Whether cattle are owned by a feedyard or a custom feeder or stocker operator, their profit potential depends mainly on the price of corn. And with the violent volatility still surrounding grain and cattle prices, it may be important for producers and feeders to “cover their corn” with futures, options or forward contracts.

A 10¢/bu. increase in corn price easily adds 1¢/lb. to the cost of gain of cattle coming out of the feedyard, says Justin Gleghorn, risk-management consultant in Amarillo, TX. He's associated with Brock Thompson, owner of Brock Thompson Trading and part owner of Quality Beef Producers, a Wildorado, TX, feedyard.

Thompson always has a risk-management plan in place for cattle he owns and helps feeder and stocker clients with their risk management. Outside forces like index funds, which caused havoc with corn markets in 2008, could “push the corn market” even higher if we see an uptrend in prices, he says.

Elaine Johnson, CattleHedging.com broker/consultant, Denver, CO, agrees with that volatility assessment. She sees opportunities for producers to manage the risk on cattle going on feed in late spring and early summer, but the strategy depends on which way the corn market breaks.

“The weak corn basis (seen in early spring) told us to lock in corn prices into July at least,” she says.

December 2010 corn futures ended March at $3.76/bu. That was after the March 31 USDA Prospective Plantings report that pegged 2010 corn planting at 88.8 million acres, what the trade had projected. However, corn stocks were higher than expected, and 10¢ was taken out of the corn market.

For Corn Belt feedyards, that $3.76 futures level put cash prices close to the $3.20-$3.30 range, due to the corn basis of minus 40-50¢ or more. But in the southern High Plains, corn was closer to the $4.00-$4.30 cash price, due to the over-futures basis.

“If the market closes below the $3.83 level, cattle feeders may want to sell the futures to protect their corn price,” Johnson says. “The potential for a strengthening basis (typically 15-20¢ heading into July), especially in the southern High Plains, tells us futures offer better protection.”

She says that if December corn takes out its February low of $3.83 (which it did), the market could break 30¢ to retest the contract low of $3.53. So if feeders had their corn bought at a cash price based on the $3.83 level, they would lose potential to lower cost of gain unless they have price protection in place.

Gleghorn says the plantings report still left him bearish corn on the technical side. “Corn was under pressure all March. Some 40-50¢ was taken out of it,” he says. “However, those looking at placing cattle on feed and paying a lot for feeder cattle are seeing small margins. The one thing out there that can bite them is corn. We're urging customers to be mindful.”

He suggests buying a December futures contract. “You'd be long the futures,” he says. “If you paid cash for corn into the feeding cycle and prices went up, you could sell the futures for the higher level to protect against the higher cash price. If corn went down, your lower cash price would offset losses on the futures contract.”

Watch seasonal patterns

For cattle placed on feed in early summer, producers should monitor the corn market closely. Corn prices normally retreat after July 1 but, just like seasonal patterns for cattle prices, not always.

“Seasonally, feeders coming off wheat pasture usually cause prices to go down (in March),” Thompson says. “It was just the opposite this year (prices went from $102/cwt. to $107).

“If feeders or stocker operators are nervous about corn prices (not falling in a seasonal pattern), other than a long hedge in futures, they may want to buy some call options,” Thompson says. “If we see trouble in getting corn planted, then calls may be in order. If we see corn in a bull market, maybe outright futures can be used to control corn prices until proven otherwise.”

When December futures were at the $3.90 level in late March, a $4.70 call had a premium cost of about 20¢/bu. Buying the call, one could take advantage of corn-price increases if a rally occurred, protecting against the higher corn price during the time the cattle were on feed.

“The out-of-the-money call gives protection against a big rally in the market. It provides some insurance in case it goes higher,” Gleghorn says.

For example, if corn futures are at $3.90, the out-of-the-money $4.70 call may, again, cost about 20¢/bu. If futures prices increase along with the cash price, the call's value would likely increase, too. If the price reached $4.70, the at-the-money value may be around 40¢, for which the holder could sell the option and gain a profit.

However, if prices take the normal seasonal plunge, then using corn put options may be the strategy. A $3.10 December put cost about 10¢/bu. in late March. If you pre-bought corn at the cash price based off the $3.90 price, you could be partially protected from the higher price by taking profits from the likely increased value of the put option.

Of course, due to market volatility, options premiums can change daily, just like futures prices. That's why good risk management can be essential in protecting a cost of gain or overall profit potential.

Options can be complex

The bull call spread is one example of a more complex strategy. It involves buying call options at one price, then selling them at a higher strike price.

For example, assume December corn is trading at $3.90. You buy, or go long, the at-the-money call for about 40¢/bu., then sell or go short a $4.60 out-of-the money call for about 20¢. If the price jumps to $4.60 or higher, the buyer can likely exercise the short $4.60 call for the lower price, even though it's likely priced much higher. You can take advantage of the higher price even though you bought cash corn at the lower price, thus likely lowering your cost of gain.

Johnson says that beyond July, “I'd look to lock in corn prices only if December corn closes above its March high of $4.15. I'd use either the futures or possibly a bull-call spread, depending on the level of risk one is willing to take.

“The tendency for a weakening basis from July through October favors using the futures instead of the cash market to cover July-September needs,” she says. “For needs beyond October, one should return to the cash market once again, as long as the trend remains up.”

Thompson rarely feeds a pen of cattle without a risk-management plan. “There are some good opportunities for the industry if you develop a risk-management plan and stick to it,” he says.

Gleghorn reminds feeders that with the poor quality seen in some of the 2009 corn crop, some test weights may be low.

“As corn is coming out of storage with potentially lower test weights, the estimation of corn supply may be overstated,” he says. “If we have 52 lbs./bu. corn instead of 56 lbs., then we'll have to feed more corn than anticipated; our supply of corn in storage may decrease more than expected. This may spur a rally in the market.”

Larry Stalcup is an Amarillo, TX-based freelance writer.