2016 Commercial Steer Study Guide · 2016 Commercial Steer Study Guide Phone: 210-225-0575 ......

2016 Commercial Steer

Study Guide

Phone: 210-225-0575 Email: [email protected]

Table of Contents Health .............................................................................................................................. Pg. 1 Proper Usage of Drugs and Chemicals in Food Animals ..............................................Pg. 2

Cattle Vaccines ...............................................................................................................Pg. 4

Immunizing Beef Calves .................................................................................................Pg. 6

Basics of Cattle Immunity ..............................................................................................Pg. 10

Recognizing and Managing Common Health Problems in Beef Cattle .......................Pg. 12

Biosecurity for Beef Cattle Operations ..........................................................................Pg. 20

Foot Rot in Beef Cattle ...................................................................................................Pg. 24

Bloat Prevention and Treatment in Cattle ....................................................................Pg. 25

Clostridial Diseases ........................................................................................................Pg. 29

Quality and Yield Grading ............................................................................................... Pg. 32

Beef Quality and Yield Grading ......................................................................................Pg. 33

Beef Quality Grades ........................................................................................................Pg. 34

Beef Yield Grades ...........................................................................................................Pg. 43

Basic Management and Information ............................................................................. Pg. 48

Beef Performance Glossary............................................................................................Pg. 49

The Cow’s Digestive System ..........................................................................................Pg. 55

Texas Adapted Genetic Strategies for Beef Cattle X: Frame Score, Frame Size, and Weight .............................................................................................................................Pg. 62

Dehorning, Castrating, and Branding ............................................................................Pg. 66

Growth-Promoting Implants for Beef Cattle ..................................................................Pg. 69

Implanting Beef Calves and Stocker Cattle ..................................................................Pg. 73

Value Added Calf (VAC) - Management Program ..........................................................Pg. 81

Cattle Handling Pointers ................................................................................................Pg. 83

BQA Cattle Care and Handling Guidelines ....................................................................Pg. 93

The Facts about OptaflexxTM: Ractopamine for Cattle ............................................... Pg. 117

Feedstuffs for Beef Cattle ............................................................................................ Pg. 120

Mineral and Vitamin Nutrition for Beef Cattle ............................................................ Pg. 132

Marketing ....................................................................................................................... Pg. 148

Ranchers’ Guide to Custom Cattle Feeding ................................................................ Pg. 149

Factors Affecting Cattle Feeding Profitability and Cost of Grain .............................. Pg. 154

Beef Cattle Marketing Alliances ................................................................................. Pg. 158

Retained Ownership Strategies for Cattlemen ........................................................... Pg. 162

Grid Pricing of Fed Cattle ............................................................................................. Pg. 166

Using a Slide in Beef Cattle Marketing ....................................................................... Pg. 171

Introduction to Futures Market ................................................................................... Pg. 173

Buying Hedge with Futures .......................................................................................... Pg. 177

Selling Hedge with Futures .......................................................................................... Pg. 181

Commodity Options as Price Insurance for Cattlemen .............................................. Pg. 185

Section 4: Marketing

Beef Cattle Handbook

Custom cattle feeding refers to sending cattle to a com-mercial feedyard that specializes in feeding and manag-ing cattle until they are ready for processing. Thispractice should be considered by ranchers as a means toevaluate the performance of cattle or as a marketingalternative. At times, custom cattle feeding can be a toolto increase the dollar return to a cow-calf or stocker pro-gram. At other times, it may be better to simply sell feed-er cattle or calves. The rancher should consider customcattle feeding when it is likely to increase net returns.

Some ranchers feed some of their cattle each yearregardless of profit potential just to see how their cattleperform in the feedlot. This may become more impor-tant as feeders require evidence of superior cattle per-formance before paying top-market price.

Cattle producers who would like to try cattle feedingbut are uneasy about sending 100 or more head of cattleto a feedlot for the first time, may want to consider par-ticipating in a feedout program. Many states offer similarprograms that allow a producer to contribute five to fif-teen head to a feedout trial in order to get performanceand carcass data on the animals. Examples of these pro-grams include: Georgia’s “Beef challenge;” Idaho’s “A toZ Retained Ownership Company;” North Dakota’s“Badlands Performance Steer Test;” Oklahoma’s “OKSteer Feedout;” South Dakota’s “ Retained OwnershipDemonstration;” and Texas’ “ Ranch to Rail” Program.

Selection of Cattle For Feeding

One key to successful feeding lies in the makeup of thecattle that constitute a pen. Cattle should be as uniformas possible in weight, body type, age, breeding, and in

previous nutritional background. When these conditionsare met, the cattle feeder can feed and sell the cattle toachieve optimum feed efficiency and market value of thecattle. When careful control is started on the producingranch, uniformity in the cattle nearly always results in a 5to 10 percent advantage in efficiency over carefully “puttogether” cattle.

