September 21, 2020
Sometimes the wheels of progress turn slowly, but at least they are moving in the right direction on one item — risk management options for livestock producers.
A couple of months ago in this forum I discussed the introduction of a cutout-based settlement contract being contemplated by the CME. As of this writing, it is not officially introduced but the structure to underpin the product is being put in place and I would expect an official announcement relatively soon.
Assuming that occurs — and in addition to a couple other changes both in the air and on the ground — pork producers will have myriad of tools to consider for their risk management needs. I will dive a little deeper into these options, including an old program that has had some new life breathed into it — a government-subsidized insurance program.
The background of basis convergence, or the lack thereof, has vexed several hedgers in the past several months. Losing money on a hedge and on your production has been a gut punch to the industry and has led to some skepticism to those using the currently available tools offered by the CME. Put bluntly, the CME index has not been reflective of the open market and has not worked well as a viable, effective hedge for those with a cash market-based contract. Recognition of this disparity is one of the compelling reasons that the CME has chosen to explore a cutout contract. (This is where my comments regarding sluggish response come from) I am pleased at their consideration now even if it is a bit delayed in the offering.
The lack of agility in responding to economic stimulus has not gone unnoticed by the financial community and other products — namely, swaps — have moved in to fill that gap. A swap is an over-the-counter instrument that is settled in a similar manner as a CME instrument with a few wrinkles. Without getting into too many details, swaps can be tailored with quantity, settlement, price discovery vehicle, etc., to fit a specific need or desire.
Board traded futures and options are structured and can't be customized. This flexibility has made the quotation of swaps more cumbersome and has in the past required an extensive bid/ask conversation that can be clumsy. Additionally, it is more difficult to move out of a swap agreement relative to a CME product, and producers may be disenchanted with the discount they have to take to trade out of the position.
This is about to change. Big Money firms have observed the difficulty in application and are doing something about it. Later this month, one firm will be offering electronic quotes on several of their products so users can quickly see the bid/ask spread and compare it to both other markets and their own risk mitigation needs. This is an important concept. The ability to compare current CME futures and options, ostensibly the CME cutout contract futures and options and the OTC swap prices is a huge step forward for producers and one that we should all embrace as a change to the positive.
The other recent change was in the insurance arena. The USDA has been subsidizing a hog revenue offering that — perhaps in typical government fashion — was seemingly written by someone with no clue how things work in the real world. To be sure, there were some bright minds in the private and academic sector that developed the underpinnings of the program, the administration by the USDA confounded the logic and thwarted their application. Recent changes in the program make this a much more palatable program and worthy of consideration to a broader scope of producers.
There are two basic buckets of government-subsidized insurance for the pork producer. One is called Livestock Gross Margin and the other is Livestock Risk Protection. Livestock Gross Margin is a combination of hogs, corn and soy to do what the name implies — cover an imputed margin. The beauty of this program is that the government will subsidize the cost of the put insurance by up to 50%. That is a huge number and one that my Libertarian bend questions regarding the benefit to society of government intervention into the economic theatre.
The program does not have limits on the quantity of head contracted and has no income limits for participants, it is currently quoted on a three-day moving average that has to be executed before 9 a.m. on the fourth day (this is likely changing to be a routine Tuesday-Wednesday-Thursday average for execution on a Friday, this will make the program easier to compute and compare) There are some other provisions, such as having to be "conservation compliant" via the USDA form AD 1026 and a couple of other bureaucratic features that your government throws in for good measure, but it is probably nothing that will surprise you if you participate in Risk Management Agency-administered crop insurance through the USDA. There are no upfront fees to the user, all credits or debits occur at the end of the marketing period, there is no commission load paid by the producer (more on this later). All in all, the concept is applaudable if you can integrate the quirks into your operation.
The second program, Livestock Risk Protection, is where the bigger changes recently occurred. This program has been in place for several years and was a favorite in my previous role in commercial pork production to take free money from the government. Literally. In its past iteration, a pork producer could hedge a maximum number 30,000 hogs annually, using a subsidized put option calculated off the previous day's close.
Let's think about how this may have a flaw. If you had a major market event, such as surprise in the Hogs and Pigs Report, that resulted in a limit-down or even expanded limit-down days, you could elect to buy a put on the previous day's market and immediately be in the money. If you wanted to collect on the "hedge" you could simply sell the put on the board for the higher value (based on the then-current market) and pocket the spread. This was clearly not the intent of the program and this same Libertarian felt a little guilty for executing the arbitrage, the economic layup was offered, and we took it.
The changes in the program do not close this loophole, they theoretically make it bigger by expanding the maximum head eligible to 150,000, a fivefold increase in the level of participation. Additionally, the level of subsidy increases dramatically. The subsidy level used to span from 25-35% depending on coverage level; that range has been expanded to 35-55%. Your tax dollars at work.
This LRP program is a bit easier to calculate and compare to a board-traded product. The subsidy level should make it attractive even after the government-imposed conditions to participate. This program is not subject to income restrictions and all bonafide owners of livestock will qualify.
You will be hearing a banging on your door by several firms offering these programs for good reason. Even though they cost the producer zero in commission, the load paid to the insurance broker by the government is insanely motivating — over 20 times more lucrative than our typical brokerage commission. This is where the title of my column comes into play — Choose wisely.
Once you have signed up with an insurance agent, you are unable to change this election until June of each year. Make sure you are dealing with a well-informed entity who is looking out for your best interests, not just churning a commission. Beware, there are a bunch of city folk in cheap suits that are more interested in flash than substance, make sure you are dealing with someone who will explain and evaluate all of the options for your consideration. We are dealing with a firm that has been writing insurance for several years and understands the programs and all of their administrative hurdles. We are developing a platform that will list a comparison of all parameters so you can better understand the alternatives (current futures and options, cutout futures and options, swaps, LGM, LRP) email me if you would like to be on the distribution list.
The September Hogs and Pigs Report is due out on Thursday with as much anticipation as we had for the June numbers to discern the COVID impact. This report will likely not substantiate the June numbers as being right or wrong; the on-farm practices to manage supply make it impossible to know whether those numbers were valid. They were — and the September numbers will be — the best information we have at our avail for the next three months. We are hoping for the best and I suspect we will see the resourcefulness of pork producers in adjusting their practices during the crisis.
If we discover that the number of pigs on the farm have, indeed, been reduced to both fit the current packing run rate and (perhaps?) even inspire that community to bid up for market-ready animals, is this time to revisit that Force Majeure letter that was shoved in your face this spring?
In conversation with the legal community (not from the city and wearing a very nicely tailored suit), those provisions run both ways. The packer's willingness to casually toss you under the proverbial bus has another implication that they may have not fully considered. The bus has a reverse gear, too.
In the event that you are able to garner more money in the spot market compared to your current pricing mechanism, you are free to do so with no negative litigation ramifications. The Force Majeure clause runs both directions and is kind of like a divorce (for some of us that know how those things work). If one party wants out, there is not much the other side can do to stop the process and once those binds are severed each party is free of obligation to the other. I encourage you to think long and hard about the implications of your decision, but this may be a very liberating factor for your financial future and could allow you to seek more favorable terms, with the ex or another potential partner. This is no time to be Iowa Nice. Accept what is put on your plate. Fight for your existence and stop apologizing for advocating for yourself.
Comments in this column are market commentary and are not to be construed as market advice. Trading is risky and not suitable for all individuals.
Source: Joseph Kerns, who is solely responsible for the information provided, and wholly owns the information. Informa Business Media and all its subsidiaries are not responsible for any of the content contained in this information asset. The opinions of this writer are not necessarily those of Farm Progress/Informa.
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