In the Basics of Hedging article we looked at what you need to know in order to use MLA/SFE Cattle Futures effectively.  Cost of production, target prices and basis (difference between futures price and cash price) were all discussed and calculated in an example.  In this article the same example will be used to calculate target futures prices and lock in a target margin using cattle futures.

The example used in our last article calculated a target price of $2.10/kg lwt and an average basis of 12¢/kg lwt.  That is the price this backgrounder receives for his feeder steers is, on average, 12¢/kg lwt higher than the Cattle Futures price, for which we use the Eastern Young Cattle Indicator as a proxy. 

Calculating Futures Targets

Now that the target price and basis have been discovered, our backgrounder knows what level he needs to sell Cattle Futures to achieve his target price.

Futures target = Target sale price - Basis

Futures target = 210 - 12

Futures target = 198¢/kg lwt, or 367¢/kg dwt at 54% dressing percentage.

The backgrounder now has a Futures target price. 

Using MLA/SFE Cattle Futures

Each MLA/SFE Cattle Futures contract is equal to 5000 kgs dwt. 

This backgrounder has 82 head of feeder steers which will weigh 452 kgs liveweight giving a total of 37,040 kgs lwt to be sold, or 20,000 kgs dwt at 54% dressing percentage. This is the equivalent of 4 Futures contracts.

For the simplicity of this example we will assume that our backgrounder has no production risk, that is, he is 100% certain he will produce 20,000 kg dwt of feeder cattle in November.  This means he can hedge 100% of his production on the futures by selling 4 futures contracts.

The backgrounder plans to sell cattle in November, so to protect against the market falling the backgrounder will sell November futures. This is also known as forward selling.

It is June and the backgrounder rings his futures broker who tells him that today he can sell November Futures at 367¢/kg dwt or 198.2¢/kg lwt, which provides him an expected price of 210.2¢/kg lwt when average basis is added. The total income expected from sale of the cattle is 37,040 kgs lwt at 210.2¢/kg which equals $77,850.  The backgrounder sees that this price is above their target price, to secure this price the backgrounder sells 4 MLA/SFE Futures Contracts at 367¢/kg dwt.

Futures Settlement Mechanics:

It is now November and the cattle are ready for delivery to the feedlot. 

It is important to understand the two scenarios' that could affect how the final price is calculated.

The first scenario involves the EYCI finishing lower than the 'locked-in' price, the second scenario involves the EYCI finishing higher than the 'locked-in' price. It is assumed that the cattle are sold at the average level of 12¢/kg lwt over the EYCI.

Scenario 1:  The November Futures contract settles on the EYCI at 350¢/kg dwt, or 189¢/kg lwt.

The backgrounder shops around for the best price for his feeder cattle and finds a feedlot that will take them for 201¢ lwt, which equates to a 12¢ lwt premium over the EYCI.

As Cattle Futures are cash settled, the process of closing out a sold position is akin to buying the position back.  The backgrounder sold 20,000 kgs dwt at 367¢/kg dwt, and buys them back at 350¢/kg dwt, realizing a profit of 17¢ dwt, or 9.2¢ lwt which totals $3400.  The backgrounder receives this amount from the futures exchange.

The backgrounder receives 201¢/kg lwt, or $74,450 in total from the feedlot as payment for his cattle, to which we add the futures profit of 9.2¢, or $3,400, giving a net price of 210¢/kg lwt, and net revenue of $77,850, the expected price that was 'locked in' in June. 

Scenario 2:  The November Futures contract settles on the EYCI at 375¢/kg dwt, or 202.5¢/kg lwt

Again the backgrounder would shop around for the best price, which he finds is 214.5¢/kg lwt, a basis of 12¢ lwt to the EYCI.

The Futures contract is cash settled - sold at 367, bought back at 375, realizing a loss of 8¢/kg dwt or 4.5¢/kg lwt.  The backgrounder pays the Futures exchange $1600.

The backgrounder receives 214.5¢/kg lwt, or $79,450 for his cattle from the feedlot.  Subtracting the loss on the futures of 4.5¢ lwt or $1,600 gives a net price of 210¢/kg lwt, or revenue of $77,850, the expected price outlined above.

Summary:

The example shown above would be described as a perfect hedge, in that the expected price equaled the actual price received when the cattle were sold.  In reality perfect hedges are rare, and factors such as differences in the weight of cattle from the expected weight, the timing of sale relative to futures settlement and the level of the basis relative to the expected basis can all throw a hedged position out by a few cents per kilo.  These risks are measurable and a good risk management plan will take them into account. 

The key point to remember is that the price risk faced by a backgrounder who has hedged all or part of their expected turnoff is much lower than if they had not hedged at all, and while hedging will not necessarily make a cattle producer more money, it will protect his business from adverse price movements in a volatile cattle market.

Take Home Messages:

• Before using Cattle Futures, producers should know their cost of production, target margin and expected basis, thereby allowing them to calculate a target futures price.
• Hedging with futures does not eliminate all price risk, the producer still carries the basis risk, however, a good risk management plan will take this into account.
• Using Futures can help protect cattle businesses from adverse price movements and secure profitable margins.