The outlook for forward hog margins is less optimistic than it was even a month ago following the release of the USDA’s September Hogs & Pigs report. The surprising data indicating there were fewer pigs than what the market anticipated produced a bullish response in the futures market, although that soon faded as the calendar turned over to October. Spot December Lean Hog futures subsequently dropped about $13/cwt., and despite a recent bounce remain below the level we were trading prior to that quarterly report. Factors including a concern over labor shortages that could impact processor capacity in the winter months when it is needed the most as well as a significant slowdown in pork export sales to China recently have in part been attributed to the recent slump.
Meanwhile, feed costs have crept higher despite what generally have been better than expected yield results for both corn and soybeans as harvest winds down. Strong corn demand from the ethanol sector as margins swell to multi-year highs have supported the spot market, while concerns over South American weather and high fertilizer prices potentially reducing corn acreage in the U.S. next spring are adding premium further out on the curve. As a result of pressure from both lower hog prices and higher projected feed costs recently, forward margins have deteriorated over the past month and are only about average from a historical perspective looking back over the past 10 years. (Figure 1)
Figure 1 – Hog Margins (Q4 2021 – Q3 2022)
Focusing on either the spot Q4 or upcoming Q1 marketing periods, where margins are currently negative, there have been ample opportunities over the past several months to protect historically strong profitability and well above average margins. In fact, Q4 margins briefly breeched the 90th percentile of the past decade following the September Hogs and Pigs report, with projected profitability at $7.89/cwt. on September 30th (Figure 2). This followed a series of opportunities to protect at least 80th percentile margins going back to the middle of May. While it is obviously too late to do anything about protecting Q4 margins now that the marketing period is almost half over, there may be upcoming opportunities to address risk further out in 2022 if the margin landscape improves.
Figure 2 – Q4 2021 Hog Margin
In order to take advantage of these opportunities however, it is important to know where your margins are at. By taking account of your various input costs and expenses, and projecting hog sales revenue against those, you can begin tracking forward profitability and put that into a historical context. This will allow you to objectively determine favorable opportunities to initiate margin protection and shield your operation from either rising feed costs or declining hog prices.
While no one can know for certain what the markets will do as we move forward in time, it is probably safe to say that we can expect more volatility given increased uncertainties. Will China begin to see sow liquidation due to depressed prices and negative margins? Are there going to be less corn acres next spring because of high input costs? Is South America going to have a drought during their growing season? If strong demand continues from the ethanol sector, is it possible that the balance sheet may end up being much tighter than what the market expects?
Looking again at the graph of Q4 hog margins in Figure 2, you will notice that there has been quite a bit of volatility over the past six months. Margins have ranged from over $7.50/cwt. positive to about $5/cwt. negative since the middle of April. Swings in both hog prices and feed input costs have led to these changes in projected profitability, and this volatility creates opportunities. In addition to signaling beneficial times to initiate margin coverage, these price swings also allow for opportunities to improve existing margin protection. Examples of this include reducing cost in hedging strategies, creating more price flexibility in hedge positions, cutting exposure to performance bonds, and taking equity out of positions.
Moreover, with recent improvements to the LRP program and new alternatives like the CME’s pork cutout contract, there are now a variety of ways that margin protection can be established and more opportunities to create complimentary or supplemental positions once this protection is put in place. Regardless of the tools used, the main point is to have a plan and be disciplined with following through on that plan. Does your operation have triggers in place to establish coverage in forward time periods? Do you anticipate what types of supplemental strategies might allow you to improve on that coverage over time?
Figure 3 – Q4 Hog Margin 10-Year Seasonal
Figure 3 displays the seasonal tendency for Q4 margins over the past 10 years. The recent spike in margins to above the 90th percentile corresponds to a typical period of strength where margins seasonally peak at the 85th percentile by the first week of October. A secondary period of strength typically occurs from mid-January to mid-April (highlighted by the green bars), suggesting that producers be ready to execute on possible opportunities that may show up into that period. Similar approaches could be taken for other periods such as Q2 and Q3 2022.
Inventorying your costs and revenues to project forward margins and putting a plan together that will allow your operation to take advantage of opportunities once they arise can put your operation in a better position to be competitive. Now more than ever, it is important to be proactive in managing forward profitability. Please feel free to contact us with questions on how to create a margin management plan and take change of your bottom line.
Trading futures and options carries a risk of loss. Past performance is not indicative of future results. Insurance coverage cannot be bound or changed via phone or email. CIH is an equal opportunity employer. © CIH. All rights reserved.
In today’s fast-paced world where everyone is connected to the 24-hour news cycle, it can be difficult to tune out noise and opinions. The constant influx of COVID-19 headlines, weather maps for crop production regions, estimates of yield potential, and animal health issues have dominated agricultural news outlets. While it is natural to focus on how each of these factors could impact lean hog, corn, and soybean meal prices, it is also important to put those factors into greater context. Using futures markets to project forward margin curves for hog producers, the market is offering favorable pricing opportunities throughout the rest of the year and the first half of 2022. These margins are offered despite a tremendous amount of uncertainty heading into the same timeframe.
Leaning on lessons learned when favorable margin opportunities eroded after the initial reaction to PED and ASF, solid margin opportunities are not static and can be fleeting. For that reason, it often makes sense to begin thinking about layering into coverage when profitability can be secured, as it can be today. Despite the rapid rise in corn and soybean meal prices since the beginning of the year and the quicker-than-expected rebound in Chinese pork production, open market margins in Q4 2021 are at their highest level for this point in the year since 2014. Notwithstanding the unknowns in the marketplace, some of which are outlined below, securing historically strong profit opportunities may be an attractive option for producers today and should be considered.
No Shortage of Unknowns
As we head into the end of summer, market participants’ focus continues to zero in on new crop corn and soybean supplies. While volatility in the corn and soybean markets has tapered in recent weeks, crop condition ratings remain toward the lower end of the historical range because of widespread hot and dry weather throughout the upper Midwest. Even though we are already in August, industry opinions on final yield projections still vary greatly, placing additional emphasis on the upcoming August 12th WASDE report. In light of the continued importance of domestic weather and recent global production challenges, market volatility seems likely to persist. Uncertainties within feed markets can be managed in conjunction lean hogs to protect solid margin opportunities.
