By Angus Brown | Source: CME, MLA
We recently received a query from a subscriber asking about the how they might manage cattle price risk when trading. Since the demise of the MLA/SFE Cattle Futures contract in 2009 there has been no local way of hedging cattle prices, so we’ll take a look at the potential to manage price using US cattle futures.
Grain growers regularly use Chicago Board of Trade Wheat futures to hedge the price of their grain. With wheat being a global commodity, prices here tend to follow those in Chicago closely as our wheat competes with US wheat into export markets.
A similar theory can be applied to beef and cattle. Regular readers will know that international markets, and the US market in particular, tend to drive set the base level of our markets here, as a large proportion of Australian beef is exported. However, the number of processing steps between live cattle and beef in export markets makes the relationship between US cattle prices, and our cattle prices rather rubbery.
Figure 1 shows the CME Feeder Cattle Futures in AU¢/kg, along with the Eastern Young Cattle Indicator (EYCI) and the Eastern States Medium Fed Feeder over the past 10 years, while figure 2 shows US Live Cattle Futures and the 100 day grainfed Qld over the hooks indicator. There appears to be some relationship between CME Feeder Futures and Australian young cattle prices, but the problem lies in the wide variation in the ‘basis’.
Basis is the difference between the price of whatever is being sold, and the futures contract being used to hedge the price. The EYCI basis to CME Feeders is shown in figure 3, along with the basis of 100 Day Grainfed QLD Over the Hooks cattle to the US Live Cattle Futures Contract.
A way of assessing whether a futures contract is a good tool for hedging is to compare the range in the actual price with the range of the basis. Over the last 10 years the EYCI has had a range of 160¢/kg lwt, while the basis to CME Feeders has had a range of 350¢/kg lwt. When hedging you really want the basis range, or variation, to be much lower than the range in actual values, or you are increasing risk, rather than decreasing it.
Using US cattle futures to hedge local cattle prices is unlikely to decrease price risk, and at times may increase it, for better or worse.
For example, a grower sells November 14 CME Feeder Cattle Futures in August 14 at the record price of 500¢/kg lwt (equivalent AUD cover is taken) with the expectation that Australian Feeder cattle prices (at 195¢/kg cwt at the time) would follow US Feeder cattle higher. In November the Futures contract has realised a loss of 100¢/kg lwt due to rapid price rise, while local feeder prices have gained just 5¢. The net result of the hedge is the final sale price, or 200¢/kg lwt, minus the futures loss of 100¢, giving a net price of 100¢/kg lwt.
Using US Feeder cattle futures in September 2015 for cattle sales in November 15 would have had the opposite result, with a net price of around 450¢/kg lwt.
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