Feeder cattle prices have been trading at historical highs over the past month and I’ve had many inquiries regarding the basics of hedging. Many cow-calf producers are looking to secure similar prices for the fall and need to learn the basics about hedging feeder cattle production.
We have all seen how quickly markets can change within a 12-month period, as in 2008. A cattle producer with 300 cows has seen income fluctuate nearly $30,000 per year if we look back from 2007 through 2010. Many producers sold off cows in 2008 and 2009 only to wish they had them back in 2010.
Hedging is one way to smooth out the income stream and when prices are this strong, it is only prudent that cow-calf operators take some protection in case markets turn for some odd reason. It only takes one new bacteria or virus to cause a retail public scare or shut borders as we have seen in the past. In this issue, I want to discuss a basic “production hedge” for feeder cattle.
SET UP SCENARIO
In February, a cow-calf producer in Saskatchewan wants to secure a price for 700 pound feeder steers for October delivery. (Notice I say “secure” a price but not “lock” in a price, which I will explain later.) In this example, the producer would probably use the November feeder cattle futures, which at the time of writing this article was $127/cwt. The expected forward price equals the futures minus the basis.
This can be somewhat confusing as most producers have trouble understanding basis, which is the difference between the cash and futures prices. When calculating an expected forward price, producers should look at the current basis level and also historical levels and use an average.
The producer decides that an average basis is $10/cwt, so the expected forward price for October delivery is November futures price of $127/cwt minus $10/cwt basis equals $117/cwt. Now in February, the producer sells a November feeder cattle futures contract at $127/cwt. We say the producer is “short the futures market” and “long in the cash market.”
In October, the producer sells the 720-pound feeder cattle for $102/cwt at the local auction market. The November feeder cattle futures are trading at $110/cwt, which implies the basis level is $8/cwt. The producer was expecting $117/cwt so let us look how thea cash and futures position balances out. On the cash side, he was expecting $117/cwt but only received $102/cwt which is a negative $15/cwt. On the futures side, he was short at $127/cwt and when the cattle were sold, he would buy back the futures contract at $110/cwt, which is a $17/ cwt gain. The $17/cwt gain offsets the negative $15/cwt loss in the cash position. The basis narrowed by $2/cwt, which often occurs when the futures decline.
In October, the producer sells the 720-pound feeder cattle for $125. At the same time, the November feeder cattle futures are trading at $137. In this scenario, the producer was expecting $117/cwt in the cash position but actually received $125/cwt, which we say is an $8/cwt gain on the cash side. In the futures position, he was short at $127 and the futures market strengthened to $137. The producer would have to buy back the futures at $137/ cwt which is a $10 loss. In this scenario, the basis has widened by $2/cwt and the $8/cwt gain on the cash side does not totally offset the $10/cwt loss on the futures side. The futures market is “marked to market” daily but the cash gain would only be realized when he obviously sold the cattle. The producer has to have some cash available to make the margin calls.
A production hedge can be an efficient way to secure a price level. The gain or loss on the futures position may not totally offset the gain or loss in the cash position. Producers need to have cash available for margin calls when selling a futures position.
GeraldKlassenanalysescattleandhogmarkets inWinnipegandalsomaintainsaninterest inthefamilyfeedlotinSouthernAlberta.For commentsorspeakingengagements,hecanbe reachedat [email protected] or2042878268