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  1. Cattle Risk Management GEOFF BENSON, PhD Extension Economist Dept of Agricultural and Resource Economics North Carolina State University

  2. Agenda • Introduction • Price forecasting • Price risk management • Hedging with cattle futures • USDA-RMA LRP Program • Cattle futures options • Setting price targets & pulling the trigger • Summary GEOFF BENSON, ARE, NCSU

  3. Risk • RISK -- the chance of loss or an unfavorable outcome or event • Anticipated or unexpected • Known probability or uncertain • RISK EXPOSURE -- The amount of a loss, if it occurs • The financial consequences for the business: cash flow, profit, solvency GEOFF BENSON, ARE, NCSU

  4. Sources of Risk • Weather & other natural phenomena • Local variation in rain, temperature, etc. • Regional, national, global weather • Extreme (tornadoes, hurricanes, floods, etc.) • “Technology” and competitiveness • Changes in your customers’ ability or willingness to buy your product • Societies attitudes & preferences • Government and other institutions rule changes • Individual human behavior • Random accidents GEOFF BENSON, ARE, NCSU

  5. Managing Risk What are the most important risks your farm business is exposed to? How vulnerable is your farm business to these risks (exposure)? What cost-effective strategies are available to manage price risk? What is your attitude to risk? Do you have the time, knowledge and risk management skills? GEOFF BENSON, ARE, NCSU

  6. Risk Management • Management strategies include: • Reducing the chance of an event • The management ability, knowledge and effectiveness of the producer is the key • Reducing the impact if an event occurs • Buying insurance • Self-insurance, which comes in many forms including carrying inventories, diversification, maintaining financial reserves, borrowing, off-farm income GEOFF BENSON, ARE, NCSU

  7. Cost:Benefit • All risk management strategies involve costs, in money or time • Effectiveness varies among alternatives • Financial benefits & costs • Time, new knowledge and skills • Evaluate trade-offs GEOFF BENSON, ARE, NCSU

  8. Agenda • Introduction • Price forecasting • Price risk management • Hedging with cattle futures • USDA-RMA LRP Program • Cattle futures options • Setting price targets & pulling the trigger • Summary GEOFF BENSON, ARE, NCSU

  9. Price Forecasting • Helpful for making marketing and business decisions • The futures market provides an industry consensus on prices as far as one year out • Takes account of known information • Changes daily as new information becomes available GEOFF BENSON, ARE, NCSU

  10. Cattle Futures • The CME Group trades two types of cattle futures – data at www.cmegroup.com • Live (or finished or fat) cattle futures -- 40,000 pound lots of 55% Choice, 45% Select, Yield Grade 3 steers, physically delivered: Feb, Apr, Jun, Aug, Oct, Dec. • Feeder cattle futures are for 50,000 pound lots of 650-849 pound L&M 1&2 steers, cash settled: Jan, Mar, Apr, May, Aug, Sept, Oct, Nov. GEOFF BENSON, ARE, NCSU

  11. Price Forecasting • Use “nearby” futures contract price for intended sale month • BUT • This is not the NC price “Basis” = futures price – local cash market price for similar cattle • If basis is predictable, then we can use the futures market to project local North Carolina prices and use this to make business decisions GEOFF BENSON, ARE, NCSU

  12. Price Forecasting, cont. • The cattle futures contract may not match the cattle you have to sell –need to adjust the futures price • What market premiums & discounts affect the value of your cattle? • Weight • Sex • Frame • Muscle • Breed • Other, e.g., market channel, truckload GEOFF BENSON, ARE, NCSU

  13. Price Worksheet GEOFF BENSON, ARE, NCSU

  14. Feeder Cattle Futures, $/100 lb, 3/26/09 GEOFF BENSON, ARE, NCSU

  15. Historic Basis • The most useful comparison is the published NC weekly auction (cash or spot) prices for a particular week or month relative to the cattle futures price for the “nearby” month • Note • NC Auction prices are reported weekly in 50 or 100 lb./head increments for small lots • CME feeder cattle futures contract is for 650-849 lb. M&L1&2 steers in truckload lots • Contract months are Jan, Mar, Apr, May, Aug, Sept, Oct, & Nov. GEOFF BENSON, ARE, NCSU

