Hedging Considerations With High Steer Calf Basis

By Darrell Mark

As discussed in recent Profit Tips articles on iGrow, the demand for lightweight feeder calves has been especially strong this year. Not only has that driven price levels to record highs in recent months, but it has also resulted in record strong basis levels as well. As shown in Figure 1, the basis for 500-599 lb steer calves in South Dakota has averaged near $50/cwt since May 2014.

Typically, the basis for these steers would average about $23/cwt, based on the previous three years. In fact, the strongest basis observed from 2011-13 was generally around $31/cwt, although it did increase to $40/cwt. Regardless, the current steer calf basis levels between $50/cwt and $60/cwt are well beyond historical levels. While this offers sellers an even more attractive cash selling price, it does impact their hedging decisions. And, for buyers, it results in higher cash market prices and some risk management considerations as well.

For cow-calf producers evaluating strategies to protect current price levels for their fall calf crop, the strong basis offers attractive cash price projections. But, it is important to note that several common hedging tools do not protect these strong basis levels. Hedges that exclusively involve futures and options do not protect against basis weakening.

So, short futures positions and purchases of put options, while effective at hedging current high price levels, will not protect against declines in basis. While that is always somewhat of a concern when using these risk management tools, it is particularly concerning when basis levels are so strong that a return to an average basis would result in a $30/cwt drop in basis and, therefore, cash price. For cow-calf producers planning to sell their calves this fall and wanting to lock in the price level, a cash forward contract would be effective at hedging both the current high price level and basis. A cash forward contract could be initiated through a private treaty arrangement with a cattle feeder or backgrounder. Many video auctions also use a forward contract that would protect against both price and basis changes. Calf sellers that want to lock in the current strong basis but remain open to price risk (hoping for higher price levels) could use a basis contract.

Here, the cow-calf producer would directly contract a specific basis level with a feedyard or other calf buyer but leave the (futures) price level unspecified. Combining such a basis contract with purchases of put options would simultaneously lock in the current high basis level and establish a floor price level in the futures market. Another possibility to gain some basis level protection might be through Livestock Risk Protection (LRP) insurance.

This insurance locks in a minimum price level that is based on the CME Group’s feeder cattle cash settlement index. However, the difference between a local producer’s actual basis in South Dakota and the feeder cattle cash index would still remain unprotected. Only the price spread between the futures contract price and the cash index is hedged with LRP insurance. Research has shown this typically offers little protection from the basis between futures price levels and local cash prices because the cash index is aggregated based on cash prices from around the nation and the futures contract price level must converge to the index when the contract expires.

Cattle feeders, backgrounders, and other calf buyers also need to be concerned about being protected from sudden basis changes. While the current strong basis means that they will pay higher cash prices to obtain calves, their primary basis risk is purchasing calves on a very strong basis and selling yearlings or fed cattle on a traditionally weak basis.

Again, basis isn’t necessarily expected to weaken substantially, but a return to historical averages alone would result in significantly lower cash prices and a squeeze on already tight backgrounding and feeding margins. So, calf buyers who are buying calves now (or for fall delivery) using cash forward contracts or basis contracts should consider simultaneously protecting their “sell” basis – the basis of the yearlings or fed cattle they intend to sell.

As discussed above, cash forward contracts or basis contract are common tools to do so. The idea behind selling the basis for the cattle to be backgrounded or fed as soon as the calves are purchased (when the basis is bought) is to protect against basis declining. Of note, though, is that the basis for yearling feeder steers is only trading $5-10/cwt over historical average levels. This effectively makes backgrounding and feeding margins tighter and underscores the importance of managing the risk of basis changes.

Figure 1.

Source:SDSU