Steers and heifers can be fed, but not in the samepen. Often heifers are discounted more as feeder calvesin marketing channels more than they should be, andcustom feeding may be a means to realize better pricesfor the rancher. When selecting a feedlot for heifers, besure to find a feedlot that can feed and market heifers.

Evaluating a Custom Feeding Opportunity

Value Your Cattle

Put a realistic value on your cattle and calves at home.This is usually either the local auction price, less costsand shrinks involved in getting cattle to market, or a bidat your scales, less a possible pencil shrink. Cattle shrinkand pencil shrink are very important. When consideringshipping cattle to custom feedlots with a ten- hour haul,it is likely they will shrink three to eight percent fromranch weights. Please refer to Table 1 to estimate cattleshrinkage.

Examples of figuring cattle costs:

A buyer offers you $68/cwt. for your steers with a threepercent pencil shrink. In reality, he offered you 97 per-cent of $68.00, or $65.96.

You need to value your cattle for custom feeding in

BCH-8040 1

BCH-8040

Ranchers’ Guide to Custom Cattle Feeding

Donald Gill, Animal Scientist, Oklahoma State UniversityKent Barnes, Animal Scientist, Oklahoma State UniversityKeith Lusby, Animal Scientist, Oklahoma State UniversityDerrell S. Peel, Ag Economist, Oklahoma State University

Product of Extension Beef Cattle Resource Committee

a lot 300 miles from home. The cattle will shrink about5.5 percent (from Table 1) from ranch weight during thehaul. Thus, your cattle would have to cost $69.80 [65.96x (100/94.5) = 69.80] laid into a feedlot to net you the$65.96 at home.

Keeping records of a few actual shipments underspecific conditions will establish the appropriate per-centage of shrink for your operation.

Freight Costs

Usually, a semi-trailer truck equipped to handle cattle isthe most economical way to move cattle. These truckswill haul from 48,000 to 52,000 pounds of cattle. Haulingrates range from $1.75 to $2.00 per mile. Typical currentrates are about $2.00 per mile to a custom feedlot.Shipment of cattle 300 miles with a 50,000-lb. load willadd about $1.20/cwt. to the cost of the cattle.

If you could get $68, less three percent shrink athome, figure that you could lay your cattle into a feedlot300 miles away for $69.80 plus $1.20 freight for a total of$71.00.

Feedlot Costs

Custom cattle feeders provide feed and services for aprice. Good feedlot managers can estimate how much itwill cost to feed your cattle from feedlot “In Weight” tofinal “Pay Weight.” Estimates of lot costs, excludingyardage, can be made by multiplying feed conversionratios (given in Table 2) times the cost of feed on a 100percent dry matter basis.

Yardage and Other Costs

Some feedlots charge a yardage fee (usually 5 cents perhead per day) in addition to the feed cost. In addition tothe yardage, a rancher should inquire about other feessuch as processing, hay, insurance, taxes, and check-offs.Cattle producers who feed cattle in a number of customlots report that the fees other than yardage are quitevariable, ranging from zero to over $14 per head. The feestructure should be spelled out and included in the bud-get.

Some feedlot rations are priced on an “as is” basis.They may be adjusted to a zero percent moisture basis(or 100 percent dry matter) by dividing the “as is” priceby the dry matter content of the ration (expressed as adecimal) If, for example, a feedlot ration containing 28percent moisture costs $5.40 per hundred, its zero- per-cent moisture cost will be $5.40/0.72 = $7.50.

Medical Costs

Most healthy yearling cattle incur medical costs (includ-ing processing and implants) of $4 to $8 per head duringfeeding. Sickly calves can at times incur costs as much as$25 per head. All good feedlots can inform a rancher ofsteps necessary to keep health costs to a minimum.

Death Loss

It is normal to figure one-half to one percent death loss inyearling cattle in feedlots. Cattle placed on feed during latefall and early winter are most susceptible to high losses.Death losses in calves are potentially quite high if man-agement of the calves prior to and during shipment andreceiving is lacking. Usual death losses are about threepercent, with a range of about one to ten percent. Mostdeath losses in calves can be traced back to stale-sale barncalves moved during adverse weather. If a rancher intendsto feed calves, it is wise to hold the cattle 20 to 30 daysfollowing weaning before shipping. Coordinate this pre-shipping program with the feedlot’s veterinarian.

Death losses that are incurred soon after arrival atthe feedlot are not as costly as losses later in the feed-ing period. Poor gains and conversions generallyaccompany high death losses. A high death loss is ofless significance with low-priced cattle than with high-priced cattle. Any rancher feeding his own cattle shouldinclude a provision in his budget for death losses. With

2 Beef Cattle Handbook

Table 1. Shrinkage Loss Due to Different Handling Conditions.

Conditions Percent Shrink

8-hour drylot stand 3.3



8 hours in moving truck 5.5



Table 2. 100 percent Dry Matter Feed Conversions on AverageCattle Types from Pay Weight to Pay Weight, Assuming HighConcentrate Rations.

