cattle at different marketing times can help you handle market shocks.
Also consider holding onto ownership of the cattle in the feedyard. Selling stockers is not an all-or-nothing choice; you can sell half of your cattle one way, then use a different risk-management strategy for the other half. Dr. Jones points out that producers should look at retained ownership on some of the cattle to take advantage of potential gains on the feeding side. You can start by contacting a feedyard to see what types of options they offer, then pencil out potential gains.
Another option for stockers is selling heifers as replacements rather than feeders. “Heifers are really attractive right now compared to steers,” Dr. Peel says. Keep flexible so that you can sell them as replacements should that market offer more opportunities than the feeder market.