2020 Commercial Steer Study Guide

Phone: 210-225-0575 Email: livestock@sarodeo.com

Table of Contents Health ...... Pg. 1 Proper Usage of Drugs and Chemicals in Food Animals ...... Pg. 2 Cattle Vaccines ...... Pg. 4 Immunizing Beef Calves ...... Pg. 6 Basics of Cattle Immunity ...... Pg. 10 Recognizing and Managing Common Health Problems in Beef Cattle ...... Pg. 12 Biosecurity for Beef Cattle Operations ...... Pg. 20 Foot Rot in Beef Cattle ...... Pg. 24 Bloat Prevention and Treatment in Cattle ...... Pg. 25 Clostridial Diseases ...... Pg. 29 Quality and Yield Grading ...... Pg. 32 Beef Quality Grading...... Pg. 33 Beef Yield Grades ...... Pg. 37 Basic Management and Information ...... Pg. 42 Beef Performance Glossary...... Pg. 43 The Cow’s Digestive System ...... Pg. 49 Texas Adapted Genetic Strategies for Beef Cattle X: Frame Score, Frame Size, and Weight ...... Pg. 56 Dehorning, Castrating, and Branding ...... Pg. 60 Implanting Beef Calves and Stocker Cattle ...... Pg. 63 Growth-Promoting Implants for Beef Cattle ...... Pg. 67 Value Added Calf (VAC) - Management Program ...... Pg. 75 Cattle Handling Pointers ...... Pg. 77 BQA Cattle Care and Handling Guidelines ...... Pg. 87 The Facts about OptaflexxTM: Ractopamine for Cattle ...... Pg. 111 Feedstuffs for Beef Cattle ...... Pg. 114 Mineral and Vitamin Nutrition for Beef Cattle ...... Pg. 126 Considerations for Retained Ownership of Feeder Cattle ...... Pg. 142 Economic Evaluation of Strategies to Reduce Feed Cost of Gain in the Feedlot ..... Pg. 144 How does the carbon footprint of U.S. beef compare to global beef? ...... Pg. 155 Does Beef Really Use That Much Water? ...... Pg. 157 If we fed corn to humans instead of cattle, would land use be more sustainable? .. Pg. 159 Is local beef more sustainable? ...... Pg. 162 Feedlot Health Series: Part 1- Receiving ...... Pg. 165 Feedlot Health Series: Part 2- Respiratory Disease Management ...... Pg. 168 Feedlot Health Series: Part 3- Bloat ...... Pg. 170 Feed Bunk Management for Maximum Consistent Intake ...... Pg. 172 Would removing beef from the diet actually reduce greenhouse gas emissions? ... Pg. 183 Do growth promotants reduce environmental impact? ...... Pg. 186 Does grass-finished beef leave a lower carbon footprint than grain-finished beef? Pg. 188 Grass-Finished or Grain Finished Beef? ...... Pg. 191 Managing Heat Stress in Feedlot Cattle ...... Pg. 192 Hidden Costs in the Feedlot ...... Pg. 196 Matching Cattle Type and Feedlot Performance ...... Pg. 200 Marketing ...... Pg. 148 Ranchers’ Guide to Custom Cattle Feeding ...... Pg. 149 Factors Affecting Cattle Feeding Profitability and Cost of Grain ...... Pg. 154 Beef Cattle Marketing Alliances ...... Pg. 158 Retained Ownership Strategies for Cattlemen ...... Pg. 162 Grid Pricing of Fed Cattle ...... Pg. 166 Using a Slide in Beef Cattle Marketing ...... Pg. 171 Introduction to Futures Market ...... Pg. 173 Buying Hedge with Futures ...... Pg. 177 Selling Hedge with Futures ...... Pg. 181 Commodity Options as Price Insurance for Cattlemen ...... Pg. 185

Section 4: Marketing

214 Beef Cattle Handbook

BCH-8040 Product of Extension Beef Cattle Resource Committee

Ranchers’ Guide to Custom Cattle Feeding

Donald Gill, Animal Scientist, Oklahoma State University Kent Barnes, Animal Scientist, Oklahoma State University Keith Lusby, Animal Scientist, Oklahoma State University Derrell S. Peel, Ag Economist, Oklahoma State University

Custom cattle feeding refers to sending cattle to a com- previous nutritional background. When these conditions mercial feedyard that specializes in feeding and manag- are met, the cattle feeder can feed and sell the cattle to ing cattle until they are ready for processing. This achieve optimum feed efficiency and market value of the practice should be considered by ranchers as a means to cattle. When careful control is started on the producing evaluate the performance of cattle or as a marketing ranch, uniformity in the cattle nearly always results in a 5 alternative. At times, custom cattle feeding can be a tool to 10 percent advantage in efficiency over carefully “put to increase the dollar return to a cow-calf or stocker pro- together” cattle. gram. At other times, it may be better to simply sell feed- Steers and heifers can be fed, but not in the same er cattle or calves. The rancher should consider custom pen. Often heifers are discounted more as feeder calves cattle feeding when it is likely to increase net returns. in marketing channels more than they should be, and Some ranchers feed some of their cattle each year custom feeding may be a means to realize better prices regardless of profit potential just to see how their cattle for the rancher. When selecting a feedlot for heifers, be perform in the feedlot. This may become more impor- sure to find a feedlot that can feed and market heifers. tant as feeders require evidence of superior cattle performance before paying top-market price. Evaluating a Custom Feeding Opportunity Cattle producers who would like to try cattle feeding but are uneasy about sending 100 or more head of cattle Value Your Cattle to a feedlot for the first time, may want to consider par- Put a realistic value on your cattle and calves at home. ticipating in a feedout program. Many states offer similar This is usually either the local auction price, less costs programs that allow a producer to contribute five to fif- and shrinks involved in getting cattle to market, or a bid teen head to a feedout trial in order to get performance at your scales, less a possible pencil shrink. Cattle shrink and carcass data on the animals. Examples of these pro- and pencil shrink are very important. When considering grams include: Georgia’s “Beef challenge;” Idaho’s “A to shipping cattle to custom feedlots with a ten- hour haul, Z Retained Ownership Company;” North Dakota’s it is likely they will shrink three to eight percent from “Badlands Performance Steer Test;” Oklahoma’s “OK ranch weights. Please refer to Table 1 to estimate cattle Steer Feedout;” South Dakota’s “ Retained Ownership shrinkage. Demonstration;” and Texas’ “ Ranch to Rail” Program. Examples of figuring cattle costs: Selection of Cattle For Feeding A buyer offers you $68/cwt. for your steers with a three One key to successful feeding lies in the makeup of the percent pencil shrink. In reality, he offered you 97 per- cattle that constitute a pen. Cattle should be as uniform cent of $68.00, or $65.96. as possible in weight, body type, age, breeding, and in You need to value your cattle for custom feeding in

BCH-8040 215 1 a lot 300 miles from home. The cattle will shrink about Table 2. 100 percent Dry Matter Feed Conversions on Average 5.5 percent (from Table 1) from ranch weight during the Cattle Types from Pay Weight to Pay Weight, Assuming High haul. Thus, your cattle would have to cost $69.80 [65.96 Concentrate Rations. x (100/94.5) = 69.80] laid into a feedlot to net you the $65.96 at home. Cattle In Wght Mrkt Wght Conversion Ratio Keeping records of a few actual shipments under Steers 500 1000 6.0 specific conditions will establish the appropriate per- 500 1050 6.3 centage of shrink for your operation. 600 1000 6.0 600 1050 6.3 Table 1. Shrinkage Loss Due to Different Handling Conditions. 700 1050 6.0 700 1100 6.3 Conditions Percent Shrink 700 1150 6.8 8-hour drylot stand 3.3 800 1150 7.1 16-hour drylot stand 6.2 800 1200 7.3 24-hour drylot stand 6.6 800 1250 7.5 8 hours in moving truck 5.5 900 1250 7.7 16 hours in moving truck 7.9 900 1300 8.0 24 hours in moving truck 8.9 Heifers 500 1000 6.9 600 1025 6.9 Freight Costs 700 1050 7.3 Usually, a semi-trailer truck equipped to handle cattle is 800 1100 8.0 the most economical way to move cattle. These trucks will haul from 48,000 to 52,000 pounds of cattle. Hauling rates range from $1.75 to $2.00 per mile. Typical current Some feedlot rations are priced on an “as is” basis. rates are about $2.00 per mile to a custom feedlot. They may be adjusted to a zero percent moisture basis Shipment of cattle 300 miles with a 50,000-lb. load will (or 100 percent dry matter) by dividing the “as is” price add about $1.20/cwt. to the cost of the cattle. by the dry matter content of the ration (expressed as a If you could get $68, less three percent shrink at decimal) If, for example, a feedlot ration containing 28 home, figure that you could lay your cattle into a feedlot percent moisture costs $5.40 per hundred, its zero- per- 300 miles away for $69.80 plus $1.20 freight for a total of cent moisture cost will be $5.40/0.72 = $7.50. $71.00. Medical Costs Feedlot Costs Most healthy yearling cattle incur medical costs (includ- Custom cattle feeders provide feed and services for a ing processing and implants) of $4 to $8 per head during price. Good feedlot managers can estimate how much it feeding. Sickly calves can at times incur costs as much as will cost to feed your cattle from feedlot “In Weight” to $25 per head. All good feedlots can inform a rancher of final “Pay Weight.” Estimates of lot costs, excluding steps necessary to keep health costs to a minimum. yardage, can be made by multiplying feed conversion ratios (given in Table 2) times the cost of feed on a 100 Death Loss percent dry matter basis. It is normal to figure one-half to one percent death loss in yearling cattle in feedlots. Cattle placed on feed during late Yardage and Other Costs fall and early winter are most susceptible to high losses. Some feedlots charge a yardage fee (usually 5 cents per Death losses in calves are potentially quite high if man- head per day) in addition to the feed cost. In addition to agement of the calves prior to and during shipment and the yardage, a rancher should inquire about other fees receiving is lacking. Usual death losses are about three such as processing, hay, insurance, taxes, and check-offs. percent, with a range of about one to ten percent. Most Cattle producers who feed cattle in a number of custom death losses in calves can be traced back to stale-sale barn lots report that the fees other than yardage are quite calves moved during adverse weather. If a rancher intends variable, ranging from zero to over $14 per head. The fee to feed calves, it is wise to hold the cattle 20 to 30 days structure should be spelled out and included in the bud- following weaning before shipping. Coordinate this pre- get. shipping program with the feedlot’s veterinarian. Death losses that are incurred soon after arrival at the feedlot are not as costly as losses later in the feeding period. Poor gains and conversions generally accompany high death losses. A high death loss is of less significance with low-priced cattle than with high- priced cattle. Any rancher feeding his own cattle should include a provision in his budget for death losses. With

2 216 Beef Cattle Handbook yearling cattle, experienced feeders whose average Interest and Financing death loss is one-half percent will often feed five or six Methods of financing cattle feeding ventures are quite pens without a death and then lose three head out of a flexible. It is usually best to use your normal sources of hundred on the next. Feedlots will notify the cattle financing when carrying your cattle through the feedlot. owner of death losses and the cause of death. If the rancher has adequate financing to cover the cattle costs throughout the period required to finish the cattle, Pen Sizes and Risk Sharing he can usually obtain additional local financing to cover Feedlot cattle are usually fed in pens of 100 to 140 head. feed bills. Feedlots usually bill for feed and services However, many feedlots have pens as small as 25 head twice monthly. These bills can be sent either to the to as large as several hundred. Several ranchers each owner, or, a cooperating financial agent for payment. having 100 steers to feed may find it desirable to pool Another option frequently available is to make arrange- their cattle into many pens, often started on feed at dif- ments to have the feedlot finance the feed bill. When this ferent times. Each rancher may own portions of each is done, feed bill and finance charges are deducted at the pen. This technique helps iron out peaks and valleys in time cattle are sold. both feeder and fed-cattle prices. One drawback to this It is important that the rancher check local interest approach is that the rancher may not get specific perfor- rates against those of the feedlot’s financing plan and mance and carcass information on cattle. select the least-costly plan. Refinancing cattle at the time Cattle should be carefully sorted so that each pen they are placed on feed is another alternative. In this has the same size and type of cattle. Cattle “type” refers case, cattle are appraised for value and the owner can to the ultimate mature size. Charolais X Hereford cross- receive cash for the difference between their appraised es are usually a much larger type than Hereford X value and the loan margin required by the lender. Margin Angus crosses. Many feedlot managers prefer to feed amounts are dependent on the owner’s financial state- Hereford X Angus cross steers because they are usually ment, and possible risk that the lender sees in the loan. easy to sell at top market price when finished. Some Current margins range from $50, to as much as $150 per exotic cross heifers make good feeders in high plains head, depending on the risk to the lending agency. feedlots because they finish at more desirable weight Interest costs are a significant item in the cost of for that market than do small type heifers. Feedlots in feeding cattle. Total interest costs may be estimated as different regions sometimes specialize in different types in the following example: of cattle. Thus, by shopping around, a rancher may locate a feedlot more comfortable with a particular type A. Cattle cost at $300 for 120 days at 10 percent of cattle. $300 X (.10/360a) X 120 = $10 As a rule, the more uniform that cattle are in back- B. Feed cost at $1.50 per day for 120 days = $180 ground, type and weight, the better job the feedlot can $180 X .5b X (.10/360a) X 120 = $3 do in terms of minimizing costs and obtaining top price. Cattle that do not grade when finished are usually des- aBankers year (360 days) tined to be overfed and to sell for discount prices. bAssuming feed is charged when fed

Fed Cattle Marketing Prepaid Feed Feedlots make no separate charge for selling a cus- A rancher can insure himself against unexpected rises in tomer’s cattle. They do provide market advice and will feed costs at times by purchasing sufficient quantities of sell according to producer instructions. Feedlot cattle grain through a feedlot either before or at the time cattle are usually sold at the feedlot (FOB) on actual weights are placed on feed. At times of uncertainty about feed less a pencil shrink (for example, 4 percent in the supplies and feed prices, a prepurchase of feed com- Southern Plains). In this case, the buyer of the cattle is modities offers a hedge against rising feed prices. The responsible for the freight and any possible condem- cost of the prepaid feed commodities are deducted from nations (i.e. carcasses lost in the plant due to disease the normal ration price at each billing period. If feeds are or injury). purchased early, interest costs on feed may be much Sometimes it is to the cattleman’s advantage to sell higher depending on the timing. The above formula for on a dressed weight basis (“in the beef”) or on a dressed estimating interest costs on feed was based on the weight and grade (“grade and yield”) basis. When cattle assumption that feed is not paid for until it is fed. Most, are sold in this manner, the cattle owner pays for the but not all, feedlots can handle prepaid commodities freight to the packing plant and also stands the risk of through their billing system. Alternatively, the basic com- any condemnations. Cattle with a high dressing percent- modities that make up a feedlot diet (i.e., corn and soy- age often bring more net money to the cattleman when bean meal) can be hedged with futures or options sold on a carcass or dressed weight basis. With “in the contracts for price protection. beef” selling, the packer/buyer takes the grading risk. When cattle are sold on a “grade and yield” basis, the Managing Fed Cattle Price Risk cattleman benefits when cattle have both a high dressing A rancher with cattle in a custom feedlot has several percentage and high quality grade percentage. alternatives to help manage the price risk of future cattle

