With the feeder cattle and live cattle markets both hitting all time highs, a lot of producers are realizing their past strategies may not be effective. CIH’s Manager of Business Development, Mike Shawver (MS) sat down for a conversation with Beef Margin Consultant, Mike Moroney (MM) to discuss ways cattlemen might adjust to their approach to risk management.
MS: What are the biggest risks facing cattle feeders today?
MM: There is an enormous amount of risk involved in paying $215 for a feeder against a 160 breakeven. The spot feeder cattle price has gone up by 61% in 12 months. This rally that we’ve seen in both the feeder cattle market and the live cattle market has allowed for some balance sheet repair after two very tough years. But markets don’t move in one direction forever, and at these price levels a continuation to still-higher prices is not a certainty. So, when it eventually turns – whether that is three months, six months, 18 months, no one knows. But when it does there will be a lot of pain out there for feedlots full of feeders that aren’t protected with hedges (whether that be options or futures based). The risk of equity destruction is large should the live cattle market correct sharply.
Also, it’s important to consider that even after this huge rally in live cattle, for many producers a placement for August at $215 would require a $160 live cattle market. The board is trading $5 below that level. Thus, maintaining flexibility is crucial.
MS: How does a feeder manage the risk when they have to pay a 61% premium year/year ($215) to place cattle?
MM: It is a difficult challenge but the objective is to meet two goals for the cattle that you place. First, protect your equity. That is imperative at these levels. For any cattle that clients are placing, we have been exploring a variety of strategies. This year, the market has been extremely volatile, and usually volatile markets correspond to high option premium. However, we’ve realized that option premium (as measured using the implied volatility of options) has been very reasonably priced. Consequently, many of our clients are using at the money puts for protection. Even though low implied volatility reduces the revenue you can generate by selling options, some of our more bullish clients are using put spreads to reduce the cost of their protection even further.
Second, cattle producers should maintain some flexibility so that if this market keeps moving they can participate. We want protection so we are inclined to buy puts. We also want to give our clients the opportunity to participate in this run so we have been selling calls or selling futures only after a significant move from the price live cattle were trading at placement.
MS: Does using the feeder cattle contract on the board make sense?
MM: Yes. It accomplishes a few goals. Where a client has an opportunity that pencils out close to a breakeven, it can act as a legitimate hedge versus waiting until the time where you are going to place the cattle and wait to see what the market offers. It also allows a feedlot operator to express a bullish or bearish bias by using options to hedge that position. If the market moves sharply in one direction then you are hedged on one side and relatively open on the other.
MS: What has been CIH’s approach in using the FC contract?
MM: One of the guys on our business development team, Bo Kizziar has been doing a terrific job hypothetically managing beef margins using some of our basic methods. He publishes his work twice a month in an email blast called, “Bo’s Notes.” I highly recommend that to cattle producers who are new to the margin approach to risk management.
Running Bo’s model, we’ve been primarily starting with futures or options in feeders and primarily using puts and put spreads on fats. That has worked out great.
MS: What about basis when placing against those hedges?
MM: Primarily, hedge gains from using flexible strategies have more than offset the basis risk.
MS: After the run we’ve seen, are you still taking the same approach?
MM:Fundamentals are still tight. Demand for beef is strong. Most clients are still using options for live cattle hedges and setting targets to firm up hedges. For forward placements using the fc contract, we are starting to implement strategies that are more option-based. There are clients who feel that this fc market has gotten ahead of itself and are buying calls on the fc side and buying puts on the lc side. Their thinking is that if both markets move lower, they can price feeders much below current levels yet have a floor established on the live side with puts. And as always, we are analyzing the corn market closely and structuring a variety of hedge strategies to fit our clients’ feeding hedge needs.