  16. NC Basis, Avg. 1990-2000 GEOFF BENSON, ARE, NCSU

  17. NC Basis, 1990-2000 • Negative (transportation cost) • Varies by market, west to east • Seasonal: • Smaller discount in spring, high demand for cattle for summer grazing • Larger negative differences in fall as cattle are sold as grass runs out • Historic data on line at: http://www2.ncsu.edu/unity/lockers/ project/arepublication/AREno32.pdf GEOFF BENSON, ARE, NCSU

  18. “Quality” Differences • What are the characteristics of your cattle and how do they affect the price (value)? • Weight • Sex • Frame • Muscle • Breed • Other, e.g., market channel, truckload GEOFF BENSON, ARE, NCSU

  19. Price Differences, NC Graded Sales, M1 Steers, 1991-2001 . GEOFF BENSON, ARE, NCSU

  20. Price Differences, Graded Sales, M1 Heifers v. Steers, 1990-2001 GEOFF BENSON, ARE, NCSU

  21. Price Differences, Graded Sales, 500-599 lb. Steers, 1990-2001 GEOFF BENSON, ARE, NCSU

  22. Angus Braford Brahman Brangus Braunveih Charolais Chianina Devon Galloway Gelbveih Hereford Holstein (dairy) Jersey (dairy) Limousin Longhorn Maine Anjou Nellore Piedmontese Pinzgaur Polled Hereford Selected Breeds • Red Poll • Sahiwal • Salers • Santa Gertrudis • Shorthorn (dual) • Simmental • South Devon • Tarentais • Zebu • + Crosses & • Composites GEOFF BENSON, ARE, NCSU

  23. Price Differences, Graded Sales, 500-599 lb. M1 Steers, 1991-2001 GEOFF BENSON, ARE, NCSU

  24. Marketing Options • Regular auction = Base • Graded sale • Special programs, e.g., Southeast Pride, pre-conditioned sales • Direct farm sale (several options) • Retained ownership GEOFF BENSON, ARE, NCSU

  25. Marketing Options • Farm situation determines opportunities and cost: • Size of herd • Number of cattle for sale • Uniformity of cattle • Market Premium offered • Marketing Cost • Risk GEOFF BENSON, ARE, NCSU

  26. Price Worksheet GEOFF BENSON, ARE, NCSU

  27. QUESTIONS OR COMMENTS ON PRICE FORECASTING? GEOFF BENSON, ARE, NCSU

  28. Hedging Price Risk • Basics of futures & options • Hedging with futures examples • USDAs Livestock Risk Protection (LRP) Program • Hedging with Options • Is hedging for you? • How much do you have at risk? • Risk management strategies GEOFF BENSON, ARE, NCSU

  29. Futures Contracts • Sell a Feeder Cattle contract for a specific month at a specific price -- Locks in a price! • “Off-set” your position in the futures market • By letting the contract expire • By buying back an identical contract (at or near the expiry date) • At the expiry date the futures price = the cash market (spot) price GEOFF BENSON, ARE, NCSU

  30. Futures Contracts • Set up a trading account with a brokerage • Pay a small commission to the broker for the transaction • You may get margin calls to ensure you can cover your position -- Deposit cash in your trading account when the futures price moves above the price you locked in GEOFF BENSON, ARE, NCSU

