1. Cattle Risk Management GEOFF BENSON, PhD Extension Economist Dept of Agricultural and Resource Economics North Carolina State University

2. GEOFF BENSON, ARE, NCSU2 Agenda n Introduction n Price forecasting n Price risk management  Hedging with cattle futures  USDA-RMA LRP Program  Cattle futures options  Setting price targets & pulling the trigger n Summary

3. GEOFF BENSON, ARE, NCSU 3 Risk Risk n RISK -- the chance of loss or an unfavorable outcome or event  Anticipated or unexpected  Known probability or uncertain n RISK EXPOSURE -- The amount of a loss, if it occurs n The financial consequences for the business: cash flow, profit, solvency

4. Sources of Risk n Weather & other natural phenomena  Local variation in rain, temperature, etc.  Regional, national, global weather  Extreme (tornadoes, hurricanes, floods, etc.) n “Technology” and competitiveness n Changes in your customers’ ability or willingness to buy your product n Societies attitudes & preferences n Government and other institutions rule changes n Individual human behavior n Random accidents GEOFF BENSON, ARE, NCSU 4

5. Managing Risk n What are the most important risks your farm business is exposed to? n How vulnerable is your farm business to these risks (exposure)? n What cost-effective strategies are available to manage price risk? n What is your attitude to risk? n Do you have the time, knowledge and risk management skills? GEOFF BENSON, ARE, NCSU 5

6. Risk Management n Management strategies include:  Reducing the chance of an event v The management ability, knowledge and effectiveness of the producer is the key  Reducing the impact if an event occurs v Buying insurance v Self-insurance, which comes in many forms including carrying inventories, diversification, maintaining financial reserves, borrowing, off-farm income GEOFF BENSON, ARE, NCSU 6

7. Cost:Benefit n All risk management strategies involve costs, in money or time n Effectiveness varies among alternatives  Financial benefits & costs  Time, new knowledge and skills  Evaluate trade-offs GEOFF BENSON, ARE, NCSU 7

8. 8 Agenda n Introduction n Price forecasting n Price risk management  Hedging with cattle futures  USDA-RMA LRP Program  Cattle futures options  Setting price targets & pulling the trigger n Summary

9. GEOFF BENSON, ARE, NCSU9 Price Forecasting n Helpful for making marketing and business decisions n The futures market provides an industry consensus on prices as far as one year out n Takes account of known information n Changes daily as new information becomes available

10. GEOFF BENSON, ARE, NCSU10 Cattle Futures n The CME Group trades two types of cattle futures – data at www.cmegroup.com n Live (or finished or fat) cattle futures -- 40,000 pound lots of 55% Choice, 45% Select, Yield Grade 3 steers, physically delivered: Feb, Apr, Jun, Aug, Oct, Dec. n Feeder cattle futures are for 50,000 pound lots of 650-849 pound L&M 1&2 steers, cash settled: Jan, Mar, Apr, May, Aug, Sept, Oct, Nov.

11. GEOFF BENSON, ARE, NCSU11 Price Forecasting n Use “nearby” futures contract price for intended sale month n BUT  This is not the NC price “Basis” = futures price – local cash market price for similar cattle  If basis is predictable, then we can use the futures market to project local North Carolina prices and use this to make business decisions

12. GEOFF BENSON, ARE, NCSU12 Price Forecasting, cont. n The cattle futures contract may not match the cattle you have to sell –need to adjust the futures price n What market premiums & discounts affect the value of your cattle?  Weight  Sex  Frame  Muscle  Breed  Other, e.g., market channel, truckload

13. Price Worksheet ITEM$ FUTURES PRICE, SALE MONTH Basis Weight adjustment (+ or -) Sex (heifer) adjustment (+ or -) Frame adjustment, if not M or L (-) Muscling, if not 1 or 2 (-) Breed or color adjustment (+ or -) Other, e.g., special sale, lot size (+ or -) Estimated price for your cattle GEOFF BENSON, ARE, NCSU13

14. GEOFF BENSON, ARE, NCSU14 Feeder Cattle Futures, $/100 lb, 3/26/09

15. GEOFF BENSON, ARE, NCSU15 Historic Basis n The most useful comparison is the published NC weekly auction (cash or spot) prices for a particular week or month relative to the cattle futures price for the “nearby” month n Note  NC Auction prices are reported weekly in 50 or 100 lb./head increments for small lots  CME feeder cattle futures contract is for 650-849 lb. M&L1&2 steers in truckload lots  Contract months are Jan, Mar, Apr, May, Aug, Sept, Oct, & Nov.