BCH-8040 217 3 sales. The need for price-risk protection will largely prices, plus the freight cost between the feedlot and the depend on the rancher’s cattle price outlook, before and packing plant. after placing cattle on feed, and may be influenced by A rancher may also establish an expected fixed or financing or other considerations. minimum price for the cattle by hedging the cattle with Cattle on feed may be forward priced with a cash- futures or options. A simple hedge with futures or forward contract. This may be a fixed price contract but options does not eliminate all market risk but replaces is more often a basis contract. A basis contract specifies price risk with basis risk, which is usually lower. As that cattle will be priced at a fixed level above or below noted above, a basis contract can be combined with the futures price for a specific futures contract month. futures or options to establish a fixed or minimum price Typically, the rancher can decide what day’s futures mar- for the cattle. ket price will be used to fix the price of the cattle. The The major factor influencing a rancher’s decision to rancher can usually price the cattle any time between use price-risk management alternatives will be the the contract date and the beginning of the futures con- rancher’s view of market outlook and the risk of price tract month that is tied to the basis contract. If the declines. However, price-risk management may affect rancher sets the price immediately, the basis contract is the feasibility and/or profitability of the custom feeding converted to a fixed-price contract. Cash-forward con- enterprise by reducing the interest rate and/or equity tracts usually specify the month of delivery, with the requirements for financing feedlot cattle. Check with packer choosing the actual delivery date. your lender to see if use of risk management tools will Until the rancher “pulls the trigger” and sets the improve the financial arrangements available to you. price, a basis contract does not reduce cattle price risk. However, a rancher could buy an option in conjunction Steps Required to Feed Cattle with a basis contract to set a minimum price for the cat- There is little justification for putting cattle on feed except tle, and subsequently, fix the cash price at a higher level to make a profit. Step one in deciding whether or not to if the futures market rises before the cattle are market- feed cattle is to calculate either the necessary selling price ed. In some cases, basis contracts also specify that the to break even, or to figure potential profit. Step two per- cattle owner is responsible for freight to the packing tains to arranging the financing for the cattle, feed bills, plant. In that case, the basis level in the contract should and contract margins, and to develop a reasonable cash reflect both the relationship between cash and futures flow so that money is available when needed.

Table 3. Feedlot Budget # Example Your Values 1. Ranch weight of cattle (lbs). = 700 ______2. Ranch value of animals ($/cwt). = $78 ______3. Estimated shrink from ranch to feedlot (%). = 5.5 ______4. Transportation cost from ranch to feedlot ($/cwt). = $1.2 ______5. Laid-in cattle price. a.($/cwt) #2/(1-(#3/100))+#4 = $83.74 ______b.($/hd) #5a*(#1/100) = $586.18 ______6. Estimated gain (lbs/day). = 3.25 ______7. Estimated feed conversion (lbs feed/lb gain). = 6.3 ______8. Estimated days to market. = 140 days ______9. Estimated final weight. #6*#8+(#1*(1-(#3/100))) = 1,116.5 ______10. Interest rate on capital (%). = 10 ______11. Death loss: a._____ (%), b. ($/hd). #5b*(#12a/100) = $4.40 (#11a=0.75) ______12. Veterinary and processing costs. = $5.00 ______13. Estimated feed price, 0% moisture ($/cwt). = $7.25 ______14. Estimated feed cost ($hd). #6*#7*#8*(#13/100) = $207.82 ______15. Yardage cost: a._____ ($/hd/day), b. ($/hd). #8*#15a = $7.00 (#15a=.05) ______16. Interest on cattle and vet ($/hd). (#5b+#12)*(#10/100)*(#8/360) = $22.99 ______17. Interest on feed and yardage ($/hd). (#14+#15b)*0.5*(#10/100)*(#8/360) = $4.18 ______18. Total cost per animal ($/hd). #5b+#11b+#12+#14+#15b+#16+#17 = $837.57 ______19. Pay weight: a. shrink (%) _____, b. (lbs). #9*(1-(#19a/100)) = 1,071.8 (19a=4) ______20. Break even cost. #18/#19b = $78.14/cwt. ______21. Expected selling price ($/cwt). = $79.00 ______22. Expected profit ($/hd). #21-#20*(#19b/100) = $9.22/head ______

4 218 Beef Cattle Handbook Authors: Donald Gill, Animal Scientist, Oklahoma State University Kent Barnes, Animal Scientist, Oklahoma State University Keith Lusby, Animal Scientist, Oklahoma State University Derrell S. Peel, Ag Economist, Oklahoma State University

This publication was prepared in cooperation with the Extension Beef Cattle Resource Committee and its member states and produced in an electronic format by the University of Wisconsin-Extension, Cooperative Extension. Issued in furtherance of Cooperative Extension work, ACTS of May 8 and June 30, 1914.

BCH-8040 Ranchers’ Guide to Custom Cattle Feeding

BCH-8040 219 5 Beef Cattle Handbook

BCH-8050 Product of Extension Beef Cattle Resource Committee

Factors Affecting Cattle Feeding Profitability and Cost Of Gain

Martin L. Albright, Ag Economist, Kansas State University Michael R. Langemeier, Ag Economist, Kansas State University James R. Mintert, Ag Economist, Kansas State University Ted C. Schroeder, Ag Economist, Kansas State University

Cattle feeding is a risky business. The variability in cattle chase price, placement weight, days on feed, total gain, feeding profit for steers in two western Kansas feedyards daily gain, sale weight, feed conversion (as fed), yardage placed on feed from January, 1980, through May, 1991 is charges, feed cost, feed consumption (as fed), feeding illustrated in Figure 1. Monthly average steer feeding PROFIT ($/hd) profit ranged from a loss of $100 per head to a gain of 175 $165 per head. The monthly average cost of gain for the 150 same group of steers varied from $38 cwt. to $65 cwt. 125 Changes in cattle prices, feed prices, and perfor- 100 mance are significant factors contributing to fluctuations 75 in cattle finishing cost of gains and profits. Approxi- 50 25 mately 93 percent of the variability in cost of gain over 0 time can be explained by changes in corn prices, feed -25 conversions, and daily gains (1). Further, 93 to 94 per- -50 cent of steer feeding profit risk can be accounted for by -75 fed steer prices, feeder prices, corn prices, interest rates, -100 -125 feed conversions, and daily gains (1). Because all of 80 81 82 83 84 85 86 87 88 89 90 91 these factors are important in explaining the risks of cat- YEAR AND MONTH PLACED ON FEED tle feeding, producers should consider them when developing budgets, calculating break-even points, or Figure 1. Monthly average steer profit for steers placed at 700-799 placing cattle on feed. lbs.

Feedyard Closeout Study cost per pound of gain, fed cattle sale price, and process- Results from the recent study (1) conducted at Kansas ing date. The feeder steer price was not available for all State University (KSU) can be used to identify the most closeouts, so the average Dodge City, Kansas cattle auc- important factors affecting cost of gain and profitability. tion price (4) for the week the steers were placed was This study utilized closeout data on 6,696 pens of steers used. Average corn prices during the placement month at two western Kansas custom feedyards placed on feed were obtained from Agricultural Prices (3). Interest rates from January, 1980, through May, 1991. Only pens of on feeder cattle loans were obtained from the Federal steers weighing between 600 and 899 lbs. at placement Reserve Bank of Kansas City (2). were used. The steers were divided into three 100-lb. Profits averaged from $25.38 to $27.28 per head for placement weight categories. Information collected from the three placement weight groups in the KSU study. the closeouts included placement date, feeder cattle pur- Feed conversion ranged from 8.24 lbs. of feed for lighter

BCH-8050 220 1 placements to 8.57 lbs. of feed per lb. of gain for heavier percent of the variation in cost of gain for lightweight weight placements, reflecting the reduced feed efficien- placements and 33 percent for heavier placed steers. cy of feeding heavier weight cattle. The heavier placed Feed conversion is more crucial to heavyweight steers steers gained 3.25 lbs. per day, while the rate of gain for because they are not as efficient as lighter weight steers. lighter placed steers was 3.06 lbs. per head per day. Finally, average daily gain accounted for 2.6 percent Average feeding cost of gain ranged from $48.66 to to 3.1 percent of the volatility in cost of gain. The daily $50.08 cwt. for the three placement weight groups. rate of gain is more important for lighter placed steers as they are on feed for a longer period of time. Cost of Gain Feeding cost of gain consists of feed costs, veterinary Steer Feeding Profitability costs, processing and yardage fees, interest charges, and Net returns to steer feeding are susceptible to risks from miscellaneous costs. The primary performance factors fluctuating feeder and fed cattle prices, feed prices, cattle affecting cost of gain are average daily gain, feed conver- performance, and interest rates. These factors should be sion, and death loss. Cattle performance, feed grain considered when determining budget projections and prices, and forage prices all influence feed costs—the contemplating placing cattle on feed. Rising feeder cattle largest component of cost of gain. Feed costs will rise as prices, feed grain prices, interest rates, and poor cattle a result of higher feed conversion rates or death loss. performance increase costs and break-even levels. A Conversely, feed costs decline as rate of gain increases. depressed fed cattle market will decrease the amount of Increases in veterinary costs and cattle health problems gross revenue a producer will receive. both increase feeding cost of gain. The profit distributions across the three placement weight categories for the January, 1980, through May, Factors Affecting Variability in Cost of Gain 1991 placement period are depicted in Figure 2. Profits Approximately 93 percent of the variability in steer feed- ranged from a negative $134 per head to a positive ing cost of gain over time was explained by corn price, $199 per head. Average profits were in the $0 to $100 feed conversion, and average daily gain. The relative per head range in approximately 58 to 65 percent of contribution of these factors to the volatility of steer the 137 months in the study. feeding cost of gain are shown in Table 1. Changes in During 5 percent of the months, steer feeding profits corn prices explained the greatest amount of cost of gain for 600-799 lb. placements averaged more than $100 per variability for all placement weights. Corn price accounted for 67 percent of the variability in cost of gain for Percent of Months (%) steers placed at 600-699 lbs. and 58 percent for steers 25 placed at 800-899 lbs. Corn price is relatively more 600 to 699 lb. 20 Placements

Table 1. Percent of Steer Feeding Cost of Gain Variability Over 10 Time Attributable to Selected Factors, January 1980 - May 1991. 5

Explanatory Placement Weight 0 Variable 600/699 700/799 800/899 25 700 to 799 lb. Placements lbs. lbs. lbs. 20 ------%------15 Corn Price 66.9 65.1 58.4 Feed Conversion 22.9 25.7 32.8 10

Daily Gain 3.1 2.6 2.6 5 Total Explaineda 92.9 93.4 93.8 b 0 Unexplained Variability 7.1 6.6 6.2 25 800 to 899 lb. Placements 20 a Total explained variability is cost of gain variability explained by 15 the explanatory variables. 10 b Unexplained variability is 100 minus total explained. 5

0 -125 -100 -75 -50 -25 0 25 50 75 100 125 150 175 200 important for lighter placed steers as they require more Profit ($/head) grain to reach processing weight than heavier placed steers. Figure 2. Monthly average fed steer profit distributions by weight Feed conversion is the second most important factor category. in determining cost of gain variability. It explained 23

2 221 Beef Cattle Handbook head. Profits for 800-899 lb. placements were greater Table 2. Percent of Total Explained Steer Feeding Net Return than $100 per head during 7 percent of the months. Variability over Time Attributable to Selected Factors, January Downside risk varied among placement weight cate- 1980 - May 1981. gories. In 34 percent of the months, 800-899 lb. placements were not profitable; in 32 percent of the months, Explanatory Placement Weight 700-799 lb. placements realized losses, as did 29 percent Variable 600/699 700/799 800/899 of the months for the lightest weight category. lbs. lbs. lbs. ------%------Factors Affecting Profit Variability Fed Price 54.3 54.2 38.0 About 93 to 94 percent of the variability in steer feeding Feeder Price 16.9 24.8 41.6 profit over time was explained by fed price, feeder steer Corn Price 15.9 8.9 6.3 price, corn price, interest rates, feed conversion, and aver- Interest Rate 2.2 1.0 0.0 age daily gain. Table 2 reports the relative contributions of Feed Conversion 3.1 3.5 4.8 these factors to the risks associated with steer feeding Daily Gain 0.4 1.4 3.7 profitability by placement weight. Together, fed and feeder steer prices explain 71 to 80 percent of profit risk. This emphasizes the importance producers need to place on Total Explaineda 92.8 93.8 94.3 cattle prices when developing budgets and preparing pro- Unexplained Variabilityb 7.2 6.2 5.7 curement and marketing strategies. Further, management of purchase prices is more important for heavyweight a Total percentage of variability in net return explained by variabili- steers since the impact of purchase price on profitability ty in the explanatory variables. increases as placement weight increases. Conversely, the b Unexplained variability is 100 minus total explained. effect of fed cattle price is greater for lighter placements as they require more days on feed, allowing for greater fluctuations in fed cattle price. input price risk. The next most important factor in explaining profit risk is corn price. Movements in corn price had the greatest impact on the profitability of lightweight steers, as they will consume more feed during the finishing Acknowledgements period than heavyweight cattle. The authors acknowledge the generosity of the two Feed conversion was the next most important ele- anonymous feedyard managers for providing data. ment, accounting for 3 to 5 percent of net return risk. Finally, the combination of average daily gain and inter- References est rates explains 2 to 4 percent of profit variability. Rate 1. Albright, M.L., T.C. Schroeder, M.R. Langemeier, J.R. of gain is more important for heavier placements as Mintert, and F. Brazle. 1993. Cattle Feeding Profit and they need to gain the last expensive pounds as quickly Cost of Gain Variability Determinants. The as possible. Professional Animal Scientist, 9:138-145. 2. Federal Reserve Bank of Kansas City. Various Issues. Management Recommendations Regional Economic Digest. Cattle prices, feed prices, and performance are important 3. Kansas Agricultural Statistics. Various Issues. in accounting for the risks of feeding cattle. Thus, produc- Agricultural Prices. ers should consider these factors when developing bud- 4. United States Department of Agriculture, gets, calculating break-even points, or placing cattle on Agricultural Marketing Service. Various Issues. LS- feed. Break-even price calculations should be calculated 214, Dodge City, Kansas. for a range of feeder cattle prices, corn prices, and performance measures when placing cattle. The information from this sensitivity analysis can be incorporated into production and marketing plans. Because 38 to 54 percent of the variation in profits is attributable to movement in sale prices, cattle feeders should consider actively managing fed cattle price risk through forward cash contracts, hedging, or the use of options. Moreover, anecdotal evidence suggests that many cattle feeders do not attempt to manage feeder cattle or feed price risk. Results from the KSU study indicate that 33 to 48 percent of the variation in cattle feeding margins is attributable to movement in feeder cattle prices and corn prices. As a result, cattle feeders should strongly consider attempting to manage their