  31. Hedging: Example 1 GEOFF BENSON, ARE, NCSU

  32. Hedging: Example 2, Part 1 GEOFF BENSON, ARE, NCSU

  33. Hedging: Ex 2, Part 2 GEOFF BENSON, ARE, NCSU

  34. Hedging: Example 3 GEOFF BENSON, ARE, NCSU

  35. USDA’s LRP Program • Price risk insurance, pay a premium • Can cover each year up to • 2,000 head of feeder cattle of up to 900 lb. – two weight categories, steers or heifers, 3 breeds – Brahman, Dairy, “all other” • 4,000 head of 1,000 to 1,400 lb fed cattle • Coverage can range from 70% to 100% of estimated ending value* • More flexible and more direct pricing than hedging with futures GEOFF BENSON, ARE, NCSU

  36. Example 1, Nash Co, 3/30/09 GEOFF BENSON, ARE, NCSU

  37. Example 2, Nash Co, 3/30/09 GEOFF BENSON, ARE, NCSU

  38. Information on LRP Fact Sheets are available on line at http://www.rma.usda.gov/livestock/ Examples of contracts are at http://www3.rma.usda.gov/apps/livestock_reports/main.aspx A premium calculator is available at http://www.rma.usda.gov/tools/premcalc.html A list of LRP insurance providers is at http://www3.rma.usda.gov/tools/agents/companies/2008/north_carolinaLPI.cfm. All are from out-of-state GEOFF BENSON, ARE, NCSU

  39. Options • The right (but not the obligation) to buy or sell a futures contract. • Puts a floor under the price but not a ceiling – you get the upside • A “put”= right to sell & allows the producer to hedge • A “call”= right to buy & allows the buyer (e.g., the feedlot operator) to hedge GEOFF BENSON, ARE, NCSU

  40. Options • An option is for a specific futures contract and a specific price • The agreed upon futures contract price is called the strike price • The cost of an option is called a premium • Premiums are established by public outcry pit trading and by electronic trading, similar to the way futures prices are established GEOFF BENSON, ARE, NCSU

  41. Options • There is a range of strike prices for each futures contract • Premiums have 2 components: • Time value -- pay more for options on far off contracts, shrinks as the expiry date approaches • Intrinsic value -- related to the relationship between the strike and current price of the futures contract GEOFF BENSON, ARE, NCSU

  42. Options • In-the-money -- Underlying futures price is favorable compared to the strike price • Out-of-the-money -- Futures price is unfavorable vs. strike price • At the money • Options automatically settle for cash at the time the underlying futures contract expires GEOFF BENSON, ARE, NCSU

  43. Feeder Cattle Options Premiums, May Contract, $/cwt., 3/25/09 *No brokers fee or cost of margin calls included GEOFF BENSON, ARE, NCSU

  44. QUESTIONS OR COMMENTS ON HEDGING? GEOFF BENSON, ARE, NCSU

  45. Is Hedging for You? • Things to consider • Size of your cattle operation • Financial importance of your cattle operation • Ability to handle price risk • Attitude to risk & expectations about hedging GEOFF BENSON, ARE, NCSU

  46. Farm Structure, 2007 Census GEOFF BENSON, ARE, NCSU

  47. Why Do You Have Cattle? OR FUN OR MONEY? GEOFF BENSON, ARE, NCSU

  48. Hedging • It is not for everyone • Very small producers • Busy producers • Producers for whom beef cattle are a sideline • All risk management strategies involve costs and effectiveness varies among alternatives • Financial benefits & costs • Time, new knowledge and skills • Evaluate trade-offs in your situation GEOFF BENSON, ARE, NCSU

  49. Hedging • How much do you have at risk? • Number of head • Possible change in price • Total financial losses • Impact of those losses on farm and family finances • Example, • I truckload of feeder cattle = 50,000 pounds (~65 head) • A $10 per cwt. price drop = - $5,000 GEOFF BENSON, ARE, NCSU

  50. Price Risk Management Strategies • Ride it out – “self-insure” • Draw on savings or borrow • Restructure debt payments • Adjust expenses, especially maintenance & new investments • Add off-farm income or cut family living expenses • Prevent unacceptably low prices with futures contracts, options, LRP – “buy insurance” GEOFF BENSON, ARE, NCSU