16. GEOFF BENSON, ARE, NCSU16 NC Basis, Avg. 1990-2000

17. GEOFF BENSON, ARE, NCSU17 NC Basis, 1990-2000 n Negative (transportation cost) n Varies by market, west to east n Seasonal:  Smaller discount in spring, high demand for cattle for summer grazing  Larger negative differences in fall as cattle are sold as grass runs out n Historic data on line at: http://www2.ncsu.edu/unity/lockers/ project/arepublication/AREno32.pdf

18. GEOFF BENSON, ARE, NCSU18 “Quality” Differences n What are the characteristics of your cattle and how do they affect the price (value)?  Weight  Sex  Frame  Muscle  Breed  Other, e.g., market channel, truckload

19. GEOFF BENSON, ARE, NCSU19 Price Differences, NC Graded Sales, M1 Steers, 1991-2001.

20. GEOFF BENSON, ARE, NCSU20 Price Differences, Graded Sales, M1 Heifers v. Steers, 1990-2001

21. GEOFF BENSON, ARE, NCSU21 Price Differences, Graded Sales, 500-599 lb. Steers, 1990-2001

22. GEOFF BENSON, ARE, NCSU22 Selected Breeds n Angus n Braford n Brahman n Brangus n Braunveih n Charolais n Chianina n Devon n Galloway n Gelbveih n Hereford n Holstein (dairy) n Jersey (dairy) n Limousin n Longhorn n Maine Anjou n Nellore n Piedmontese n Pinzgaur n Polled Hereford n Red Poll Sahiwal Salers Santa Gertrudis Shorthorn (dual) Simmental South Devon Tarentais Zebu + Crosses & Composites

23. GEOFF BENSON, ARE, NCSU23 Price Differences, Graded Sales, 500-599 lb. M1 Steers, 1991-2001

24. GEOFF BENSON, ARE, NCSU24 Marketing Options n Regular auction = Base n Graded sale n Special programs, e.g., Southeast Pride, pre- conditioned sales n Direct farm sale (several options) n Retained ownership

25. GEOFF BENSON, ARE, NCSU25 Marketing Options n Farm situation determines opportunities and cost:  Size of herd v Number of cattle for sale v Uniformity of cattle  Market Premium offered  Marketing Cost  Risk

26. Price Worksheet ITEM$ FUTURES PRICE, SALE MONTH Basis Weight adjustment (+ or -) Sex (heifer) adjustment (+ or -) Frame adjustment, if not M or L (-) Muscling, if not 1 or 2 (-) Breed or color adjustment (+ or -) Other, e.g., special sale, lot size (+ or -) Estimated price for your cattle GEOFF BENSON, ARE, NCSU26

27. GEOFF BENSON, ARE, NCSU27 QUESTIONS OR COMMENTS ON PRICE FORECASTING?

28. GEOFF BENSON, ARE, NCSU28 Hedging Price Risk n Basics of futures & options n Hedging with futures examples n USDAs Livestock Risk Protection (LRP) Program n Hedging with Options n Is hedging for you?  How much do you have at risk?  Risk management strategies

29. GEOFF BENSON, ARE, NCSU29 Futures Contracts n Sell a Feeder Cattle contract for a specific month at a specific price -- Locks in a price! n “Off-set” your position in the futures market  By letting the contract expire  By buying back an identical contract (at or near the expiry date) n At the expiry date the futures price = the cash market (spot) price

30. GEOFF BENSON, ARE, NCSU30 Futures Contracts n Set up a trading account with a brokerage n Pay a small commission to the broker for the transaction n You may get margin calls to ensure you can cover your position -- Deposit cash in your trading account when the futures price moves above the price you locked in

31. GEOFF BENSON, ARE, NCSU31 Hedging: Example 1 Item Market Falls Market Rises 1.Sell an October contract in April$100 2.Future price in Oct$85$110 3. Your Gain or Loss$15-$10 4.Cash Price in Oct$85$110 5.Net Proceeds$100

