Livestock Risk Protection

LIVESTOCK RISK PROTECTION

CATTLEFAX TRENDS

Cow-calf producers have several tools to mitigate price risk. While none are perfect for everyone, Livestock Risk Protection (LRP) has gained a lot of popularity from producers over the last couple of years. Just like forward contracting or hedging with futures, it is still particularly important to have an outlook of the market to decide when and at what price level makes sense to incorporate LRP. Knowing breakevens, therefore potential profitability should always be considered when using a risk management tool.

LRP is insurance that protects against a drop in price, or essentially creating a floor. At the same time, the upside potential is unlimited. The concept is similar to buying a put option. Although, LRP is a USDA program, and the premium is subsidized. The subsidy increase a couple of years ago made the program a lot more attractive and competitive relative to buying put options. The subsidy rate varies depending on the coverage level. The lower the coverage level, or more risk a producer is willing to accept, the higher the subsidy.

One major difference between LRP and options that can be a significant benefit to producers, especially smaller operations, is LRP policies are written on a headcount basis, whereas a feeder cattle options contract is 50,000 pounds. Producers can use LRP for as few as 1 head to as many as 12,000 per endorsement, for a total of 25,000 head per year.

The protection levels and costs are listed each day after the futures market closes, since the levels are, to some degree, comparable to futures quotes. Producers can purchase LRP from 4 PM central time until 9 AM the next morning. The endorsement minimum is 13 weeks, or roughly 3 months, and up to 52 weeks if pricing and rating information is available. Typically, there is one coverage option for each month. Because producers can potentially set a floor price up to one year in advance, and unborn calves can be insured with LRP, the next calf crop could be insured before the current one is marketed. Again, it is important to understand the long-term market trends to help with risk management decisions.

Arguably the most important thing to understand about LRP is the settlement methodology. Feeder cattle and calf policies are settled against the CME Feeder Cattle Index. In other words, the cash price a producer receives when the cattle are marketed has no effect on the LRP policy. The only price that dictates whether a producer receives an indemnity is the CME Feeder Cattle Index. If the index is below the coverage price, or floor, at the end of the coverage period, the producer receives the difference, after the premium cost is subtracted. It is important to note, the policy premium does not have to be paid until the cattle are sold, and the producer has up to 30 days after the endorsement ends to pay the premium. If the index settles above the coverage price, the producer still must pay the premium. However, the ability to do delayed payment can be beneficial from a cashflow standpoint compared to utilizing options which requires payment up front. In the case of a drought or a change in marketing plans, producers can sell cattle up to 60 days prior to policy expiration. They do not have to be sold when the endorsement expires.

Unlike options and futures, producers cannot offset or buy back their position with LRP. Once the policy is written, there are no changes that can be made. However, LRP could be combined with other futures or options positions, such as selling a put or call to cheapen up the strategy.

LRP is purchased through licensed insurance agents. Because it is a government backed program, the premium or costs to purchase is the same from all insurance agents. While most of the important details have already been discussed, it is recommended to ask an agent to provide more information regarding the program and be sure to ask any specific questions. Producers may want to get more clarification on a new protocol this year that requires proof of ownership before an indemnity is issued. In addition, there are price adjustment factors depending on weight and breed-type that need to be discussed with an agent before finalizing a deal.

Just like any risk management strategy, producers need to have a plan and should have a reason why LRP is being implemented. If a fairly accurate breakeven is known, the reason might be to lock in a positive margin. In some instances, it could be utilized to simply protect equity, especially depending on the market outlook and potential costs. This is likely the case for most producers in the short-term, given the significant increase in expenses over the last couple of years.

Driven by the aggressive liquidation in recent years, the calf market will trend significantly higher into the middle of the decade. While markets will continue to be volatile, producers may consider being more patient and having a greater risk tolerance the next few years. Because LRP does not limit upside potential, this could be an especially useful tool to protect against any unpredictable market pressures while also capitalizing on the uptrend into the middle of the decade. LRP typically offers coverage levels that range from nearly 100 percent to 70 percent. If producers are willing to take on more risk, it can easily be done with a lower coverage level per endorsement. This would also result in cheaper premiums.

It is important to keep in mind the cyclical nature of the cattle markets. At some point, likely the second half of the decade, the market will roll over – potentially at a fast rate. If producers use LRP over the next few years, there may be several times that an indemnity is not received, depending on the coverage price and level. While it may be frustrating to pay the premium with no indemnity, do not lose confidence in LRP because it could be very beneficial once the markets correct cyclically several years down the road.

As producers develop a plan to use LRP, it is critical to know what price floor is being set with LRP. As mentioned earlier, the calf and feeder cattle LRP settles against the CME Feeder Cattle Index. For example, purchasing a policy with a $190/cwt coverage price does not guarantee that is the price floor for your cattle that sell at the sale barn or video auction. Because LRP settles to the feeder index, which is tied to feeder cattle futures to some degree depending on basis, understanding the seasonality of the futures complex can help producers create a plan. The October feeder cattle futures seasonal index shows a gradual uptrend into expiration. The index based on the last twenty years suggests most of the rally is in by early August. Corn, feedyard capacity, profitability, and other factors, especially Black Swan events, can derail those index trends; however, time is on your side most years. Since LRP does not cap upside, it can be used to help you sleep at night by protecting equity or margin without missing out on seasonal tendencies. The seasonal for other futures months, especially the winter contracts, show slightly different trends, so it is critical that producers do their homework and consider other market factors.

There is not a “one size fits all” risk management tool. But it is important producers understand what options are available, how they can be beneficial, and how they function. Some tools work better compared to others during different phases of the cattle cycle depending on the market outlook. A person’s risk tolerance will also have a big say on which risk management strategy is a better fit. It is important to remember risk management does not have to be an all or nothing approach.