BCH-8050 222 3 Authors: Martin L. Albright, Ag Economist, Kansas State University Michael R. Langemeier, Ag Economist, Kansas State University James R. Mintert, Ag Economist, Kansas State University Ted C. Schroeder, Ag Economist, Kansas State University

BCH-8050 Factors Affecting Cattle Feeding Profitability and Cost Of Gain

4 223 Beef Cattle Handbook L-5356 (RM 1-9.0) 5-00 Beef Cattle Marketing Alliances

James D. Sartwelle, III, Ernest E. Davis, James Mintert and Rob Borchardt*

Ever-tightening profit margins and recurring cyclical downturns in cattle and calf markets have forced many cattle producers to search for ways to make their operations more profitable. Of course, cutting the costs of production is one way. However, a new concept called “strategic alliance,” a way to increase revenues through vertical affiliations, is being widely discussed as a route to a more finan- cially stable ranching operation. Alliance is defined by Webster as “an association to further the common interests of the members.” In the past 10 years many producer groups have worked to secure marketing agreements with beef packers. Many of these agreements, or alliances, are available to many beef cattle producers. Beef carcass alliances (BCAs) can be grouped into three broad categories: breed association-sponsored, commercial, and natural/implant-free. In addition to these categories, two types of beef carcass targets have emerged. One is a high quality grade target with an acceptably muscled carcass. The other target includes animals that excel in red meat production with acceptable quality grades. BCAs will be identified here by category and the appropriate carcass target. Carcass Alliances Endorsed by Breed Associations Several purebred cattle associations have established programs to encourage commercial cattlemen to use their breed’s bulls by providing additional marketing angles for their progeny. This category was dominated by British breeds (Angus, Hereford, Red Angus) for several years; recently, however, some Continental breeds have entered the field. Most of these programs target high quality beef production. The American Hereford Association (Certified Hereford Beef), American- International Charolais Association (Beef-Charolais), Red Angus Association of America (Red Angus Feeder Cattle Certification Program/Supreme Angus Beef), American Gelbvieh Association (Gelbvieh Alliance), and North American Limousin Foundation (Limousin Grid) all offer direct access to carcass pricing devices that are at least partially negotiated by association personnel. (For a sample carcass pricing grid and a more detailed introduction to the concept, please see “Fed Cattle Grid Pricing,” RM1-11.0 in this series.) agement E an duc Certified Angus Beef (CAB, established by the American Angus M at k io Association in 1978) is one of the oldest and best known of the is n R BCAs. This program is dissimilar from most breed association programs in that CAB doesn’t directly price cattle on a grid system. Rather, it identifies carcasses that meet several criteria for CAB designation and allows other value-oriented marketing programs to use CAB as a valuation tool. In addition to fed cattle marketing programs, most beef breed associations have developed commercial marketing programs that ª range from listing feeder cattle for sale to sponsoring group marketing ventures such as special sales. Judging from the proliferation of marketing services launched in the past few years, stiffening competition among

*Extension Program Specialist-Risk Management, and Professor and Extension Economist, The Texas A&M University System; Extension Agricultural Economist, Kansas State University; and Extension Program Page 76 of 104 Specialist-Risk Management, The Texas224 A&M University System. breeds for commercial bull buyers will ensure a data analysis, and improved herd management healthy array of options in the future. programs. Producers might work together to cut production costs and effect an even greater Commercial Carcass Alliances change in profitability. For example, some Many firms now offer BCAs to cattle produc- alliance managers are developing connections ers. These firms offer grids or marketing between seedstock producers and commercial arrangements that fit the high quality beef target cow-calf operators who market cattle through and/or the red meat yield target. Most of these their alliances. One program has offered bonus firms create their niche with cattlemen who are coupons worth $3 per head for each source-veri- likely to produce certain types of carcasses and fied animal, consigned and fed on a retained beef procurers who merchandise that type of ownership basis, that grades Prime and/or quali- beef. The firms that put such alliances together fies for the Certified Angus Beef program. Those are usually paid for this service by producers, bonuses can be used toward the purchase of with fees for feedlot performance information bulls at an alliance-affiliated seedstock sale. and/or carcass quality information. Services such as these will likely be common in the future. Firms/alliances in this category include Angus America, Angus GeneNet, Farmland Supreme The Future of Beef Carcass Alliances Beef Alliance, HiPro Producer’s Edge, U.S. One difficulty with natural/implant-free BCAs Premium Beef, and Western Beef Alliance. In is the trade-off between “all-natural” beef pro- addition to providing access (for a fee) to a beef duction and feedlot performance. The producer processor’s carcass pricing mechanism, some of who joins one of these BCAs must weigh the firms/alliances offer other services to mem- increased animal morbidity and mortality bers. These include discounted semen or bull (because of the prohibition of antibiotics) and purchases from carcass-proven sires, members- decreased feedlot gain and feed efficiencies only replacement heifer and feeder cattle sales, (because of the lack of growth-promoting and listings of “approved” feedyards. implants and/or feed additives) against potential Natural/Implant-Free Carcass Alliances carcass premiums for the cattle that actually ful- fill alliance specifications. BCAs that target all-natural, implant-free beef production were among the first programs. USDA has recently mandated that entities Many of them have been in existence more than claiming to market a source-verified product 10 years. Their business has greatly increased in must file and maintain a Product Quality recent years and many of their innovations have Control protocol. This requirement could affect been adopted by other programs. While these BCAs that market breed-specific products. Breed alliances are all offered by commercial interests, association-sponsored BCAs would seem to have their “all-natural” orientation places them in a the upper hand in verifying the parentage of different classification. Generally, these agree- individual animals. In time, BCAs that require ments aim for the red meat yield target. (or limit) a certain percentage of different breeds Examples of these alliances are Coleman’s or breed types will have to prove to the USDA Natural Meats, Laura’s Lean Beef, Maverick that they can verify the sources of their partici- Ranches Beef, and B3R Country Meats. pating cattle. Common features of these marketing pro- Although the number of head currently grams are prohibitions against various common- slaughtered under alliance programs is a very ly used medications or growth enhancers small portion of the total slaughter, most (implants). Some programs also ban the use of alliance marketing managers report that the ionophores and other feed additives. number of cattle enrolled in their programs is increasing. BCAs that consistently return higher Targeting health-conscious consumers, the prices than cash markets to participating produc- grid pricing structures encourage the production ers will most likely continue to expand. How- of lean carcasses. Significant premiums are ever, most, if not all, BCAs rely on the regular given for Yield Grade 1 and 2 carcasses. Some production of sufficient quantities of cattle that programs even discount carcasses that grade meet narrow live and carcass specifications and, USDA Prime. in turn, satisfy supply quotas with the packer. If a producer is to prosper in the long run by mar- What Else Could Alliances Offer? keting cattle under these types of premium and While most alliances have concentrated on discount schedules, he must be able to fine tune marketing and price enhancement strategies, the genetic makeup of the cowherd to “hit the producer groups might also organize input pro- specs” with a degree of regularity while main- curement, production cost analysis, performance taining flexibility in the cowherd to adjust to Page 22577 of 104 changing trends. More consistent, improved Beef Carcass Alliances and Risk genetics does not come without a cost, and producers must weigh these costs against the poten- Under grid pricing programs, performance tial benefits of participating in these programs. risk lies with the cattle feeder/seller. That is, premiums and discounts are not assessed until Advice to the Producer: Maintain the live cattle have been processed and carcass- Flexibility es evaluated. Sound risk management dictates that producers have some idea how their cattle Many producers have the attitude that they are likely to perform, both in the feedlot and at will produce specific cattle for specific carcass the carcass level, before enrolling a significant targets if, and only if, there are clear economic portion of their production in an alliance. There incentives. Other producers are refining their are Extension programs across the country that herds’ genetic makeups with full faith that car- can help producers send sample calves through cass price premiums already exist. One fact feedlots and get information on feeding perfor- upon which all producers can agree is that formance and carcass quality. While no sample is mula pricing systems, whether based on quality perfect, many producers have learned a lot or red meat yield, are constantly changing. about the cattle they produce through such pro- Genetic change, however, does not happen grams. This could be the first step in determin- quickly. The average producer will turn only six ing whether you have the type of cattle to fit or seven generations in his herd in his lifetime. certain alliance programs and their pricing grids. Producers cannot be expected to constantly change the genetics of their herds in hopes of When comparing different pricing structures, hitting some specification marketing program remember that different grids use different base that may or may not exist in the future. prices (for example, plant average prices versus USDA-reported regional prices) and different Producers must maintain flexibility while base grades (for example, one grid uses USDA developing the herd genetics that appears to be Choice as a base and discounts cattle that grade the most economically viable in the short term. USDA Select, while another grid uses Select as a In short, producers might be best served by base and awards premiums to cattle that grade developing cattle that can produce progeny for Choice). Examine the pricing structures and either the high quality target or the red meat make sure you are making accurate compar- yield target, as situations dictate. This is not isons. contradictory. On the Great Plains, for example, a producer could develop a cowherd of moder- The same performance and financial risks ate framed, Angus x Hereford Black Baldy faced by a producer considering traditional females selected for maternal and fertility traits. retained ownership programs also face a produc- On the Gulf Coast, a producer could develop a er considering a BCA. Please consult “Retained Brahman x Hereford or Brahman x Angus based Ownership Strategies for Cattlemen,” RM1-3.0 herd. If market trends indicate premiums for in this series, for more information. high quality targets, either producer could breed Many breed associations and commercial enti- those cows to British bulls with high marbling ties maintain listings of alliance program contact traits. If the signals indicate premiums for cattle information on their web sites. One such site is that excel in lean, red meat production, the pro- http://www.beefshorthornusa.com/logo/beef.html. ducers could breed the same cows to heavy This is the official site of the Amercian muscled, Continental sires. With at least a 2- Shorthorn Association. year lag between making breeding decisions and marketing finished steers and heifers, it is appar- ent that a producer must have a sound understanding of industry trends and directions.

Page 22678 of 104 Partial funding support has been provided by the Texas Wheat Producers Board, Texas Corn Producers Board, Texas Farm Bureau and the Houston Livestock Show and Rodeo.

Page 22779 of 104 L-5246 RM1-3.0 5-99 Retained Ownership Strategies for Cattlemen

Ernest E. Davis, James McGrann and James Mintert*

Market Integration Market integration, or retained ownership, involves carrying over a production activity into the next phase of preparation for the marketplace. There are certain advantages associated with this production and marketing strategy. Retained ownership through the stocker/feeder and finishing phase eliminates some trading points, which can lower procurement, transportation and selling costs. Cattle or calves may still be moved, but without the stress of being cycled through regular market channels. Such cattle can be shipped directly to the place where they will be grazed, backgrounded or finished in a feedlot. Retained ownership also allows producers to spread risk from one production activity to another and from one period of time to another. Cattle producers should seriously investigate the possibilities of retained ownership and then elect the alternative that most closely meets their profit objectives. History reveals that between birth and slaughter, someone will often profit from cattle before they reach slaughter weight. One of the objectives of retained ownership is to take advantage of this tendency. During certain periods and conditions, retaining ownership can be, and has been, more profitable than selling calves at weaning. Ranchers must carefully evaluate each decision period, because by retaining ownership they are assuming more production and marketing risks. If the producer misjudges future market conditions, or if the cattle are not properly contracted, retaining ownership can cause an accumulation of losses rather than profits. There are other important conditions to consider when deciding whether to retain ownership. First, retaining ownership will increase management and decision-making requirements. More capital will be required for the additional production expenses. The cattle producer’s cash flow will change because retained ownership delays income and adds production costs. Producer Size agement E Many cattle producers do not have enough calves of similar an duc M at kind at one time to use the retained ownership strategy. Usually k io is n 100 head are required for a pen at most commercial feedyards. R But this should not deter you from using this strategy when trying to make a profit. Producers can form marketing associations, cooperatives or partnerships to put together the necessary cattle. In some cases, it may be feasible to sort and com- mingle calves or feeder cattle into lots large enough to achieve this minimum size, thus making retained ownership a feasible alternative. ™

*Professors and Extension Economists, The Texas A&M University System; and Extension Agricultural Economist, Kansas State University Agricultural Experiment Station and Cooperative Extension Service.

228 The First Decision Point Table 1 illustrates the effects of cost of gain and total pounds of gain on cattle break-even The most important piece of information for prices. The table assumes you are grazing or making marketing decisions comes from you, backgrounding a 500-pound stocker calf with a the producer. It’s important to know your indi- value at the program’s outset of $80 per hun- vidual production costs for each stage of produc- dredweight. Costs of gain are given in units of tion. Sometimes cattle producers pass up profit $5 per hundredweight, beginning at $35 and opportunities because they do not know their increasing to $55. If, for example, the stocker own production costs and, as a result, are gained 200 pounds during this period at a cost unable to project profitability accurately in the of $40 per hundredweight, the break-even price next production phase. For example, if at wean- at the program’s end would be $70.29 per hun- ing time a cow-calf producer determines that a dredweight, including interest charges on the profit is not available on the cash market, nor calf and other feeding costs. As one would has it been locked in by contracting calf sales, expect, the price per hundredweight required to the logical strategy is to maximize returns from break even is below the calf’s per hundred- that point on. Although the initial production weight price at the program’s outset because of phase, in this case the cow-calf stage, may not the lower cost of gain. Also note that as the total be profitable, it’s possible the cattle enterprise’s pounds of gain during the feeding program total profitability may be improved by retaining increase, you can tolerate a larger price rollback. ownership into the next production phase. But to accurately assess profitability, you need to be able to project costs for the next production phase. Table 1. Break-even prices for a 500-pound calf grazed to different endpoint weights at Buy-Sell Price Relationships various costs of gain.1 One reason some cattle producers have not Costs of gain $/cwt. used retained ownership strategies more often is Pounds to avoid the adverse buy-sell price situations gained 35 40 45 50 55 associated with buying lighter calves and selling heavier cattle. Generally, as cattle gain more Break-even prices $/cwt. weight their price per pounds drops, or as a 100 73.45 74.29 75.13 75.97 76.81 term commonly used in the industry implies, 150 70.96 72.13 73.29 74.46 75.63 the price “rolls-back.” This means that producers will generally sell heavier weight feeder cattle at 200 68.85 70.29 71.74 73.19 74.64 a price per hundredweight that is lower than the 250 67.03 68.72 70.42 72.11 73.81 price per hundredweight they are accustomed to 300 65.45 67.36 69.28 71.19 73.10 receiving for lighter weight calves. 1500-pound calf at $80.00 per cwt.; costs of gain include all Cost Considerations production, management, marketing, finance and transportation costs. Even with price roll-backs, retained ownership programs can be profitable. An important consideration in determining whether or not to retain ownership of a group of cattle is the relationship between calf prices and cost of gain. Knowing this enables you to determine the required price relationship between the beginning and end of the production period. For example, if expected costs of gain exceed weaned calf prices, the sale price at the end of the production period will need to be above the weaned calf price at the program’s outset. If costs of gain are less than weaned calf prices, some roll-back in prices of feeder cattle can be endured without suffering a loss.

