As a general note, declining feed prices have been a boon for the livestock industry and come as welcome relief from the last several years of limited supplies due to drought and soaring demand from the export market and ethanol industries. While not all livestock producers have benefited to the same degree depending on their particular feed rations, lower costs generally have translated into improved margins for livestock producers. Hay availability remains limited and costs are high for dairy producers. Soybean meal prices, likewise, have maintained historically high prices due to strong export demand and short old-crop soybean supplies. Corn prices however have come down substantially from a combination of demand pressure and expectations for sharply increased supplies this season. While it is still early, weather has been quite favorable for the corn crop’s development, and many people are openly discussing the possibility of above-trend yield potential. Meanwhile, China has been in the news recently for halting DDG imports due to concern over contamination with MIR-162, a GMO strain not yet approved in the country. There is also concern that their corn stocks are much larger than current USDA estimates, and this may further limit future demand from the country.
Although lower corn prices are certainly welcome for many livestock producers, what about those operations that actually raise their own corn? Looking at the corn situation strictly from the perspective of a crop producer, margins are presently negative at current price levels. In other words, if I simply grow corn as a crop farmer and do not finish livestock, I am projected to lose money on this year’s harvest. Assuming I do raise hogs, finish cattle or milk a dairy herd, I may very well be realizing a profit on these animals given my cost of production on corn, but how do I handle this cost in light of the fact that current corn crop margins are negative? This is not an easy topic to address, although it brings up an important distinction in how a livestock operation evaluates their forward profit margins and how they approach their risk associated with those margins.
There are two basic ways that I may choose to look at my operation if I finish hogs, cattle, or milk dairy cows and also grow my own corn. First, I may consider the crop and livestock operations as separate businesses and manage them independently. This may very well be the case if there is a different ownership structure between the two units. As an example, my wife and I may own a farm where we have a row-crop operation producing corn and soybeans. Separately, my brother and I might go into business together and invest in finishing barns to raise hogs. In this case, the decision to manage them separately will be fairly straightforward as each business will have its own tax ID and keeping the financials independent of one another will be important.
In other cases though, both the crop and livestock operations may have the same beneficial ownership which will make it more complex. In this case, I have a choice of how I want to treat the crop entity. I can either run it as an independent business with its own profit and loss, or I can treat it as a cost center for my livestock operation. In the former case, I will make marketing decisions on my corn independent of the needs of my livestock operation. In the latter case, the crop production exists to accommodate the feed needs of my livestock herd, and I essentially account for it at my cost of production. In either case, the corn is assumed to never leave the farm; in other words, even if I were to treat them as separate businesses, I would never actually market the corn outside of the farm where I would need to replace the physical bushels for my livestock feed needs.
With this in mind, how I make my crop marketing decisions becomes more complex if I choose to run them as separate businesses. Even though the corn will never leave the farm, the point at which the crop entity may want to sell the corn will probably not coincide with when the livestock entity wants to purchase that same corn for feed. Their interests are opposed as the crop entity is trying to sell the corn as high as possible while the livestock operation is trying to buy the corn as low as possible. If I treat my crop operation as a cost center to my livestock, in a case such as the past few years where the replacement cost of corn is above my cost of production, I am penalizing the crop farm and subsidizing the livestock. In a scenario such as is playing out in the current year, I may find that I am raising my corn crop for more than the replacement cost in the open market such that the crop farm will break even but there is an opportunity cost to the livestock operation.
Ideally, I would like to maximize the return for each business without creating a burden on one or the other. In doing so, I will need to be careful with the types of strategies I use to manage my margin for each operation. The pitfalls with running the crop farm as a cost center were previously outlined. If I simply feed my corn at its cost of production, one of the operations is losing out depending on whether the market price of corn is above or below my cost of production. If I run them separately and manage the strategies for each operation independent of one another, I still have to give consideration to how margin management decisions on one operation impacts the other.
As an example, let’s assume that I am running them separately and looking at my corn crop margin specifically. Corn is trading at $6.50/bushel which is currently $2.00 above my cost of production assuming I produce trendline yields based on my average production history. Because $2.00 represents a tremendous margin opportunity for the crop operation from a historical perspective, I decide to lock this in by selling a futures contract to set the $6.50/bushel sale price. At the same time however, $6.50/bushel does not represent a good purchase price for my cattle feeding operation. Moreover, let’s also assume that I do not have a margin opportunity that looks attractive against this same new-crop corn so there is no upside protection in place against the feed needs of these cattle.
Now consider a scenario where corn continues to increase in price to $8.00/bushel as has happened in past years. On the crop side, I am already locked into a sale price of $6.50/bushel so that entity is not participating in any improved margin opportunity resulting from higher prices on the open market. At the same time, the cattle operation remains open on their feed needs which are becoming more expensive on the open market. Both operations are now worse off as a result. A better approach may be to coordinate the strategies between the two entities. In the above example, I may choose to sell futures for my crop operation without consideration for the needs of my feedlot if I am considering that alternative in isolation. This may very well be a sound hedging decision given the $2.00/bushel profit margin being projected, but it may not be the best decision in light of the fact that I do not have feed protection in place for my cattle herd. In this case, I may choose to put a floor under the value of my corn to protect the crop entity’s profit margin, while leaving flexibility in place to allow for higher prices.
As another example, let’s assume the same feedlot is looking at a margin opportunity for placing cattle in the current year, and decides that $5.00/bushel corn translates favorably for a projected return on a group of cattle. On the crop side, the same $5.00 corn may be at or below a breakeven cost of growing that corn such that there is not a margin opportunity for the crop entity. If the feedlot entity protects their margin by purchasing a corn futures contract while the crop operation has no protection to lower prices in the open market, a situation such is currently playing out where corn declines in price to $4.50 means that the crop entity’s margin is now further in the red where the feedlot has also lost out on the opportunity to participate in more favorable prices.
In both cases, the need for increased flexibility becomes pretty clear. If I am growing my own corn and choosing to treat my livestock feeding business and crop production operation as separate entities, I need to be mindful of how contracting decisions for one impacts the other, and coordinate my strategies between the two. In revisiting the prior examples, where selling corn futures at $6.50/bushel may have represented a sound decision for the crop entity from a margin standpoint, buying a call option at the same time for the cattle feedlot would have been a prudent supplemental strategy to address the risk of higher prices for both operations. In the second example, where buying futures may make sense for the feedlot in light of their margin opportunity, purchasing a put option at the same time for the crop entity to address the risk of lower prices for both businesses also would have been a sound decision. This may require increased management and greater coordination among those involved in the decision making process, but in the end will likely result in improved margin management success over the long run.