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HUNTIN' DAYLIGHT -- DOWN SIDES OF UP STRATEGIES

by: Wes Ishmael

The drought and plenty of market uncertainty, notwithstanding, in the mid-term--say, the next 18 months or so--this is one of those odd, too rare moments in the cattle business when supply, demand and the attendant market prices mean each production segment has an opportunity for profit.

Unfortunately, these times also tend to make it the easiest to ignore ongoing trends that impact long-term profitability.

What's True Today…

For instance, producers continue to hear about the increasing percentage of fed cattle trading away from the cash markets. The very fact those percentages have increased dramatically during the past decade underscores the fact that at least part of the industry is paying attention to the evolution because they're making it happen. Others, however, are content with the, "I'll believe it when I see it,” approach.

Well, if the hog industry--with all due respect to its intrinsic, confined and controllable production environments--is any indication, it's not a question of whether marketing contracts and non-cash pricing mechanisms are the wave of the future, but when exactly they'll supplant the spot market.

In that industry, Ron Plain, an agricultural economist with the University of Missouri, says, "We really have to wonder how long the spot market will be around." He explained to the crowd on hand and online for AgStar Financial Services' Swine Update that as recently as 1994 62 percent of all finished hogs still traded in the spot market. In 2002 that figure had submarined to 15 percent and is expected to keep on dropping.

While Plain estimates only 5-10 percent of hogs need to trade in the spot market for it to continue to be a valid basis for use in other pricing mechanisms he predicts there won't even be that much volume by 2005-06.

For perspective, a spot market is basically a market in which the animal is ready for slaughter when the price is negotiated, whether the pricing mechanism assesses value of the live animal, the carcass or in tandem with some future or formula price. In other words, the spot market represents harvest-ready stock that is trading currently, versus what someone expects for harvest-ready stock to trade for a few weeks or a few months down the road. Conversely, non-spot transactions represent all trades and value negotiation prior to the product being ready for harvest. As an example, you're a cattle feeder and you "sell" a pen of 8-weight feeder steers that you just put on feed, and you sell them for a calculated base price or formula when the cattle are ready to harvest--you still own the cattle, but at least to a degree, you've already locked in a future price for them, while also removing them from the future spot-market population that will determine spot prices in the future.

Some of the reasons for increasing use of non-spot trades revolve around the desire to be rewarded for a better than average product with better than average prices. But plenty of it has to do with managing price risk and ensuring market access.

In surveys of pork producers Plain says those who use non-spot (contract) marketing cite these advantages: it lowers the transaction cost; it assures shackle space (market access); it makes getting carcass data easier and less expensive in some cases; it makes it easier to borrow money because there is less wonderment about what they will be paid for the product.

Plus, tracking a variety of historical pricing information, Plain points out contract prices tend to run higher than spot market prices over time. In part, he says that's due to the fact that transaction costs are shared by buyer and seller, and because both tend to be more optimistic about what future prices will end up being than where they actually land.

Not surprisingly, the same surveys also indicate larger producers tend to like using contracts and non-spot markets more than smaller producers, according to Plain. Although larger producers are undoubtedly better able to employ such mechanisms because they have enough volume, it also speaks to the fact that firms shipping hogs ever day, for instance, find value in negotiating a formula periodically, rather than negotiating the value of every load going out the door. The same applies to the cattle business.

Obviously, there are plenty of detractors in both industries, too, even among those who use non-spot marketing. For one thing, as non-spot supplies grow there are fewer transactions left to define the spot-market price, which is often used as the basis in non-spot pricing. Besides diluting the depth of that market test, if more higher valuable animals are trading away from spot markets, which is presumably the case, that leaves more lower value spot-priced animals to determine the base value of the presumably higher value animals.

The Old Kid in Town

Even so, at least in the hog market, the train has apparently left already. Like it or not, spot marketing may not even be an option in the not-too-distant future.

By and large, even though some economists predict spot markets will remain an option for cattle producers, many expect as much as 75 percent of the cattle market could be traded away from the spot market within the next decade.

That means, whether cattle producers choose non-spot options today, tomorrow or ever, it will pay them to familiarize themselves with the concept and its variety. Just give the myriad of hog contracts available today a flea's blush and you can't question the fact non-spot options open up a whole new maze of possibility.

Try this array of hog marketing options on for size: window contracts, in which buyers and sellers agree to share the risk of extremely high and low markets--when prices drop through a pre-determined floor, the producer is paid more than market price and vice-versa; floor contracts--like buying insurance, you're guaranteed a floor price but you pay a premium on the upside potential to have the insurance; ledger contracts where, in essence, packers loan the producer money to make up for the deficit when prices fall below a pre-determined amount--in turn the producer loans money to the packer when prices exceed a pre-determined sum; and the list goes on.

In each case, the rule of reward and risk drives the equation: You want to remove some of the potential downside in the market; it will cost you some of the potential upside. Overall, the effect is to lop off the extremes and even out market volatility, which in theory at least should reduce risk.

That is, as long as producers understand the ins and outs of any contract they enter, and pay attention to the long-term.

In pork, Plain explains, "Market contact length varies from a few months to seven years. The longer the contract, the more risk there is." Indeed, the market environment that makes a contract profitable today may mean just the opposite as the environment shifts another direction.

Spun differently, Plain explains while risk management may be necessary, a competitive price is essential for the risk management associated with non-spot contracts to work.

In other words, all the risk management in the world can't change the market. Since 1930, Plain explains U.S. pork production has increased an average of 1.5 percent per year, i.e. that's been the demand for growth. Since 1964, every year in which the industry grew less than that producers made an average profit per head of $14.99. Every year production exceeded that average--and pork production per sow has increased four percent per year for the past six years--the average profit per head has been 22 cents.

The point is, non-spot marketing options promise to account for a growing share of beef industry transactions. Even if you never plan to sell away from the cash, understanding and considering these options in tandem with supply and demand fundamentals--especially when profit potential in the current marketplace affords the luxury of time--allows you to consider value in different ways, which can ultimately return more value to you.

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