Cattle In Wght Mrkt Wght Conversion Ratio

Steers 500 1000 6.0

500 1050 6.3

600 1000 6.0

600 1050 6.3

700 1050 6.0

700 1100 6.3

700 1150 6.8

800 1150 7.1

800 1200 7.3

800 1250 7.5

900 1250 7.7

900 1300 8.0

Heifers 500 1000 6.9

600 1025 6.9

700 1050 7.3

800 1100 8.0

yearling cattle, experienced feeders whose averagedeath loss is one-half percent will often feed five or sixpens without a death and then lose three head out of ahundred on the next. Feedlots will notify the cattleowner of death losses and the cause of death.

Pen Sizes and Risk Sharing

Feedlot cattle are usually fed in pens of 100 to 140 head.However, many feedlots have pens as small as 25 headto as large as several hundred. Several ranchers eachhaving 100 steers to feed may find it desirable to pooltheir cattle into many pens, often started on feed at dif-ferent times. Each rancher may own portions of eachpen. This technique helps iron out peaks and valleys inboth feeder and fed-cattle prices. One drawback to thisapproach is that the rancher may not get specific perfor-mance and carcass information on cattle.

Cattle should be carefully sorted so that each penhas the same size and type of cattle. Cattle “type” refersto the ultimate mature size. Charolais X Hereford cross-es are usually a much larger type than Hereford XAngus crosses. Many feedlot managers prefer to feedHereford X Angus cross steers because they are usuallyeasy to sell at top market price when finished. Someexotic cross heifers make good feeders in high plainsfeedlots because they finish at more desirable weightfor that market than do small type heifers. Feedlots indifferent regions sometimes specialize in different typesof cattle. Thus, by shopping around, a rancher maylocate a feedlot more comfortable with a particular typeof cattle.

As a rule, the more uniform that cattle are in back-ground, type and weight, the better job the feedlot cando in terms of minimizing costs and obtaining top price.Cattle that do not grade when finished are usually des-tined to be overfed and to sell for discount prices.

Fed Cattle Marketing

Feedlots make no separate charge for selling a cus-tomer’s cattle. They do provide market advice and willsell according to producer instructions. Feedlot cattleare usually sold at the feedlot (FOB) on actual weightsless a pencil shrink (for example, 4 percent in theSouthern Plains). In this case, the buyer of the cattle isresponsible for the freight and any possible condem-nations (i.e. carcasses lost in the plant due to diseaseor injury).

Sometimes it is to the cattleman’s advantage to sellon a dressed weight basis (“in the beef”) or on a dressedweight and grade (“grade and yield”) basis. When cattleare sold in this manner, the cattle owner pays for thefreight to the packing plant and also stands the risk ofany condemnations. Cattle with a high dressing percent-age often bring more net money to the cattleman whensold on a carcass or dressed weight basis. With “in thebeef” selling, the packer/buyer takes the grading risk.When cattle are sold on a “grade and yield” basis, thecattleman benefits when cattle have both a high dressingpercentage and high quality grade percentage.

Interest and Financing

Methods of financing cattle feeding ventures are quiteflexible. It is usually best to use your normal sources offinancing when carrying your cattle through the feedlot.If the rancher has adequate financing to cover the cattlecosts throughout the period required to finish the cattle,he can usually obtain additional local financing to coverfeed bills. Feedlots usually bill for feed and servicestwice monthly. These bills can be sent either to theowner, or, a cooperating financial agent for payment.Another option frequently available is to make arrange-ments to have the feedlot finance the feed bill. When thisis done, feed bill and finance charges are deducted at thetime cattle are sold.

It is important that the rancher check local interestrates against those of the feedlot’s financing plan andselect the least-costly plan. Refinancing cattle at the timethey are placed on feed is another alternative. In thiscase, cattle are appraised for value and the owner canreceive cash for the difference between their appraisedvalue and the loan margin required by the lender. Marginamounts are dependent on the owner’s financial state-ment, and possible risk that the lender sees in the loan.Current margins range from $50, to as much as $150 perhead, depending on the risk to the lending agency.

Interest costs are a significant item in the cost offeeding cattle. Total interest costs may be estimated asin the following example:

A. Cattle cost at $300 for 120 days at 10 percent$300 X (.10/360a) X 120 = $10

B. Feed cost at $1.50 per day for 120 days = $180$180 X .5b X (.10/360a) X 120 = $3

aBankers year (360 days)bAssuming feed is charged when fed

Prepaid Feed

A rancher can insure himself against unexpected rises infeed costs at times by purchasing sufficient quantities ofgrain through a feedlot either before or at the time cattleare placed on feed. At times of uncertainty about feedsupplies and feed prices, a prepurchase of feed com-modities offers a hedge against rising feed prices. Thecost of the prepaid feed commodities are deducted fromthe normal ration price at each billing period. If feeds arepurchased early, interest costs on feed may be muchhigher depending on the timing. The above formula forestimating interest costs on feed was based on theassumption that feed is not paid for until it is fed. Most,but not all, feedlots can handle prepaid commoditiesthrough their billing system. Alternatively, the basic com-modities that make up a feedlot diet (i.e., corn and soy-bean meal) can be hedged with futures or optionscontracts for price protection.