Figure 1. Corn Crop Progress
Figure 2. Soybean Crop Progress
Robust domestic demand and strong export shipments throughout the first half of this year have continued to support hog prices. Lower production, strong grocery sales, and lower weights have underpinned a hog market that made a remarkable rebound from the lows seen in the first half of 2020. While high feed prices will likely curtail expansion in the near term, there are also some uncertainties which could derail an otherwise optimistic outlook. Global swine health is always an important variable in margin outlooks and has dominated headlines in recent weeks. A common theme at recent industry events has been the impact PRRS continues to have on the domestic hog herd. On July 19, Germany confirmed its first case of African swine fever (ASF) in a domestic swine herd after more than 1,200 cases in wild boars in the eastern region of the country. On July 28, the USDA confirmed ASF in samples from pigs in the Dominican Republic, marking the first detection of the disease in the Western Hemisphere in about 40 years offering another reminder that ASF continues its march around the globe and the pork industry remains a single event away from a market-altering headline.
China was a major driver of pork export growth over the last two years but shipments and sales of pork exports to China have slowed in recent weeks. Widespread floods across China’s Henan province present another hurdle in its herd rebuilding efforts. After the province’s worst flash floods in centuries, reports of widespread crop and infrastructure losses were prevalent. More than a million livestock are reported to have died across nearly 1,700 farms, causing concern about the potential for disease to spread. Henan was the country’s second largest grain producer and the third largest pig producer in 2020.
Figure 3. Pork Export Commitments to China
Supply chain issues throughout the economy have been well-documented since the beginning of the pandemic and the hog sector has not been immune. The recent federal court ruling to repeal the provision of the New Swine Slaughter Inspection System (NSIS) that enabled pork processors to safely increase maximum line speeds adds to the uncertainty for this coming fall and winter. Combined with questions surrounding California’s Proposition 12 and its potential impact on demand as well as the recent resurgence of COVID, there are many factors that could impact future margins – both good and bad. When you consider that August 2020 hog futures traded as low as $47 and August 2021 futures traded as high as $120, protecting strong margins seems to be a prudent idea.
Current Opportunities and Structuring Your Coverage
Open market margins for Q4 2021 are at the 87th percentile of profitability over the past 10 years, offering producers a chance to protect historically strong profitability. Likewise, open market margin levels in Q1 and Q2 2022 are at the 83rd and 74th percentiles, respectively. Projected Q4 2021 margins for a demonstration operation can be seen below.
Figure 4. Q4 Open Market Margin
There are many different strategies that one may consider to protect the opportunities the market is offering today. Each strategy differs in its level of margin protection to the downside, opportunity to the upside, and cash flow considerations. A producers’ position should also reflect his or her individual bias. Given the risk and uncertainty on both the input and revenue side of the margin equation, it likely makes sense to protect both components in some way, shape, or form. Futures, options, and the recently-revamped Livestock Risk Protection (LRP) program may by viable tools to fit into your margin management approach.
Protecting favorable margin levels does not necessarily mean one must “lock in” each component with futures. For example, if a farmer is bullish on hogs, a flexible strategy could be developed to allow for an improvement in lean hog futures between today and the Q4 2021. Allowing for $10 of upside would increase the open market margin to the 95th percentile. Likewise, a producer may be bearish corn and believe there is a chance December corn futures could be trading down at $5.00 per bushel by the end of the year. Allowing for 50 cents to the downside from today’s price level would increase the open market margin to the 90th percentile of historical profitability.
With all the risks inherent in the management of forward hog margins, it is important to remain disciplined. With positive margins that are historically strong, it may make sense to examine a mix of futures, options, physical, and/or LRP to protect these margin levels. Opportunities and risks abound heading into the end of the year, from crop size to unknown exports and domestic demand. Whether focusing on margins through Q4 2021 or beginning to scale into coverage throughout the first half of 2022, a variety of different strategies can address the tradeoff between trying to preserve forward opportunity and protect existing profitability. For more help on evaluating specific strategy alternatives or to review your operation’s risk profile, please feel free to contact us.
Trading futures and options carries a risk of loss. Past performance is not indicative of future results. Insurance coverage cannot be bound or changed via phone or email. CIH is an equal opportunity employer and provider. © CIH 2021. All rights reserved.
Most growers are probably reluctant sellers of new-crop corn in the current market for a variety of reasons. First, with old-crop corn trading at life-of-contract highs, whatever previous sales they had on bushels already relinquished were done at worse prices than now exist in the open market. Second, current spot prices are also at a significant premium to new-crop values, with an approximate 75-cent inverse between May and December futures. Many may feel that new-crop corn is therefore “undervalued” and does not adequately reflect what corn should be worth come harvest. Moreover, the inverse should close at some point with new-crop prices rising to meet old-crop price levels.
Over the previous 25 years, there have only been 5 others besides 2021 when this type of inverse has existed as of early April: 2013, 2012, 2011, 1997, and 1996. It is instructive to compare these “analog” years historically to determine whether selling December corn futures into a seasonal spring/summer rally has been beneficial to the grower versus staying open to the market into the harvest period.
Looking over this history that extends back to 1996, we can examine the seasonal tendency of December corn futures; or rather, at what time(s) of year generally does the contract tend to record its highest price? This history reveals that December corn futures generally peak by now, or by sometime in mid-June (Figure 1).
This suggests that savvy marketers should probably be prepared with some type of plan to scale into sales over the next several weeks. Obviously, there are risks that prices this year may behave counter-seasonally and possibly peak later in the summer or potentially not until the harvest period. There is one example in this history of analog years that is interesting where such a risk may play out in the current year.
Figure 1. December Corn Futures Seasonal Chart (1985-2020):
The analog years span a wide history, with three recent examples and two during the pre-ethanol era when corn prices were trading at much lower levels than what is the case now. Price peaks for December corn futures came as early as March 27 during 1997 (the 1996-97 crop marketing year), and as late as August 30 in 2011.
In one year, the low for December corn futures on June 15th preceded the high for the contract that year on August 21st. This was the infamous drought year of 2012 when a 60-year event across the Corn Belt shrank national corn yields to 123 bushels/acre and sent the domestic stocks/use ratio down to 7.4% vs. the 10.2% projected this year. Not only did the high come later that particular year, but harvest prices were over $7.00/bushel and considerably higher than where spring prices that year were trading in the low to mid-$5.00 range.
