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Evening Out Market Highs And Lows

Kirk Caldwell dodged a bullet. He knows most pork producers have been losing a fistful of dollars on every hog they sold in 1998-99.During the same time, the Forest, IN, producer maintained a positive cash flow using forward pricing. He has consistently been getting $40-plus/cwt. for his hogs."The combination of futures options and market risk-share agreements I have been using have been a life-saver,

Kirk Caldwell dodged a bullet. He knows most pork producers have been losing a fistful of dollars on every hog they sold in 1998-99.

During the same time, the Forest, IN, producer maintained a positive cash flow using forward pricing. He has consistently been getting $40-plus/cwt. for his hogs.

"The combination of futures options and market risk-share agreements I have been using have been a life-saver, they really have," comments the 37-year-old, 650-sow, farrow-to-finish producer.

"I sell my hogs in advance and buy my feedgrain needs in advance, just to guarantee the margins, and because I don't like surprises," observes Caldwell.

He says the move to forward price contracting was out of necessity. There really was no other way for him to get started in the hog business. The hog operation he and his wife started back in 1988 in central Indiana was built on the guarantee of profit margins afforded by the futures markets and feed company contracts. Lenders were requiring the guarantee after the agricultural economic crisis of the early 1980s, he points out.

Even with prices locked in, he admits raising hogs has been a bit of a struggle. He borrowed every dime to start his operation at 300 sows. He expanded in 1993, more than doubling the size to 650 sows. Since day one, he and his wife worked long hours with little help to keep costs down. His wife takes care of their two small children now, but still manages to process all the baby pigs and does all the farm paperwork. Caldwell has worked in the units seven days a week since the operation began; he now has two, full-time employees.

Caldwell realizes that simply working long hours, without market price protection, wouldn't guarantee profitability. Most of his hard-working neighbors found that out the hard way. "There were hogs being raised every few miles around here a few months ago," Caldwell says. "Now I am the only one left on this side of Clinton County who's got hogs," he laments.

Keys To Survival For his part, two long-standing practices have been integral to survival.

First, he makes a habit of socking away funds when possible, for the hard times. He believes his level of equity (he only has three years of payments left on one building) could probably have saved him in this current crisis.

Second, the use of futures pricing contracts keeps his margins in the black. He buys a large part of his feedgrains a year ahead, and also sells his hogs in advance, using a combination of futures and option contracts. Caldwell markets hogs to IBP Inc. at 225-230 lb., just above weight cutoffs if carcasses yield well, and making his goal of increasing building throughput.

To make commodity trading work, Caldwell stresses you need to closely measure your feed needs to know how much to purchase that far in advance. And you need to balance major hog operation costs vs. revenues before you venture into hog futures marketing, he advises.

The Indiana producer says pork producers turn to the lean hog futures market, instead of futures options contracts that hold much less price risk, because options are newer and aren't well understood.

Put Option "When you buy a 'put option,' it allows you to take advantage of a market price rise and be protected in a market price fall," says Caldwell. "An options strategy is just like buying an insurance policy."

For example, in a "call option" it could cost you $1-1.50/cwt. to guarantee a cash hog equivalent price of $40/cwt. That insurance or premium places a floor under cash prices. You are guaranteed at least that price. If the price on your contract rises, you get the higher figure, minus deduction of the premium from your options check, explains Caldwell.

Options Hedge The use of an options hedge does involve the use of the futures market, but instead of selling the actual futures contract, the producer would buy the right to sell the futures contract at a certain price, points out Brian Buhr, extension agricultural economist, University of Minnesota. This would be a put option and the purchase price of the put option is the premium. This premium is all the put option will ever cost - there are no margin calls or other financial requirements beyond the "insurance fee" and brokerage commission, he explains.

Of course, the closer the strike price is to the futures price, the more the insurance or premium is going to cost you, points out Dana Scott, Logansport, IN. The disadvantage to the options insurance or premium is that it effectively adds to the cost of production, explains ag economist Gary Schnitkey of the University of Illinois.

Like Caldwell, Scott, a 400-sow, farrow-to-finish producer, mostly relies on futures option hedges to forward contract his hogs. But he has also used fixed, short-term packer contracts to provide some market price protection.

For the options contracts, he buys 40,000 lb. carcass weight contracts, which for him comes out to about 155 hogs at 260 lb. Using an options premium of $2/cwt., he figures it costs about $800 to sell a contract of 155 hogs.

"If you dabble in the futures market, you can have big gains or big losses that can hurt you and sometimes have bankrupted producers," says Scott. "But if you stick with options, you won't have that big of losses."

Caldwell, who has traded forward price contracts for 18 years, suggests using options when hog prices are high, not when they are low. "For instance, when cash hog prices got to $60, I hedged for a year and a half out so I guaranteed myself $55 hogs when everybody else ended up getting $30-35 on the cash market," he explains. "Then you take that money and pay down principal on payments and put the rest in the bank, because if you have been in the hog business long enough, you know that $60 hogs can soon become $30 hogs. And when prices go back up again, you hedge further out and do it all over again."

Monte Moss, DVM, producer from Burnettsville, IN, agrees with that marketing philosophy. "In the past, I used to forward contract my hogs when the futures market was at the bottom and when I was getting scared of cash market prices.