229 Table 2 provides break-even prices for 750- It may at first appear to be a difficult task to pound feeders entering a feedlot at a price of access such information, but it is not. Much of $68 per hundredweight. Once again, costs of the information is available at little or no cost gain and total weight gain are allowed to vary. through the U.S Department of Agriculture, the Finishing a 750-pound animal to 1,150 pounds Extension Service or cattlemen’s associations. at $55 direct cost of gain would require a $65.45 The next step is to determine what factors are break-even price with interest. Interest is having the most impact on the current market charged on the full cost of the feeder and all and to watch those trends carefully. other costs, adjusted for the time the cattle are One of the simplest ways to monitor market on feed. conditions is to subscribe to weekly or monthly newsletters with analyses of current trends and Table 2. Break-even prices for a 750-pound factors that affect the markets. Such newsletters feeder fed to different endpoint weights at are available through Extension Services or vari- different costs.1 ous commercial consulting firms. These resources may help you fine-tune your market Costs of gain $/cwt. awareness and decision-making skills. Examples Pounds of these newsletters are the K-State Ag Update gained 50 55 60 65 70 from the Kansas State University Cooperative Break-even prices $/cwt. Extension Service (via subscription, or free on the Internet at http://www.agecon.ksu.edu/ 300 64.38 65.83 67.28 68.73 70.18 livestock), and Texas Livestock Roundup 350 64.01 65.63 67.24 68.86 70.47 (http://livestock-marketing.tamu.edu) from the 400 63.68 65.45 67.22 68.99 70.76 Texas Agricultural Extension Service. 450 63.38 65.30 67.21 69.12 71.04 Financial Considerations 500 63.12 65.17 67.21 69.26 71.30 Retained ownership increases capital require- 1750-pound calf at $68.00 per cwt.; costs of gain include all pro- ments and delays income. This must be consid- duction, management, marketing, finance and transportation ered and some adjustment to cash flow expecta- costs. Average daily gain of 3 lbs. per day assumed. tions must be made if retained ownership is going to be successful. You may need to prepare Information Sources a balance sheet, projected income statement, cash flow, and a marketing plan before the It is essential that cattlemen have good infor- lender will provide the additional capital mation on current conditions and trends in the required for increased production costs and livestock, grain and meat sectors as they become delayed income. Some lenders may require that involved with retained ownership strategies. a portion of the cattle be hedged before lending They must also be current on consumer eating additional capital. trends, as well as the general conditions of the U.S. and world economies. Feeding Arrangements Trends in domestic cattle numbers and prices In today’s cattle industry, leased grazing and should be considered before deciding whether custom feeding are options available to most cat- or not to retain ownership. Cattlemen should be tlemen. In both options there are various aware of the size of the U.S. cow herd and the arrangements for assessing charges. The two calf crop and also have some knowledge of the most common methods are a fixed charge based current cattle cycle. Perhaps the most important on cost of gain, and the sale of feed and ser- piece of market information to consider is vices. These two approaches differ primarily in whether cattle prices are expected to rise or fall, the way risk is shared between the feeder and as a function of the cattle cycle. Generally, cattle owner. Under a fixed cost of gain arrange- retained ownership strategies will work best ment, the cattle owner shares in the risks of when cattle prices are expected to rise cyclically death loss and assumes all the risks of falling over the course of the feeding period, although cattle prices, whereas the custom grazier or retained ownership can still be profitable even feeder shares in the death risks and assumes all without a significant rise in price level. the risks of poor cattle performance, bad weather, poor facilities, sickness, rising feed costs,

230 weight shrink and management. If the feeder If cattle are being fed in one year and sold in simply sells feed and services to the cattle the next, prepayment of feed and production owner, virtually all of the risks are shifted away expenses, not to exceed 50 percent of the total, from the feeder to the cattle owner. Very few may be charged against income received during commercial cattle feeders will feed cattle for a the year the cattle were placed on feed. This fixed cost of gain, but it is not uncommon for allows cattlemen some flexibility in planning custom graziers or custom backgrounders to their taxable income and tax liabilities from one offer a fixed cost of gain program. The relative year to the next. merits of the two approaches to custom feeding depend on the individual situation, but be aware Decision Aids of the big difference in the risk profile under the The Texas Agricultural Extension Service has two approaches. computer software that helps prepare financial Tax Advantages statements, set up retained ownership budget- ing, and summarize closeouts. This software can Retained ownership also offers cattle produc- be obtained from Extension livestock marketing ers some flexibility in managing their annual and management economists or on the Internet income tax liabilities. By retaining ownership, a at http://agecoext.tamu.edu/irm-spa/irm-spa.htm. producer may transfer taxable income from one For estimating returns in a cattle feeding year to the next. This may be especially useful program, you may obtain a copy of publication in years when sales have been high. It is possi- C-734, “Seasonality in Steer Feeding Profitability, ble that some sales can be carried over to the Prices and Performance,” from the Kansas State next year at reduced risk by using futures or University Cooperative Extension Service. It is options contracts. It is important to discuss these available at county Extension offices in Kansas options with your financial advisor. or on the Internet at http://www.agecon.ksu. edu/livestock.

Partial funding support has been provided by the Texas Wheat Producers Board, Texas Corn Producers Board, and the Texas Farm Bureau.

Produced by AgriLife Communications & Marketing, The Texas A&M System Extension publications can be found on the Web at: http://AgriLifebookstore.org

Educational programs of the Texas AgriLife Extension Service are open to all citizens without regard to race, color, sex, disability, religion, age or national origin. Issued in furtherance of Cooperative Extension Work in Agriculture and Home Economics, Acts of Congress of May 8, 1914, as amended, and June 30, 1914, in cooperation with the United States Department of Agriculture. Texas AgriLife Extension Service, The Texas A&M System. 1.5M, Reprint ECO

231 E-557 RM1-11.0 03-09

Risk Management Grid Pricing of Fed Cattle Robert Hogan, Jr., David Anderson and Ted Schroeder*

Grid prices, or value-based marketing, refers sell to? The answer to both questions is, “It to pricing cattle on an individual animal basis. depends.” The most critical factors that influ- Prices differ according to the underlying value ence the profitability of these decisions include: of the beef and by-products produced from 1) the quality and dressing percent of the cattle each animal. Schroeder et al. have reported that you produce; 2) the Choice-Select market price pricing fed cattle on averages is detrimental to spread; 3) production and feeding cost dif- the industry because it does not send appropri- ferences associated with targeting your cattle ate price signals to cattle feeders, stockers and, to a particular price grid or packer; and most ultimately, cow-calf producers. However, incen- important 4) your knowledge about the price/ tives to sell cattle on averages and problems quality distribution of your cattle and your (or associated with identifying beef quality have the feeder’s) ability to sort your cattle to meet inhibited the development of value-based pric- the criteria for a particular grid or formula. ing. Both cattle feeders and packers have been The following analyses focus on the price/ reluctant to change from a live animal pricing cattle quality relationship, without consider- system to a carcass pricing system. ing production costs. This is not to imply that Opportunities to profit from better match- production costs associated with attaining a ing fed cattle prices to value have encour- particular quality-related price incentive are aged packers, alliances and producers to use not important. They are critical to profitability. carcass-based pricing. Now, there are several However, production costs differ with produc- value-based fed cattle pricing systems, includ- ers and cattle types and are not explicitly evalu- ing formula pricing, price grids and alliances. ated here. Is there one “best” pricing method? How are live weight, dressed weight and grid or formula Cattle Pricing Methods prices related? The purpose of this publication Fed cattle usually are priced in one of three is to help producers decide which form of fed ways: 1) live; 2) dressed weight or “in the beef;” cattle pricing may be most profitable for them. or 3) carcass grade and yield or grid pricing. Is Carcass Merit Pricing For You? Live Cattle Pricing Should you market your cattle on a carcass When fed cattle are priced on a live basis, merit basis? If so, does it matter which pricing price is generally negotiated between the system you use or which packer or alliance you packer and the feedlot based upon the expected

*Assistant Professor and Extension Economist–Management, and Professor and Extension Economist–Livestock and Food Marketing, The Texas A&M System; and Professor and Extension Economist, Kansas State University.

232 value of the cattle when processed (a 4 percent pected quality and yield grade, weight premiums pencil shrink on the cattle from the feedlot to the and discounts, by-products, slaughter costs (seller packing plant is usually included). To establish generally pays transportation on dressed cattle a buy order, the packer starts with a base Choice sales), and the packer’s profit. carcass price and then adds or subtracts expected In principle, the dressed-weight price will be quality and yield grade premiums and discounts comparable to a live price adjusted for dressing associated with quality traits the pen of cattle are percentage for the same pen of cattle. In practice, expected to exhibit when processed. The adjusted the dressed price (after transportation costs) may carcass price is converted to a live animal price by be higher or lower because there are no errors in multiplying it by the expected dressing percent- estimating dressing percentage. Over time, across age. This live price is adjusted with by-product a large number of pens, the average dressed and hide values and further adjusted for slaughter price should be greater than the average dressing costs, transportation costs, and the packer’s profit percentage-adjusted live price, other things being margin1 to establish an estimated live animal bid equal. price. If packers can purchase a large number of Grid Pricing cattle from one location at one time, they may increase their bid price to reflect reduced transac- Pricing cattle on a grade and yield or grid basis tions and procurement costs. is essentially the same as pricing on a dressed- Pricing cattle on a live basis is appealing to weight basis, except that in addition to dressing some cattle feeders who want to maintain com- percentage, the seller assumes the risk of the plete flexibility in cattle pricing until the transac- quality and yield grade of each animal in the pen. tion price is established. Live pricing may also Many beef packers offer cattle producers the op- be preferred if the producer does not know the portunity to price cattle on a carcass grid basis. characteristics of the cattle or expects the dressing Most packer grids list a base price for a Choice, percentage, quality grade or yield grade to be be- yield grade 3, 550- to 900-pound steer carcass. For low average. However, because meat quality and example, a typical price premium and discount carcass dressing percentage are difficult to predict schedule offered by beef packers is shown in accurately on live animals, premiums and dis- Table 1. counts paid on a live basis generally do not reflect the true value of the final product. In other words, Table 1. Example grid, as presented by a packer high-quality cattle are often undervalued and ($/dressed cwt). low-quality cattle often overvalued. This gives Choice YG3 550- to 900-lb Base price producers no incentive to invest in better genetics Prime-Choice Premium 6.00 and produce a better product. CAB-Choice Premium 1.00 Dressed Weight Pricing Choice-Select Discount -9.00 When cattle are marketed on a dressed-weight basis, the cattle seller assumes the risk of dressing Choice-Standard Discount -18.00 percentage. Price is based upon the actual hot car- Yield Grade I 2.00 cass weight. The dressed price offered is similar Yield Grade II 1.00 to the live price bid in that the buyer starts with a Yield Grade IV -15.00 base Choice carcass price and adjusts it for ex- Yield Grade V -20.00 1 It’s important to note that the packer is not guaranteed a Light Carcasses (<550 lb) -19.00 profit. The cattle market is a competitive market where Heavy Carcasses (>900 lb) -19.00 packers still have to bid to get the cattle. That bidding sometimes is easier or harder. Packers do lose money, Dark Cutters -25.00 at times, when market conditions dictate that they pay Bullocks/Stags -25.00 more for the cattle than was profitable.

233 2 The assorted premiums and discounts are then The price received for each carcass is the base simply copied into the grid as shown in Table 2. price plus the particular premiums and discounts. For example, if the Choice, yield grade 3, 550- to Table 2. Example of grid premiums and discounts. 900-pound carcass price is $105.00/cwt, a Select, Quality Yield grade yield grade 4, 700-pound carcass would receive grades 1 2 3 4 5 a price of $81/cwt ($105.00/cwt - $24.00/cwt, the ($/cwt carcass) Select-yield grade 4 discount). The USDA reports a weekly survey summariz- Prime 6.00 ing selected beef packer grid premium and dis- CAB 1.00 count schedules. This report is on the internet at Choice 2.00 1.00 Base -15.00 -20.00 http://www.ams.usda.gov/mnreports/lm_ct155.txt (Na- Select -9.00 tional Weekly Direct Slaughter Cattle – Premiums and Discounts). The LM CT155 report is useful for Standard -18.00 understanding average grid price premiums and CARCASS WEIGHTS OTHER discounts being offered by packers, and for raising 550-900 lb Base Dark Cutter, etc. -25.00 awareness of the range of discounts and premiums. (105.00) Bullock/Stags -25.00 Table 3 illustrates how quickly net price can Less than 550 lb -19.00 decrease with yield grades 4 and 5 and with quality grades below Choice (Select and Standard). In More than 900 lb -19.00 this example, the discount from Choice to Select is a relatively severe $9/cwt. The discounts between Choice and Select quality grades typically range The rest of the grid is now filled in typically by from $1.00/cwt to $12.00/cwt, depending on the just adding premiums and discounts. For exam- supplies of Choice versus Select carcasses, the de- ple, to get the premium for Prime-Yield Grade 1, mand for each, and seasonal purchasing patterns add the $6.00 Prime premium and the $2.00 Yield and habits. (The weekly Choice-Select spread has Grade 1 premium to get $8.00. As another exam- been as large as $23.08 and as small as $0.68 over ple, to compute the discount for Select-Yield Grade the past 5 years.) There are usually large discounts 5, add the $9.00 Select discount and the $20.00 for Standard grade carcasses, dark cutter carcasses, Yield Grade 5 discount to get $-29.00. The entire and carcasses lighter than 550 pounds or heavier grid is shown in Table 3. than 900 to 950 pounds. Some grids also offer premiums and discounts for hide quality. Table 3. Example grid premiums and discounts. For many packers’ grids, price premiums and Quality Yield grade discounts are additive. That is, the base price is grades 1 2 3 4 5 adjusted in an additive manner for the associated ($/cwt carcass) characteristics of the carcass (as in our example Prime 8.00 7.0 0 6.00 -9.00 -14.00 above). For some packers, not all premiums and discounts in their price grid are additive. For CAB 3.00 2.00 1.00 N.A. N.A. example, some packers quote the same price for Choice 2.00 1.00 Base -15.00 -20.00 all Standard grade cattle regardless of yield grade. Select -7.0 0 -8.00 -9.00 -24.00 -29.00 The USDA grid summary report assumes additive discounts and premiums. In addition, this report Standard -16.00 -17.0 0 -18.00 -33.00 -38.00 is not volume-weighted and includes only packer- CARCASS WEIGHTS OTHER stated grids, not actual purchases. As a result, the 550-900 lb Base Dark Cutter, etc. -25.00 report does not represent market average grid (105.00) Bullock/Stags -25.00 prices. This is important to understand when Less than 550 lb -19.00 interpreting the USDA price report and comparing it with any particular packers’ grids you may be More than 900 lb -19.00 considering.