Figure 2 shows a table of these 5 analog years, with the inverse between May and December corn futures as of the beginning of April noted along with highs, lows, and dates of the December corn futures contract for comparison. The 2012 year is indicated with an asterisk to reflect the one year where a marketing strategy based on a seasonally scaled-in selling approach was disadvantageous to the grower by harvest time and expiration of the contract.
Figure 2. Comparison of Analog Years for the December Corn Futures Contract:
Inverted Corn Markets are Not Predictive
While most growers will naturally be reluctant to sell forward new-crop bushels this season, there are compelling reasons to consider doing so. While prospective acreage based on the USDA’s preliminary report is below market expectations and only marginally above last year, that may yet change by the final figure in late June. Moreover, a fast start to planting this season may also encourage additional corn acreage that may not have been intended.
In addition, much of the bullish fundamental outlook is predicated on the continuation of strong demand, particularly from China. Given recent news of new ASF variants taking out around 9 million sows, forward demand is questionable despite clear intentions and incentives to rebuild the herd there. Also, high prices are likely to encourage additional corn acreage outside of the U.S., and the world supply/demand balance is not as historically tight relative to the U.S.
In conclusion, there is strong historical evidence that selling into this type of market structure has been beneficial based on past analog years. Moreover, inverted markets are not predictive of future price direction. It is not true that forward prices will always rise to meet spot values. Unless there is a widespread drought this summer, it may be difficult for corn futures to push significantly higher from current levels, particularly given the degree of fund length already in the current market.
As a result, it may be the case this year that adhering to a disciplined, normal schedule of progressively scaling into new-crop corn sales over the spring and summer will prove beneficial by harvest this fall. While most growers will likely be bullish, new-crop marketing plans might be a timely thing to prepare as we move further into the spring.
For more help on initiating marketing strategies or to review your own strategies, please feel free to contact us.
There is a risk of loss in futures trading. Past performance is not indicative of future results.
The last twelve months is a period most of us would just as soon move past. While much attention was focused on a global pandemic, a summer of civil unrest, and a November election, USDA was revamping a livestock insurance product that can significantly bolster producers’ ability to manage risk today and for years to come.
Livestock Risk Protection (LRP) is an insurance product designed to protect against a decline in market price. First introduced in 2003, LRP protects pig farmers against declines in the CME Lean Hog Index in exchange for a premium paid by the producer. Policyholders make customizable selections to match their farm’s risk profile, including the length of the endorsement and coverage levels of an expected ending value, ranging from 70 to 100 percent.
Three rounds of program modifications approved by the Federal Crop Insurance Corporation (FCIC) over the past year have made LRP a valuable component to producers’ toolbox to manage risk. In June 2020, revisions included allowing premiums to be paid at the end of the endorsement period and an increase in premium subsidies. Moving the premium due date to after the policy ends could provide a cash flow advantage over traditional put options at the CME, which require premium costs to be in a brokerage account upfront at the time of purchase. September 2020 modifications included further additional subsidy rate increases. The net impact of these two rounds of subsidy rate increases are summarized below.
The most recent round of revisions, which went into effect in January 2021, increased head limits to 40,000 swine per endorsement and 150,000 head annually. It also lengthened the sales window from 30 to 60 days. This will allow for a larger swath of producers to use the program and allow for greater flexibility in marketing decisions than the program traditionally offered. The most recent revisions also made coverage available for unborn swine and increased the insurance endorsement lengths, extending coverage from 26 to 52 weeks in 4-week increments. These changes more closely align to how many pork producers are already managing their risk through time and ensure LRP can be used in conjunction with traditional derivatives.
LRP offers several advantages over exchange-traded futures and options products. With no minimum head limit per endorsement, the program is fully customizable and does not require units to be priced in 40,000 carcass pound increments. At times, premiums for LRP may offer a potential discount to put options due to the recently revamped subsidy levels. Over the past year, the highest coverage level of a 26-week LRP policy has averaged $1.10 less than the CIH board estimate for an equivalent level of protection. Because LRP is offered nearly every day, it also allows for the ability to protect animals against adverse price movements marketed between option expiration dates.
The past year has been tough for hog farmers to navigate. Tightening crop balance sheets, supply chain bottlenecks, and the COVID-19 pandemic introduced a spike in volatility and a reduction in profit margins. Looking at forward price curves through the end of the year, open market margins have slowly moved higher to positive levels. This is in part due to expected lighter supplies in the second half of the year, a reopening of local economies, and is a testament to strong demand for U.S. pork, both domestically and internationally. From a historical perspective, margins are above average, as you can see below. According to the data, 3rd quarter open market margins currently rank at about the 77th percentile of historical profitability over the past decade. In other words, 3rd quarter margins have been lower than they are currently trading 77 percent of the time over the past decade. Hog producers may want to engage in a flexible strategy that provides protection to lower price levels and opportunity to participate should the market move higher, such as LRP or put options.
We have created several tools to help producers navigate the LRP decision-making process. One such tool helps determine when LRP prices are more or less expensive than equivalent put options and can be viewed below. At the time of this writing, October lean hogs are trading near $79 per hundredweight. An LRP policy may be purchased to protect a coverage price of $77.11 in mid-October for a net premium of $4.42 ($6.80 minus the 35% subsidy). In this case, the premium would not be due until the end of November. An equivalent put option in the same timeframe would be valued at $5.43. This premium would be due at the time of purchase. Both strategies would provide protection on animals if the market moved below $77.11, but LRP comes at a lower cost.
The most straightforward use of LRP is for outright, at-the-money protection such as the example outlined above. It is important to note, however, that the decision to use LRP is not an either/or decision with exchange-traded instruments. Many producers have also found utility in pairing the LRP coverage as the root of more advanced futures and options strategies, such as collars and position adjustments. Producers who use LRP also have the opportunity to layer into relatively cheap coverage below where the market is currently trading. This allows for major market disruption insurance at a subsidized price level should a catastrophic event send the hog market tumbling lower.
LRP could be an excellent tool for someone who is looking to establish cash flow-friendly, cost effective coverage. Much like a put option, the endorsements establish some level of protection while maintaining opportunity to the upside should the market move higher. The sign-up process is simple and program costs are uniform across all agencies. The value the agent brings is their expertise, tools, and analysis. Contact us with any questions how LRP may fit into your risk management approach.
Trading futures and options carries a risk of loss. Past performance is not indicative of future results. Insurance coverage cannot be bound or changed via phone or email. CIH is an equal opportunity employer. © CIH. All rights reserved.
