Feeding cattle is a unique business. Feedlot margins are often in negative territory. When there is a profitable period, it is relatively short lived.
I often receive calls from cow-calf producers and other readers asking about margins for the feedlot operator. How can feedlots continue to operate after a prolonged period of negative margins?
In many cases, feeder cattle don’t pencil profitably at the time of purchase. Feedlot operators are professionals at risk management. In most cases, they have a strategy. Questions about negative margins often assume unhedged cattle or no risk management. There is no forward contracting of sales or purchases.
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In this article, I will discuss a few characteristics of the fed cattle market and cattle feeding margins. There are three legs to the feeding margin structure — two inputs and one output. Feedlot operators buy feeder cattle and feed grains, and sell fed cattle. Each leg of the margin structure is managed differently.
A competitive business
First, cattle feeding is a pure competitive market. In the long run, margins are zero dollars per head as the market is driven by the least-cost producer. There are many studies in Canada and the U.S. that show that cattle feeding margins are negative in the long run. Feedlot operators bid up the price of feeder cattle until there is no margin.
Producers need economies of scale. For example, if a feedlot bought 850-pound steers every week and fed the animals barley and silage to 1,300 pounds, the average margin in the long run would average negative $5-$15 per head. The standard deviation would be about $130 per head and two standard deviations would be $260 per head. This is the financial environment that cattle feeders face. When an animal is purchased, the feedlot operator will likely lose about $10 per head on average, with the potential to either make $120 per head or lose $140 per head 66 per cent of the time. Given the margins, feedlot operators need economies of scale to compete long term and bring down costs per head.
An example
Consider this example from January 2023. In the accompanying table below, I’ve included the economics for buying steers weighing 750 to 900 pounds. It shows the breakeven for feed or input costs only and breakeven for all costs, including yardage and labour. The final row shows the current forward contract prices for fed cattle in January for May and June delivery.
Remember that third-year university course in cost accounting. The firm operates if the margin covers variable costs. The company has fixed costs regardless of how many cattle are on feed.
In the example, the market structure shows that the feedlot would cover its feed costs and a portion of the fixed costs. The feedlot bid up the price of feeder cattle so that the margin structure only covered variable costs. This is based on market prices at that specific moment for all legs of the margin structure. Each feedlot will have different costs. The cost of production per animal can vary by $100 to $150 per head. The market falls to the least-cost producer. There is always an operation willing to sell at a lower price in a pure competitive market.
This is where risk management comes into play. The average fed cattle basis in Alberta in the long run is about C$10/cwt under the futures. However, the basis levels can swing from C$5/cwt over the futures to C$25/cwt under the futures. This extremely wide fed cattle basis level in Alberta was evident this past winter. Obviously, if feedlots forward-contracted their fed cattle during August or September 2022 for delivery in December 2022 or January 2023, they had a stronger fed cattle selling price. Many feedlots will sell their cattle on basis at the time the replacements are brought. By doing this, they eliminate the basis risk, which in Alberta can be as significant as the volatility in the futures market.
Many feedlots will buy the bulk of their feed grain requirements during the harvest period. During the last week of August 2022, Lethbridge feed barley was trading in the range of $350-$370/tonne delivered. Over the winter, feed barley was trading $450-$460/tonne delivered Lethbridge. This would bring down the cost of gain significantly.
Each feedlot has its own cost structure and various ways to manage the risk of feed grains, feeder cattle and fed cattle. In most cases, feedlot operators cannot buy feeder cattle and feed grains and lock in a profitable margin. Each leg of the margin structure needs to be managed individually. Media sources will often quote margins on unhedged cattle, but this is not representative for every feedlot.
