Ranchers don't like to lose money, but often they don't think about managing their risk until it's too late to do anything about it,” says Kevin Hughes. He's the risk manager for Idaho-based AgriBeef, a sprawling customer-driven ranching and cattle feeding enterprise.
Or, if they do ponder risks associated with potentially market-capsizing events like a foot-and-mouth outbreak, they often equate risk management to the futures market and something only the largest cattle feeding and ranching operations can practically utilize.
In fact, Hughes says the underlying principle of risk management means cow/calf operations have more tools available to them than feedlots. He explains, “What you try to do in managing risk is figure out how to get the most protection for the least amount of money, while still participating in the upside if you need to.”
With that in mind, Ben Brophy, manager of value-added alliances for Caprock Industries, one of the nation's largest cattle feeders, points out that forward contracting, retained ownership and the options market are all viable risk management tools.
Rather than a marketing or procurement tool, Brophy explains forward contracting is really a way to manage price risk — either paying or accepting a known price today rather than an unknown one several months down the road.
But, Brophy says, “If you're going to forward-contract you must know your costs and be comfortable with the margin you are capturing.”
As for retained ownership, although owning cattle longer means risk is retained longer, it also means there are more opportunities to dilute the risk in total. Of course, timing is the key.
“Last summer, we were recommending that ranchers sell their calves or forward contract them; there was so much profit in selling them there just wasn't much reason to retain ownership in them,” says Hughes.
Likewise, the opportunity to purchase a guaranteed price further out is why both Hughes and Brophy believe cattle options can offer cow/calf producers protection against market catastrophe.
As an example, a put option on feeder cattle gives you the right to sell a feeder cattle contract in the futures market at a particular strike price. If January feeder cattle were trading for $84.80 in September and you wanted to insure against a market wreck, you might buy an $80 put to cover the tonnage you'd be selling as feeder cattle rather than as feeder calves (the stocker futures contract no longer exists). Rather than taking a short position in the futures market, you're buying the right to take that position if you choose.
AgriBeef uses a twist to this: a put option spread in which you purchase a put at near-money (futures price is trading under strike price) and sell one out of the money (futures price is trading above the strike price), thereby creating a window of price protection.
“It doesn't give you absolute downside protection, but it gives you quite a bit and still lets you participate in the upside,” says Hughes.
Of course, when you're buying puts and either making the time to manage your position or paying someone else to do it, you're adding to your production cost. You're basically paying for insurance — since no practical commercial insurance exists — and hoping you never have to use it.
The details up front matter less than considering risk management overall. That's one thing Brophy says Caprock is emphasizing at alliance meetings this fall — just recognizing the opportunity is there and evaluating risk management alternatives.
After all, Brophy and Hughes say none of these or other risk management tools can be effective until a producer first determines his price objectives and then the risk management required to achieve them.
“If you've got equity in cattle, you have to draw a line in the sand that you won't cross because crossing it means your equity is eroding,” says Brophy. But, you have to know where to draw that line in the first place.