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Protecting Higher Cattle Prices

May 8, 2017

In early 2017 cattle producers were frustrated by price levels below where fundamental indications suggested they could be. In recent weeks the cash and futures prices have moved higher, finally providing an opportunity for producers wanting solid price protection across different cattle sectors. It may also be a time for any hedgers that implemented protection strategies early in the year to revisit coverage and perhaps roll up to higher floor prices or lock in higher price levels available now.

Cattle Futures Market
The price change is most evident in the live cattle futures market. Consider the levels and changes during the last quarter. On Feb. 1, 2017, the price level for most trading contracts was about $100 per cwt. On May 1, 2017, the prices had increased to about $120 per cwt across delivery months (Figure 1). The nearby contracts are most useful for those with cattle on feed. Deferred contracts are useful as an indicator of the potential value of yearlings and calves. The feeder cattle futures prices have also increased, following the live cattle prices higher. The prospect of live cattle continuing to trade at $120 into 2018 suggests much higher calve prices in the fall of 2017 than realized in the fall of 2016.

Cattle Market Volatility
One downside to the current rally is a corresponding increase in the implied volatility in the cattle markets. The feeder cattle, in particular, have had the prices and volatility increase across contract months. The effect can be observed by considering the November feeder cattle contract. The mid-year volatility was very low in 2012, 2013, 2014 and 2015 (Figure 2). Low futures prices in 2016 were coupled with high volatility levels. The recent rally in deferred futures prices has been accompanied by implied volatility that has recently increased to 22% for the November contract. As a result, the premiums for options and Livestock Risk Protection (LRP) are high for the price level available. Regardless of the higher volatility, the much higher price levels would offset higher premiums on any feeder cattle that have been unprotected up to this point.

Protecting Calf Crops
Seasonally, this is a common time of the year for cow-calf producers to begin protecting the calf crop that is likely to be sold this fall. The higher feeder cattle futures prices provide some indication of calf prices. A common strategy in the cow-calf sector is to use LRP as it can cover a small number of head with a basis adjustment for calves. Recently, there has been enough options volume trading to give a wide range of ending dates and coverage levels that align with selling calves this fall.

For example, on May 1, 2017, the LRP ending value for Oct. 30, 2017, was $167.32 per cwt. after applying the adjustment factor. Different coverage levels were available reflecting various deductibles (Figure 3). Subtracting the premiums results in floor prices for the different coverage levels. Thus, at the 99% coverage level, the premium would have been $8.61 per cwt after the subsidy, resulting in a floor price of $157.47 per cwt for calves to be sold in late October of 2017.

The Bottom Line
Monitoring rallies are necessary to stay aware of opportunities to lock in favorable floor prices. Seasonally, this time of year often results in price rallies and is before any major crop volatility that can carry over to cattle volatility.

Source: Matthew Diersen, South Dakota State University, iGrow