234 3 Summary of Pricing Methods whereas others were on a live weight basis based upon yields of the cattle slaughtered. Table 4 summarizes and compares issues as- Many packers have established base prices sociated with typical fed cattle pricing arrange- using plant average quality grades and dressing ments. Differences in the various methods are percentages of cattle slaughtered during the week. important because they use different kinds of Before agreeing to deliver cattle to a particular information and cause prices to differ even for the packer on formula or grid, the producer should same pen of cattle. The key is that as a producer understand in detail how the base price is calcu- moves from live cattle pricing to dressed-weight lated and obtain some base price quotes over time to grid pricing, it is increasingly important to from several packers. The producer does not want understand the type of cattle being marketed and any surprises at this point. the pricing system being used, and to assess prob- able net price received. Importance of Grid Over time, average cattle or cattle with little background information may sell better with live Premium/Discounts pricing. A somewhat better class of cattle may When selling cattle on price grids, in addition sell better with dressed pricing. First rate classes to considering base prices, cattle producers should of cattle whose characteristics are known by the carefully evaluate the price premium/discount producer may sell better by pricing on the grid. structures of various packers’ grids and determine which grid is most advantageous to them. Table 4. Assessing ways to sell fed cattle. Different grids may offer significantly different Cattle pricing method prices for the same quality of cattle. In addition, Producer pricing packers value traits differently. For example, one attribute Live Dressed Grid packer might not discount select cattle and another packer might not discount Yield Grade 4 as Pricing level pen level pen level animal much as another packer. level Pens of cattle that are fairly uniform generally Paid for quality No No Yes bring similar prices with different packer grids. Paid for yield No No Yes However, pens with even small percentages of Paid for dressing % No Yes Yes higher or lower grade carcasses, heavier or lighter animals, or more than the average number of Who pays trucking? Buyer Seller Seller “out” cattle (dark cutters, stags, bullocks, etc.) have much more variable prices. For this reason, Formulas: Importance of Base Price it is important for cattle producers to know their When fed cattle are priced on formula, an cattle, sort their cattle carefully for uniformity, important consideration, in addition to the and target them for specific packers. premium/discount structure, is the base price. Grid Price Determinants over Time In interviews with packers and cattle feeders, Schroeder et al. discovered several different types In addition to variability in prices across grids, of base prices being used. One was the average it is important that producers understand de- price of cattle purchased by the plant where the terminants of price differences over time. Small cattle were to be slaughtered. The average price changes in dressing percentage alter the relative of cattle was usually for the week prior to, or the advantages of selling on either a live or dressed week of, slaughter. Other base prices were specific basis. For example, with a $65/cwt live steer price market reports such as highest reported price for and a $102.50/cwt dressed carcass price, cattle a specific market for the week prior to, or week dressing higher than 63.4 percent will receive a of, slaughter. One base price was tied to live cattle higher price per head if sold dressed than if sold futures prices. Some base prices were negotiated. live, and cattle with a lower dressing percentage Some base prices were on a carcass weight basis, will receive a higher price on a live basis. With

235 4 these prices, a 1200-pound live steer will gain narrows based on seasonal patterns in relative $6/head in value for each 0.5 percent increase in supplies of Choice and Select cattle. Seasonal dressing percentage. demand patterns for different cuts and qualities Over time, one of the most important deter- also affect the spread. minants of price grid premiums and discounts Yield grade premiums and discounts have is the Choice-Select carcass price spread. The remained relatively stable over time for all greater the Choice-Select spread, the greater packer grids. Therefore, this pricing factor is the price discount for lower quality cattle. The expected to remain more predictable than the Choice-Select price spread varies over time as Choice-Select price spread. the cattle supply and demand for specific quality grades change. References There is a seasonal pattern to the Choice- Schroeder, T.C., C.E. Ward, J. Mintert and D.S. Select spread. It typically is the widest in May- Peel. “Beef Industry Price Discovery: A Look June and narrowest in February and again in Ahead.” Research Institute on Livestock August. The Choice-Select spread widens and Pricing, Research Bulletin 1-98, March 1998.

Partial funding support has been provided by the Texas Corn Producers, Texas Farm Bureau, and Cotton Inc.–Texas State Support Committee.

Produced by AgriLife Communications, The Texas A&M System Extension publications can be found on the Web at: http://AgriLifeBookstore.org. Visit Texas AgriLife Extension Service at http://AgriLifeExtension.tamu.edu.

Educational programs of the Texas AgriLife Extension Service are open to all people without regard to race, color, sex, disability, religion, age, or national origin. Issued in furtherance of Cooperative Extension Work in Agriculture and Home Economics, Acts of Congress of May 8, 1914, as amended, and June 30, 1914, in cooperation with the United States Department of Agriculture. Edward G. Smith, Director, Texas AgriLife Extension Service, The Texas A&M System. 236 L-5063 8-98

Using a Slide in Beef Cattle Marketing

Rick Machen and Ronald Gill*

Selling cattle well in advance of their delivery Up Slide date, or forward contracting, is a marketing An up slide is exercised when the weight of option available to beef producers. Such a trans- the cattle upon delivery is heavier than expect- action requires the seller to estimate the weight ed. Selling with an up slide locks in a maximum of the cattle prior to delivery. Weights estimated price (dollars per hundredweight or $/cwt) that at the time of sale and those recorded upon will be paid for the cattle. delivery often differ. Therefore, to ensure fair market value upon delivery, an adjustment of Example A the sale price is often necessary. In a mid-July sale, 600-pound calves con- The “slide” is a predetermined adjustment in signed for November delivery sell for $80/cwt. the sale price of cattle and is included in the The slide is $5/cwt. Calves will be weighed at contract (forward contracting) or in the descrip- the ranch with a 2 percent shrink. Upon deliv- tion of the cattle (video or Internet marketing) ery in November, the cattle average 630 pounds being offered for sale. It is based on the differ- per head. ence between the weight estimated prior to con- signment or contracting and the actual pay slide = $5/cwt weight. Pay weight is the actual live weight of slide weight = 600 lbs. the cattle upon delivery minus a “pencil” shrink. shrink = 2% This pencil shrink is negotiable and normally sale price = $80/cwt ranges from 2 to 4 percent. delivered weight = 630 lbs. Three slides are used: up, down or both ways. The seller decides the magnitude and direction. The slide will be exercised because the cattle Liveweight and the magnitude of the slide are were heavier than expected at delivery. inversely related; as liveweights increase, the slide will usually decrease. Calves (less than 600 shrink = 630 lbs. x 2% = 12.6 or 13 lbs. pounds) often are sold with a two-way slide. pay weight = 630 lbs. – 13 lbs. = 617 lbs. Sliding cattle both ways is particularly useful weight subject to slide = 617 – 600 = 17 lbs. when environmental conditions such as rainfall and forage availability can drastically affect 17 lbs. = 0.17 cwt weaning weights. The two-way slide protects the 0.17 cwt x $5/cwt = $0.85/cwt buyer if the cattle deliver heavier than expected, and ensures the seller will receive a fair market $80/cwt – $0.85/cwt = $79.15/cwt price if the cattle are lighter than expected. The weight of yearling cattle is more predictable; The extra 17 pounds (expressed as cwt) is therefore, yearlings are usually offered with an multiplied by the slide, yielding $0.85/cwt. The up slide only. $0.85/cwt is then subtracted from the sale price of $80/cwt to yield the actual price of $79.15 per hundredweight. The actual price paid for the cattle under this agreement is $488.36 per head. *Extension Livestock Specialists, The Texas A&M University System. 6.17 cwt (617 lbs.) x $79.15/cwt = $488.36

237 Down Slide A worksheet for evaluating the use of a down slide (line A is greater than line E) follows. A down slide is exercised when the delivered weight of the cattle is less than expected at the time of sale (contract). Selling with a down slide locks in the minimum price ($/cwt) to be paid Contract (Expected) Values for the cattle. A. Expected weight _____lbs. Example B B. Price _____$/cwt In a mid-June sale, 500-pound calves con- C. Pencil shrink _____% signed for October delivery sell at $90/cwt. The D. Slide _____$/cwt slide is $10/cwt. Calves will be weighed at the ranch with a 3 percent shrink. Upon delivery in Expected value October, the cattle average 480 pounds per [(A/100) – C] x B _____$/hd head. Actual Values slide = $10/cwt E. Scale weight (avg.) _____lbs. slide weight = 500 lbs. F. Pay weight shrink = 3 % (E/100) – C _____cwt sale price = $90/cwt delivered weight = 480 lbs. G. Weight subject to slide (A/100) – F _____cwt The down slide will be exercised because the H. Slide adjustment cattle weighed less than expected upon delivery. G x D _____$/cwt

pay weight = 480 lbs. – 3% = 466 lbs. J. Adjusted sale price B + H _____$/cwt 500 lbs. – 466 lbs. = 34 lbs. K. Price received This 34-pound (.34 cwt) difference is multi- F x J _____$/head plied by the slide ($10/cwt) to get $3.40/cwt, which is added to the sale price of $90/cwt to obtain the actual price of $93.40 per hundred- To evaluate an up slide (line A is less than weight. line E), calculations in lines G and J change as shown. 34 lbs. = 0.34 cwt 0.34 cwt x $10/cwt = $3.40/cwt $90/cwt + $3.40/cwt = $93.40/cwt G. Weight subject to slide $93.40/cwt x 4.66 cwt (466 lbs.) = $435.24 F – (A/100) ______cwt J. Adjusted sale price Therefore, the actual price received for the B – H ______$/cwt cattle is $435.24 per head.

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Educational programs of the Texas Agricultural Extension Service are open to all people without regard to race, color, sex, disability, religion, age or national origin. ?????? ?? ??????????? ?? ??????????? ????????? ? ??? ?? ??????????? ??? ???? ?????????? ???? ?? ???????? ?? ??? ?? ????? ?? ???????? ??? ???? ??? ????? ?? ??????????? ???? ??? ?????? ?????? ?????????? ?? ???????????? ?????? ?? ????? ? ??????? ???????? ? ????? ???????????? ????????? ???????? ??? ????? ??? ?????????? ??????? ????? ??????? ???????? ?? ? 238 E-496 RM2-1.0 01-09

Risk Management Introduction To Futures Markets James Mintert and Mark Welch*

Futures trading has a long history, both in the (CME) was formed in 1874 when the Chicago U.S. and around the world. Futures trading on Product Exchange was organized to trade butter. a formal futures exchange in the U.S. originated In each case the exchanges were formed because with the formation of the Chicago Board of commercial dealers in corn, wheat and butter Trade (CBOT) in the middle of the 19th Century. needed a way to reduce some of their price risk, Grain dealers in Illinois were having trouble which hampered the day-to-day management financing their grain inventories. The risk of of their businesses. Sellers wanted to rid them- grain prices falling after harvest made lenders selves of the price risk associated with owning reluctant to extend grain dealers credit to pur- inventories of grain or butter and buyers wanted chase grain for subsequent sale in Chicago. To to establish prices for these products in advance reduce their risk exposure, grain dealers began of delivery. In recent years futures contracts have selling “To Arrive” contracts, which specified proliferated, particularly in the financial arena, the future date (usually the month) a speci- as businesses become more aware of the price fied quantity of grain would be delivered to a risks they face and seek ways to reduce them. particular location at a price identified in the contract. Fixing the price in advance of deliv- What Is A Futures Contract? ery reduced the grain dealer’s risk and made it easier to obtain credit to finance grain purchas- A futures contract is a binding agreement be- es from farmers. The “To Arrive” contracts were tween a seller and a buyer to make (seller) and to a forerunner of the futures contracts traded take (buyer) delivery of the underlying commod- today. Although dealers found it advantageous ity (or financial instrument) at a specified future to trade what essentially were forward cash con- date with agreed upon payment terms. Most tracts in various commodities, they soon found futures contracts don’t actually result in delivery these forward cash contract markets inadequate of the underlying commodity. Instead, most trad- and formed futures exchanges. ers find it advantageous to settle their futures The first U.S. futures exchange was the Chi- market obligation by selling the contract (in the cago Board of Trade (CBOT), formed in 1848. case of a contract that was purchased initially) or Other U.S. exchanges also began in the last by buying it back (in the case of a contract that half of the 1800s. For example, the Kansas City was sold initially). The trader then completes the Board of Trade (KCBT) traces its roots to January actual cash transaction in his or her local cash 1876 when a precursor to today’s hard red wheat market. futures contract was first traded. Similarly, a Futures contracts are standardized with forerunner of the Chicago Mercantile Exchange respect to the delivery month; the commodity’s quantity, quality, and delivery location; and the

*Professor and Extension Agricultural Economist, Kansas State University Agricultural Experiment Station and Cooperative Extension Service, and Assistant Professor and Extension Economist–Grain Marketing, The Texas A&M System.