"However, what you want to do is watch the charts and try to lock in prices off some sort of a peak." A lot of times it takes patience to wait to lock in prices until the market starts to move down, he admits.

The other thing that Moss, a 1,200-sow, farrow-to-finish producer, has done is base his forward pricing decisions on projected cash flows. "I project in prices that I think the equivalent cash hog market is going to be for the coming year and put those in my cash flow. And then I look down at the bottom line to see if I have a profit or a loss. If I look at futures prices and can forward contract at a better price than what I've got projected, then I am going to forward contract my hogs and increase my profit picture."

Like Caldwell, Moss has used the lean hog futures market of the Chicago Mercantile Exchange (CME). The idea is simple, contracting for a price in the future that exceeds the cash price you can get for your hogs.

Futures Hedge But instead of the options hedge as described by Caldwell, Moss started out using the futures hedge. For that basic hedging program, the producer would simply sell the lean hog futures contract nearest the date the hogs are expected to be delivered. The live hog equivalent price is based on the futures price, times 0.74 (estimated carcass yield). Packers or whomever is buying the pigs will deduct a basis amount when they believe that the range between futures market and the cash price is too wide, says Moss. Sometimes there is a plus basis when the range between futures and cash prices narrows. Producer cash equivalent prices will vary depending on their marketing arrangements, location and pork quality.

According to Moss, both full and mini contracts are available through CME. A full contract runs 40,000 lb. carcass weight, a mini is 20,000 lb. A full contract converts to roughly a semi-load of 200 hogs for Moss' double-deck truck.

The biggest reason that Moss has not used the futures hedge program much anymore is the amount of future price risk. Producers may be responsible for margin calls. He observes, "Say I lock in $56.30 for August and hog prices go down to $54 on the futures hedge contracts. They are going to call me up and ask that I pay margin calls on my contract, the difference between the price I contracted and the current lean hog futures price. That can quickly get into tens of thousands of dollars."

Fed up with costly margin calls, Moss switched to forward pricing with a packer. In a packer contract, futures hedging responsibility falls on the packer, not on the producer.

Declares Moss, "I like this a lot better because I am no longer responsible for margin calls. The packer or whomever carries the contract is responsible for that."

Of late, Moss has been using short-term packer contracts for the majority of his hogs, selling the rest on the open market. For example, October 1998-February 1999, he forward contracted 80% of production at $29/cwt. During that period of the lowest hog prices in history, the average cash hog price for his peers on United Feeds records program was $14/cwt. He locked in a price that was unprofitable. But the lesson was that the return was still a good deal better than selling solely on the open market, "and I was glad he made that move," remarks brother and partner Mark Moss.

Mark details another important lesson in using market contracts to forward price hogs. "It's risk management. You have to be satisfied with what you are doing. If you locked in a profit, then be happy with what you locked in, not the additional profit you may have missed."

And to their benefit, unlike the futures contracts, forward pricing with a packer does afford market access protection, points out University of Minnesota's Buhr.

The Mosses finish half their hogs, selling the other half as early weaned pigs to a Michigan producer.

Forward Pricing Basically, there are only two types of forward price contracts for pork producers: futures market forward pricing and forward pricing with packers.

Indiana producer Scott says for those interested, there are seminars available to help you do your own forward price contracting.

Scott does his own contracting, instead of paying a broker. His advice, start small to test the waters, such as a 20,000-lb. mini-contract. And if you need to buy a lot of grain, also consider using grain option calls, to buy price protection. A grain shortfall could end up being worse than the hog price crisis, he warns.

Scott used a few short-term packer contracts in 1998, and they paid off for him. While the industry's average price in 1998 was $33/cwt., his was about $37/cwt., and about $3/cwt. higher than his peers on United Feeds records.

Scott explains in futures hedges, which he has also used, you buy the whole contract and can sell it again the next day on paper if the price warrants it. Or you can wait it out until its due date.

That contrasts with options, which he prefers, where the only cost is the insurance or premium amount you pay per hundredweight. With both, you market your hogs as you would normally to your packer and take the cash price offered.

In these tight times, even the futures market has taken its lumps. There is a narrow window of high-level profit and you have to time your move, warns Scott. Remember though, the goal of forward price contracting shouldn't be trying to hit the market highs, but rather avoiding the low prices which can bankrupt your operation.

As with Caldwell, Scott has built equity to weather the hog price storm. Scott's rule of thumb is, "If we don't make money, we don't spend money." All of their buildings are paid for, a collection of remodeled '60s and '70s barns and a complement of newer facilities.

The goal of your marketing plan should be to manage risk and protect profit potential, says Brian Buhr, University of Minnesota extension agricultural economist.

Develop a marketing plan that will help you manage price risk. Use these five steps:

* Collect information. It includes personal and business financial data and marketing information.

* Set price goals. These goals should be based on cost of production, financial information and personal risk tolerance. As well, they should take into account market conditions.

* Carry out your strategies. "This step often is the one that destroys a marketing plan," states Buhr. It is also called "pulling the trigger."

* Check performance of your marketing plan relative to your marketing goals.

"The biggest reason people fail to repeatedly use marketing plans is that their performance is compared to what might have been, which is typically the highest price alternative," he says, "which is probably an unrealistic goal."

Buhr says forward pricing contracts are common risk management marketing strategies. "No one strategy is best all the time. Each has its place under certain circumstances as risk-reducing strategies," he says.