32. GEOFF BENSON, ARE, NCSU32 Hedging: Example 2, Part 1 Item Market Falls Market Rises 1. Sell October contract in April$100 2. Local basis-$5 3. Expected local cash price$95

33. GEOFF BENSON, ARE, NCSU33 Hedging: Ex 2, Part 2 Item Market Falls Market Rises 5. Future price in Oct$85$110 6. Gain or Loss$15-$10 7. NC Oct Cash Price$80$105 8.Net Proceeds$95 9. Actual Basis$5

34. GEOFF BENSON, ARE, NCSU34 Hedging: Example 3 Item Market Falls Market Rises Sold Oct. futures$100 5.Future price in Oct$85$110 6.Gain or Loss$15-$10 7. NC Oct. Cash Price$82$101 8.Net Proceeds$97$91 9. Actual Basis$3$9

35. USDA’s LRP Program n Price risk insurance, pay a premium n Can cover each year up to  2,000 head of feeder cattle of up to 900 lb. – two weight categories, steers or heifers, 3 breeds – Brahman, Dairy, “all other”  4,000 head of 1,000 to 1,400 lb fed cattle n Coverage can range from 70% to 100% of estimated ending value* n More flexible and more direct pricing than hedging with futures GEOFF BENSON, ARE, NCSU35

36. Example 1, Nash Co, 3/30/09 ITEMSTEERS Number of head20 Sale weight, cwt.5.5 Coverage price per cwt.$92.39$94.59 Coverage level.8669.8875 Insured value$10,163$10,405 Premium rate0.0142520.018142 Premium cost$126$164 GEOFF BENSON, ARE, NCSU36

37. Example 2, Nash Co, 3/30/09 ITEMHEIFERS Number of head20 Sale weight, cwt.5.5 Coverage price per cwt.$83.99$85.99 Coverage level.8669.8875 Insured value$9,239$9,455 Premium rate0.0142520.018142 Premium cost$115$150 GEOFF BENSON, ARE, NCSU37

38. Information on LRP n Fact Sheets are available on line at http://www.rma.usda.gov/livestock/ n Examples of contracts are at http://www3.rma.usda.gov/apps/livestock_rep orts/main.aspx n A premium calculator is available at http://www.rma.usda.gov/tools/premcalc.html n A list of LRP insurance providers is at http://www3.rma.usda.gov/tools/agents/compa nies/2008/north_carolinaLPI.cfm. All are from out-of-state GEOFF BENSON, ARE, NCSU38

39. GEOFF BENSON, ARE, NCSU39 Options n The right (but not the obligation) to buy or sell a futures contract.  Puts a floor under the price but not a ceiling – you get the upside n A “put”= right to sell & allows the producer to hedge n A “call”= right to buy & allows the buyer (e.g., the feedlot operator) to hedge

40. GEOFF BENSON, ARE, NCSU40 Options n An option is for a specific futures contract and a specific price n The agreed upon futures contract price is called the strike price n The cost of an option is called a premium n Premiums are established by public outcry pit trading and by electronic trading, similar to the way futures prices are established

41. GEOFF BENSON, ARE, NCSU41 Options n There is a range of strike prices for each futures contract n Premiums have 2 components:  Time value -- pay more for options on far off contracts, shrinks as the expiry date approaches  Intrinsic value -- related to the relationship between the strike and current price of the futures contract

42. GEOFF BENSON, ARE, NCSU42 Options n In-the-money -- Underlying futures price is favorable compared to the strike price n Out-of-the-money -- Futures price is unfavorable vs. strike price n At the money n Options automatically settle for cash at the time the underlying futures contract expires

43. Feeder Cattle Options Premiums, May Contract, $/cwt., 3/25/09 ITEMPRICENET Futures contract price$95.375$95.375* Put Option at $92.00$1.80$90.20 Put Option at $94.00$2.50$91.50 Put Option at $96.00$3.35$92.65 Put Option at $98.00$4.425$93.575 Put Option at $100.00$5.95$94.05 GEOFF BENSON, ARE, NCSU43 * No brokers fee or cost of margin calls included

44. GEOFF BENSON, ARE, NCSU44 QUESTIONS OR COMMENTS ON HEDGING?

45. GEOFF BENSON, ARE, NCSU45 Is Hedging for You? n Things to consider  Size of your cattle operation  Financial importance of your cattle operation  Ability to handle price risk  Attitude to risk & expectations about hedging