239 payment terms. The fact that the terms of futures Changes in a Futures contracts are standardized is important because it enables traders to focus their attention on one Contract’s Value variable, price. Standardization also makes it A futures contract’s value is simply the num- possible for traders anywhere in the world to ber of units (bushels, hundredweight, etc.) in trade in these markets and know exactly what each contract times the current price. Each con- they are trading. This is in sharp contrast to the tract specifies the volume of grain or livestock it cash forward contract market, in which changes covers. Both Chicago and Kansas City Board of in specifications from one contract to another Trade grain and oilseed futures contracts cover might cause price changes from one transac- 5,000 bushels. The CME’s live cattle futures con- tion to another. One reason futures markets are tract covers 40,000 pounds (400 hundredweight) considered a good source of commodity price of live weight steers. The lean hogs futures con- information is because price changes are attrib- tract covers 40,000 pounds (400 hundredweight) utable to changes in the commodity’s price level, of carcass weight pork and the feeder cattle not changes in contract terms. futures contract covers 50,000 pounds (500 hun- Unlike the forward cash contract market, dredweight) of feeder steers. To determine both futures exchanges provide: contract value and changes in contract value, • Rules of conduct that traders must follow examine the July KCBT wheat futures contract or risk expulsion on a day when the settlement price is $6.00 per • An organized market place with estab- bushel. The total contract value would simply be lished trading hours by which traders 5,000 bushels times $6.00 or $30,000. If the July must abide KCBT wheat futures price changes to $6.10 per • Standardized trading through rigid con- bushel the next day, the new contract value is tract specifications, which ensure that 5,000 bushels times $6.10 or $30,500. The change the commodity being traded in every in contract value is $30,500 minus $30,000, or contract is virtually identical $500. Alternatively, you can compute the change • A focal point for the collection and in contract value by simply multiplying the price dissemination of information about change per unit ($6.10-$6.00=$0.10/bushel) times the commodity’s supply and demand, the number of units in the contract ($0.10/bushel which helps ensure all traders have x 5,000 bushels= $500). equal access to information The effect of a change in contract value de- • A mechanism for settling disputes pends on whether you previously sold or pur- among traders without resorting to the chased a futures contract. A decrease in contract costly and often slow U.S. court system value (a price decline) is a loss to anyone who • Guaranteed settlement of contractual previously purchased a futures contract, but a and financial obligations via the ex- gain for a trader who previously sold a futures change clearinghouse contract. Conversely, an increase in contract value (a price increase) is a gain to anyone who The Purpose of Futures Markets previously purchased a futures contract (i.e., is long), but is a loss for a trader who previously Futures markets serve two primary purposes. sold a futures contract (i.e., is short). One trader’s The first is price discovery. Futures markets loss is another trader’s gain. For example, in the provide a central market place where buyers previous wheat futures example, a trader who and sellers from all over the world can interact purchased July KCBT wheat futures at $6.00/ to determine prices. The second purpose is to bushel saw the value of his futures market ac- transfer price risk. Futures give buyers and sell- count increase by $500 when the price rose to ers of commodities the opportunity to establish $6.10; a trader who sold a futures contract at prices for future delivery. This price risk transfer $6.00/bushel saw the value of his futures market process is called hedging.

240 2 account decline by $500. The $500 gain earned contract (typically less than 5 percent of contract by the futures contract buyer came from the fu- value), traders of futures contracts are relieved of tures contract seller’s $500 loss via the exchange the responsibility of worrying that the trader on clearinghouse, as outlined in Figure 1. the other side of the contract will default on his Futures contract performance is guaranteed or her financial obligations by the mark-to-mar- by the exchange through an institution known ket margin system and by a series of checks and as the exchange clearinghouse, which tracks balances put in place by the exchange to ensure the value of each trader’s position and ensures that sufficient funds are available to cover each that sufficient funds are available to cover each account’s risk exposure. trader’s obligations. The exchange clearinghouse requires that traders (via the futures Futures Trading Terminology Figure 1. Marking-to-Market Buyer and Seller Accounts To trade futures contracts you must become at Exchange Clearinghouse. familiar with the terminology used in the trade. Buyer (Long) Here are some terms and definitions. Date Action Price Long A buyer of a futures contract. Someone Day 1 Buy at $6.00/bu who buys a futures contract is often referred to as being long that particular Day 2 No action (but $6.10/bu contract. price increases) Short A seller of a futures contract. Someone who $0.10/bu gain sells a futures contract is often referred to x 5,000 bu as being short that particular contract. $500 gain Bull A person who expects a commodity’s price from day 1 to increase. If you are bullish about wheat Seller (Short) prices you expect them to increase. Date Action Price Bear A person who expects a commodity’s price to decline. If you are bearish about wheat Day 1 Sell at $6.00/bu prices you expect them to decline. Day 2 No action (but $6.10/bu Market An order to buy or sell a futures contract at price increases) order the best available price. A market order is executed by the broker immediately. “Sell $0.10/bu loss one July KCBT wheat, at the market” is an x 5,000 bu example of a market order. $500 loss Limit order An order to buy or sell a futures contract from day 1 at a specific price, or at a price that is more favorable than the price specified. For commission merchant or broker) deposit money example, “Buy one March KCBT wheat at before a trade to ensure contract performance. $6.30 limit” means buy one March KCBT wheat contract at $6.30 or less. In this This deposit is usually referred to as the initial example, the order will not be executed at a margin deposit. Each trader’s margin money is price higher than $6.30. maintained in a separate margin account, which Stop order An order which becomes a market order is adjusted daily to reflect the gain or loss in con- if the market reaches a specified price. A tract value that occurred that day. This process is stop order to buy a futures contract would sometimes referred to as “Marking-to-Market,” be placed with the stop price set above the because the account is adjusted to reflect its cur- current futures price. Conversely, a stop rent market value based on that day’s closing or order to sell a futures contract would be placed with the stop price set below the settlement price. Although the margin require- current futures price. ments are small relative to the total value of the

241 3 Using Futures Contracts in Futures contract prices also can be used as a source of price forecasts. A futures contract price a Farm Marketing Program represents today’s opinion of what a commod- There are a number of ways futures contracts ity’s value will be when the futures contract can be used in a farm marketing program. expires. If a history of the difference between a Futures contracts can be useful when marketing commodity’s futures contract and cash prices, grain or livestock because they can be a tempo- for a particular grade and specific location of rary substitute for an intended transaction in the interest (known as the basis) is available, it can cash market that will occur at a later date. This be used to estimate a futures market-based is a working definition of hedging. For example, cash price forecast. For example, assume that on if you plan on selling wheat for cash at harvest, March 15 the KCBT July wheat futures contract but would like to lock in the futures price ahead is trading at $6.00 per bushel, and your local of harvest, you could sell a KCBT July wheat cash market price at harvest is generally $0.40 futures contract as a temporary substitute for the per bushel below the KCBT July wheat futures cash grain you plan to sell in the future. When contract price (i.e., a basis of negative $0.40 per you actually make the cash grain sale at harvest, bushel). In this case, a futures-based local cash you will no longer need the “temporary substi- price forecast at harvest time would be $5.60/ tute,” which was your sale of the wheat futures bushel. This forecast can be compared with price contract. Thus, as soon as you sell the cash wheat forecasts from other sources such as university you would exit your “temporary substitute Extension economists, market advisory services, contract” by buying a KCBT July wheat futures and the U.S. Department of Agriculture when contract. Doing so means you no longer have preparing budgets and making marketing deci- an open position on the futures exchange. Your sions. actual net sale price for the wheat would be the For more details on basis and how hedging amount you received for the cash wheat at the works, see the following publications in this se- elevator, plus any gain or minus any loss on the ries: Selling Hedge with Futures (E-497) and Buying futures transaction. Hedge with Futures (E-498).

Partial funding support has been provided by the Texas Corn Producers, Texas Farm Bureau, and Cotton Inc.–Texas State Support Committee.

242 4 E-498 RM2-15.0 01-09

Risk Management Buying Hedge with Futures Mark Welch and David Anderson*

Many bulk purchasers of agricultural com- as corn price (the input in question) modities need price risk management tools to changes. Only then can the producer help stabilize input prices. Livestock feeders know if the corn price he could anticipating future feed needs or grain export- hedge would allow the cattle feeding ers making commitments to sell grain are two enterprise to achieve its corn pricing users of agricultural commodities who could goal for the period, holding all other benefit from input price management strate- input prices and animal performance gies. A common tool is a buying, or long, hedge constant. using futures. Producers concerned with price 2. Be sure to hedge the correct quantity. fluctuations for agricultural inputs can use a Check contract quantity specifications buying hedge with futures to manage that price and be sure the proper amount of risk. inputs is hedged. For example: A cattle feeder plans to feed 120 head of What Is a Hedge? steers weighing 700 pounds each. His A buying hedge involves taking a position in targeted out-weight for the steers is the futures market that is equal and opposite to 1,150 pounds (140 days on feed x 3.2 the position one expects to take later in the cash pounds average daily gain) and the market. The hedger is covered against input projected feed conversion (pounds of price increases during the intervening period. feed per pound of gain) is 7. The cattle If prices rise while the hedge is in place, the feeder’s projected feed requirement higher cash price the producer must pay for his is 6,750 bushels (54,000 pounds total or her inputs is offset by a profit in the futures gain x 7 pounds of feed per pound of market. Conversely, if prices fall, losses in the gain ÷ 56 pounds per bushel). Since one futures market are offset by the lower cash Chicago Board of Trade (CBOT) corn price. contract is specified as 5,000 bushels, the feeder would need to hedge two There are five steps to implementing a buying contracts to fully cover the projected hedge that will likely meet your pricing objec- feed requirements. tives. 3. Use the proper futures contract. 1. Analyze the expected profit of the Most widely produced agricultural enterprise in question. For example, commodities have a corresponding a cattle feeder should analyze how futures contract. Fed and feeder cattle, expected profits for fed cattle change

*Assistant Professor and Extension Economist–Grain Marketing, and Professor and Extension Economist–Livestock and Food Marketing and Policy, The Texas A&M System.

243 hogs, corn, wheat and soybeans are futures prices leads him to project a feeder steer a few examples. A notable exception purchase price of $104 per hundredweight ($105 is grain sorghum. Because of grain - $1) for October 1. At that price, he projects a $20 sorghum’s close price relationship to per head profit under normal feeding conditions. corn, producers can use corn futures Joe fears feeder cattle prices may increase be- to manage grain sorghum price risk. tween June and October. He elects to implement Once the proper futures contract is a buying hedge to lock in the purchase price selected, pay close attention to the for 120 steers (120 steers x 750 pounds per steer contract month. Project the date of the ÷ 50,000 pounds per contract = two contracts) anticipated cash market transaction (Table 1). and select the nearest futures contract month after the anticipated purchase in Table 1. the cash market. 4. Understand basis and develop a basis Cash market Futures Basis market forecast. Basis (which is covered in depth in another publication in this June 15 Objective: Buys two Projected at series) is the relationship between to realize a CME -$1/c w t local cash prices and futures prices. If feeder cattle November purchase Feeder Cattle projected basis and actual basis at the price of $104/ contracts at time of cash purchase are the same, cwt $105/c w t then the purchase price that was hedged will be achieved. Failure to account for October 1 Buys 120 Sells two Actual basis, head of CME -$1/c w t basis and basis risk could mean not 750-lb feeder November ($110-$111) meeting the buying hedge pricing goal. steers at Feeder Cattle 5. Be disciplined and maintain the hedge $110/c w t contracts at until the commodity is purchased in $111/cwt the cash market or the hedge is offset Gain or loss in futures: Gain of $6/cwt ($111 - $105) by another price risk management tool. Results: Producers should hedge only prices that are acceptable to them. Once Actual cash purchase price ...... $110.00 you have initiated a hedge position, Futures profit ...... - $ 6.00 do not remove the hedge before the Realized purchase price...... $104.00* cash purchase date without carefully *Without commission and interest considering the risk exposure. Case Example: Buying Hedge How Did the Feeder Steer for Feeder Steers Buying Hedge Work? Joe has a pen of cattle on feed that he will Joe projected an October 1 purchase price of sell in early October. He will need to purchase $104 per hundredweight on June 15. On Octo- feeder cattle at that time to replace the fed cattle ber 1, he purchased his feeder steers for $110 he sells. In June, Joe sees that November Chicago per hundredweight and liquidated his futures Mercantile Exchange (CME) Feeder Cattle fu- position at $111 per hundredweight, for a basis tures are trading at $105 per hundredweight. Joe of -$1 per hundredweight. The increase in feeder knows the historical basis for 750-pound feeder cattle prices he feared occurred; thus, the cash cattle the first week of October is -$1 per hun- price he paid for the steers was greater than dredweight (i.e., cash price is $1 per hundred- his projection. However, Joe realized a $6 per weight less than futures price). Observation of hundredweight profit from the increase in the

244 2 CME November feeder cattle price. Applying the Joe’s pricing objective of $104 per hundred- $6 per hundredweight futures profit to the cash weight was achieved. This example illustrates purchase price, the realized (or net) purchase the discipline necessary when hedging. Al- price was $104 per hundredweight, just as Joe though Joe might be frustrated with the results projected. of this buying hedge in a declining market, he Without Joe’s accurate basis forecast, the pro- should remember that the decision to hedge was jected purchase price and realized price would made after careful analysis and his best price have been different. A favorable basis move (i.e., forecast. While Joe might not be happy about a a widened basis) would have yielded a lower net price of $104 per hundredweight, his plan realized purchase price, while an unfavorable was sound, he still made a profit feeding these basis move would have increased the net buying cattle, and he will likely maintain, if not im- price. In a hedged position, the producer trades prove, his overall financial position. price risk for basis risk. Once more, the basis forecast is a key to hedging with futures. Table 3. Advantages and disadvantages of a buying hedge with futures.

What if Joe’s Price Advantages Disadvantages Outlook Was Incorrect? Reduces risk of price Gains from price declines Let’s examine the effects of a price decline increases are limited on the performance of Joe’s feeder steer buying Could make it easier to Risk that actual basis will hedge (Table 2). obtain credit differ from projection Establishing a price aids Futures position requires Table 2. in management decisions a margin deposit and margin calls are possible Cash Futures Basis market market Easier to cancel than a Contract quantity is forward contract standardized and may June 15 Objective: Buys two Projected at arrangement not match cash quantity to realize a CME -$1/c w t feeder cattle November purchase Feeder price of Cattle $104/c w t contracts at $105/c w t October 1 Buys 120 Sells two Actual basis, head of CME -$1/c w t 750-lb feeder November ($100-$101) steers at Feeder $10 0/c w t Cattle contracts at $101/c w t Gain or loss in Futures: Loss of $4/cwt ($101 - $105)

Results: Actual cash purchase price ...... $100.00 Futures loss ...... + $ 4.00 Realized purchase price...... $104.00* *Without commission and interest

245 3 Partial funding support has been provided by the Texas Corn Producers, Texas Farm Bureau, and Cotton Inc.–Texas State Support Committee.