Pork cutout futures start trading later this month. For many producers, this can be a significant addition to their margin management strategy.
Pork producers often price their animals using cash hogs, the pork cutout, or some combination of the two. The CME Lean Hog Index is calculated from a weighted average of the daily price and volume for producer-sold negotiated, swine or pork market formula, and negotiated formula transactions as reported by USDA. The CME’s Pork Cutout Index will offer a new opportunity to customize a producers’ risk management approach to their unique circumstances. With cutout futures set to begin trading November 9, it is important to understand how buying or selling these derivatives can better align your hedges with your actual price discovery process and improve your basis risk.
Pricing methods have evolved over time and so, too, have producers’ risk profiles. Cash hog volumes negotiated directly between buyers and sellers in the spot market have slowly diminished and now represent about 2-3% of total barrow and gilt slaughter. At the same time, an increasing number of hogs under the swine and pork market formula purchase type have been referencing the pork cutout value in their base price calculations. The weighted average price can significantly vary between the different purchase types. It is now estimated that approximately 35-40% of the Lean Hog Index is based off the pork cutout, with the remainder tied to the swine market.
The correlation between the Lean Hog Index and base price formulas that use exclusively cash market hog values has weakened in extreme periods. This was especially evident during the supply chain disruptions we experienced this past spring. While the bottleneck at packing plants temporarily restricted packing capacity and lowered demand for cash hogs and the ability to process the animals, the pork carcass cutout value increased dramatically as end users attempted to secure physical product. Because of the influence of the pork carcass cutout on the Lean Hog Index, futures increased in late April and early May despite the swine market remaining at historically low levels.
No two pig farmers are the same and their price discovery methods are equally diverse. We know there are many different manners of cash hog price discovery and some producers have multiple formulas upon which they get paid. With the introduction of pork cutout futures as a tool to manage risk, it is crucial that both the optimal quantity and type of hedging instrument(s) to be used is determined. Regression analysis can be used to determine the optimal mix of lean hog and cutout futures to improve your hedge’s correlation to cash and reduce basis risk.
Consider a producer who has a formula pricing agreement with a packer that is half the national negotiated cash price plus $3.50 and half of 90% of pork cutout value. Since 2015, the performance of the lean hog index against this formula (the producer’s cash contract) is displayed below.
While the two series moved together, deviation can be seen in extreme periods. To reduce this deviation, we can use a regression to determine whether it makes sense to include Pork Cutout Index as part of our hedging strategy. The results of the regression are summarized below.
The coefficients above of 0.67 and 0.28 imply that to hedge 1,000,000 pounds of production, the market participant would need 670,000 pounds of lean hog futures and 280,000 pounds of cutout futures. Utilizing this strategy would have tightened the range of outcomes much closer to this producer’s actual cash price, as displayed below.
Over the past five years, the Lean Hog Index and the pricing formula described above exhibited a correlation of 96%. Utilizing the hedge ratios described above, the correlation improves to 98%. The deviation between cash and futures would also have been reduced by using a mix of lean hog and pork cutout futures.
For producers whose hogs are entirely priced on cash markets, he or she may need to be short lean hog futures and be long the cutout. On the other hand, a producer priced exclusively on the cutout could simply avoid engaging in lean hog futures at all and instead be short cutout futures. It is important you understand what this new hedging tool means to you and how it relates to your particular price discovery. Reach out to us to run the math on your pricing agreements to provide a better idea on the optimal hedge ratio for you and your operation to improve your hedge’s correlation, reduce basis risk, and take control of your bottom line.
Tumultuous market conditions and repeated ad-hoc disaster payments highlight need for improved longer-term, market-based support for livestock producers.
The term “unprecedented” has been overused throughout the COVID-19 pandemic, but it truly is the only way to describe the environment hog farmers have had to navigate over the past several months. Record production, coupled with supply chain disruptions and a sudden change in consumption patterns, created a perfect storm that has resulted in significantly negative margins throughout most of the year. As of July 27, pork producers have received $416 million from the federal government’s Coronavirus Food Assistance Program (CFAP). These payments, while welcomed by the industry, pale in comparison to the economic harm faced by the sector. According to a study commissioned by the National Pork Producers Council, hog farmer losses will approach $5 billion by year-end due to a decline in market prices, euthanasia, and carcass disposal. While Congress is currently considering further aid for the industry to subsidize producers for losses incurred, there also should be consideration into longer-term support for the industry to better weather similar black swan events that are inevitable in future crises. Fortunately, the structure of one such program already exists and, with slight modifications, could serve as a sustainable, long-term program to avoid or reduce the need for ad-hoc livestock disaster payments in the future.
The USDA Risk Management Agency (RMA) offers single-peril price risk coverage for future livestock sales under the Livestock Risk Protection Insurance (LRP) program. In other words, LRP protects farmers from unexpected price declines. Although the program has existed for years, its uptake has been lackluster due to several shortcomings initially put in place during its pilot project period. Policyholders of LRP-Swine choose a variety of coverage levels (from 70% to 100% of the expected price) and insurance periods (13, 17, 21, or 26 weeks) to match the timeframe during which their pigs would normally be marketed. There is a limit of 20,000 head per endorsement and an annual limit of 75,000 hogs for each crop year, which runs from July 1 to June 30.
A subsidy makes these programs more attractive when market volatility is elevated – reflecting a time when producers need risk protection but may find it prohibitively expensive. Active risk management decisions can continue to be made throughout the production period by incorporating insurance with other tools, such as futures and options. Unfortunately, this subsidy has been below levels needed to make the product attractive to producers. Additionally, the size limitations reduce the number of head eligible for participation and the short duration of LRP-Swine reduces the efficacy of the program for a sector where active risk management decisions are routinely being made up to 52 weeks ahead of time. Despite widespread use of futures and options by market participants, total LRP participation has only covered more than 100,000 head annually once in the past 15 years.
Futures contracts can fluctuate daily and often post highs and lows prior to expiration, sometimes many months before expiration. Looking at seasonal charts for the February and December lean hog contracts over the past five years, it is clear the highs for some contracts tend to occur well before the 6-month window for which the program is currently available. In other words, by the time the LRP window of opportunity was available for hogs ready to be marketed in February, the contract high would have already passed because, on average, it would have occurred in early June. Likewise, a seasonal tendency to post contract highs in mid-April for the December lean hog contract represents lost opportunity for producers to utilize LRP for hogs coming to market late in the year.
