Two years ago in the summer of 2014, we featured an article in Margin Manager on the topic of how livestock operations like dairies, cattle and hog finishers handle the management of their corn costs in a margin management plan when they grow their own feed. Many remember that period as one of moderating prices with corn coming off of significantly higher values following the drought of 2012 and the ensuing summer of 2013 with limited supplies and record-high basis levels in several cash markets. During that period of high prices, a feeding operation that controlled their own corn production had a distinct advantage over those that did not and were required to purchase their feed needs. Some of these operations would account for their feed inputs at the cost of production for growing the corn, which at the time was well below the replacement value in the open market. Today, the situation is much different with these same operations finding that their cost of corn production exceeds the price in the market at which they could buy the feed if they did not grow their own crops.
This has raised the question again on what is a sensible approach to handling corn as an input cost in a margin management plan when you both produce and feed the crop to your livestock operation. One thing we highlighted in the previous article was that there are essentially two separate businesses – a crop operation on the one hand and a livestock operation on the other. As a result, you might elect to handle the two businesses as separate entities and manage their risks independent of one another. Under this approach, you would manage the corn on the crop side to maximize its sale value while separately managing the corn as an input for your livestock operation by trying to minimize its cost. Obviously these two goals are opposed to one another and could potentially lead to offsetting positions in the market. Many of the livestock operations we work with are integrated in that both the crop production and livestock production enterprises have the same beneficial ownership. Moreover, as the previous article pointed out, the corn will never leave the farm as it is grown specifically to supply the needs of the livestock operation.
For these entities, it is important to acknowledge that the farm produces two assets from two separate operations, both of which are exposed to depreciation from lower prices in a declining market. I remember when I first started working in the industry 20 years ago, farmers that raised hogs would explain that their livestock was basically “value-added corn.” Hog production was obviously much different in the mid-1990’s than it is today with much larger, sophisticated operations now that are highly specialized and focused on specific aspects of production. In the past, farmers might have gotten into and out of hog production as margins to produce pigs made it attractive to add value to their corn production on the farm, and then “walk their corn off the farm” as the saying went. What they were basically trying to tell me was that there were certain times (in strong hog margin periods) when it made more sense to sell their corn production as hogs and other times (in weak hog margin periods) when it was better to sell their corn as corn and simply not raise hogs.
Today, it is not quite as simple as most hog operations in addition to being larger and highly specialized have huge investments in their buildings, equipment and other overhead that does not allow them to be “part-time” producers. They have to manage their assets efficiently to remain competitive and preserve margins. With respect to the management of their corn and livestock, it therefore becomes necessary to explore the relationship between these two assets in order to determine how best to protect the risk of depreciation from falling prices. One way to think about it is to consider a matrix of potential scenarios that they could be experiencing in the marketplace. Given that they are producing both corn and livestock, it is prudent to evaluate the profitability for each enterprise as an initial starting point in the process. First, is the price of corn above or below the cost of production? In other words, is the margin positive or negative with respect to the crop operation? Second, is the feeding margin positive or negative when considering the price of corn in relation to the value of the livestock or milk being produced. In this way, one of four possible scenarios could be the case.
First, it may be that both the corn price is above the cost of production such that the crop margin is positive at the same time that the livestock margin for feeding the corn is also positive. This would be the best-case scenario as far as both operations are concerned. Second, it could be that the corn price is above the cost of production such that the crop margin is positive, but the feeding margin is negative. Conversely, it might so happen that the corn price is below the cost of production so that the crop margin is negative; however, the feeding margin is positive for the livestock operation. Finally, it may be that both margins are negative at the same time. This obviously would be the worst-case scenario. The following grid displays each of the four possible scenarios:
Margin Corn Livestock
Positive (+) (+)
Negative (–) (–)
Coming back to the question of how to manage the corn price under each of these scenarios, let’s consider them separately. In the best-case scenario where both margins are positive, this likely corresponds to a situation where the best value for the corn is through the sale of the milk or livestock. By establishing a margin for the feeding operation, the value of the corn is protected through this sale. In the second scenario where the crop margin is positive but the feeding margin is negative, it would be better to protect the value of the corn while waiting for a better margin opportunity on the livestock. This might correspond to a situation of high prices where establishing flexible protection on the corn through an option strategy that places a floor under the market might work well. In the third scenario where the crop margin is negative but the livestock margin is positive, protecting the price of corn by establishing a margin for the feeding operation may again be best approach. This might be a situation similar to the present environment where prices are historically lower. The main difference then between having both margins positive or having the scenario where the feeding margin is positive and the crop margin is negative would be the lost opportunity of not participating in stronger feeding margins because the price of corn is below the cost of production. In the final scenario where both margins are negative, the choice will not be so obvious. Because both operations are losing money but both assets remain at risk to further depreciation, least cost strategies to protect each value should probably be considered to mitigate further losses.
There are certainly other nuances that go along with each of these possible outcomes. For example, while both margins may be positive it could be the case that the crop margin is stronger than the feeding margin, or vice versa. Here, some discretion is needed to determine the best possible approach. In a very high priced environment for both the corn and livestock or milk, leaving more flexibility on the input side might make sense to allow for improvement if prices begin moving lower. Conversely, in a low-priced environment, leaving more flexibility on the revenue side might be wise to allow for improvement should prices start moving higher. Specific strategies to protect the corn and livestock or milk prices will also be influenced by other considerations such as the cost of options with respect to time value and implied volatility, as well as seasonality.
Regardless of the strategies employed, there are certain risks this type of entity will always face. First, as previously mentioned, the corn will never actually leave the farm. Because of this, it probably does not make sense to protect the value of the corn by setting a fixed sale price. Just as you would not sell the corn to your neighbor or local elevator, protecting the value by selling futures would not be wise. Even though the corn price might represent a good return to the crop operation, if it is capped at a fixed level and the market continues moving higher, both operations are worse off as the livestock margin contracts with higher feed costs at the same time that the crop operation loses out on the opportunity to participate in higher prices. At the other end of the spectrum, there will always be risk below the cost of production if you grow your own corn. If corn prices decline below the cost of producing it, the crop operation is losing money at the same time that the livestock operation faces the opportunity cost of not being able to participate in cheaper feed prices. As a result, options will likely be used most of the time to protect the price of corn, and the specific strategies employed will be a function of many different factors.