46. GEOFF BENSON, ARE, NCSU46 Farm Structure, 2007 Census

47. GEOFF BENSON, ARE, NCSU47 Why Do You Have Cattle? OR FUN OR MONEY?

48. GEOFF BENSON, ARE, NCSU48 Hedging n It is not for everyone  Very small producers  Busy producers  Producers for whom beef cattle are a sideline n All risk management strategies involve costs and effectiveness varies among alternatives  Financial benefits & costs  Time, new knowledge and skills  Evaluate trade-offs in your situation

49. GEOFF BENSON, ARE, NCSU49 Hedging n How much do you have at risk?  Number of head  Possible change in price  Total financial losses  Impact of those losses on farm and family finances n Example,  I truckload of feeder cattle = 50,000 pounds (~65 head)  A $10 per cwt. price drop = - $5,000

50. GEOFF BENSON, ARE, NCSU50 Price Risk Management Strategies n Ride it out – “self-insure”  Draw on savings or borrow  Restructure debt payments  Adjust expenses, especially maintenance & new investments  Add off-farm income or cut family living expenses n Prevent unacceptably low prices with futures contracts, options, LRP – “buy insurance”

51. GEOFF BENSON, ARE, NCSU51 Hedging n Attitude & Expectations  Futures, options & LRP are tools to manage downside price risk and prevent or moderate the financial problems lower prices would cause  It is unrealistic to expect that using futures and options will increase your average or long run profit but using them may help keep you in business!  Using them may help you sleep better!

52. GEOFF BENSON, ARE, NCSU52 Attitude to Risk n Attitude to risk affects an individual’s decision in a given risk situation  Are you risk averse? v Willing pay to reduce risk (insurance) v Willing to accept a somewhat lower expected profit to avoid downside risk  Are you a “risk preferer” – NOT willing to pay for risk reduction and possibly accept lower average profit

53. GEOFF BENSON, ARE, NCSU53 Setting Hedging Price Targets n A minimum profit  Full cost of production + margin  Break even n Cash flow protection  Stocker purchase price  + or - debt service  + or - cash production costs  + or - $$ for family living

54. GEOFF BENSON, ARE, NCSU54 Do you know your cost of production & profit margin? n Operating cost - Out of pocket expenses, e.g. forage, other feed, fertilizer, vet, repairs, n Investment (fixed) costs— Depreciation, interest, property taxes & insurance (DITI) n Opportunity cost – charge for your time and equity capital invested

55. GEOFF BENSON, ARE, NCSU55 MN Cow-calf Cost & Returns, 2007 Low Profit Avg. Profit High Profit Revenue$394$524$710 Operating cost$481$437$376 Margin over op. cost-$87$87$334 Fixed & O/H cost$149$115$79 Labor & Mgt charge$83$84$102 Total cost$713$836$556 Net Return-$319-$112$154 Source: MN Farm Business Management database

56. GEOFF BENSON, ARE, NCSU 56 MN Stocker Cost & Returns, 2007 Low Profit Avg. Profit High Profit Revenue, net$110$207$252 Operating cost$200$179$149 Margin over op. cost-$90$28$103 Fixed & O/H cost$59$25$21 Labor & Mgt charge$75$19$16 Total cost$333$223$187 Net Return-$223-$16$65 Source: MN Farm Business Management database

57. GEOFF BENSON, ARE, NCSU57 NCSU beef & forage budgets n Beef: cow-calf, backgrounding, summer grazing, pasture finishing, conventional finishing, pre- conditioning n Forages: perennials, annuals, hay making, silages n Available on line at: http://www.ag-econ.ncsu.edu/ extension/Ag_budgets.html

58. GEOFF BENSON, ARE, NCSU58 Costs in the Budgets Costs in the Budgets n Operating inputs -- fuel, fertilizer, chemicals, labor, seed, interest n Fixed costs -- depreciation, interest, taxes, insurance on machinery and buildings n Full labor and interest costs and charges n Forage budgets  Do not include storage, feeding or pasture management costs  Some include harvesting costs  Include yield estimates and “unit costs” n NO farm overhead cost n NO land charges