Managing Fed Cattle Price Risk

A rancher with cattle in a custom feedlot has severalalternatives to help manage the price risk of future cattle

BCH-8040 3

sales. The need for price-risk protection will largelydepend on the rancher’s cattle price outlook, before andafter placing cattle on feed, and may be influenced byfinancing or other considerations.

Cattle on feed may be forward priced with a cash-forward contract. This may be a fixed price contract butis more often a basis contract. A basis contract specifiesthat cattle will be priced at a fixed level above or belowthe futures price for a specific futures contract month.Typically, the rancher can decide what day’s futures mar-ket price will be used to fix the price of the cattle. Therancher can usually price the cattle any time betweenthe contract date and the beginning of the futures con-tract month that is tied to the basis contract. If therancher sets the price immediately, the basis contract isconverted to a fixed-price contract. Cash-forward con-tracts usually specify the month of delivery, with thepacker choosing the actual delivery date.

Until the rancher “pulls the trigger” and sets theprice, a basis contract does not reduce cattle price risk.However, a rancher could buy an option in conjunctionwith a basis contract to set a minimum price for the cat-tle, and subsequently, fix the cash price at a higher levelif the futures market rises before the cattle are market-ed. In some cases, basis contracts also specify that thecattle owner is responsible for freight to the packingplant. In that case, the basis level in the contract shouldreflect both the relationship between cash and futures

prices, plus the freight cost between the feedlot and thepacking plant.

A rancher may also establish an expected fixed orminimum price for the cattle by hedging the cattle withfutures or options. A simple hedge with futures oroptions does not eliminate all market risk but replacesprice risk with basis risk, which is usually lower. Asnoted above, a basis contract can be combined withfutures or options to establish a fixed or minimum pricefor the cattle.

The major factor influencing a rancher’s decision touse price-risk management alternatives will be therancher’s view of market outlook and the risk of pricedeclines. However, price-risk management may affectthe feasibility and/or profitability of the custom feedingenterprise by reducing the interest rate and/or equityrequirements for financing feedlot cattle. Check withyour lender to see if use of risk management tools willimprove the financial arrangements available to you.

Steps Required to Feed Cattle

There is little justification for putting cattle on feed exceptto make a profit. Step one in deciding whether or not tofeed cattle is to calculate either the necessary selling priceto break even, or to figure potential profit. Step two per-tains to arranging the financing for the cattle, feed bills,and contract margins, and to develop a reasonable cashflow so that money is available when needed.


Table 3. Feedlot Budget# Example Your Values1. Ranch weight of cattle (lbs). = 700 __________

2. Ranch value of animals ($/cwt). = $78 __________

3. Estimated shrink from ranch to feedlot (%). = 5.5 __________

4. Transportation cost from ranch to feedlot ($/cwt). = $1.2 __________

5. Laid-in cattle price. a.($/cwt) #2/(1-(#3/100))+#4 = $83.74 __________

b.($/hd) #5a*(#1/100) = $586.18 __________

6. Estimated gain (lbs/day). = 3.25 __________

7. Estimated feed conversion (lbs feed/lb gain). = 6.3 __________

8. Estimated days to market. = 140 days __________

9. Estimated final weight. #6*#8+(#1*(1-(#3/100))) = 1,116.5 __________

10. Interest rate on capital (%). = 10 __________

11. Death loss: a._____ (%), b. ($/hd). #5b*(#12a/100) = $4.40 (#11a=0.75) __________

12. Veterinary and processing costs. = $5.00 __________

13. Estimated feed price, 0% moisture ($/cwt). = $7.25 __________

14. Estimated feed cost ($hd). #6*#7*#8*(#13/100) = $207.82 __________

15. Yardage cost: a._____ ($/hd/day), b. ($/hd). #8*#15a = $7.00 (#15a=.05) __________

16. Interest on cattle and vet ($/hd).

(#5b+#12)*(#10/100)*(#8/360) = $22.99 __________

17. Interest on feed and yardage ($/hd).

(#14+#15b)*0.5*(#10/100)*(#8/360) = $4.18 __________

18. Total cost per animal ($/hd).

#5b+#11b+#12+#14+#15b+#16+#17 = $837.57 __________

19. Pay weight:

a. shrink (%) _____, b. (lbs). #9*(1-(#19a/100)) = 1,071.8 (19a=4) __________

20. Break even cost. #18/#19b = $78.14/cwt. __________

21. Expected selling price ($/cwt). = $79.00 __________

22. Expected profit ($/hd). #21-#20*(#19b/100) = $9.22/head __________

BCH-8040 5

Authors:Donald Gill, Animal Scientist, Oklahoma State UniversityKent Barnes, Animal Scientist, Oklahoma State UniversityKeith Lusby, Animal Scientist, Oklahoma State UniversityDerrell S. Peel, Ag Economist, Oklahoma State University

This publication was prepared in cooperation with the Extension Beef Cattle Resource Committee and its member states and produced inan electronic format by the University of Wisconsin-Extension, Cooperative Extension. Issued in furtherance of Cooperative Extensionwork, ACTS of May 8 and June 30, 1914.

