Opportunities to Manage Price Risk in 2021

– Kenny Burdine, Livestock Marketing Specialist, University of Kentucky

When Josh, James, and I put together our spring market outlook article and video in early March, we shared an expectation of improving feeder cattle prices throughout 2021. Similar forecasts have been made by many analysts given an expectation of improving domestic demand and some encouraging export levels to start the year. This same general optimism can be seen in CME© feeder cattle futures prices as deferred months are trading at significant premiums to nearer months. This is not uncommon in the spring of the year, but the magnitude of this carry in 2021 is much larger than usual. James referenced the wide April to September spread in his article last week. As I write this on April 12, 2021, the August through November feeder cattle futures contracts were trading at a $14-$18 premium over the April contract. The settle prices from Friday April 9th are shown in the table below.

The simple way to think about this is that the futures market is expecting heavy feeder cattle prices to increase by $14-$18 per cwt between now and the August to November time period. While there is value in that implied forecast, it also speaks of opportunity. From a price risk management perspective, the futures market is giving us an opportunity to capitalize on a much higher price expectation for summer and fall. Cow-calf operators who plan to keep calves through until summer or stocker operators / backgrounders who will be selling heavy feeders this fall, may want to consider what the market is currently offering. Fortunately, there are several ways this can be done.

The first possibility would be to enter into a cash forward contract with a buyer looking to place feeders later in the year. The two parties would agree on a price now for cattle to be delivered at a later date and this expectation of higher prices should be reflected in the contract price. Assuming the contract is binding and enforceable, this strategy eliminates price risk. However, production risk remains a concern if cattle don’t perform as expected, fail to reach the agreed upon weight, or if weather conditions necessitate earlier sale of the cattle. While I certainly feel forward contracts are an excellent price risk management tool, they are very limited in much of the South.

Hedging, through the sale of deferred futures contracts, is another way to capitalize on a strong futures market. As an example, a producer who plans to sell cattle in September, may choose to sell a September CME© Feeder Cattle futures contract now in order to have downside price protection. If feeder cattle markets decline between now and September, they can make money on the short futures position, which will offset the loss in value of the cattle they will sell. Producers who choose to implement this strategy need to be certain they have access to considerable capital for potential margin calls. In a bull market, producers can lose a lot of money on short futures positions well before they are able to sell their cattle on the stronger market. Lenders need to be fully aware of the plans if this strategy is used. Producers must also consider basis as they evaluate this strategy. A September CME© feeder cattle futures price of $160 per cwt, likely translates into something closer to $150 for an 800 lb steer in the Southeast, but this will vary based on the location, type and quality of the cattle.

Options on futures contracts provide an opportunity to have some downside protection, but also keep the ability to capitalize on rising prices. For example, if the September CME© feeder cattle futures contract were trading at $160 per cwt, the producer might buy a put option with a strike price of $154. The put option gives the producer the right to sell September futures at $154, which means they will gain on the option as the market falls below $154. They will pay a premium for this right, which becomes an additional cost. They must also self-insure the first $6 per cwt drop in the market (the difference between the futures price and the strike price on the put). Much like hedging through the sale of a futures contract, basis must also be considered with an option strategy as the strike price is based on the futures market.

An additional limitation of both futures based strategies (sale of futures and purchasing of options) is the 50,000 lb CME© Feeder Cattle contract size. The vast majority of cattle producers in the South are not large enough to utilize futures and options. Fortunately, Livestock Risk Protection (LRP) insurance provides an opportunity to purchase an insurance product very much like a put option, but that can be scaled to any sized operation. Additionally, the subsidy on LRP has been increased substantially over the last couple of year, which makes it much more attractive from a premium perspective.

LRP is an insurance product that pays an indemnity if the CME© Feeder Cattle Index is below a selected coverage level on the ending date of the insurance policy. The CME© Feeder Cattle Index is used to cash settle open CME© Feeder Cattle contracts at expiration, so this insurance product is very similar to a put option. Consider the option example from before for a producer that planned to sell 800 lb feeder steers in September. Rather than purchasing a September put, that producer could instead purchase LRP insurance with a coverage level of $154 per cwt and an ending date in September. If the CME© Feeder Cattle Index was below $154 on the ending date of the policy, they would be indemnified for the difference on every cwt they covered. They must still self-insure the decrease until the index reaches $154 and they must also understand basis – the policy is indemnified based on the CME© Feeder Cattle Index, rather than what they sell their cattle for.

Risk management strategies are very much dependent on the financial situation and risk preferences of the individual. The purpose of this week’s article was largely to point out what is being offered by the market and review some price risk management strategies that are available. The futures market does seem to be offering some attractive opportunities right now for someone who wants to establish some downside price risk protection for the rest of the year. By no means is that to say that this market can’t go higher. Ask anyone who jumped on the 2014 market too early and they will quickly tell you that markets can always go higher. But, there are just as many examples of producers who chose not to cover their downside and watched expected profits quickly turn into losses. Predicting the future direction of the cattle market is impossible, but having risk management as part of a marketing plan is something every producer should consider.