Agricultural Marketing ECON 337: Agricultural Marketing Lee Schulz Assistant Professor lschulz@iastate.edu 515-294-3356 Chad Hart Associate Professor chart@iastate.edu 515-294-9911 1

Choosing from livestock risk management tactics

Livestock Price Risk Tools Livestock Futures and Options Livestock Revenue Insurance Livestock Revenue Protection (LRP) Livestock Gross Margin (LGM) http://www.rma.usda.gov/livestock/ Factsheets Premium calculator http://www.extension.iastate.edu/agdm/ldcostsreturns.html 7 3

Livestock Risk Protection (LRP) Price risk insurance coverage for hogs, fed cattle, feeder cattle, and lamb Insurance protects against low livestock prices 70% to 100% guarantees available for cattle and hogs, based on CME futures prices

Livestock Risk Protection Coverage is available for up to 26 weeks for hogs and 52 weeks for cattle Works sort of like a put option Premiums are subsidized, the government pays 13% of the premium

Buy LRP insurance policy… Characteristics - locks in a “floor” price (CME cash index) subject to basis risk contract specifications somewhat flexible (e.g., weight) contract size flexible (FC: 1 hd up to 1,000 – max of 2,000 hd/yr) (LC: 1 hd up to 2,000 – max of 4,000 hd/yr) deal with crop insurance agent pay premium for LRP policy have to buy in “off hours” (i.e., ~4:00 pm – 9:00 am) tied to options market (determines availability) price quotes available on RMA website (70% - 100% coverage) no risk of other party “backing out” no risk of low quality cattle being “refused” cash settled contract (no delivery ability / obligation)

Comparison of Livestock Risk Protection Policies… http://www.extension.iastate.edu/agdm/livestock/pdf/b1-50.pdf

LRP Example… Coverage Expected Cost per Length Price Level % cwt 13 weeks $143.30 $135.47 94.54% $0.670 $125.47 87.56% $0.095 17 weeks $145.04 $134.44 92.69% $0.527 $128.44 88.56% $0.171 *Other coverage lengths and prices available. Projected sales are for 100 head marketed in 17 weeks at a live weight of 1,250 cwt, with 100% ownership. A 92.69% guarantee is chosen. Premiums are subsidized, the government pays 13% of the premium. Insured value = 100 head x $134.44 x 12.50 cwt = $168,050 Premium = 100 head x $0.527 x 12.50 cwt x 87% = $573 The final price at the end of the 7 week period is $134 per cwt. Actual revenue = 100 head x $134 x 12.50 cwt = $162,500 Indemnity payment = $168,050 - $162,500 = $5,550 http://www3.rma.usda.gov/apps/livestock_reports/main.aspx

LRP vs. Futures/Options Futures and options have fixed contract sizes Hogs: 400 cwt. or about 150 head Fed cattle: 400 cwt. or about 32 head Feeder cattle: 500 cwt., 60-100 head LRP can be purchased for any number of head or weight

LRP vs. Futures/Options Futures hedge or options can be offset at any time before the contract expires LRP can not be offset, once you buy the coverage, you’re locked in

Livestock Gross Margin (LGM) Insures a “margin” between revenue and cost of major inputs for cattle, hogs, and dairy Protects against decreases in cattle/hog prices and/or increases in input costs Hogs Value of hog – corn and soybean meal costs Cattle Value of cattle – feeder cattle and corn costs There is a version for dairy as well 7 11

Livestock Gross Margin Cattle (coverage for up to a year out) Calves Yearlings Hogs (coverage for up to 6 months out) Farrow to finish Finishing feeder pig Finishing SEW pig 7 12

LGM Guarantees for Hogs Farrow to Finish Gross margin per hogt = 2.6*0.74*Lean Hog Pricet - 12 bu. * Corn Pricet-3 - (138.55 lb./2000 lb.) * SoyMeal Pricet-3 Finishing 2.6*0.74*Lean Hog Pricet - 9 bu. * Corn Pricet-2 (82 lb./2000 lb.) * SoyMeal Pricet-2 SEW 2.6*0.74*Lean Hog Pricet – 9.05 bu. * Corn Pricet-2 (91 lb./2000 lb.) * SoyMeal Pricet-2

LGM Guarantees for Cattle Yearlings Gross margin per headt = 12.5*Live Cattle Pricet – 7.5*Feeder Cattle Pricet-5 - 50 bu. * Corn Pricet-2 Calves 11.5*Live Cattle Pricet – 5.5*Feeder Cattle Pricet-8 - 52 bu. * Corn Pricet-4

Livestock Gross Margin Has deductibles, like car or home insurance For cattle, deductibles from $0 to $150 per head by $10 increments For hogs, deductibles from $0 to $20 per head by $2 increments 7 15

LGM yearlings example… Dec Jan Feb Mar Apr Gross Margin $118.69 $89.77 $81.07 $104.61 $164.11 Live Cattle Price $146.32 $147.07 $146.27 $148.43 $150.88 Feeder Cattle Price $199.48 $202.41 $203.54 $204.91 $200.78 Corn Price $4.28 $4.61 $4.42 $4.32 7 16

LGM yearlings example… Say we insure 100 cattle in April and choose a $20 deductible. Our LGM policy is protecting us against gross margins below $144.11 per head When April comes, the insurance company will compute the actual margin using the same formula as was used for the guarantee 7 17

LGM yearlings example… If the live cattle price fell to $146.00 per cwt., the corn price increased to $4.80 per bu., and the feeder cattle price stayed at $200.78 per cwt, then the actual gross margin is: Actual gross margin per fed cattlet = (12.5 * $146.00) – (7.5 * $200.78) – (50 * $4.80) = $79.12 per head Per head indemnity = $144.11 – $79.12 = $64.99 7 18

LGM Issues Only available on the last business Friday of the month Is a complicated insurance policy Works like an Asian basket option Asian = uses a price average Basket = covers more than one commodity Like a put on cattle/hogs and calls on feeder cattle, corn, and soybean meal 7 19

Who can benefit from LGM/LRP? Producers who depend on the daily cash market or a formula related to it. Producers with low cash reserves. Smaller producers who do not have the volume to use futures contracts or put options. Producers who prefer insurance to the futures market. No margin account.

Some Risks Remain LRP, LGM do not insure against production risks Futures prices and cash index prices may differ from local cash prices (basis risk) Selling weights and dates may differ from the guarantees

Class web site: http://www2.econ.iastate.edu/faculty/hart/Classes/econ337/Spring2016/index.htm