246 E-497 RM2-14.0 01-09

Risk Management Selling Hedge with Futures Mark Welch*

When a commodity price is acceptable prior 2. Be sure to hedge the correct quantity. to the time the commodity will be sold in the Check contract quantity specifications cash market, a producer can use a selling hedge and be sure the proper amount of a to reduce the risk of declining prices. commodity is hedged. For example: A cattle feeder has 100 head of steers on What Is a Hedge? feed that have a projected out-weight of 1,200 pounds each. The total pounds A selling hedge involves taking a position in of fed cattle produced divided by the the futures market that is equal and opposite Chicago Mercantile Exchange (CME) to the position one expects to have in the cash Live Cattle contract weight specification market, so one is covered (subject to basis risk) yields the number of contracts against price declines during the intervening necessary to fully hedge the cattle (100 period. If futures and cash prices decrease while head x 1,200 pounds per head ÷ 40,000 the hedge is in place, the lower cash price the pounds per contract = three contracts). producer realizes for his production is offset Similarly, a producer who wants to by a profit in the futures market. Conversely, if hedge 100 percent of an expected 10,000 prices increase, losses in the futures market are bushels of corn would use two futures offset by the improved cash price. contracts (one Chicago Board of Trade, There are five steps to implementing a selling or CBOT, corn futures contract is for hedge that will likely meet your pricing objec- 5,000 bushels). tives. 3. Use the proper futures contract. 1. Analyze the expected profit of the Most widely produced agricultural enterprise in question. Whether or commodities have a corresponding not you decide to implement a selling futures contract. Fed and feeder cattle, hedge will depend somewhat on the hogs, corn, wheat and soybeans are cost of production for the enterprise a few examples. A notable exception and on having an acceptable profit is grain sorghum. Because of grain expectation. However, protecting an sorghum’s close price relationship to acceptable profit might not always be corn, producers can use corn futures to possible. A prudent manager might manage grain sorghum price risk. also use a selling hedge to limit losses Once the proper futures contract is when market conditions dictate. selected, pay close attention to the

*Assistant Professor and Extension Economist–Grain Marketing, The Texas A&M System.

247 contract month. Project the date of the projects a harvest time price of $5.60 per bushel anticipated cash market transaction and ($5.65 - $0.05), which is acceptable to him. Be- select the nearest contract month after cause Bill fears a possible price decline between the anticipated sale in the cash market. March and harvest, he elects to implement a Futures contracts expire before the end selling hedge on 15,000 bushels (three contracts of the month and this ensures that all at 5,000 each) because he has a reasonable expec- cash sales will take place before futures tation of producing this quantity based on his contracts expire. For example, an production history (Table 1). expected September corn sale would be hedged against December CBOT corn futures, since there are no contracts Table 1. available for October or November. Cash market Futures Basis 4. Understand basis and develop an market accurate basis forecast. Basis (which is March 5 Objective: to Sells three Projected at covered in depth in another publication realize a corn CBOT -$0.05/bu in this series) is the relationship sales price of December between local cash prices and futures $5.60/bu corn prices. Basis is defined as cash minus contracts at $5.65/bu futures. If projected basis and actual basis at the time of purchase are the October Sells 15,000 Buys three Actual basis, same, then the selling price that was 10 bu of corn at CBOT -$0.05/bu $5.40/bu December ($5.40-$5.45) hedged will be achieved. Failure to corn account for basis and basis risk could contracts at mean not meeting your selling hedge $5.45/bu pricing goals. Gain or loss in futures: Gain of $0.20 ($5.65 - $5.45) 5. Be disciplined and hold the hedge until the cash sale of the commodity or until Results: the hedge is offset by another price risk Actual cash sales price ...... $5.40 management tool. Producers should Futures profit ...... + $0.20 hedge only prices that are acceptable Realized sales price ...... $5.60* to them. Once you have initiated a hedge position, do not remove the *Without commission and interest hedge before the cash sale date without carefully considering the risk exposure. How Did the Corn Case Example: Selling Hedge Work? On March 5 Bill projected a harvest-time sell- Selling Hedge for Corn ing price of $5.60 per bushel. On October 10, he Bill is a corn farmer in the Texas Panhandle. sold his corn for $5.40 per bushel and liquidated He has a 10-year average corn production of his futures position. The decrease in corn prices 24,000 bushels and at no time in the past 5 years he had feared did occur, and the cash price he has that production dropped below 15,000 bush- received for his corn was less than his projec- els. In March, Bill notices that December CBOT tion. However, Bill realized a $0.20 per bushel corn futures are trading at $5.65 per bushel. He profit from the decrease in the CBOT December knows the historical harvest time basis for corn corn futures price. Applying the $0.20 per bushel in his county is -$0.05 per bushel relative to fu- futures profit to the cash price, the realized (or tures (i.e., cash price is $0.05 per bushel less than net) selling price for the 15,000 bushels he hedged futures price). Based on futures information, he was $5.60 per bushel, just as he had projected.

248 2 Without Bill’s accurate basis forecast, the Results: projected selling price and realized selling price Actual cash sales price ...... $5.85 would have been different. A favorable basis Futures loss ...... - $0.25 move (i.e., a narrowed basis) would have yielded Realized sales price ...... $5.60* a higher realized sales price, while an unfavor- *Without commission and interest able basis move would have decreased the net selling price. In a hedged position, the producer trades price risk for basis risk. Once more, the Bill’s pricing objective of $5.60 per bushel basis forecast is a key to hedging with futures. was achieved for the 15,000 bushels hedged. This example illustrates the discipline necessary Did Bill receive $5.60 per bushel for his en- when hedging. Although Bill might be frustrated tire crop? The answer depends on the quantity with the results of this selling hedge in a rising produced. If he produced his historical average market, he should remember that the decision to of 24,000 bushels, he was protected at $5.60 per hedge was made after careful analysis and his bushel for the 15,000 bushels he hedged and best price forecast. While Bill might not be happy received a price at harvest of $5.40 per bushel for about a net price of $5.60 per bushel, his plan was the unhedged 9,000 bushels. This yields a weight- sound, he still made his desired profit for this ed average price of $5.525 per bushel. Had he part of his corn crop, and he will likely maintain, produced more than his historical average yield, if not improve, his overall financial position. the weighted average price would have been less than $5.525 per bushel. If he produced less than his historical average yield, the weighted average Table 3. Advantages and disadvantages of a buying hedge price would have been higher than $5.525 per with futures. bushel. Actual production determines the final Advantages Disadvantages average price per bushel. Reduces risk of price Gains from price What if Bill’s Price Outlook Was Incorrect? increases increases are limited Let’s examine the effects of a price increase Could make it easier to Risk that actual on the performance of Bill’s corn selling hedge obtain credit basis will differ from (Table 2). projection Establishing a price aids in Year-to-year income management decisions and fluctuations may not be Table 2. can help stabilize crop income reduced with hedging within a crop year Cash market Futures Basis market Easier to cancel than a Contract quantity is forward contract arrangement standardized and may March 5 Objective: to Sells three Projected at not match cash quantity realize a corn CBOT -$0.05/bu sales price of December Futures position $5.60/bu corn requires a margin contracts at deposit and margin $5.65/bu calls are possible October Sells 15,000 Buys three Actual basis, 10 bu of corn at CBOT -$0.05/bu $5.85/bu December ($5.85-$5.90) corn contracts at $5.90/bu Gain or loss in futures: Loss of $0.25 ($5.65 - $5.90)

249 3 Partial funding support has been provided by the Texas Corn Producers, Texas Farm Bureau, and Cotton Inc.–Texas State Support Committee.

250 Commodity Options as Price Insurance for Cattlemen

R. Curt Lacy1, Andrew P. Griffith2 and John C. McKissick3 Adapted from “Managing For Today’s Cattle Market and Beyond”

Introduction For instance, if a cattleman wanted to buy the right to sell Most cattlemen are familiar with insurance. Examples feeder cattle for $175/cwt., the feeder cattle options market include insuring buildings against fire, equipment against might provide the opportunity. By paying the market-de- accidents and lives against death or injury. Purchasing termined premium, the cattleman could then collect on the insurance trades the possibility of a large but uncertain loss option if prices fell below $175/cwt. when the cattle were for a small but certain cost: the insurance premium. actually sold. If prices are higher than $175/cwt., the cattle are sold for the higher price, and the cost of the premium is One of the greatest risks cattle producers face is price risk. absorbed. Price changes can come in the form of declining cattle prices for sellers, increasing cattle prices for buyers or increas- While this is a simplified version of the actual way in which ing feed prices for feed users. producers might operate in the options market, the reality behind this concept is not much different. Just as with other Because of this risk, producers might want to “insure” feed- types of insurance, by paying a premium, insurance can be er cattle, fed cattle or feed against unfavorable price move- purchased against price declines or increases. Collecting on ments, while still being able to take advantage of favorable the insurance would be an option if the price moves in an price movements. Cattlemen have this opportunity by using unfavorable direction. the commodity options market4. The “Ins” and “Outs” of Options: Puts and Calls What is the Commodity Options Market? There are two types of commodity options: a put option The commodity options market is a market in which and a call option. The put option gives the holder (usually a producers may purchase the opportunity to sell or buy a commodity seller) the right -- but not the obligation -- to sell commodity futures contract at a specified price. Purchasers the underlying commodity contract to the option writer at a in options markets have the “opportunity” or “right” but not specified price on or before the commodity expiration date. the “obligation” to exercise their agreement. Therefore, the The call option gives the holder (usually a commodity pur- markets are appropriately named “options markets” since chaser) the right -- but not the obligation -- to buy the under- they deal in an option, not an obligation. lying commodity contract from the option writer (seller) at a specified price on or before the option expiration date. Just as a cattleman may purchase the right from an insurance firm to collect on a policy if a building burns, he can The put option and the call option are two different and purchase the right to sell commodities at a specific price in distinct contracts. A call option is not the opposite of a put case prices drop below the specified price. A separate op- option. Distinguish between the two types of options by tions market also exists to allow the purchase of commodi- remembering that the holder of the put option can choose to ties at a specified price in case prices increase. “put-it-to-them”; that is, sell the product, while the holder of the call option can “call-upon-‘em” to provide the product.

1 Associate Professor and Extension Economist-Livestock, University of Georgia 2 Assistant Professor and Extension Economist-Livestock, University of Tennessee 3 Professor Emeritus and Distinguished Marketing Professor, University of Georgia 4 Cattle producers can purchase Livestock Risk Protection (LRP) through crop insurance agents. A good reference on LRP for feeder cattle producers is “Livestock Risk Protection Insurance (LRP): How It Works for Feeder Cattle,”251 publication number W 312, available through the University of Tennessee at http://economics.ag.utk.edu/riskmgmt.html. Buyers and Sellers showing the option contract specifications for feeder In the option market, as in every other market, transactions cattle and live cattle is shown at the end of this bulletin require both buyers and sellers. The buyer of an option is (Table 1). referred to as an option holder. Holders of options may be either seekers of price insurance or speculators. Expiration Futures contracts have a definite predetermined matu- The seller of an option is sometimes referred to as an option writer. The seller may also be either a speculator or some- rity date during the delivery month. Likewise, options one who desires partial price protection. The choice to buy have a date at which they mature and expire. The (hold) or sell (write) an option depends primarily upon specific date of expiration for the feeder cattle option one’s objectives. contract is the same as its underlying futures contract – the last Thursday of each month, with the exception Buyers and sellers of cattle options “meet” on the Chicago of November and any month when a holiday falls on Mercantile Exchange. Rather than physically meeting, all the last Thursday or any of the four weekdays prior to transactions are carried out through brokerage firms that that Thursday. act as the buyer’s and seller’s representative at the exchange. For this service, the brokerage firm charges a commission. Because fed cattle futures contracts can be settled by The exchange has no part in the transaction other than to physically delivering the cattle, the fed cattle option insure its financial integrity. In effect, the exchange offers a place for option buyers and sellers to get together under contract expires the first Friday of the futures contract organized rules of trade. month, prior to the futures contract expiration around the 20th of the month. For example, a $175/cwt. Strike Price October fed cattle put option is an opportunity to sell The “specified price” in the option is referred to as the one October live cattle futures contract at $175/cwt. exercise price or strike price. This is the price at which The holder can execute this option on any business day the underlying commodity contract can be bought or sold until the first Friday in October. and is fixed for any given option, put or call. There could be several options with different strike prices traded during Option Premiums any period of time. If the price of the underlying commod- The option writer is willing to incur an obligation in ity changes over time, then additional strike prices may be return for some compensation. The compensation is listed for trade. called the option premium. Using the insurance anal- Underlying Commodity ogy, a premium is paid on an insurance policy to gain The “underlying commodity” for the commodity option is the coverage it provides. Similarly, an option premium not the commodity itself but rather a futures contract for is paid to gain the rights granted in the option. The that commodity. For example, an October feeder cattle op- option premium is determined either by public outcry tion is an option to obtain an October feeder cattle futures and acceptance in an exchange trading pit or electron- contract. In this sense, options are ically through a “virtual” trading pit. Like all commod- the right to buy or sell a futures A more extensive ity prices, option premiums can be expected to change explanation of contract and not the physical com- not only daily but often by the minute. modity. futures contracts is available in UGA Extension Bulle- While the interaction of supply and demand for op- Because options have futures tin 1404, “Using tions will ultimately determine the option premium, contracts as their underly- Futures Markets to two major factors will interact to affect the level of ing commodity, each option Manage Price Risk premiums. The first factor is the difference between the contract represents the same in Feeder Cattle strike price of the option and the futures price of the quantity as the underlying Operations.” underlying commodity. futures contract. That is, most grain options represent 5,000 bushels, while the live This differential in prices may give the option “intrin- cattle option represents 40,000 pounds of fed cattle. sic” or exercise value. For example, consider an Octo- The feeder cattle option represents 50,000 pounds of ber feeder cattle put option with a strike price of $175/ feeder cattle. Options are traded for each of the futures cwt. and the underlying October feeder cattle futures contract months in each of these commodities. A table with a current price of $172/cwt. The option could be 252 Commodity Options as Price Insurance for Cattlemen 2 UGA Extension Bulletin 1405 sold for at least $3/cwt. since anyone would be willing anytime between their purchase and expiration date to purchase the right to sell at $175 when the market is if the holder so desires. Most option buyers will offset currently $172. This $3 is said to be the intrinsic value. their position rather than exercise the option to avoid As long as the market price on the option’s underlying losing any remaining time premium and (or) assuming futures contract is below the strike price on a put op- a futures market position and its resultant decisions, tion, the option has intrinsic value. The converse of the margin deposits and commissions. In most situations, price relationship is true for a call option. A call option the option can be resold to another trader at a premi- has intrinsic value when the futures market price is um at least equivalent to the intrinsic value that results above the strike price. from an “in-the-money” price relationship.

