I’ve received many inquiries over the past few weeks in regards to managing price risk in a declining market. Many producers have been using the Western Livestock Price Insurance Program (WLPIP) over the past couple of years. Recently, backgrounding operators have been asking how they buy price insurance when the costs are not conducive to insuring a positive margin. As one producer stated, it was going to cost him $80 per head to secure a $200 loss. I’ve also received questions from producers stating that the index on the price insurance program was lower than their local markets; thus these producers were expecting a payout but they did not receive one. In this issue, I will discuss a few aspects of the current market environment to address these concerns. We’ve seen a $30 drop in the fed cattle market since the summer highs, which has trickled down to a similar decline in feeder cattle prices.
Backgrounding operators or cow-calf producers who are backgrounding calves this fall need to understand the Livestock Price Insurance Program. This program is based on the Chicago Mercantile Exchange feeder cattle futures, which is used to calculate a forward price. The forward price is the expected price when the feeder cattle will be sold. Looking at the appropriate futures month, the forward currency is used to convert the price into Canadian dollars and then the basis is subtracted from this forward price. The basis is made up of projected currency swings, current market conditions, the three-year average basis for the selected time frame and along with forecast of the basis at the current time. After calculating the forward price, the program administration comes up with the premiums for the appropriate amount of insurance starting at 95 per cent of the forecasted price. The administration has an index based on the market for each region of Western Canada on which the settlements will be made. This index can sometimes be higher or lower than the local auction market values.
The premiums or the cost of the insurance is very similar to buying insurance for any other program. If you require 95 per cent coverage, then of course this will cost more than if you only require 75 per cent coverage. Also, the program offers coverage in four-week increments from 12 to 36 weeks so if you want a longer time frame, the premium will be more than if you want a shorter period of insurance. Finally, the volatility in the market also comes into the equation because when the market is more volatile, such as a $20/cwt drop within a four-week period, the premium will more expensive. Very simply, when there is a higher probability of a payout, the premium will be more expensive.
The U.S. and Canadian cattle complex reached historical highs this past summer and the market is now factoring larger beef production for 2016. Certain analysts are factoring in a one-billion pound year-over-year increase in U.S. beef production. The futures market, on which the Livestock Price Insurance Program is based, is weaker in the deferred months than in nearby position. For example, at the time of writing this article, the October feeder cattle futures was trading at US$193 whereas the May 2016 contract was at US$179. Secondly, it is very important to realize that in declining markets, the futures market leads the cash market lower, hence a futures market. Thirdly, studying past market behaviour, there is a “constellation in price activity” whereby, the deferred market can behave similar to the nearby market although trade at a discount. This can artificially lift or support the deferred market but when the delivery period arrives, the fundamentals can actually be heavier causing prices to weaken. All these factors can lower the “index” of the price insurance program.
What do these backgrounding operators do in this declining market and environment of uncertainty? Owning unhedged cattle in a declining market can be painful. For cow-calf producers, the choice is obvious which is to sell sooner rather than later and don’t background your calves. For backgrounding operators, the logical option is to wait for signs of stability or bottoming action in the market. The nearby futures will eventually trade at even money (the same price) as the deferred contract, which should allow a more realistic or risk-enduring scenario. Producers can then buy price insurance at a decent price that can protect against losses.
If you can’t wait to buy cattle, the producer is merely speculating that the market will recover. There are three options in this scenario. First, backgrounding operators can be a scale-down buyer over time, which will also lengthen out the marketing period on the cattle. This will hopefully average out the losses and gains. From the onset, producers know they are in a difficult financial position and may need to cut back on numbers. Secondly, backgrounding operators may decide to actually finish a portion of the cattle when pencilling out if they should sell midway through the production cycle. This also spreads out the marketing time frame but it is a double-edged sword if the market continues to decline.
The third scenario is to be patient when buying your price insurance or your hedging opportunity. The cattle market is known for seasonal swings and the speculative fund influence in the futures market can often push the market to extremes. Given the volatility, the futures market may provide an opportunity to buy price insurance at a break-even through the four- or eight-month feeding period. Producers need to constantly monitor the market for these opportunities. If you buy cattle when the market is not allowing an opportunity for price protection, a seasonal swing in the market “due to the constellation factor” may allow an opportunity for buying the price insurance one or two or three months after the purchase of the calves. The cattle market is known for this due to the large swings in production from quarter to quarter and also the consumer herd behaviour throughout the year.
Last year’s unprecedented margins are not likely to continue. We are back in a period when producers need to be realistic about their margin potential because beef production is increasing and the uncertain economic outlook is influencing consumer activity.