Chart 1. February Lean Hog 5-Year Seasonal Chart
Chart 2. December Lean Hog 5-Year Seasonal Chart
Recent changes to LRP have been a step in the right direction, but unfortunately fall short of fully transforming it into a reliable and worthwhile tool for hog farmers. USDA RMA announced on June 8 changes that include moving premium due dates to the end of the endorsement period (to better align with cash flows) and increasing premium subsidies to assist producers. The previous subsidy level near the market for LRP products was 20-25%. Subsidy levels farther from the market were 30-35%. After RMA’s recent action, these were slightly increased to a subsidy range of 25%-30% near the market and remain capped at 35% farther from the market.
Success in federal crop insurance and the newer Dairy Revenue Protection (DRP) program demonstrate there is an appetite for these types of tools in the countryside if the program is designed effectively. After recognizing the inadequacy of existing government-sponsored tools for dairy farmers to manage a volatile environment, DRP was established to provide insurance for the difference between the revenue guarantee and actual milk revenue. It was first made available for purchase nationwide in October 2018 and has quickly become a critical component for many producers’ margin management policies. Unlike LRP, there is no coverage quantity limit for DRP, subsidy levels are much higher, and coverage periods extend 5 quarters out in time.
Total current DRP purchases represent over 25% of the milk likely to be produced in the United States in 2020. DRP is not viewed as a standalone program for many dairy farmers; rather, it serves as a foundation for a comprehensive risk management program in conjunction with other tools, such as forward contracts, swaps, or futures and options. With further modifications, LRP could similarly provide a baseline against which hog farmers build out their overall risk management plan.
The Federal Crop Insurance Corporation (FCIC) meets in August and has the authority to approve changes to improve LRP. Chief among the changes that should be considered is bringing subsidy levels across all coverage ranges more in line with insurance programs offered to dairy and crop producers. This can be done by basing the subsidies on their proximity to the market. Stated simply, the LRP pricing is market driven so it allows a producer to put a floor on price, similar to a put option at expiration, at a highly subsidized cost. Furthermore, the current total annual and per endorsement cap should be reexamined to ensure the program can be utilized by any producer who shows interest. If the caps cannot be completely removed, they should be doubled for the near term with a long-term plan of continued expansion. This would allow a larger number of farmers and a greater share of production to participate in the program if they so choose.
The process of evaluating the advantages and disadvantages of changes to programs is known as the 508(h) submission process. The method relies on support from practitioners, producers, industry groups and others to convince the FCIC to approve such modifications. Specifically, letters of support to the FCIC can be very useful to implement any proposed changes. Voice your support for these changes to the program with your state and/or national producer association or directly to the FCIC.
The above modifications would increase usage of LRP across the livestock sector and bolster the ability of hog producers to proactively weather black swan events in the future. The 508(h) process can be cumbersome, but it is past time for the livestock sectors to have access to viable tools that have been offered to crop and dairy producers for years. LRP-Swine has the potential to be a practical addition to the toolbox to help farmers take a proactive approach to their margin management strategy, no matter how unprecedented the market environment may be.
The CARES Act was passed by Congress to provide quick and direct economic assistance to Americas to combat the economic impacts of COVID-19. The Act also directed the USDA to administer the newly-created Coronavirus Food Assistance Program (CFAP). CFAP has two components. The first is the Farmers for Families Food Box program, which uses $3 billion to prepare and deliver emergency food boxes to food pantries across the country. The second component of CFAP is direct payments to agricultural producers. While much has been written about the direct payments to eligible producers, there remains a degree of confusion regarding payment rates and calculations.
Beginning May 26, USDA’s Farm Service Agency will be accepting applications from agricultural producers who have suffered marketing losses due to COVID-19. The program, announced May 19, provides assistance to producers of eligible commodities that have suffered a five percent (or greater) price decline as a result of the pandemic. The direct payments program requires one application and results in a single benefit, but the funding and legislative authority derives from two separate programs. The dual sources of funding have caused some confusion among stakeholders but are further outlined below. This allows for a larger level of payment to be delivered than either single program could provide. USDA estimates the first source of funding, the CARES Act, will account for about $9.5 billion in CFAP payments. The other source of funding, the Commodity Credit Corporation, will account for an additional $6.5 billion in payments. The CCC is a business entity with the USDA and was created under the New Deal, providing the Secretary of Agriculture with broad and discretionary authority for various purposes, including direct payments. Calculations for covered commodity categories are included below.
USDA will make an initial payment of 80% of the eligible 2020 CFAP participant’s calculated 2020 CFAP payment. This allows for checks to be delivered to farmers quickly and allows for USDA to evaluate how well the program is performing compared to expectations. There is a possibility the final 20% could be subject to pro-rationing, depending how close to expectations initial payments end up.
Farm Service Agency staff at local USDA Service Centers will work with producers to file applications. CFAP payments are subject to payment limitations per person or legal entity of $250,000. This cap is on total CFAP payments for all eligible commodities. Direct payment limits also apply to LLCs, corporations, and limited partnerships. These entities may receive up to $750,000 based on the number of shareholders (not to exceed three shareholders) who contribute at least 400 hours of active person management or personal active labor. To be eligible for payments, the person or legal entity must have an adjusted gross income of less than $900,000 for tax years 2016, 2017, and 2018 or demonstrate that 75 percent of their adjusted gross income comes from farming, ranching, or forestry.
Cattle, hogs, and sheep are included in the CFAP direct payment program. The components of the livestock CFAP payment are as follow:
- CARES Act funding is used to compensate producers for price losses on sales of eligible livestock from January 15 through April 15
- CCC funds are used to compensate producers for the highest inventory of eligible livestock between April 16 and May 14
For example, consider a cattle feedlot with sales of 800 fed cattle from January 15 through April 15 and a maximum inventory of 400 head from April 16 through May 14. The producer’s CFAP payment would be calculated as follows:
((800 x $214) + (400 x $33)) x 80% = $147,520
Consider a hog farmer with 7,200 head in sales of finished animals from January 15 through April 15 and a maximum inventory of 4,800 head from April 16 through May 14. The producer’s CFAP payment would be calculated as:
((7,200 x $18) + (4,800 x $17)) x 80% = $168,960
Milk production is also included in the CFAP direct payment program. The components of the dairy payment are as follow:
- CARES Act funding is used to compensate producers for price losses during the first quarter of 2020. This value is equal to $4.71 per hundredweight multiplied by actual milk production in the first quarter.
