In the winter of 2017 I wrote a series of articles about price risk management for feeder cattle. I discussed hedging feeder cattle on the CME feeder cattle futures and also conducted a risk analysis on the basis for feeder cattle prices in Manitoba.
- Read more: Understanding feeder cattle risk: Pt. 1
- Read more: Understanding feeder cattle risk: Pt. 2
- Read more: Understanding feeder cattle risk: Pt. 3
Producers used this information to calculate an expected forward price and implement an optimal risk-management program involving the Livestock Price Insurance program or using futures and options themselves. Given the favourable response, I will get into more details, but first a quick review.
The feeder cattle futures market (which trades on the CME Globex electronic platform) is the price discovery mechanism for North American feeder cattle. The contract is 50,000 pounds and is based on the CME feeder cattle index.
Without going into detail, this feeder cattle price index is based upon a sample of transactions in the 12 major feeder cattle-producing states for 700- to 899-pound medium- and larger-frame feeder steers. The CME publishes a composite price, which is the official cash settlement price for the CME feeder cattle futures at contract final settlement. Figures have been calculated by the CME Group from prices reported by the USDA.
It’s always important that producers are aware of the cash settlement price because it can vary from the futures market. We’ve seen significant speculative fund activity in the futures, which can often sway the market away from the cash direction; however, at settlement, the cash settlement price and the futures market usually converge as the funds limit their activity in advance of the deliverable month.
The local price at the auction market is called the “cash market.” The difference between the cash market and the futures market is called the “basis.” I always advise producers to convert the futures into Canadian dollars using the spot exchange rate. The basis is calculated by subtracting the cash price from the futures price. Very simply, the basis equals the futures price in Canadian dollars minus the local price at the auction market.
Example from 2017
For this project, I analyzed monthly data from January 2010 to December 2017. I calculated the average basis and the standard deviation for the data. I believe everyone understands what the average represents. The standard deviation is the quantity calculated to indicate the extent of deviation for the group as a whole. One standard deviation is approximately 68.2 per cent of the data.
In this example (see below), for 550-pound steers the basis is negative 18 so the cash price was above the futures price in Canadian dollars. Last year, I used data from 2007 to 2016 and the average on the 550-lb. steers was negative 10 but the standard deviation was the same. To make the analysis more applicable, I excluded feeder cattle during the 2009 recession because of extreme data. There was no change to the standard deviation for the 850-lb. steers and I believe the average is more representative of the current market environment.
Before we move on into deeper analysis, I want to point out how producers can use this information. During September 2017, the basis for 550-lb. steers in Manitoba was negative $20, which is very close to the average. The cash price was $20 above the futures price in Canadian dollars. For backgrounding operators, this would be an optimal time to purchase 550-lb. steers. For cow-calf operators, one could easily make the argument that they should wait until the basis is stronger. Very simply, the cash market is functioning to attract buyers when the basis is average or below average.
By November the basis for 550-lb. feeder cattle was negative $31. The cash price was $31 above the futures market in Canadian dollars. The standard deviation is 19, which means that the basis can fluctuate from plus one to negative 37. (The average negative 18 plus-or-minus the standard deviation of 19). A basis of negative 31 is in the upper end of the range of one standard deviation. The market is telling cow-calf producers this is the optimal time to sell their feeder cattle. For backgrounding operators, the market is telling them to wait until the basis is more favourable. Demand is very strong; the cash market is functioning to attract sellers when the basis is above average.
The average Manitoba cash price for 550-lb. feeders in September was $210 and in November, the average cash price was $230. By paying attention to the basis, producers have a better idea of when to sell their feeder cattle. Producers can immediately understand what the cash market is trying to accomplish.