BCH-8040 Ranchers’ Guide to Custom Cattle Feeding

Beef Cattle Handbook

Cattle feeding is a risky business. The variability in cattlefeeding profit for steers in two western Kansas feedyardsplaced on feed from January, 1980, through May, 1991 isillustrated in Figure 1. Monthly average steer feedingprofit ranged from a loss of $100 per head to a gain of$165 per head. The monthly average cost of gain for thesame group of steers varied from $38 cwt. to $65 cwt.

Changes in cattle prices, feed prices, and perfor-mance are significant factors contributing to fluctuationsin cattle finishing cost of gains and profits. Approxi-mately 93 percent of the variability in cost of gain overtime can be explained by changes in corn prices, feedconversions, and daily gains (1). Further, 93 to 94 per-cent of steer feeding profit risk can be accounted for byfed steer prices, feeder prices, corn prices, interest rates,feed conversions, and daily gains (1). Because all ofthese factors are important in explaining the risks of cat-tle feeding, producers should consider them whendeveloping budgets, calculating break-even points, orplacing cattle on feed.

Feedyard Closeout Study

Results from the recent study (1) conducted at KansasState University (KSU) can be used to identify the mostimportant factors affecting cost of gain and profitability.This study utilized closeout data on 6,696 pens of steersat two western Kansas custom feedyards placed on feedfrom January, 1980, through May, 1991. Only pens ofsteers weighing between 600 and 899 lbs. at placementwere used. The steers were divided into three 100-lb.placement weight categories. Information collected fromthe closeouts included placement date, feeder cattle pur-

chase price, placement weight, days on feed, total gain,daily gain, sale weight, feed conversion (as fed), yardagecharges, feed cost, feed consumption (as fed), feeding

cost per pound of gain, fed cattle sale price, and process-ing date. The feeder steer price was not available for allcloseouts, so the average Dodge City, Kansas cattle auc-tion price (4) for the week the steers were placed wasused. Average corn prices during the placement monthwere obtained from Agricultural Prices (3). Interest rateson feeder cattle loans were obtained from the FederalReserve Bank of Kansas City (2).

Profits averaged from $25.38 to $27.28 per head forthe three placement weight groups in the KSU study.Feed conversion ranged from 8.24 lbs. of feed for lighter

BCH-8050 1

BCH-8050

Factors Affecting Cattle Feeding Profitability and Cost Of Gain

Martin L. Albright, Ag Economist, Kansas State UniversityMichael R. Langemeier, Ag Economist, Kansas State University

James R. Mintert, Ag Economist, Kansas State UniversityTed C. Schroeder, Ag Economist, Kansas State University

YEAR AND MONTH PLACED ON FEED

PROFIT ($/hd)

80 81 82 83 84 85 86 87 88 89 90 91

0

25

50

75

100

125

150

175

0

-25

-50

-75

-100

-125

Figure 1. Monthly average steer profit for steers placed at 700-799lbs.

Product of Extension Beef Cattle Resource Committee

placements to 8.57 lbs. of feed per lb. of gain for heavierweight placements, reflecting the reduced feed efficien-cy of feeding heavier weight cattle. The heavier placedsteers gained 3.25 lbs. per day, while the rate of gain forlighter placed steers was 3.06 lbs. per head per day.Average feeding cost of gain ranged from $48.66 to$50.08 cwt. for the three placement weight groups.

Cost of Gain

Feeding cost of gain consists of feed costs, veterinarycosts, processing and yardage fees, interest charges, andmiscellaneous costs. The primary performance factorsaffecting cost of gain are average daily gain, feed conver-sion, and death loss. Cattle performance, feed grainprices, and forage prices all influence feed costs—thelargest component of cost of gain. Feed costs will rise asa result of higher feed conversion rates or death loss.Conversely, feed costs decline as rate of gain increases.Increases in veterinary costs and cattle health problemsboth increase feeding cost of gain.

Factors Affecting Variability in Cost of Gain

Approximately 93 percent of the variability in steer feed-ing cost of gain over time was explained by corn price,feed conversion, and average daily gain. The relativecontribution of these factors to the volatility of steerfeeding cost of gain are shown in Table 1. Changes incorn prices explained the greatest amount of cost of gainvariability for all placement weights. Corn price account-ed for 67 percent of the variability in cost of gain forsteers placed at 600-699 lbs. and 58 percent for steersplaced at 800-899 lbs. Corn price is relatively more

important for lighter placed steers as they require moregrain to reach processing weight than heavier placedsteers.

