This is the third article on price risk management for feeder cattle. In the first article, I provided a review of using the average basis to project an expected forward price for 550-pound steer calves and 850-pound yearlings. In the second article, I answered some common questions from producers. I showed producers should factor in the current exchange rate when calculating their expected forward price. Secondly, producers should not use the live cattle futures for calculating their expected forward price for feeder cattle. Finally, I showed that cow-calf producers should calculate the potential profit margin for their calves when they’re 550 pounds, 850 pounds and when the cattle are finished.
If the backgrounding operator and finishing feedlot are all factoring in a margin, cow-calf producers can essentially be more profitable over the long run by backgrounding the cattle themselves and then placing the cattle in a custom feedlot. Vertical integration is not a new concept; at the same time, most producers shy away from the unknown.
In this article, I want to take a step back and focus once again on the cow-calf producer who is planning to sell calves at 550 pounds now in February or background the calves to 850 pounds. I will focus on the current market structure to make the example more applicable. As of mid-February, 550-pound tan steers in central Alberta were selling for $248 and 850-pound medium-frame steers with no special feature were trading for $175. The March feeder cattle futures are at US$150 while the August contract closed at US$155. The exchange rate is US$0.80/Cdn. I’ve included the average basis level and standard deviation below from the previous issue.
First, I want to set up a quadrant on the possible scenarios for the producer analyzing the market for 550-pound steers and the best marketing option. The basis for the 550-pound steers is -60.5 (US$150 divided by the exchange US$0.80/Cdn minus $248) Consider the following.
Quadrant 1: The answer is very simple, sell the 550-pound steers at the current market.
Quadrant 2: The producer could sell the futures, buy put options or price insurance. Wait until the basis improves and then sell the cattle.
Quadrant 3: The producer should probably background the 550-pound steers to 850 pounds. If possible, the producer could look at a basis contract with a larger feedlot that would offer such contracts.
Quadrant 4: The producer will probably want to background the steers to 850 pounds because the market is telling you not to sell at this time with a weak basis and low futures. The odds favour waiting because eventually the basis will come back to the average level.
In our current example with 550-steers selling at $248, the basis is extremely strong. A cash price $60 above the futures price is the average basis plus two standard deviations. One can consider this an outlier because it is uncommon from a historical perspective.
Why should the cow-calf producer not background the calves to 850 pounds? Let’s look at the expected forward price. Using the August futures divided by the exchange rate minus the average basis of $18, the expected forward price in August is $175 for the 850-pound steers. If a backgrounding operator were looking at buying the 550-pound calves, they would be faced with the following economics.
The backgrounding operator would need a cash price of $199 in July or August if the calves gained 2.2 pounds per day. The breakeven price of $199 is also two standard deviations of the average basis above the expected price for $175. The probability of this occurring is very slim. These are not odds that one wants to take on because you are probably going to lose money, in the range of $150 to $200 per head.
I know the most obvious question that will come to me after this article is how does a producer know if the futures are too high or too low? It’s easy to say the basis is strong or weak because we have a historical average over an extended period. As a rule of thumb, produces should use the average futures price over past 18 to 24 months. Over the past two years, the nearby futures have a monthly close low of $121 and high of $159. In this case, the futures are at the upper end of the range because the average price is $143. Now a producer has the futures and the basis in perspective.