Producers in Alberta have access to the Cattle Price Insurance Program and it appears that Saskatchewan and Manitoba will likely implement a similar program in the future. Government price insurance programs are just another way to minimize risk similar to futures and options markets. The mechanics of the program are fairly simple but I’ve received many calls and emails from cattle producers looking for recommendations. In my discussion, I’ve found that producers have very little understanding about risk management and the potential risk reward of their operation. In this article, I’m going to discuss risk management and how this relates to an individual’s operation or risk profile.
Over the past two years, the price of fed cattle in Alberta has gone from lows of $78 during December of 2009 to highs of $116 this past April, as you can see on the chart. There have been some severe price swings within a short period of time. Prior to the rally last winter, the highs of fed cattle were near $100 and the lows were around $80. For a producer, this represents a fluctuation in value of $250 on a 1,250- pound steer. Notice that the price highs are usually quite short lived.
Another factor to consider is the long-term risk reward ratio. If a feedlot in southern Alberta was to buy 800-pound feeders every week and sell them at 1,250 pounds feeding silage and barley, the average return would be in the range of plus $10 to minus $10 per head. Looking at different studies and also conducting this exercise myself, the potential long-run margin in a feedlot buying and selling cattle every week is likely near $0 per head. The Canadian feedlot industry is extremely efficient and unless producers have some edge or are the most efficient, it is difficult to compete long term. Keep in mind it is a pure competitive market. The fluctuation in financial returns or “risk” can be plus or minus $150 per head and on the outset, there are instances where the returns are plus or minus $250 per head. We saw some severe losses during the recessionary meltdown and the feedlot industry experienced some better times this last fall.
If a producer was to buy price insurance on all animals, the long-term average return would be lower. For example, if a producer endures another $15 per head cost on every animal and the long-term average return is $0 per head, this automatically makes your long-term average negative $15 per head. Producers also have to remember that they can only insure the cattle for the potential value in a certain time frame. Put simply, you can’t insure a house that is worth $250,000 for $1 million and the same principle goes for price insurance on fed cattle or feeder cattle. Additional coverage increases the cost of the insurance package.
There are two main questions I ask producers when purchasing price insurance or put options on a futures market. Where is the current cattle price relative to history and how much risk can the individual endure on their own accord. For example, if prices are at historical highs and the producer has a low-risk tolerance due to expensive barley and higher-priced feeder cattle, then the feedlot operator should be looking at insuring a larger portion of the production at current market prices. On the contrary, if the feedlot operator has purchased feeder cattle near 10-year lows and the fed market has been hovering near five-year lows, there is not a significant reason to spend a lot of money on insurance. Producers who are highly leveraged should also increase their insurance coverage.
In conclusion, buying price insurance on every animal can significantly increase costs and lower long-term financial returns. Producers have to be cognizant of where feeder and fed cattle have been trading relative to the long-term average to determine the risk reward of the current price structure. Do producers really need insurance when the markets are at historical lows?
Looking at this chart, where do producers need insurance?
GeraldKlassenanalysesmarketsinWinnipeg andalsomaintainsaninterestin thefamilyfeedlotinsouthernAlberta. Hecanbereachedat [email protected] or 204-287-8268.