Any option that has intrinsic value is said to be “in- Another method by which the holder of an option the-money.” An “in-the-money” option has value to could realize accrued profits is by “exercising” the others because the futures market price is below the option. Options are only exercised at the direction of put or above the call strike price. An option is said to the owner or if there is intrinsic value at expiration. be “out-of-the-money” and has no intrinsic value if the The opportunity to exercise the option means the current futures market price is above the put or below option buyer can always get the intrinsic value of the the call strike price. When the futures market price of option premium even if there is little or no trading in the commodity and the strike price are equal, the op- the option being held. It also provides for a means of tion is said to be “at-the-money,” and has no intrinsic continuing price protection after the option expires. value. If the decision is made to exercise, the following proce- A second factor influencing the option premium is the dures are followed. For a put, the holder is assigned a length of time to expiration of the option. Assuming all short (sell) position in the futures market equal to the else is held constant, option premiums usually decline strike price. At the same time, the option writer is obli- in value as the time to expiration decreases. This phe- gated to take a long (buy) futures position at the same nomenon reflects the time value of an option. For ex- price. Both positions are then adjusted to reflect the ample, in August the time premium on a $175 Septem- current settlement price. It is rational to exercise a put ber feeder cattle option will be less than the premium option only when the futures market price is below the on a $175 November option. The option with a longer strike price, so the holder’s futures position will show time to expiration has a greater probability of moving a profit. The futures position of the writer will show an “in-the-money” than the option with less time. There- equivalent loss. At this point the option contract has fore, it is worth more on that factor alone. The longer been fulfilled and both parties are free to trade their the time period, the greater the chance that events futures contracts as they see fit. will occur that could cause substantial movement in futures prices and change the value of the option. As a Evaluating and Using Options Markets result, the option writer requires a greater premium to Now that the mechanics of options trading have been assume the risk of writing a longer-term option. explored, it is time to consider two critical questions: 1) What do varying strike prices mean in terms of “Out-of-the-money” options have a value that reflects price insurance? and 2) How does a producer actually time value. “In-the-money” options possess both time obtain this insurance? value and intrinsic value. The total cost of a premium minus the intrinsic value yields the time value of an There are three steps to consider in evaluating option option (Time Value = Premium – Intrinsic Value). prices.

Offsetting an Option 1. Select the appropriate option contract month. To The method by which most holders of “in-the-mon- do this, select the option whose underlying futures ey” options realize accrued profit is by resale of the will expire closest to, but not before, the time the option. This is referred to as “offsetting” an option physical commodity will be sold or purchased. position and completing a round turn (the buy and sell or the sell and buy of an option). Options can be offset 253 Commodity Options as Price Insurance for Cattlemen 3 UGA Extension Bulletin 1405 For example, if a group of feeder calves were to be for 50,000 lbs., $75/500 Basis estimation is a sold in early October, the October option would be critical component in cwt.). The net price is now appropriate. estimating the expected $172.19 - $0.15 = $172.04/ net purchase or sale cwt. 2. Select the appropriate type of option. To insure price. Interested readers products for sale at a later time against price de- should also consult UGA 5. One final adjustment Extension Bulletin 1406, clines, the producer would be interested in buying “Understanding and Us- must be made to these a put (the right to sell). If the producer’s motive is ing Cattle Basis in Man- prices. The option strike to insure future commodity purchases against cost aging Price Risk” to help price must be localized increases (for instance, corn needed to feed cattle), them better understand to reflect the difference then purchasing a call would be an appropriate the various factors that between prices in the local can affect basis. strategy. markets where the cattle will be sold or grains To continue the example: If the cattleman wishes to purchased, and the futures market price. This insure the feeders he will be selling in early Oc- difference is called basis (Basis = Local Cash tober, then he will be interested in purchasing an Price – Futures Price). The basis differs for cattle October put option. at different weights, sex, location and time of year across the country. See UGA Extension Bulletin 3. Calculate the minimum cash selling price being 1406, “Understanding and Using Cattle Basis in offered by the put option selected. For a call option, Managing Price Risk” for some of the factors that the maximum purchase price would need to be affect cattle basis. Many state Extension offic- calculated. These calculations can be accomplished es have historical basis estimates for cattle and in five steps: inputs that may be helpful in determining the appropriate basis. 1. Select a strike price within the option month. For instance, a $175/cwt. October feeder cattle put. By adjusting the option price for basis, a minimum 2. Subtract the premium from the strike price for a selling price can be obtained for a put or a maximum put or add the premium for a call. For example, if purchase price obtained for a call. For the example, if a $175 October put costs $2.75/cwt., the result is in early October, 600 lb. feeder steers normally bring $175 - $2.75 = $172.25/cwt. $10/cwt. less than the feeder cattle futures market, then 3. Subtract (for a put) or add (for a call) the “op- the likely minimum local cash price becomes $172.04- portunity cost” of paying the premium for the $10 = $162.04/cwt. In the end, the only thing that will period it will be outstanding. For example, if the change this price is the fluctuation in the basis. option premium of $2.75/cwt. is paid in June and the option is expected to be liquidated by an More or less price insurance can be purchased by buy- offsetting resale in early October, an interest cost ing options with different strike prices. To determine for the three-month period needs to be added. the minimum selling price suggested by each strike If borrowed funds are used and the interest rate price, repeat steps one through five for the various is 9 percent, then the interest (opportunity) cost strike prices and their associated premiums. would be .75 percent per month, or 2.25 percent for three months. The interest cost associated Options Arithmetic: Two Examples with a $2.75/cwt. put option premium would be Once the relevant options prices have been evaluat- $0.06/cwt. This leaves a net price of $172.25 - ed, the next question is, how would the producer go $0.06 = $172.19/cwt. about obtaining a certain level of price insurance? Two 4. Subtract (for a put) or add (for a call) the com- examples, one using a put to establish a price floor (an mission fee for both buying and offsetting the op- expected minimum selling price) and one using a call tion. Assume the brokerage firm charges $75 per to establish a price ceiling (an expected maximum pur- round turn for handling each option contract. chase price), will help illustrate the total process. The commission fee would be $0.15/cwt. ($75

254 Commodity Options as Price Insurance for Cattlemen 4 UGA Extension Bulletin 1405 Put Option Example Figure 1. Put Option Example. Feeder cattle pricing example where the option expires as worthless. In the following put option example (Figures 1 and 2), we discuss a cattleman who will be selling a load of feeder cattle in early October. In our example, he checks the options quotes in June and finds he could purchase an October feeder cattle put option to sell at $175/cwt. at a premium of $2.75/cwt. To further localize this strike price, he subtracts $10/cwt. basis since he normally sells 600 lb. steer calves for a somewhat lower local cash price in October than the October futures price. Commission ($75 per contract) and interest on the premium cost will be about $0.25/cwt., so the $175 put would provide an expected minimum selling price of $175 - $10 - $2.75 - $0.25, or $162/cwt. By comparing this with his other pricing alternatives and his production cost, he decides that purchasing this “out-of-the-money.” Since no one is willing to pay for an put would be an appropriate strategy for the 83 steers option to sell at $175/cwt. when they could sell current- he plans to sell in October. He advises his broker that ly for $185/cwt., the option expires as worthless (Figure he wants to purchase one “$175 October feeder cattle 1). In this case, the cattleman sells the load of feeders put at $2.75.” He then forwards a check for $1,450 (500 and does not use the option. The net price would be the cwt. X $2.75/cwt. plus $75 brokerage fee) to his broker. cash price received less the net premium cost originally paid. Assuming the basis did not change (-$10/cwt.) As October approaches, one of three things will hap- and the cattle brought $175/cwt., the actual net received pen: prices will stay relatively unchanged, rise above would be $172/cwt. ($185 - $10 basis - $2.75 premium - the option strike price (thus making the option worth- $0.25 commission and interest). less) or fall below the strike price (thus making the producer’s option valuable). Remember that for a put In this case, the insurance policy was not needed. Had option, if the current futures price is above the strike this been known in advance, the cattleman could have price, the option is said to be “out-of-the-money.” If saved the premium. However, just as fire or other disas- futures are below the strike price, it is “in-the-money.” ters can’t be predicted, price movements can’t be predicted with accuracy either. For this reason, the cattle- First, assume the futures market prices in early Octo- man was willing to substitute the known loss (premium) ber are $185/cwt. -- well above the put option strike for the possibility of a larger unknown loss. price of $175/cwt. This makes the producer’s option 255 Commodity Options as Price Insurance for Cattlemen 5 UGA Extension Bulletin 1405 Figure 2. Put Option Example. Feeder Cattle Pricing Example where market declines and on the option market to option is sold. get the net price of $162/ cwt. Thus, the option was successful in assuring the minimum price when he bought it in June.

In this case, the producer collected on his option (policy). Just as with insurance, he collects to the extent of his loss. In options terminology, we are talking about the strike price (the face amount of the policy) less the current futures price of feeder cattle.

A second way in which the “insurance” could have been recovered would be to exercise the option, converting it into a sell (short) position in the futures market. If the futures position were then immediately closed out with a purchased October futures (long), the $5/cwt. difference would be realized ($175 - $170 current What happens if the cattleman does need to collect on futures) with only an additional commission for the his option position? The mechanics of this instance are futures purchase. Since fed cattle options expire before shown in Figure 2. Assume the futures market price at the underlying futures, this may be the route to com- the first of October is $170/cwt. In this case, the option pleting the options “insurance” if the cattle were not to sell does have value, because others are willing to sold until after the option had expired. With feeder cat- purchase the right to sell at $175 when they are cur- tle, however, this is not a problem, because the futures rently only able to sell at $170/cwt. Remember, this and options expire together. means the option is “in-the-money.” One way to collect on an options policy (offset) is very much like collect- Figure 3 summarizes the resulting net price from ing on insurance. Since the value of the loss is $5/cwt., purchasing an October put for $2.75/cwt. with $0.25/ the cattleman should be able to sell the option back cwt. trading cost under several futures market prices for at least this amount. He calls his broker and tells in October and a realized -$10/cwt. basis. It also makes him to sell the October put at $5 or better. The sale of a clear why put option purchases are sometimes referred previously bought put cancels the option, and the bro- to as “floor pricing.” ker sends a check for $5 per cwt. X 500 cwt. or $2,500. Since he paid a premium of $2.75/cwt. plus the $0.25/ In reality, the producer will only be able to estimate cwt. option trading cost, he really netted $2/cwt. on what his basis will be when he sells the cattle. If the ac- the option trade. The producer sells his calves for $160/ tual basis is better (stronger) than anticipated, then the cwt. on the cash market and adds the $2/cwt. gained 256 Commodity Options as Price Insurance for Cattlemen 6 UGA Extension Bulletin 1405 has been used throughout this publication, then net cash prices will range from $164.70 to $175.90/cwt.

This graphic illustrates the impacts of strike prices and premiums on net futures prices. Selecting the “right” strike price involves knowing not only what level of protection is afforded, but also how much the protection costs.

Call Option Example As mentioned previously, call options can be used to establish an expected maximum Figure 3. purchase price. Call options may be use- realized net price from the options will be higher. If the ful for stocker operators or feedlots to set a maximum actual basis is worse (weaker) than anticipated, then purchase price of incoming cattle. Likewise, livestock the realized net price from the options will be lower. In producers can use corn or soybean meal options to set either case, the actual net price will vary by the differ- a maximum purchase price for feed ingredients. Similar ence in forecast and actual basis. to a put option establishing a price floor, call options establish a price ceiling. Buying More or Less Insurance Figure 4 shows the net futures floor prices achieved at Call options give the holder the right but not the obliga- various strike prices. Basis would still need to be sub- tion to BUY a futures contract at a given price. The same tracted to arrive at an estimated cash price. terms (strike price, premium, etc.) apply for call options as they do with put options except the objective is to set a maximum purchase price for feeder cattle, live cattle or feed ingredients as opposed to a minimum price. As a result, premiums and other transaction costs are added to the strike price in calculating the net price paid, where with put options they were subtracted. In either instance, the result is the same. The holder experiences a small but known loss in exchange for Figure 4. Net futures prices for put option at various strike levels. Nov FC mitigating the risk of upward price contract. Prices quoted in June. movements in the market.

The crosshatched area indicates the amount of the To illustrate a call option, consider the feeder cattle ex- premium paid. For instance, a $180 put could have ample presented for the put option (Figure 5) except that been purchased for $6.70/cwt. This would have provid- a feeder cattle buyer wants to set a maximum purchase ed a higher floor price but at an unreasonable expense. price of $168/cwt. Alternatively, a $170 put could be purchased for $3/ cwt., providing a net futures price of $169. Finally, a In this instance, prices increased enough to make the call $166 put would have cost only $1.30/cwt. but provid- option “in-the-money.” As result, the owner offset the ed a futures floor of only $164.70/cwt. Again, readers option for the intrinsic value and reduced his net pur- are reminded that these prices are calculated before chase price to $168/cwt. any basis adjustment. So, if the basis is -$10/cwt., as

257 Commodity Options as Price Insurance for Cattlemen 7 UGA Extension Bulletin 1405 If the futures market had Figure 5. Call Option Example. Feeder Cattle Price Increase Example. gone down to, say, $165/ cwt., the cattleman would have purchased the cattle for $155/cwt. ($165 - $10 basis) and let his call expire as worthless. Because his total purchase price (premium + commission + interest) was $3/cwt., his net purchase price would have been $158/ cwt.

Summary Purchasing options for price insurance is a way cattlemen can use the futures markets as a pricing alternative. This alternative should be carefully compared to all other pricing alternatives in light of the producer’s objectives and risk-bearing ability. Options purchased for price insurance provide a “hybrid” market with characteristics of both doing nothing (cash market pricing) and hedging or forward-contracting. That is, the producer who purchases an option for price Table 1. Comparison of Options Specifications insurance has some of the same price protection offered Item Feeder Cattle Live Cattle through a hedge or forward contract. On the other Underlying 50,000 pounds 40,000 hand, options are not as protective against unfavorable Contract pounds price movements as hedging or forward contracting or Size as attractive as the open cash market if prices become Delivery Cash settled Physically more favorable. In fact, option purchases will always be, delivered at best, second to either of the other two pricing alterna- Months Jan, Mar, Apr, May, Aug, Sep, Feb, Apr, tives when evaluated after the fact. However, cattlemen traded Oct and Nov Jun, Aug, Oct, Dec do not have the luxury of making pricing decision after Last day of Last Thursday of the con- First Friday the fact. Because of this, many cattlemen may find a trading1 tract month with exceptions of the place in their pricing plans for the kind of “hybrid vigor” for November and other contract offered through the option market. months when a holiday falls month, on the last Thursday or any 1:00 p.m. of the four weekdays prior to Bulletin 1405 June 2014 that Thursday, 12:00 p.m. See CME Rule The University of Georgia, Fort Valley State University, the U.S. Department of See CME Rule 102A01.I. 101A01.I. Agriculture and counties of the state cooperating. UGA Extension offers educational programs, assistance and materials to all people without regard to race, 1 Source CME website – accessed May 27, 2014 color, national origin, age, gender or disability. http://www.cmegroup.com/trading/agricultural/livestock/feeder-cat- tle_contractSpecs_options.html The University of Georgia is committed to principles of equal opportunity http://www.cmegroup.com/trading/agricultural/livestock/live-cattle_con- and affirmative action. tractSpecs_options.html

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