By Jennifer Ifft, agricultural policy extension specialist
Farmers and ranchers face risk every day. Individual producers have many tools to mitigate risk, such as vaccination or irrigation, but never have complete control over production outcomes. Price risk is one example of the many types of risk that can influence farm income.
After calving, it is typically at least 6 months before a cow-calf producer receives any income. While futures markets can be used to predict feeder prices several months in advance, actual prices might be different than expected. For example, consider a producer that calves in April and plans to sell in October. October feeder futures are around $194/cwt.[1] In other words, $194 is the expected market price for October 2022, or $194/cwt is best estimate we have for average national prices in October, based on currently available information. The price risk faced by the producer is that when October arrives, prices may have dropped below $194/cwt. If prices decrease by October, will the producer still be able to make a profit?
In some years, prices decline or stay the same. The largest decline in recent years was in 2015. In April 2015, October feeder cattle futures were around $214/cwt. By October, prices had declined to around $183/cwt. Some producers might have still made money at $183, but this was substantially less than the expected price in April.
Prices were similarly high in April 2014: October feeder futures were over $230/cwt. Actual 2014 October prices were a little higher than this. An unexpected increase in prices is technically a form of price risk, or “upside risk”, but most producers are more worried about price declines, or “downside risk”.
Producers may also face unexpected declines in local prices, that may not be reflected in national or futures markets. This type of risk is often referred to as “basis risk”. Basis risk is defined as the difference between the current (or nearby) futures price and local cash prices. For example, prices at the local sale barn may experience a larger decline than futures prices.
Three major price risk management strategies are self-insurance, marketing flexibility, and use of formal price risk management tools. More than one strategy can be used. The primary price risk management strategy used by most cow-calf producers is self-insurance. While self-insurance might be perceived as “not managing price risk”, any producer who continues a cow-calf operation after a low-income year manages price risk. The primary method of self-insurance is income diversification, either through farm income diversification or off-farm income or both. For example, a producer may both produce crops and have a cow herd, with crop income typically being sufficient to absorb losses from low calf prices and (potentially) vice versa. Similarly, a producer and/or their family members may work off farm. In addition to the advantage of access to affordable health insurance, off-farm income can cover family living expenses during low price years. A potential disadvantage is that opportunities for herd expansion and time spent on management may be limited.
A second strategy is marketing flexibility, in terms of both the type of market and the timing of marketing. Niche or value-added markets, such as direct-marketing, as well as marketing arrangements with breeders, processors or a feed yard are examples of types of markets that that can be part of a price risk management strategy. More specifically, a marketing relationship with a feed yard might result in more predictable prices than with a sale barn. Some producers also use the timing of marketing to manage price risk. For example, a producer might feed calves for a few months after weaning in hopes of stronger markets in the late fall or early winter. All of these marketing strategies have the advantage of shielding a producer from price risk in commercial markets. However, these strategies are not fail-proof or without risk: no market is guaranteed, or prices might not increase enough to cover additional feed or other costs.
The third strategy is using formal price risk management tools: specifically hedging or insurance. Both hedging (future and options) and insurance (Livestock Risk Protection-LRP) allow a producer to protect themselves against unexpected declines in the market price. These strategies require some upfront costs and an investment of time into learning about commodity markets. An advantage is they can protect a producer who is expanding or highly leveraged or otherwise would be hurt by a decline in expected prices.
Cow-calf producers use various price risk management strategies that are tailored to their individual situation and needs; there is no single correct way to manage price risk. However, the next article in this series on price risk management will compare hedging to LRP, with a focus on relative costs.
More information is available at https://agmanager.info/crop-insurance/livestock-insurance-papers-and-information and https://agmanager.info/farm-mgmt-guides/livestock-budgets/ksu-detailed-cow-calf-budget. Funding for this work was provided by the North Central Extension Risk Management Education Center, the USDA National Institute of Food and Agriculture Award Number 2018-70024-28586.
[1] As observed the week February 21, 2022; futures prices can change on a daily basis.