In my previous article, I provided a brief overview of last year’s series of articles on price risk management for feeder cattle. In this column I will continue the discussion and also answer some of the main questions producers had last year.
Cow-calf producers are becoming more familiar with the basis level for their local area. The basis is just as important to watch as the local cash price because producers can gain an understanding of what the market is trying to tell them. This will help determine the timing of their sales and also aid in their hedging strategy.
When calculating the basis for 550-pound and 850-pound feeder cattle, producers should convert the futures market into Canadian dollars and then subtract the local cash price. (Futures in Canadian dollars minus the local cash price equals the basis). In these columns I am analyzing monthly data from January 2007 through December 2017. Below is the average basis level in Manitoba and the standard deviation around the average.
During September, a producer in Manitoba with 550-pound steers can use the above data to calculate an expected forward price for February. The producer will take the March feeder cattle futures and convert this into Canadian dollars and subtract the average basis. The March feeder cattle futures at US$146.73 divided by the exchange rate of US$0.8122/Cdn equals $180.65. The expected forward price would be $180.65 minus the basis of $18 equals $162. Using the standard deviation, the price will probably fall with a range of $150 to $174, which is the expected forward price plus or minus the standard deviation.
Before we move on, I want to answer three common questions I received last year. The first is “Does the exchange rate have to be fixed?” I ran the data again without using a fixed exchange rate. The result came in as follows. One could say that if the exchange rate is not fixed, the basis is essentially accounting for the change in the currency. Notice the basis is wider and the standard deviation is more than double for both weight categories. This suggests that you have nearly twice as much risk if you don’t have a fixed exchange rate.
The second most common question: “Can I use the live cattle futures to calculate an expected forward price?”
Backgrounding operators thought when the major feedlots were competing for lighter calves, they were using the live cattle futures rather than the feeder cattle futures. Therefore, I ran the data using the live cattle futures.
I simply converted the live cattle futures to Canadian dollars and then subtracted the cash price for feeder cattle. The result — the standard deviation is once again nearly double using the live cattle futures compared to the feeder cattle futures.
It’s very clear. Producers should not use the live cattle futures for hedging feeder cattle. Secondly, the exchange rate should be fixed when using the feeder cattle futures for hedging or for calculating an expected forward price.
The third most common question concerned the basis and standard deviation for the finishing feedlot in Alberta. Cow-calf producers often wonder about the market environment faced by the purchaser of their feeder cattle. Logically, a feedlot would only buy feeder cattle if it can justify a profit when selling the finished animal. Therefore let’s look at the risk profile for Alberta fed cattle prices from 2010 through 2017.
The standard deviation for fed cattle is lower than the standard deviation for 850-lb. steers. This is important for two main reasons. First, finishing feedlots are buying in a high-risk environment and selling into a lower-risk market. This is very helpful for the feedlot operator when making their purchasing decisions because they can draw feeder cattle from regions of Western Canada where the basis is more favourable.
Secondly, the cow-calf producer or backgrounding operator can decide if they should place the feeders in a custom feedlot or finish the cattle themselves. I often hear comments from cow-calf operators that they think the feedlot is making “excessive margins” at their expense. Now they can have a good idea of the expected price of the finished animal. The largest risk for the finishing feedlot is the purchase price of the feeder cattle. However, if the cow-calf operator owns the feeder cattle and chooses to finish the animal, this is actually the lowest risk profile available in the cattle-feeding business.
The cow-calf producer can calculate an expected forward price for the finished animal and then decide to place the steer in a custom feedlot or sell at the local auction mart. I’m not going to discuss in detail; however, one can take this a step further and show this is the lowest risk profile also showing the largest return throughout the last eight years. The cow-calf producer should always finish a portion of their calf crop. By doing this, you’ll will lower and diversify your marketing risk profile and enhance your overall financial return.