- CCC funds are used to compensate producers for marketing channel disruptions for the second quarter of 2020. This value is based on a national adjustment to each producer’s production in the first quarter multiplied by $1.47 per hundredweight.
In other words, the first component compensates for value lost on actual first quarter production and the second component compensates for value lost on a calculation of second quarter production. The second quarter production is calculated by multiplying the first quarter production by 1.014 (to account for increased production in the second quarter). It is expected milk production will be established in the same manner as was used for Dairy Margin Coverage. Generally, this includes cooperative- or processor-verified documentation for marketings of milk and includes dumped milk that was pooled under a federal marketing order.
Milk production is also included in the CFAP direct payment program. The components of the dairy payment are as follow:
For example, for a dairy farmer with 400 cows and 2,440,000 pounds of milk production in Q1 2020, his CFP calculation would be the following:
((24,400 x $4.71) + (24,400 x 1.014 x $1.47)) x 80% = $121,035
CFAP direct payments are also available for eligible producers of non-specialty crops that have suffered significant price decline due to the pandemic. The source of the non-specialty crop direct payments also comes from two sources—CARE Act funding and the CCC program. Payment rates for each commodity are included below.
A direct payment will be made based on 50 percent of a producer’s 2019 production or the 2019 inventory as of January 15, whichever is smaller. The smaller value is multiplied by 50 percent and then multiplied by the commodity’s applicable payment rates.
For example, consider a corn farmer who had production of 800,000 bushels in 2019 and on January 15 had 500,000 bushels in inventory. The first step in calculating the CFAP payment is to determine the smallest value between 50 percent of 2019 production (50% x 800,000 = 400,000 bushels) or January 15 inventory of 500,000 bushels. Because 50 percent of 2019 production is smaller, 400,000 bushels is used for the first variable. The rest of the calculation can be found below:
400,000 bushels x 50% x ($0.32 + $0.35) x 80% = $107,200
If the same farmer instead had only 250,000 bushels in inventory on January 15, the calculation would change. Because 200,000 bushels is less than 50 percent of the 2019 production (50% x 800,000 = 400,000 bushels), the inventory value would be the first variable in the calculation:
250,000 bushels x 50% x ($0.32 + $0.35) x 80% = $67,000
The USDA’s Farm Service Agency is the entity charged with interpreting and carrying out the final rule. The aforementioned information is an attempt to bring clarity to the program based upon our reading and interpretation. Additional information on the program can be found at https://www.farmers.gov/cfap.
What is the best way to determine the fair market value of a pig? This seemingly innocuous question has resulted in a multitude of opinions over the years as market dynamics, participants, and trends change. As the volume in the negotiated market has dwindled, some market participants have noted the rise in the use of cutout-based contracts to price hogs. But given the large amount of information published by USDA on a daily basis, how is the carcass cutout calculated and what can be gleaned from the various cutout reports?
Wholesale pork reporting as part of the USDA’s Livestock Mandatory Reporting Program (LMR, or oftentimes referred to as MPR) began in 2013 at the request of industry participants. USDA AMS publishes four daily and eight weekly pork reports from their Des Moines office by analyzing 8,000-10,000 records per day. These reports cover approximately 87% of total pork sales. All packers slaughtering more than 100,000 head of barrows and gilts (or more than 200,000 head of sows and/or boars) annually are required to report the prices and quantities of all wholesale pork sold prior to the established reporting times to USDA twice daily.
The pork carcass cutout value is a calculation of the approximate value of a carcass based on the prices received for its respective components. The USDA’s pork carcass cutout value is the estimated value of a standardized 55-56 percent lean, 215-pound carcass based upon industry-average cut yields and average market prices of sub-primal pork cuts. In other words, weighted average prices of individual items are used to calculate a weighted average value for primal cuts. The primal cut values are then used to calculate a carcass equivalent value. USDA surveys packers in July and updates the cut yields the following January if necessary. The current yields can be found below. The loin primal constitutes the largest share of the cutout value, followed by the ham, and so on.
While it is important to understand what is included in the cutout calculation, it is also vital to understand what is not. Not included in LMR reports are carcasses, some variety meats (including ears, hearts, blood meal, cheek meat, and heads), some processed items (including bacon, sausage, ground pork), case ready items, and intracompany sales.
The National Weekly Comprehensive Pork Report (LM_PK680) includes the comprehensive value and volumes of all reported wholesale pork trade with the exception of specialty pork product and is a great resource, but unfortunately did not begin until May 23, 2019. Its use for looking at long term trends is therefore limited but is an important report moving forward. One last note—FOB plant prices are as reported by the packers at their dock before transportation costs have been added. USDA also publishes FOB Omaha prices series, which are an antiquated data set that include a freight adjustment based on the distance from the reporting plant to Omaha, Nebraska. Most market participants utilize FOB plant for formulas and analyses today, of which USDA AMS publishes four national weekly pork reports:
- Negotiated Sales (LM_PK610): price determined by seller-buyer interaction and agreement, scheduled for delivery not later than 14 days for boxed product and 10 days for combo products after the date of agreement.
- Formula Sales (LM_PK620): price is established in reference to publicly available quoted prices.
- Forward Sales (LM_PK630): agreement for sale of pork beyond the timeframe for a negotiated sale.
- Export Sales (LM_PK640): as its name implies, contains sales to export markets. Unlike the other three, however, this report does not include sales to Canada or Mexico.
Each load reported in the cutout reports represents 40,000 pounds. Formula pork sales reported on the LM_PK620 report represented about 53.2% of all reported pork wholesale volume in 2019, followed by negotiated sales (25.3%), export sales (11.4%), and forward sales (10.0%).
As exports play an ever-increasing role in price discovery, an often-overlooked source of information is included in the LM_PK640 report. This data has the potential to provide an indication of export demand developments well ahead of the official figures from the U.S. Census Bureau. A single data point does not make a trend, but it is interesting to note that during the first week of the Phase One trade deal with China, the weekly volume reported on the LM_PK640 report was the 5th highest since the beginning of 2014. This data is released on Monday mornings for the week preceding, as opposed to the FAS Weekly Export Sales reports which are released on Thursdays for the week ending the preceding Thursday and official export figures which are lagged by at least five weeks.