Feed conversion is the second most important factorin determining cost of gain variability. It explained 23

percent of the variation in cost of gain for lightweightplacements and 33 percent for heavier placed steers.Feed conversion is more crucial to heavyweight steersbecause they are not as efficient as lighter weight steers.

Finally, average daily gain accounted for 2.6 percentto 3.1 percent of the volatility in cost of gain. The dailyrate of gain is more important for lighter placed steersas they are on feed for a longer period of time.

Steer Feeding Profitability

Net returns to steer feeding are susceptible to risks fromfluctuating feeder and fed cattle prices, feed prices, cattleperformance, and interest rates. These factors should beconsidered when determining budget projections andcontemplating placing cattle on feed. Rising feeder cattleprices, feed grain prices, interest rates, and poor cattleperformance increase costs and break-even levels. Adepressed fed cattle market will decrease the amount ofgross revenue a producer will receive.

The profit distributions across the three placementweight categories for the January, 1980, through May,1991 placement period are depicted in Figure 2. Profitsranged from a negative $134 per head to a positive$199 per head. Average profits were in the $0 to $100per head range in approximately 58 to 65 percent ofthe 137 months in the study.

During 5 percent of the months, steer feeding profitsfor 600-799 lb. placements averaged more than $100 per


Percent of Months (%)

-125 -100 -75 -50 -25 0 25 50 75 100 125 150 175 200

Profit ($/head)

0

5

10

15

20

25

600 to 699 lb.Placements

0

5

10

15

20

25


0

5

10

15

20

25


Figure 2. Monthly average fed steer profit distributions by weightcategory.

Table 1. Percent of Steer Feeding Cost of Gain Variability OverTime Attributable to Selected Factors, January 1980 - May 1991.

Explanatory Placement Weight

Variable 600/699 700/799 800/899

lbs. lbs. lbs.

- - - - - - - % - - - - - - -

Corn Price 66.9 65.1 58.4

Feed Conversion 22.9 25.7 32.8

Daily Gain 3.1 2.6 2.6

Total Explaineda 92.9 93.4 93.8

Unexplained Variabilityb 7.1 6.6 6.2

a Total explained variability is cost of gain variability explained by

the explanatory variables.b Unexplained variability is 100 minus total explained.

head. Profits for 800-899 lb. placements were greaterthan $100 per head during 7 percent of the months.Downside risk varied among placement weight cate-gories. In 34 percent of the months, 800-899 lb. place-ments were not profitable; in 32 percent of the months,700-799 lb. placements realized losses, as did 29 percentof the months for the lightest weight category.

Factors Affecting Profit Variability

About 93 to 94 percent of the variability in steer feedingprofit over time was explained by fed price, feeder steerprice, corn price, interest rates, feed conversion, and aver-age daily gain. Table 2 reports the relative contributions ofthese factors to the risks associated with steer feedingprofitability by placement weight. Together, fed and feed-er steer prices explain 71 to 80 percent of profit risk. Thisemphasizes the importance producers need to place oncattle prices when developing budgets and preparing pro-curement and marketing strategies. Further, managementof purchase prices is more important for heavyweightsteers since the impact of purchase price on profitabilityincreases as placement weight increases. Conversely, theeffect of fed cattle price is greater for lighter placementsas they require more days on feed, allowing for greaterfluctuations in fed cattle price.

The next most important factor in explaining profitrisk is corn price. Movements in corn price had thegreatest impact on the profitability of lightweight steers,as they will consume more feed during the finishingperiod than heavyweight cattle.

Feed conversion was the next most important ele-ment, accounting for 3 to 5 percent of net return risk.Finally, the combination of average daily gain and inter-est rates explains 2 to 4 percent of profit variability. Rateof gain is more important for heavier placements asthey need to gain the last expensive pounds as quicklyas possible.

Management Recommendations

Cattle prices, feed prices, and performance are importantin accounting for the risks of feeding cattle. Thus, produc-ers should consider these factors when developing bud-gets, calculating break-even points, or placing cattle onfeed. Break-even price calculations should be calculatedfor a range of feeder cattle prices, corn prices, and per-formance measures when placing cattle. The informationfrom this sensitivity analysis can be incorporated intoproduction and marketing plans.

Because 38 to 54 percent of the variation in profitsis attributable to movement in sale prices, cattle feedersshould consider actively managing fed cattle price riskthrough forward cash contracts, hedging, or the use ofoptions. Moreover, anecdotal evidence suggests thatmany cattle feeders do not attempt to manage feedercattle or feed price risk. Results from the KSU studyindicate that 33 to 48 percent of the variation in cattlefeeding margins is attributable to movement in feedercattle prices and corn prices. As a result, cattle feedersshould strongly consider attempting to manage their

input price risk.

