Managing risk in the livestock sector

Livestock

Highlights

  • A clear marketing strategy and risk management plan provides focus for a business
  • Develop your marketing plan well in advance, focusing on your product, customers and market seasonality
  • Future contracts, forward contracts and price insurance are all options for protection you may want to consider when developing your risk management strategy

Everyone in agriculture likely knows circumstances, not people, can sometimes determine what happens. From weather risk to market risk – for both outputs and inputs – the stakes are high in this business. Luckily, there’s a growing range of options available to help Canadian livestock producers cope with price uncertainty.

“(Having) a clear marketing strategy and risk management plan provides focus for a business. It helps producers analyze what they’re doing and why, enabling measurement for review and continual improvement. A good strategy simplifies production decisions and provides protection, especially when things don’t go as planned,” says Brian Perillat, manager and market analyst at Canfax.

By exploring all available tools, cattle and hog producers can determine the best solution, or combination of solutions, to match their marketing plan and risk tolerance.

Marketing versus risk management

In exploring the tools for risk management, it’s important to differentiate between it and marketing.

“A risk management plan is part of a good marketing strategy,” says Alberta Agriculture pork specialist Ron Gietz. “The marketing strategy is about revenue maximization, while the risk management plan is about reducing the variability of returns and providing greater stability of cash flow.”

Understanding your product, your customers and market seasonality, along with collaborating with other players along the value chain, are key components of a marketing plan.

“To create a solid marketing strategy, find preferred and alternate customers for what you produce. Fine-tune production practices to mesh with those customers’ needs; this allows you to extract the maximum value for your products,” Gietz recommends.

“Even with a commodity such as slaughter hogs, there is a wide range in what producers are getting paid for the end product, depending on quality, distance to market and other factors.”

The first step for creating a good risk management strategy is to understand your operation’s cost of production.

“In difficult market conditions, you may be looking for opportunities just to cover cash costs so the operation stays solvent. In more upbeat markets, you want to protect strong margins that rebuild equity, yet still limit downside risk,” Gietz explains.

Planning pays

With recent record high cattle prices, fourth generation Alberta rancher and finance expert Ryan Copithorne is working to help cow-calf producers capitalize on market upswings. His Cows in Control Marketing Group builds customized marketing strategies and risk management plans that often include forward selling calves and setting up hedge accounts.

“It’s important to know the market value of your animals, and the dollars lost by a 10, 20 or even 50 per cent price drop. Cattle markets move up and down by 10 to 20 per cent in an average year, so know your risk tolerance,” he advises.

“Create a marketing plan a year in advance, and review it every year. Then, know your market price ahead of time by having a solid risk management plan. Set a desired rate of return, and try to hedge that rate of return as much as possible through the course of the year. This allows you to confidently show your lender – and yourself – that you have locked in a profit or minimized losses.”

A multi-faceted approach to risk management is recommended. By exploring all available tools, cattle and hog producers can determine the best solution, or combination of solutions, to match their marketing plan and risk tolerance.

Futures markets

The use of futures contracts can effectively protect against major swings in agricultural commodity prices. However, capital requirements for hedging activities can be high. Margin calls may require large amounts of cash to maintain effective coverage, which is one reason most producers tend to employ other options.

“It’s a complicated business,” Copithorne says. While futures and options can be useful, he suggests investing in an advisor and a good broker.

Livestock producers should also explore the correlation between their local market and the futures market they’re trading in.

“The Canadian dollar can have a much bigger impact on calf prices than the Chicago futures price: a one-cent decrease in the value of our dollar increases calf prices by five cents,” Perillat says.

For hogs, the correlation between Canadian prices and U.S.-based futures prices is stronger, but you still have exchange rate risk to deal with.

“To manage all your price risk, you must be active in both the Canadian dollar and hog futures markets,” says Gietz.

And what about feed? Minimizing volatility in prices for major inputs should certainly be considered. While feed grain prices can be hedged using futures markets, thin trade on the western barley futures contract and a low correlation between corn futures and Prairie feed grain values can mean less than ideal hedging opportunities.

Instead, Gietz sees some livestock producers forward pricing their inputs through a grain broker. Alternative strategies to manage feed costs include running a mixed grain and livestock operation, or purchasing large volumes of grain off the combine at harvest.

Forward contracts

Fewer than 10 per cent of hog producers are active in futures markets, Gietz estimates. The use of forward pricing contracts with packers, or their marketing agents, is much more common. Forward pricing contracts can be negotiated a few months or even a year before delivery, and long-term supply contracts can be up to five years in duration.

For cattle, forward contracts for fed animals are also prevalent between feedlots and packers.

“Forward contracting has become a Canadian feedlot’s most common risk management practice, because the Canadian cattle market isn’t directly linked to the U.S. futures market. Over half of all calves purchased by Canadian feedlots are forward contracted to packers, up to 12 months out,” Perillat says.

Cow-calf producers are also beginning to explore forward contract options. The number of calves offered via electronic auction for forward delivery is growing, and with record-high prices, feedlots may be more interested in purchasing animals in advance to secure supply and margins.

Price insurance

After launching in Alberta in 2009, the Western Livestock Price Insurance Program (WLPIP) and Western Hog Price Insurance Program (WHPIP) have been extended to cattle and hog producers in British Columbia, Saskatchewan and Manitoba. WLPIP and WHPIP offer the ability to lock in floor prices for calves, feeder cattle, fed cattle and slaughter hogs.

While premiums for WLPIP and WHPIP policies have given some producers pause, Copithorne believes price insurance can be an important tool in today’s volatile commodity markets.

“The price you can guarantee is more important than the cost of the premiums. The floor price is the insurable price minus the cost of the premium. If the market goes up, the rise in the price of the livestock covers the premium. If the market goes down, you’re locked in at the insured price minus the cost of the premium, saving potentially costly losses.”

Copithorne also points out that WLPIP and WHPIP allow producers to lock in prices in Canadian dollars, thereby eliminating basis and currency risk. In addition, there are no margin calls, and anyone with cattle or hogs can sign up.

The biggest downside to price insurance is that insurable prices are often lower than the cash market.

Where to go for help

“Many producers are intimidated by all the information and numbers, but it’s no different than the production side of the farm: some things you do yourself and others you are more comfortable having someone else handle for you,” Gietz says.

“The primary cost of implementing a marketing and risk management strategy is time: do you want to use your time, the time of an employee, or the time of a hired professional?”

Livestock producers looking for help creating marketing and risk management plans can contact their provincial agriculture department.

While peace of mind doesn’t come without a price tag, it can be bought. Livestock producers can’t control the weather or the markets, but they can seize opportunities to secure desirable profit levels or minimize losses. A good risk management plan – crafted on your own or with the help of a qualified professional – is worth the investment in the long run.

From an AgriSuccess article (Nov/Dec 2015) by Trish Henderson (@TrishHenderson3).

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