Because a spike in volume on the LM_PK640 report could indicate robust demand, forward domestic volume as measured by the LM_PK630 Forward Sales report can, and oftentimes is, also impacted. For example, amidst robust export pork sales beginning in late September and lasting through mid-November, a perceived forward market shortage sentiment developed among participants. As a result, forward wholesale pork sales volume also posted all-time highs for the data series.
This competition for securing physical led to a counter-seasonal rise in the cutout during a period of record-breaking hog slaughter, as can be viewed below. The first chart demonstrates how the cutout typically declines from a time period beginning in the summer months into the holiday season. In 2019, however, the negotiated cutout value increased by more than 27% from September through mid-November.
The pork carcass cutout calculations produced by USDA AMS provide utility to market participants and offer context to marketplace fundamentals. Utilizing these reports may reveal perceived strength or weakness in cutout sales and provide glimpses of market conditions ahead of other more frequently leveraged data sources. As producers continue to search for the best method to determine a fair market value for their animals, it is important to understand the difference between the various cutout reports, what is included in their calculations, and what is omitted. These reports are another essential tool to employ to obtain greater clarity in an ever-dynamic, evolving marketplace, gather clues into forward demand, and potentially leverage to take control of your bottom line.Past performance is not indicative of future results.
Following a difficult period earlier this spring in May and June when hog margins plummeted on rising domestic production and a sharp increase in corn prices, profitability has returned as falling slaughter weights and current inventories have allowed cash hog prices to recover. While much of the attention in the market continues to focus on the global demand picture, and China in particular, the recent improvement probably has as much to do with current cash market dynamics. Cooler than usual spring weather during May delayed the normal seasonal decline in hog weights, causing producers to increase marketings in June in order to catch up. As a result, June slaughter was up 9% from 2018, with some weeks posting double digit percentage increases over 2018. This had a big negative impact on cash hog prices, with the Iowa/Southern Minnesota Lean Hog Carcass base price declining 20% from around $85 to $65/cwt. by early July (see Figure 1).
With the Iowa/Southern Minnesota cash hog price having recovered all of that decline and actually now making new highs on the year, there is renewed optimism in the market. Moreover, a resumption of trade talks between the U.S. and China has stoked optimism that a deal can finally be struck which will allow the U.S. to take full advantage of the historic opportunity to supply China’s market with pork as they continue to struggle with the fallout of their African Swine Fever outbreak. The futures market is certainly reflecting this optimism, with February 2020 trading at a $1.69/cwt. premium to the CME Lean Hog Index compared to what would typically be a $14.81/cwt. discount on average based upon the past 10 years of history (see Figure 2).
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This optimism on the demand side of the ledger, and for exports in particular, is obviously due to the China factor. Even with punitive tariffs imposed on U.S. pork, exports to China are up sharply over the past several weeks since the beginning of June (see Figure 3).
While weekly exports and especially shipments to China have been encouraging, the monthly GATS data still shows that year-to-date, total U.S. export shipments in 2019 to all destinations through May are actually down 3.8% from 2018. As a result, USDA lowered their annual projection for exports in the latest July WASDE by 25 million pounds to 6.441 billion. Even with this revised figure, that export projection would still be up 565 million pounds or 9.6% from 2018. In order to meet this revised figure, U.S. pork exports will need to increase 20.8% over 2018 through the remainder of the year from June through December (see Figure 4).
Other Supply and Demand Considerations
The surge in hog slaughter and pork production witnessed through June was validated in the latest Quarterly Hogs and Pigs report, and USDA raised their projection for 2019 pork production accordingly in the July WASDE. The new estimate of 27.662 billion pounds would be up 360 million from June and 1.332 billion or 5.1% over last year (see Figure 5). While 590 million pounds of that increase is expected to be consumed by increased exports, that still leaves 742 million pounds of additional production to be cleared through domestic demand channels – either through increased consumption or cold storage. Accordingly, USDA raised their forecast for projected annual per capita consumption from 51.4 pounds in June to 52.3 pounds in July, which would also be up 1.4 pounds from 2018. Should exports fall short of what is now being projected, this will leave even more product that will have to be cleared through domestic demand channels through the remainder of the year.
Source: USDA/World Agricultural Outlook Board – released July 11, 2019
Risk Management Implications
Q4 margins are now back to almost the 90th percentile of the past 10 years, offering producers a second chance to protect historically strong profitability after margins were recently projected below breakeven earlier this month (see Figure 6). While not as strong as what was projected back in April, which would have been the best margin since 2014, current margins still represent a very good opportunity that should not be overlooked. Even margins for Q1 and Q2 are above or close to the 90th percentile of profitability over the past decade.
It is natural to focus on the bullish fundamentals of the market, and these factors are certainly very compelling; however, it is also wise to put those factors into context. On one hand, China has indicated its intention to make goodwill agricultural purchases from the U.S. in conjunction with this latest round of trade negotiations, and also recently granted tariff exemptions to some buyers. In addition, China’s domestic hog prices continue to increase even with a surge of imports, indicating a clear need for additional supplies.
On the other, it is important to keep in mind that we have a large supply of pork in the market, and we will soon be moving into the cooler months of fall where the domestic supply situation may become more of a headwind than a tailwind for the market. Producers are being given a second chance to remove significant financial risk from their operations, and a variety of different strategies can address the tradeoff between trying to preserve forward opportunity and protect existing profitability.
For more help on evaluating specific strategy alternatives or to review your operation’s risk profile, please feel free to contact us. There is a risk of loss in futures trading.Past performance is not indicative of future results.
Recent volatility in the hog market has been both a blessing and a curse for producers trying to navigate the current environment as they evaluate risk management decisions. On the one hand, profitability projections are as strong as they have been since the PED year in 2014, in some cases exceeding what was available at this point of the year for those particular periods. Assuming hog prices and feed costs stay at these levels into next year, the industry looks to be extremely profitable. On the other hand, there is massive uncertainty surrounding the extent and duration of potential additional pork exports to China as well as whether or not ASF eventually spreads to the U.S. This uncertainty has sharply raised volatility in the hog market, which has led to a surge in the cost of option premium for producers.