Acknowledgements

The authors acknowledge the generosity of the twoanonymous feedyard managers for providing data.

References

1. Albright, M.L., T.C. Schroeder, M.R. Langemeier, J.R.Mintert, and F. Brazle. 1993. Cattle Feeding Profit andCost of Gain Variability Determinants. TheProfessional Animal Scientist, 9:138-145.

2. Federal Reserve Bank of Kansas City. Various Issues.Regional Economic Digest.

3. Kansas Agricultural Statistics. Various Issues.Agricultural Prices.

4. United States Department of Agriculture,Agricultural Marketing Service. Various Issues. LS-214, Dodge City, Kansas.

BCH-8050 3

Table 2. Percent of Total Explained Steer Feeding Net ReturnVariability over Time Attributable to Selected Factors, January1980 - May 1981.

Explanatory Placement Weight

Variable 600/699 700/799 800/899

lbs. lbs. lbs.

- - - - - - - % - - - - - - -

Fed Price 54.3 54.2 38.0

Feeder Price 16.9 24.8 41.6

Corn Price 15.9 8.9 6.3

Interest Rate 2.2 1.0 0.0

Feed Conversion 3.1 3.5 4.8

Daily Gain 0.4 1.4 3.7

Total Explaineda 92.8 93.8 94.3

Unexplained Variabilityb 7.2 6.2 5.7

a Total percentage of variability in net return explained by variabili-

ty in the explanatory variables.b Unexplained variability is 100 minus total explained.


Authors:Martin L. Albright, Ag Economist, Kansas State UniversityMichael R. Langemeier, Ag Economist, Kansas State UniversityJames R. Mintert, Ag Economist, Kansas State UniversityTed C. Schroeder, Ag Economist, Kansas State University

This publication was prepared in cooperation with the Extension Beef Cattle Resource Committee and its member states and produced inan electronic format by the University of Wisconsin-Extension, Cooperative Extension. Issued in furtherance of Cooperative Extensionwork, ACTS of May 8 and June 30, 1914.

BCH-8050 Factors Affecting Cattle Feeding Profitability and Cost Of Gain

Beef Cattle Marketing AlliancesJames D. Sartwelle, III, Ernest E. Davis, James Mintert and Rob Borchardt*

Ever-tightening profit margins and recurring cyclical downturns in cattle andcalf markets have forced many cattle producers to search for ways to make theiroperations more profitable. Of course, cutting the costs of production is one way.However, a new concept called “strategic alliance,” a way to increase revenuesthrough vertical affiliations, is being widely discussed as a route to a more finan-cially stable ranching operation.

Alliance is defined by Webster as “an association to further the common inter-ests of the members.” In the past 10 years many producer groups have worked tosecure marketing agreements with beef packers. Many of these agreements, oralliances, are available to many beef cattle producers.

Beef carcass alliances (BCAs) can be grouped into three broad categories: breedassociation-sponsored, commercial, and natural/implant-free. In addition to thesecategories, two types of beef carcass targets have emerged. One is a high qualitygrade target with an acceptably muscled carcass. The other target includes ani-mals that excel in red meat production with acceptable quality grades. BCAs willbe identified here by category and the appropriate carcass target.

Carcass Alliances Endorsed by Breed AssociationsSeveral purebred cattle associations have established programs to encourage

commercial cattlemen to use their breed’s bulls by providing additional marketingangles for their progeny. This category was dominated by British breeds (Angus,Hereford, Red Angus) for several years; recently, however, some Continentalbreeds have entered the field. Most of these programs target high quality beefproduction.

The American Hereford Association (Certified Hereford Beef), American-International Charolais Association (Beef-Charolais), Red Angus Association ofAmerica (Red Angus Feeder Cattle Certification Program/Supreme Angus Beef),American Gelbvieh Association (Gelbvieh Alliance), and North AmericanLimousin Foundation (Limousin Grid) all offer direct access to carcass pricingdevices that are at least partially negotiated by association personnel. (For a

sample carcass pricing grid and a more detailed introduction to the concept,please see “Fed Cattle Grid Pricing,” RM1-11.0 in this series.)

Certified Angus Beef (CAB, established by the American AngusAssociation in 1978) is one of the oldest and best known of the

BCAs. This program is dissimilar from most breed associationprograms in that CAB doesn’t directly price cattle on a gridsystem. Rather, it identifies carcasses that meet several crite-ria for CAB designation and allows other value-oriented mar-keting programs to use CAB as a valuation tool.

