Over the past year, I’ve received many inquiries from cow-calf producers about hedging feeder cattle. Most producers calve during the winter or spring and sell their feeders in the fall or the following winter after backgrounding. We’ve all seen how the prices can change within a six- to 10-month period.
One of the most common questions I receive is “What price can I expect when I sell my feeder cattle?” The simple exercise of using a futures market for price discovery is actually quite foreign to many operators. Secondly, many producers have a difficult time understanding the mechanics of a hedging program and the terms involved.
Some of the basics
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 index is based on a sample of transactions in the 12 major feeder cattle-producing U.S. states for 700- to 899-pound medium- and larger-frame feeder steers. As a rule, I often tell producers it is based on average U.S. prices for 800-pound steers.
One of the most important factors for western Canadian cow-calf producers to understand is the basis. The basis is the difference between the CME feeder cattle futures price and the local price at the auction market. If the March feeder cattle futures are trading at US$124 and the local price for 800-pound feeders is C$160, the basis is calculated by multiplying the futures US$124 by the exchange rate of C$1.3300/US$, which equates to C$165; then subtract the local price of C$160 for a basis of negative C$5. The futures price and the local price should be converted to the same currency. In some cases, an organization will say the basis is plus 36 which is the difference between US$124 and C$160 but this is not correct for reasons I’ll explain at a later date.
The feeder cattle futures prices takes into account the overall macro situation such as major economic changes or large changes in the fundamentals such as a drop in the North American calf crop by one million head. The basis takes into account the currency and the local situation such as a drought conditions. If there is a local drought, there will be more cattle on the market earlier, which may pressure the basis or the local price.
Follow the basis
For an example, lets say that in April a cow-calf producer plans to sell 800-pound steers in October and is wondering what price to expect. The November futures price is US$119 and multiplying US$119 by the December exchange rate of C$1.3250/US$ would equate to C$158. Using a basis of C$5, the expected forward price would be C$153. This is very important to understand the expected forward price. In April, a producer hedging calves would sell a November feeder cattle futures contract at US$119.
Let’s say in November, the producer buys back the futures contract at US$110. At the same time, the producer sells feeders at the local auction market and receives C$137. Assuming the currency stays the same at C$1.3250, the basis has widened. The feeder cattle futures at US$110 multiplied by 1.3250 minus the local price of C$137 equals C$8.75. The net result of the futures position is a gain of US$9, which is US$119 minus US$110. If we convert this US$9 to Canadian funds using the exchange of $1.3250, the gain is C$12.
The gain on the futures of C$12 is added to the actual selling price at the local auction market of C$137 for a net price of C$149. The net price in November is a bit lower than the expected forward price because the basis weakened from C$5 to C$8.75.
If the futures would have gone up to US$130, there would be a net loss on the futures of US$11 or C$14.56 (using the exchange of 1.3250). However, the local cash price would likely be around C$167.25 (US$130 times the exchange of 1.3250 minus the basis of C$5). In this case, the net price would be the local auction market price of C$167.25 minus the loss on the futures of C$14.56, which equates to C$152.70. Notice the net price is very close to the expected price because the basis stayed the same.
A futures market protects the producer but the price is not “locked in” because the basis can change over time. You won’t go broke hedging because a producer truly hedging also owns the feeder cattle. The price change at the local auction market, up or down, is offset with the change in the futures market.