While hog producers realize the opportunities that currently exist to capture forward profitability and are keen to protect margins following a very difficult market throughout 2018 into early 2019, they understandably are concerned over the potential for further price increases. Recent industry estimates suggest that China’s pork production this year could drop 30% from 2018, with the extent of that loss 30% larger than the annual production in the U.S. Moreover, it has also been mentioned that the regional fallout will take years to correct, making this a long-term structural issue that will disrupt global trade and the supply chain. Figures 1-3 show the current projections for forward hog margins in Q3, Q4 and Q1 of 2020 relative to the past 10 years.
Sky High Option Volatility
The surge in projected margins from mid-March into mid-April due to a sharp rally in hog futures that was partially aided by a concurrent drop in in feed costs, also accompanied a significant increase in hog option volatility. Looking at the December Lean Hog Futures contract, implied volatility recently spiked to 45% and very close to the near 50% levels achieved in 2009, 2016 and 2018, although it should be pointed out that in those years, the spikes occurred much later and closer to expiration. Also, notwithstanding the 1998 December hog market when option volatility spiked to over 60% during the extreme price meltdown in that year’s Q4, 50% has historically been the peak for implied volatility in December hog options (see Figures 4 and 5).
Certainly part of this year’s spike in volatility can be attributed to the sharp move in futures from early to mid-March. The June contract ran $20/cwt. from around $75 to $95 in the span of just 2 weeks, as the market adjusted to new information quickly. The move was similar to a run-up in the 2014 market, when June futures rallied from around $110 to over $130 in a comparable span of time between late February and mid-March (see Figures 6 and 7).
As a result of the increased volatility, option premiums have become much more expensive. As an example, December hog at-the-money options are currently trading over $10/cwt. Even August hog options that are closer to expiration carry at-the-money premiums over $8/cwt. These are about double what they were prior to the volatility spike in March, when option volatility was already quite expensive within a historical context.
Risk Management Implications
With strong forward profit margins that extend well into 2020 and following on what was a very poor period for profitability over the past year, reducing risk in this environment is prudent. The best way to go about that however is complicated to say the least. Ideally, a hog producer could simply purchase puts on their projected production to place a floor under the market, leaving all the upside open to hopefully achieve windfall profits if prices continue surging higher. The problem with that is the significant cost associated with retaining that much flexibility. Using December as an example, the $10/cwt. cost of an at-the-money option is currently more than half the actual margin that is there to protect. Given this prohibitive cost, producers are exploring ways to strike a balance between keeping upside opportunity open while also protecting downside risk.
Some may still feel that buying puts outright makes sense in the present environment, and there is certainly room for volatility to increase further. Also, if the puts are for a deferred production period, there is sufficient time to eventually reduce that expense by selling other options against those puts to create lower-cost spreads. The problem though is that implied volatility is already high, so if you are just buying puts, you are purchasing an inflated asset that could see its value erode quickly if the volatility begins to come out of the market. So while buying outright puts on a portion of one’s production probably makes sense, it maybe shouldn’t be the only alternative considered.
One thing to keep in mind is how strong margins are currently projected within a historical context. At the 95th percentile of the previous 10 years, hog producers have only made more money than this around 5% of the time over the past decade. This is significant and should not be overlooked. Perhaps it would be wise to just take these very strong margins on a portion of one’s forward production and eliminate that risk altogether. You might simply ask yourself what percentage of your production is ok to accept current margins on, and remove that piece of risk from the total exposure pool.
As another example, some producers may want to put a floor underneath the current market and may be ok with giving up some of the current margin to maintain opportunity for higher prices to a degree. By accepting a cap or price ceiling above the market, they can assure themselves a floor that will still allow a profitable margin to be realized in a worst-case scenario, but allow for stronger margins in a best-case outcome. Again, this might apply to a portion of the overall production, but not the whole thing. A lower cost way still might be to only protect a range of lower prices below current levels while also accepting a price cap above the market. The benefit with this approach is that it might allow a producer to start the protection closer to the market, and/or use a higher cap for their ceiling. It also takes advantage of the high volatility environment by receiving more credits from selling options. Here also, this would probably be appropriate for some but not all of one’s total risk exposure.
Finally, some might be fine selling at current price levels, but want to retain opportunity for prices to continue rising further. Here, a producer might consider buying call options against a portion of their sales in the futures market or the cash market to create some degree of participation in higher prices. The call options might be purchased “out of the money” such that the upside participation doesn’t begin right away, but kicks in should a significantly higher price outcome eventually be realized. The benefit with this approach is that a producer might feel more comfortable locking in a larger percentage of their production with the margins that are currently available, knowing that some of this production will be open to participate in a sharply higher market.
Portfolio Approach to Risk Management
What this amounts to from a practical standpoint is using a mix of different contracting alternatives to protect current margins. This spreads the risk that any one price or margin outcome will negatively impact profitability if a variety of different strategies are employed at the same time. Just like a portfolio manager will use a mix of stocks, bonds, and cash to construct an asset allocation that allows an investor to realize their long-term goals, this approach to risk management might be a good way to hedge against different outcomes or scenarios.
If volatility plummets, having part of the risk management portfolio comprised of futures or cash sales along with short volatility option positions will limit the damage from the portion that consists solely of long puts or call options purchased against futures. If volatility continues to rise, the portion of the portfolio consisting of outright long options will benefit. From a price standpoint, having a decent percentage of one’s production floored will guard against a sharply lower price scenario, such as in the event of an ASF outbreak in the U.S. At the same time, leaving upside open on a percentage of the total production will hedge against a higher price outcome in a sharply rising market.
In the investing world, passive strategies have become very popular, such as index funds that track the broader performance of the market against a benchmark like the S&P 500. Some investors will allocate a portion of their stock portfolio to simply track the market, while allocating other strategies to sectors of the market they feel will outperform given the current point of the economic cycle. Perhaps staying open on a portion of one’s production might also be a choice within a risk management portfolio, such that the performance of this piece will track whatever the market eventually does.
One good question to ask in deciding on the balance of various strategies that would work best for your particular operation is this: “what percentage of your production do you want to have floored (to secure current profitability), and what percentage are you comfortable having capped?” This certainly does not have to be the same number, but answering that question can go a long way to helping you determine what mix of strategies may be a good fit for your particular goals and circumstances. While the current market environment definitely presents challenges in managing risk, the good news is that there are strong margins to manage, and this reality should not get lost in the discussion.
For more help on evaluating specific strategy alternatives or to review your operation’s risk profile, please feel free to contact us.
There is a risk of loss in futures trading. Past performance is not indicative of future results.