When the market offers historically high prices for any commodity, it is a good idea to put protection in place, even if your bias is that the price cannot go down. That is the case for cull cattle prices right now.
Milk and feed price risk management get the lion’s share of attention; meanwhile, cull cow and steer sales have become larger line items for dairy producers. It’s possible to hedge this production.
Here’s how it works:
There is no direct hedge for dairy cull cattle prices, so a «cross hedge» is used. In this case, the market we use is the Live Cattle (LC) market. As you can see from the chart below, dairy cull prices and LC futures track fairly closely.
Live Cattle futures are much more volatile than dairy cull prices, in both direction and magnitude of price changes. Volatility has increased in recent years, and, as a result, there are times when the markets do not move in sync. So, for this reason, selling LC futures to lock in dairy cull prices is not the recommended approach. A simpler and more worry-free approach is to buy LC put options.
When you buy a put option, you are protecting the value of a commodity you intend to sell at a future time. Buying put option gives you the right (but not the obligation) to sell a futures contract at a certain price (called the «strike price»). That right comes with a cost—a premium.
Here is an example of how a put option can protect cull prices:
One LC put option contract covers 40,000 lbs. Let’s say you as a dairy producer cull the equivalent of 20,000 lbs. per month and want to protect against a pullback in the cull price through October of this year. A producer may choose to buy one LC put option for each of these months leading up to October: April, June, August and October. Buying one 40,000-lb. contract every other month matches the producer’s expected culling of 20,000 lbs. monthly.
To break this down further, let’s look at the month of April. April Live Cattle is currently trading at $140.775 per cwt. The April LC put with a strike price of $140 can currently be purchased for $1.35 per cwt. or $540. Should the value of the April LC contract fall even a small amount, say, to its November low of around $132, the LC put option would net $6.65 per cwt. (not including fees and commissions). The math goes like this:
$140 strike price – $132 futures price – $1.35 put option premium = $6.65
That equation represents an additional $6.65 per cwt. for the cows culled during the two-month period of April and May. Historically, much greater sell-offs than this modest price drop example have occurred. This is especially true when you consider the possibility of a dramatic drop in the LC futures prices off of their record highs. If the Live Cattle market does indeed have a significant drop, the gains in these puts, especially later in the year, could be significantly higher than this example.
Why act now? Cull cattle prices are at record highs, and from a supply side standpoint, many people see no reason for cull cattle prices to fall any time soon. So why would a dairy producer want to act?
Besides the supply side picture, there is another side to the cull cattle price picture, and it has to do with the correlation to Live Cattle prices. Currently, boxed beef prices are being supported by strong demand and strong exports. It’s important to remember that there is always something that can change the demand side. Higher beef prices could start to curb consumer taste for beef in favor of less pricey proteins. Our beef export market, which is sensitive to changes in the US Dollar or any sort of trade dispute, could also be disrupted at any time. Any of these things could change the supply-demand balance in beef and send LC futures lower.
We’re not saying that any of this will happen; we’re saying that it could happen. We are recommending that producers have cull cattle price coverage for the latter half of this year. It’s important to examine every avenue to protect good prices for everything that is produced on your dairy operation.
Warren Wagner is a dairy advisor with Stewart-Peterson Inc., a commodity marketing consulting firm based in West Bend, Wis. You may reach Warren at 800-334-9779, or email him at wwagner@stewart-peterson.com.
The data contained herein is believed to be drawn from reliable sources but cannot be guaranteed. This material has been prepared by a sales or trading employee or agent of Stewart-Peterson and is, or is in the nature of, promoting the use of marketing tools, including futures and options. Any decisions you may make to buy, sell or hold a futures or options position on such research are entirely your own and not in any way deemed to be endorsed by or attributed to Stewart-Peterson. Commodity trading may not be suitable for all recipients of this report. Futures trading involves risk of loss and should be carefully considered before investing. Past performance may not be indicative of future results. Copyright 2014 Stewart-Peterson Inc. All rights reserved.
Source: AgWeb