59. GEOFF BENSON, ARE, NCSU59 Cash Flow n Budgets include full economic costs n For cash flow price targets, evaluate the revenue needed to cover  Out of pocket production expenses, including cattle purchases  + or - Debt payments  + or - Family living n Remember, the purpose is to lock in or set a floor price at an acceptable level to insure against a financial disaster

60. GEOFF BENSON, ARE, NCSU60 Pulling the Trigger n Futures price volatility means pricing opportunities come and go n Futures prices respond to:  Market fundamentals, so track key economic factors and understand their impact on prices v Supply factors v Demand factors  Technical trading driven by market psychology, so following price moves and interpreting trading patterns can help

61. GEOFF BENSON, ARE, NCSU61 Demand & Supply Factors n Consumer Demand  General economy – income, unemployment, exchange rates  Competition from other meats  Demographic changes – age, race, pop. n Supply  Availability of cattle – stage of cycle  Feedlot costs  Transportation costs  Trade

62. GEOFF BENSON, ARE, NCSU62.

63. GEOFF BENSON, ARE, NCSU63 Cattle cycles n Low prices force liquidation of breeding stock, adding to beef supplies and reducing prices further n Reduced production leads to higher prices encouraging heifer retention for breeding, reducing beef supplies and raising prices further n Lags  Decision making takes time  15 months to raise a heifer to breeding age  Seasonality in breeding & 9-month gestation  14-18 month production period

64. GEOFF BENSON, ARE, NCSU64 Beef Product & $$ Flows $ CONSUMER $ RETAILER WHOLESALER PACKER FEEDLOT STOCKER COW-CALF PROCESSOR

65. GEOFF BENSON, ARE, NCSU65 Price Volatility n Unexpected changes in significant supply & demand factors n “Known unknowns”  Weather v Crop prices & feed costs v Forage supplies & quality v Cattle supplies n “Unknown unknowns”  Disease outbreaks, e.g., BSE  Economic crises

66. Feeder Cattle October Contract Price History GEOFF BENSON, ARE, NCSU66

67. Hedging n Takes time to learn to follow market conditions  Marketing club?  Paper trading  Finding a market adviser and/or broker you trust n Takes confidence to learn when to “pull the trigger” GEOFF BENSON, ARE, NCSU67

68. GEOFF BENSON, ARE, NCSU68 Summary n All producers can use futures and other price information to project prices for their cattle as part of marketing and business decisions n Benefits of hedging  Protecting yourself from unfavorable price movements that would cause you serious financial problems  For the seller -- protection from price drops  For the buyer – protection from price increases

69. GEOFF BENSON, ARE, NCSU69 Summary n Several factors affect profits  For cow-calf v Prices & premiums related to selling weight, frame, breed/color, season, choice of market etc. v Animal performance v Cost of production  Base hedging decisions on feeder cattle futures prices, adjusted for basis, weight, other cattle characteristics, and market choice

70. GEOFF BENSON, ARE, NCSU70 Summary n For Stockers, key factors:  Purchase price  Selling price  Feed costs  Average daily gain & change in body condition n Use feeder cattle futures prices as the basis for profit projections n Base hedging decisions on feeder cattle futures prices, adjusted for basis, weight, other cattle characteristics, and market choice

71. GEOFF BENSON, ARE, NCSU71 Summary n Price risk management tools include futures, options and LRP n Set price targets based on your own cost of production or cash flow needs n Track market conditions to time your actions n Producers need good financial records to set price targets, and monitor performance, costs & profit margins n No $imple or ea$y an$wer$!!

72. GEOFF BENSON, ARE, NCSU72 “If it’s easy, fun or can be done from the seat of a tractor, there ain’t no money in it” Anonymous Cowboy

73. GEOFF BENSON, ARE, NCSU73 What Next? n What more assistance do you want or need, if any? n Topics  Price forecasting  Hedging with futures  USDA’s Livestock Risk Protection Program n How would you like this help delivered?  One-on-one with an adviser & broker  Group meetings  Materials, publications, etc.

74. GEOFF BENSON, ARE, NCSU74 Geoff Benson n Phone: (919) 515-5184 n Fax: (919) 515-6268 n E-mail: geoff_benson@ncsu.edu n Web page: http://www.ag-econ.ncsu.edu/ faculty/benson/benson.html