Should Cow-Calf Producers Lock In Fall Calf Prices?

Cow-calf producers have a lot to consider when it comes to marketing their calves this year.
By: Darrell Mark, SDSU Economics Adjunct Professor

In an iGrow article last month, I discussed record high feeder cattle prices as well as the lack of profits for current feedlot placements. While current price levels offer little or no profit opportunity for buyers of feeder cattle, those same prices could result in record or near record profits for cow-calf producers this year. The Livestock Marketing Information Center projects returns over cash costs (including pasture rent) to be near $350/head for an "average" cow-calf operation in 2014. If realized, that would be sharply higher than the $123/head return in 2013 and the previous record high of $150/head in 2004. Of course, many production and marketing risks could quickly reduce those projected returns, as they did in 2012 and 2013. Drought could reduce pasture and range productivity, thereby raising grazing costs and forage and hay demand. And, although the corn growing season appears to be off to an average start so far this year, should weather problems develop that significantly lower the national corn yield, higher corn prices will force feeder cattle prices lower.

As cow-calf producers are turning pairs out to summer pasture right now, it is appropriate to start considering marketing plans for those calves. Last year, the price for 500-599 lb steer calves in South Dakota was about $191/cwt during October. At this point, the prospects for a large corn crop and increasingly tight calf supplies indicates prices this fall could be 10-15% higher than last year, which would put steer calf prices close to $215/cwt this fall. October 2014 CME feeder cattle futures are currently trading near $198/cwt. Historically, the basis for 500-599 lb steer calves in South Dakota in October is close to +$20/cwt. So, a futures-based price forecast adjusted for local basis would also suggest prices in the mid- to upper $210s this fall. Although reports of forward contracted feeder cattle sales for fall delivery are limited yet, it appears that buyers are willing to bid much higher than the $215-220/cwt for 500-599 lb steers. Some regional reports have steer calves in the $240s/cwt for October delivery.

With that background, it is useful to consider the advantages and disadvantages for three of the more common hedging alternatives:

• Cash Forward Contract: Forward contracts lock in a cash price (both futures price level and basis) and typically require delivery at a specific future time (possibly a range of dates). By locking in both price level and basis, risk of lower prices and weaker basis is eliminated. However, the cow-calf producer wouldn’t be able to take advantage of higher prices or stronger basis if they occurred at delivery time. Typically, cash forward contracted feeder cattle are sold using a price slide, where the dollars per hundredweight price is adjusted lower if the cattle’s weight exceeds the estimated base weight. Cash forward contracts for feeder cattle can be executed either through direct negotiation between the seller (i.e., cow-calf producer) and buyer (i.e., feedlot) or using video/Internet based sales. In some cases, the seller may need to have load lots available to sell. An additional consideration this year is the requirement to deliver at a certain time. If drought conditions worsen, calves may not grow to their projected base weight by the delivery period or the producer may need to wean calves early to save late summer forage. In the latter case, the producer might need pens to background the calves until the delivery period if the buyer is unable/unwilling to take the calves early.
• Short Futures Hedge: Selling a feeder cattle futures contract can protect the cow-calf producer against declining futures price levels. Basis is not protected when solely hedging in the futures market because the feeder cattle are still physically exchanged in the cash market in the fall (e.g., at the auction market, video/Internet sale, private treaty). Essentially, the short futures position is used to make money to offset the declining value of the feeder cattle. Similarly, the futures position will lose money if price levels rise and the value of the feeder cattle increases. Therefore, the cow-calf producer can’t participate in a price level increase through a short futures hedge. Regardless of whether basis weakens or strengthens, the cow-calf producer would realize the current basis (i.e., there is no basis protection as there is with a cash forward contract). Trading futures contracts requires having a margin account with a broker and could result in margin calls. Using a futures hedge, though, offers flexibility in the timing of cash marketing the cattle because the hedge could be lifted earlier if the calves are sold early due to drought.
• Minimum Price Hedge: There are a variety of methods used to create a minimum price hedge, or one that locks in a floor price while leaving the upside potential open to the seller. Commonly, a put option is purchased to create a minimum price hedge. While this requires trading through a brokerage account, losses in the margin account are limited to the premium paid for the put option. Currently, an at-the-money October 2014 feeder cattle put option with a strike price of $198/cwt costs about $4.50/cwt. Cheaper, out-of-the-money puts with a strike price of $187/cwt could be bought for closer to $1/cwt. Like hedging with futures, a put option hedge does not provide basis protection. Instead, expected basis in October is used to adjust the strike price (less premium) to a cash price equivalent in evaluating the hedge. For example, the at-the-money put would create a floor price of about $213.50/cwt ($198/cwt - $4.50 + $20.00/cwt), although basis risk is still present. The out-of-the-money put provides a floor price of about $206/cwt ($187/cwt - $1/cwt + $20/cwt). Another alternative way to place a minimum price hedge is to purchase Livestock Risk Protection (LRP) insurance through a licensed crop insurance agent. This insurance provides a similar type of price level protection by insuring a floor price and leaving upside potential for the seller. It does not protect against basis risk either, although the basis that remains unhedged with LRP is slightly different than the basis when hedging with put options or the futures market. LRP does not require a margin account and coverage can be purchased for small-sized lots of cattle (as little as one head), unlike futures and options that are based on 50,000 lb. Finally, another method of creating a minimum price hedge is through a private treaty negotiated forward contract. In this case, the cow-calf producer (as the seller) and feedlot (as the buyer) would agree on a minimum price (likely a cash price that protects both price level and basis) and a mechanism to increase the contract price in the event that price levels are higher at delivery time. This type of minimum price hedge might provide basis protection as well as create a floor price and it would likely not require trading through a margin account.

While there are countless variations on these hedges, these three main alternatives provide a context for considering hedging this fall’s calf crop. Of course, the need for hedging the calf price and the method used will differ across producers. A first question to consider is whether any hedge is needed, or if the cow-calf producer should just take whatever the cash price is this fall. Unlike some years, not hedging might be a good strategy for some producers this year. The downside price risk will primarily be related to increases in corn and feedstuff prices. That is certainly a possibility, but with national corn crop progress at an average pace, there is little evidence yet to suggest that is a large risk. Lower corn prices associated with a large national yield, if realized, could prompt further increases in feeder cattle prices later this summer and fall. Certainly, the very tight feeder calf supply resulting from the historically small beef cow herd underpins the bullish argument for the feeder cattle market. For that reason and the potential for still higher prices, locking in price levels through futures hedges and forward contracts may not be optimal this year for many producers. These alternatives would prevent cow-calf producers from participating in higher prices. Instead, using some type of minimum price hedge, like put options, might be the preferred strategy for many producers who want to take advantage of current high prices yet leave the upside open. Although at-the-money protection is relatively expensive, out-of-the-money coverage could still protect price levels above break-even for most producers. Alternatively, an options fence wherein a call option is simultaneously sold at a strike price higher than the strike price of the put option that is purchased can make the options hedge less expensive (although short options do present additional margin risks unsuitable for some hedgers).

Regardless of whether a cow-calf producer decides to hedge calves or what strategy is used to do so, now is a good time to consider the alternatives. Prices could certainly move to higher highs, but the opportunity to protect record prices now is quite attractive, especially in light of the projected losses that current feeder cattle placements are incurring (discussed in last week’s article).