The Importance of Maintaining Flexibility

Beef cattle producers unfortunately are not enjoying the same degree of profitability as their companion industries in the dairy and swine sectors. While feed costs have moderated amidst a backdrop of soaring protein prices, feedlots find themselves on both the purchase and sale side of cattle having to bid up for feeder supplies in the open market. Due to the impact of drought over the last few seasons in the Central and Southern Plains, feeder cattle supplies have dwindled and costs have skyrocketed to secure what animals do become available at auction. As a result, while cattle prices and feed costs have moved in opposite directions, much of the positive impact to margins has been muted since feeder cattle costs are rising faster than fat cattle prices. This presents a significant challenge for feedlots trying to manage forward profit margins as they may face a loss or breakeven scenario at best once the cattle enter the feedlot.

While live cattle prices have not been keeping up with the strength in the feeder market, both markets have been printing all-time high prices recently in response to the strong demand for beef. For the time being, it appears that consumers are willing to dig deeper in their pockets to pay up for protein, and this has helped to support not only beef prices, but pork and dairy product values as well. Although this is certainly a positive dynamic from the standpoint of forward profitability, it also carries with it a high degree of risk should the demand begin to weaken over time. While a feedlot may have diminished power at auction to control feeder costs in the current environment, they do have more control over how they choose to manage the other legs of their profit margin.

Consider fat cattle prices. Let’s assume I am placing cattle today in my yard which will be marketed to a packer 6 months from now against the February futures contract at the CME. The February futures price is right around $152/cwt. currently, about $2.00 below its life-of-contract high. While conventional wisdom might dictate to simply sell futures into this rally, the reality is that projected profit margins are currently negative so this would effectively lock my feedlot into a loss for the period. As an alternative, I might instead consider placing a floor under my cattle by purchasing a put option. The right to sell February 2015 Live Cattle futures at a price of $152/cwt. is currently valued at a cost of around $4.00/cwt. By purchasing this right, I establish a floor under my fat cattle for this marketing period at $148, which was the life-of-contract high as recently as 2 weeks ago. The following chart diagrams this strategy for the February futures contract:

February 2015 Live Cattle Futures Chart:


Assuming I purchase the put option, ideally the market would move higher over time so that my projected profit margin improves and I have the opportunity to capture a positive margin by making an adjustment. As a worst case scenario, if the market instead moves lower, I at least know that I have established a floor underneath the value of my finished cattle. While that would represent a loss for this particular marketing period, it would at least be a defined loss at that point holding my feed costs constant. The alternative of staying open to the market on the value of my finished cattle would present the possibility of an undefined loss which might be catastrophic if the demand picture changes between now and next winter.

Getting back to the more optimistic scenario, I would ideally like to see the live cattle market move higher after purchasing the put option so that I have the opportunity to make an adjustment. How exactly does this work? One way to evaluate the potential benefit of making an adjustment to this position is to consider the cost. If I am spending $4.00/cwt. to purchase the put option in this particular example, I would want to see the February futures price rise by at least that much before I would begin considering an adjustment. From a cost standpoint, the most I can lose on the put option is the premium paid for it; therefore, I would want to benefit by at least that much by retaining the opportunity to participate in higher prices. This means that if I pay $4.00 for the right to sell February Live Cattle futures at $152.00, I would want to see the February futures price be above $156.00 at a minimum before considering an adjustment.

At that point, there are a few potential alternatives I could consider. The simplest one would be to offset the put option, salvage any residual value remaining in the option, and lock in a sale price by selling a futures contract. I could evaluate this adjustment by looking at what the net price would be that I am locking myself into at that point. If the market moves higher, there will be a loss on the put option that I will have to subtract from my sales price on the futures contract. I had the ability to sell futures at $152.00 when I initially purchased the put option, so at a minimum, I would want my net price to be above this level. I also have to consider my overall profit margin. I purchased the put option to retain the opportunity to realize a positive margin over time. What would my margin be given a net sales price at this level? If I am not realizing a positive margin, I probably would not want to lock in a futures price yet.

As an alternative, perhaps there is a target futures price that would represent an acceptable sale price and profit margin for this group of cattle. I might consider selling a call option which would obligate me to this sale price should the market continue rising. I would receive a premium for selling the call option, which I could in turn use to help re-establish my floor at a higher level. This would entail selling the put I currently own at $152, and replacing it by buying a put at a higher strike price. As an example, if February Live Cattle futures are now trading at $156.00/cwt., I might consider selling a call option for instance at $162, and using those proceeds to roll up my put from the $152 to $156 strike price. In this way, instead of having a floor at $152 for a $4.00 cost, I would now have a floor at $156 and a ceiling at $162 for the net price of my original $4.00 cost plus any additional expense related to the adjustment. Depending on option prices at the time of making this adjustment, there may not be any additional cost at all, as the premium received from selling the call option may completely pay for the cost of rolling the put to a higher strike price.

While we have not discussed the feed side of the margin equation, this too would also represent an area where I might improve upon my price and margin over time by maintaining flexibility. As opposed to locking in a corn price at current levels, I may consider establishing a ceiling or maximum price on my feed by purchasing a call option. In a similar way, I would look for the opportunity to improve upon my margin through declining feed costs over time, and consider adjustment opportunities to either lock in a lower corn purchase price by buying futures, or rolling down my call option in a declining market. Like the cattle example, I might consider paying for this by accepting a price at which I would be willing to buy futures, and receive a premium by selling a put option. However I choose to approach it, the current environment in the beef cattle market demonstrates the value of remaining flexible with a feedlot’s margin management decisions.