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Manage feeder cattle price risk

Curt Arens Herd of cattle
MANAGING RISK: With a declining national cow herd, feeder cattle may be a valuable commodity going into 2022, but producers should be aware of feeder cattle price risk management tools available to help improve chances for profitability and reduce overall risk exposure.
Tough Decisions: A livestock marketing economist looks at potential feeder cattle price risk management tools.

As we enter the new year and start to prepare for calving, the direction of the feeder cattle market is a question that will need to be addressed. Price for feeder cattle results from the supply of feeder cattle by cow-calf producers and the demand of feeder cattle from feedlots.

Market expectations for feeder cattle demand are exceptionally positive given strong domestic meat demand and a historically high export market. Supply is projected to be lower as there has been a growing contraction in the feeder cattle market over the past several years. Combined, this suggests there is a high probability, with current market conditions, that feeder cattle prices will be higher into 2022.

With a steady-to-positive price outlook into 2022, what (if anything) should be done about feeder cattle price risk management? If market situations continue to remain in the “steady-to-higher” scenario, then the best option for producers is to stay in the local cash market.

If prices begin to weaken given changing market fundamentals (i.e. Chinese beef demand starts to weaken given a stronger dollar), then we need some expectation of basis (i.e. basis = cash – futures) to determine what risk management tool to use.

In a weakening market, if the futures price is expected to weaken quicker than the local cash market, then selling CME futures or buying Livestock Risk Protection is the best form of risk management. However, if the cash market weakens quicker than the futures price, then forward- or cash-contracting is preferred.

Livestock risk production

If prices do weaken between the beginning of the year and calving, the USDA Risk Management Agency Livestock Risk Protection product is one option producers should consider. LRP was first offered in 2002, but its use by livestock producers has been relatively minor.

For example, only about 0.5% of all cattle in the U.S. are insured using any form of USDA insurance. In 2018, USDA-RMA began a series of changes to LRP to try increasing its use by producers. Three of these changes have direct implications for cow-calf producers.

First was increasing the subsidy level from 13% to 35%. This made it cheaper for producers to insure livestock. Second, it allowed for insurance premiums to be due when the insurance product is completed rather than at the time when the product was purchased. This change more accurately matches cash flow of operations and frees up more working capital to be used during the growing phase.

Third, it created a new insurance product for unborn feeder cattle. Historically, LRP required calves to be born before insuring. With long uneven calving windows, this change allows producers to insure against price movements prior to calves being born. Combined, these changes are having a positive effect on LRP feeder cattle use. In the 2020 and 2021 crop years, LRP contracts and head insured were at historical highs.

Insurance quotes for unborn calves

As an example of obtaining insurance quotes for calves yet unborn — if I visited the reports from USDA-RMA for Nov. 29, 2021, for unborn feeder cattle in Nebraska to be sold on Sept. 26, 2022 (see Table 1) — here is how I would read those quotes:

The second quote listed in Table 1 has expected end value as $186.920, or what the market on Nov. 29, 2021, expects feeder cattle to sell at, nationally, on Sept. 26, 2022. The coverage level is the proportion of the expected end value that you want to insure — in this case 0.999800.

The coverage price is the price that the actual feeder cattle price must fall below before an indemnity will be paid out to producers. It is calculated by multiplying the expected end value and coverage level (186.920 x 0.999800 = 186.890).

Table

The cost per hundredweight is the unsubsidized insurance premium set by USDA-RMA. The rate is the proportion of the unsubsidized insurance premium to the coverage price (i.e. 11.449 / 186.890 = 0.061262) and gives an indication of how much price has to decrease below the coverage price before the premium will be fully recovered. The producer premium per hundredweight is the subsided rate and is the premium the producer actually pays. In this case, $7.44 per cwt.

While not indicated, the subsidy level can also be calculated ([11.449-7.44]/11.449 = 0.35016). This is how much of the premium USDA-RMA is paying. Total premium required to be paid to USDA-RMA would be the producer premium times the number of hundredweight insured. In the case of 500 cwt of production, total insurance premiums would be $3,720 (i.e. 500 x 7.44 = $3,720).

Differences between LRP, CME put options

LRP works like CME put options by creating a price floor. Both are subject to basis risk (i.e. difference between what we expect basis to be and what basis actually becomes). However, there are two significant differences between these two products.

First, once LRP is purchased, it must remain in place until the insurance product expires. This is different than CME, which allows the options to be bought and sold until they expire worthless. Second, it allows producers to insure a flexible amount of production rather than a fixed quantity prescribed in CME contracts.

For example, if a cow-calf producer expected to sell 40 head of 550-pound steers, total pounds of production would be 220 cwt (i.e. 40×550/100 = 220 cwt). A CME feeder cattle options contract requires 500 cwt of production. If this producer used CME options to insure their production, they would be more exposed to movements in the national market. In this case, a producer who was wanting to set a floor price may be better suited to use LRP relative to CME put options.

Over the past several years there has been growing contraction of the national beef cow inventory. This trend appears to continue into 2022. Most analyst estimates suggest that beef cow inventories are going to be down 1% nationally. This, combined with high domestic and export meat demand, has created a situation for high feeder cattle prices.

If market situations remain unchanged, it is acceptable to take all the price risk in the cash market. However, if market prices start to deteriorate, then there needs to be some expectation of the direction of basis. Using USDA-RMA’s LRP products is one product that can be used if basis is expected to be strengthening. Under each market scenario, we should strive to use the correct market tool to match the present market risk.

Elliott is a livestock marketing economist at the University of Nebraska-Lincoln.

TAGS: Livestock
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