Make the Most of Strong Margins

Hog producers are starting off the year with much better prospects than many had expected as recently as a few months ago, and there are reasons to be optimistic that margins could rise further. But agriculture producers know all too well that any number of variables could also turn markets quickly in the other direction. The good news is that you can use simple, flexible hedging strategies to both protect today’s attractive margin opportunities and leave open the possibility of benefitting if margins do continue to improve.

Pulls from Supply and Demand
Hog finishing margins improved steadily through the fall into the winter despite increased production, as both exports and domestic disappearance have been able to absorb the larger supply. The opening of two new hog processing plants in Sioux City, Iowa and Coldwater, Michigan has helped support cash hog prices, as better indicative demand leads processors to bid up supplies on the open market. In addition, the stronger-than-expected margin profile for hog finishers has been aided by a continued backdrop of historically low feed costs. Corn prices in particular have been languishing near the bottom decile of the past decade.

Risks Remain Despite Optimistic Outlook
There are certainly reasons for optimism about the margin outlook, including a weak dollar that may continue to bolster purchasing power for buyers of U.S. pork in the global export market. Yet, risk factors remain that could erode profitability over the medium to longer term. As an example, the sixth round of NAFTA negotiations recently concluded in Montreal, with two new rounds scheduled later this winter and spring in both Mexico and the U.S. It remains to be seen if Mexican and Canadian negotiators will eventually acquiesce to U.S. demands. Some in the Canadian government have voiced concern that the U.S. may declare an intention to withdraw from the treaty. Even if such a tactic is employed primarily for negotiating leverage, any move that disrupts cross-border trade between the U.S. and its neighbors could negatively impact the export demand structure currently in place.

In addition, while feed costs have remained subdued, we are moving into a time of year when increased uncertainty may begin to have more impact on prices. Today’s negative crop margins could lead to significantly reduced corn plantings in the spring, and South American crops are not yet harvested. Poor spring weather could augment the impact of reduced acreage if planting falls behind. And commodity funds, which are holding a near-record short position in the market, could move to cover those positions at some point in time as a result of one or more of these crop market factors.

Flexible Solutions for Uncertain Markets
Given the strong projected profitability, hog producers may be tempted to lock in their margins, but they would give up on any further improvement should hog prices continue to rise. Alternatively, they could remain open to the market so they don’t miss out on additional hog market strength, but they would carry the full risk of losses if the margin picture deteriorates. An alternative would be to establish a flexible position to address both objectives.

Strategy Example 1: Forward Sale Plus Call Options
One flexible strategy might entail a forward sale of hogs to the packer in combination with a purchase of call options. If hog prices rise after the sale, the value of the options would also rise. That means the producer could sell them and effectively increase his net sale price. For instance, the operation might establish a packer sale on June hogs at around the current market price of $82.50 and subsequently buy call options at a strike price of $84.00 for a cost of about $3.00. If hog prices rise to $90, the producer would still receive $82.50 from the packer, but he could sell the call options for more than he paid for them. In this way, the producer will participate in all higher prices above $87, while maintaining a firm sale with the packer.

Strategy Example 2: Incremental Futures Sales
Another flexible strategy, independent of a packer, could consist of selling futures contracts on the exchange. The producer could sell a set amount initially, then scale up to incrementally higher levels as prices rise. For example, they could make an initial sale on 25% of expected production at current price levels, with a plan to initiate additional sales at two pre-determined trigger points. They may, for instance, set targets at $4 above their initial sale, and $4 above that subsequent sale, thus eventually locking into around 75% coverage on this forward production period.

Strategy Example 3: Put Options
A third flexible strategy might be establishing a floor on production by purchasing put options. For example, again assuming a market price of $82.50, the producer might buy June puts at a strike price of $82. Similar to strategy example 1, above, these put options might cost around $3.00-$4.00, but would provide a minimum price on the expected production while allowing the hog operation to participate in all higher prices.

However, for this strategy to be effective, the producer should establish a plan to eventually convert those put options to fixed sales at higher prices if the hog market continues to rise. Given a historical tendency for June hog futures prices to rise into the middle of March, the producer might set a target to gradually scale out of the puts in 25% increments every $2 higher starting at $84 and ending at $90, for example, with the intention of converting all of their puts to fixed sales by mid-March. Alternatively, they could establish these sales with the packer, and capture any remaining time value in the option ahead of expiration.

Don’t Forget the Feed Side
As some of the current strong margin profile can be attributed to historically cheap corn, a producer may want to protect this risk exposure by purchasing call options on their anticipated forward feed purchases. An example might be to buy a July $3.80 call option for a cost of around 15 cents. This would assure a maximum price of corn and protect the producer against a potential increase in price later this spring if market conditions change. Similar to strategy example 3, the producer would want to scale out of the call options as they purchase physical corn in their local cash market to salvage the residual time value of the options prior to expiration.

These are all relatively simple strategies that are flexible and help balance the dual priorities of mitigating risk exposure while retaining opportunity for margins to improve. The key to success with any strategy is to determine a plan that is based on a tangible goal or objective – such as protecting a minimum level of profitability – which makes sense for your operation. And then stick with it. While it’s human nature to try to maximize gains as margins are improving, no one knows what the markets will do, so it’s important to have the discipline to carry out a well-conceived plan.

If you have questions or would like to discuss how to implement a margin management plan for your operation, please call 1.866.299.9333.