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Because outside events continue to have a greater impact on cattle markets, and reliance on ever-changing international outlets has grown the last couple decades, it is important for producers to thoroughly evaluate their current risk management plan. If nothing else, everyone needs to be aware of what it is available for price protection. While the outlook over the next few years is for higher trending calf prices, being able to act quickly could be the difference between red or black ink on your bottom line. The following discussion is not intended to promote one strategy over others, but instead give a broad overview on what is available.

The most basic form of risk management is understanding the typical seasonality of markets. A “seasonal” year occurs about eight out of every ten. For the calf market this means the annual highs occur in late winter or early spring, before breaking to a low in the fall when peak numbers are sold. Eighty percent of the time producers are better off selling prior to or retaining ownership/weaning after the fall-run, to avoid receiving the lowest prices of the year. As with anything there are some exceptions and why the odds are about eight out of 10 for a “seasonal” year. Given what is known today, 2021 may not perfectly fit the seasonal pattern. Because of smaller calf numbers and the long-term expectations, the break into the fall will be limited, if it occurs at all. Understanding the market seasonality for all segments of the industry is important and necessary to make sound risk management decisions.

To avoid selling in the spot fall market, producers can forward contract calves for future delivery. There are a few ways to achieve this. Consigning to a summer video sale or marketing calves via private treaty/direct trade are a couple of avenues. The 10-year average premium for calves sold on summer videos for fall delivery versus those marketed in the fall spot market is $58/head. It is not a guarantee a higher price will be received, because like a seasonal year, the advantage occurred in eight out of ten years, with a wide range of less than $10/head to over $330 in 2015. Also, accuracy of the projected base weight is one of the most important variables when forward contracting calves. A big miss can be detrimental, depending on the slide specifications.

Another form of forward contracting is entering into a basis contract. As a reminder, basis is the difference between the cash price and futures price. While this is not real popular for calves due to the basis volatility and uncertainty from year to year discouraging buyers to make an offer, it can be useful for those who retain ownership. The buyer and seller agree to a basis level against a specific feeder or live cattle futures contract and delivery period. Once the basis is set and prior to the delivery period, the seller will price the cattle using the specified futures contract. The primary advantages of basis contracting are eliminating all basis risk, reducing market emotion once the price objective is set, and no margin calls.

Use historical basis levels for the respective region as a benchmark to compare against basis bids. However, the range around the historical levels can be fairly wide for calves because the feeder futures complex truly represents an 800-pound feeder steer in the Central Plains. CattleFax has historical basis data for most states or regions, by weight and sex, to help producers understand if the basis bid is adequate. Current and future fundamentals will also play a role in basis levels.

Variation in basis, or basis risk, is the biggest pitfall when futures are utilized to hedge as a risk management strategy. However, if basis performs better than expected, hedging can pay huge dividends. Without going into too much detail, sellers want stronger than anticipated basis when cattle are sold. Hedging, or taking a short futures position, can be used by virtually everyone and is essentially locking in a price and protecting against a drop in the market. Although, producers need to be financially prepared for a margin call if futures move against their hedge – higher in this example. To limit the risk of answering a margin call, following the seasonality of the feeder market will be beneficial most years. In a seasonal year, about eighty percent of the time, fall feeder futures will trend higher at least into the summer. The odds favor, having patience to wait until that time of the year allows producers to lock in a better price compared to winter or spring.

Applying an expected basis to the futures price is the cash price a producer is locking in when a hedge is put in place. For example, the 10-year average basis for a U.S. average 550-pound steer is roughly $15/cwt against October feeder cattle futures. If an October futures contract was sold at $160/cwt, the producer is locking in a $175/cwt cash price, given the $15 basis assumption. Again, it is important basis meets or exceeds expectations when cattle are marketed, and the hedge is lifted to receive the anticipated net revenue.

A couple other risk management tools that share similar concepts are options and Livestock Risk Protection Insurance (LRP). Purchasing a Put option is like an insurance policy that gives the individual the right to sell a futures contract at the predetermined price level. Buying a Put option allows the producer to set a minimum selling price without eliminating the opportunity to sell cattle or futures at a higher price. Essentially a floor is set, but the upside potential is unlimited. The premium that is paid upfront, which can be expensive at times, and broker commissions, are the only costs associated with buying a Put option.

An LRP policy allows producers to insure their desired head count, up to the current limits of 6,000 head per endorsement and 12,000 per year. If the actual ending value (based on the CME Feeder Cattle Index) is below the coverage price, then the producer receives the difference minus the premium. Similar to purchasing a put option, the upside potential is unlimited. The premium can be paid at the end of the endorsement period and is subsidized, which is dependent on the coverage level.

If a producer is serious about utilizing one of the risk management tools discussed, it is recommended to seek expert advice or conduct more thorough research before putting anything into action. There are additional pros or cons and details for each possibility. This article was intended to provide an overview of each opportunity. The first step to making a critical business decision is knowing what is available.

Finally, it is important to understand that managing price risk is not always an all or nothing strategy. Depending on the market outlook there will be times when only a portion of the inventory should have some sort of equity protection. Profit potential, which requires estimating an accurate breakeven, is a factor that also needs to be considered when making risk management decisions.

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