Drovers is running a series of articles by agricultural economist and industry consultant Nevil Speer explaining how futures work. With permission by Drovers, these articles will be edited for space and republished here from time to time over the next several weeks.
STRAIGHT HEDGE EXAMPLE
Some market commentary in early May proclaimed cattle feeders had achieved their best sales of the year (despite the cash market trading in the low $120s).
The logic was something like this: feedlots sold cattle early in the week at $122 (per cwt), meanwhile the spot futures market on that day was $112; that equated to a $10 basis – meaning, “you can add that on to the sale price of $122 because when they’re short the board that means they can pick up that extra money – tack $10 on $122 and you’re suddenly at $132.”
Unfortunately, that’s NOT how it works. Perhaps one of the most misunderstood principles of hedging revolves around the concept of basis.
Basis equals the difference between the cash market and the futures market (cash minus futures). Here are two generalized examples outlining its importance.
Let’s assume that cattle marketed in early to mid-May went on feed at some point between mid-November and mid-December when the CME’s June live cattle contract averaged roughly $114.50. A feedlot would sell (or short) June futures contracts to implement a hedged position (at $114.50).
During the past five years, May’s basis average has been a positive $9.75. Therefore, at the time of placing the hedge, the feed yard’s expected selling price would be $124.25 ($114.50 + $9.75).
The feedlot is now indifferent to what occurs in the futures market – they are protected against downside market risk. The only remaining price risk revolves around basis.
Fast-forward to the first week of May, and the cattle are ready to be marketed. The cash market averaged $123.75 while the futures had drifted back to $114 (basis was right in line with the five-year average).
The feedlot markets the cattle at $123.75 while simultaneously negating the short position in the futures market by purchasing June contracts at $114 – thereby facilitating a 50¢ profit. The net selling price is $124.25 ($123.75 + $.50).
Basis is NOT added on to the cash market to determine net sales price as the commentator noted.
Two weeks later, the basis had weakened to $6.50 against $110 live cattle futures contract. The outcome being a relatively lower net sales price.
The net selling price in that instance is $121 ($114.50 – $110 in the futures market totals $4.50, plus cash market of $116.50). In other words, the hedge remains the same but the net selling price is less because basis had weakened.
So even though the hedge is placed, the feedlot is still exposed to risk from a weakening basis.
A straight hedge also means there is potential to miss strong moves to the upside; that’s where put options come into play.
CATTLE, BEEF RECAP
Cash cattle traded in the Plains last week at mostly $111 to $112 per cwt on a live basis with some in Nebraska at $114 to $115. Dressed-basis trading was reported at mostly $182 to $183 per cwt with some early up to $185.
The USDA choice cutout Monday was up $0.47 per cwt at $213.27, while select was off $0.39 at $189.21. The choice/select spread widened to $24.06 from $23.20 with 101 loads of fabricated product sold into the spot market.
The CME Feeder Cattle index for the seven days ended Friday was $140.46 per cwt, down $0.62 from the previous day. This compares with Monday’s Aug contract settlement of $141.65, up $0.05.