In addition to fed cattle marketing programs, most beef breedassociations have developed commercial marketing programs that

range from listing feeder cattle for sale to sponsoring group market-ing ventures such as special sales. Judging from the proliferation of mar-

keting services launched in the past few years, stiffening competition among

RiskManagement Education

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L-5356(RM 1-9.0)

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*Extension Program Specialist-Risk Management, and Professor and Extension Economist, The Texas A&MUniversity System; Extension Agricultural Economist, Kansas State University; and Extension ProgramSpecialist-Risk Management, The Texas A&M University System.

Page 76 of 104

breeds for commercial bull buyers will ensure ahealthy array of options in the future.

Commercial Carcass AlliancesMany firms now offer BCAs to cattle produc-

ers. These firms offer grids or marketingarrangements that fit the high quality beef targetand/or the red meat yield target. Most of thesefirms create their niche with cattlemen who arelikely to produce certain types of carcasses andbeef procurers who merchandise that type ofbeef. The firms that put such alliances togetherare usually paid for this service by producers,with fees for feedlot performance informationand/or carcass quality information.

Firms/alliances in this category include AngusAmerica, Angus GeneNet, Farmland SupremeBeef Alliance, HiPro Producer’s Edge, U.S.Premium Beef, and Western Beef Alliance. Inaddition to providing access (for a fee) to a beefprocessor’s carcass pricing mechanism, some ofthe firms/alliances offer other services to mem-bers. These include discounted semen or bullpurchases from carcass-proven sires, members-only replacement heifer and feeder cattle sales,and listings of “approved” feedyards.

Natural/Implant-Free Carcass AlliancesBCAs that target all-natural, implant-free beef

production were among the first programs.Many of them have been in existence more than10 years. Their business has greatly increased inrecent years and many of their innovations havebeen adopted by other programs. While thesealliances are all offered by commercial interests,their “all-natural” orientation places them in adifferent classification. Generally, these agree-ments aim for the red meat yield target.Examples of these alliances are Coleman’sNatural Meats, Laura’s Lean Beef, MaverickRanches Beef, and B3R Country Meats.

Common features of these marketing pro-grams are prohibitions against various common-ly used medications or growth enhancers(implants). Some programs also ban the use ofionophores and other feed additives.

Targeting health-conscious consumers, thegrid pricing structures encourage the productionof lean carcasses. Significant premiums aregiven for Yield Grade 1 and 2 carcasses. Someprograms even discount carcasses that gradeUSDA Prime.

What Else Could Alliances Offer?While most alliances have concentrated on

marketing and price enhancement strategies,producer groups might also organize input pro-curement, production cost analysis, performance

data analysis, and improved herd managementprograms. Producers might work together to cutproduction costs and effect an even greaterchange in profitability. For example, somealliance managers are developing connectionsbetween seedstock producers and commercialcow-calf operators who market cattle throughtheir alliances. One program has offered bonuscoupons worth $3 per head for each source-veri-fied animal, consigned and fed on a retainedownership basis, that grades Prime and/or quali-fies for the Certified Angus Beef program. Thosebonuses can be used toward the purchase ofbulls at an alliance-affiliated seedstock sale.Services such as these will likely be common inthe future.

The Future of Beef Carcass AlliancesOne difficulty with natural/implant-free BCAs

is the trade-off between “all-natural” beef pro-duction and feedlot performance. The producerwho joins one of these BCAs must weighincreased animal morbidity and mortality(because of the prohibition of antibiotics) anddecreased feedlot gain and feed efficiencies(because of the lack of growth-promotingimplants and/or feed additives) against potentialcarcass premiums for the cattle that actually ful-fill alliance specifications.

USDA has recently mandated that entitiesclaiming to market a source-verified productmust file and maintain a Product QualityControl protocol. This requirement could affectBCAs that market breed-specific products. Breedassociation-sponsored BCAs would seem to havethe upper hand in verifying the parentage ofindividual animals. In time, BCAs that require(or limit) a certain percentage of different breedsor breed types will have to prove to the USDAthat they can verify the sources of their partici-pating cattle.

Although the number of head currentlyslaughtered under alliance programs is a verysmall portion of the total slaughter, mostalliance marketing managers report that thenumber of cattle enrolled in their programs isincreasing. BCAs that consistently return higherprices than cash markets to participating produc-ers will most likely continue to expand. How-ever, most, if not all, BCAs rely on the regularproduction of sufficient quantities of cattle thatmeet narrow live and carcass specifications and,in turn, satisfy supply quotas with the packer. Ifa producer is to prosper in the long run by mar-keting cattle under these types of premium anddiscount schedules, he must be able to fine tunethe genetic makeup of the cowherd to “hit thespecs” with a degree of regularity while main-taining flexibility in the cowherd to adjust to

Page 77 of 104

changing trends. More consistent, improvedgenetics does not come without a cost, and pro-ducers must weigh these costs against the poten-tial benefits of participating in these programs.

Advice to the Producer: MaintainFlexibility

Many producers have the attitude that theywill produce specific cattle for specific carcasstargets if, and only if, there are clear economicincentives. Other producers are refining theirherds’ genetic makeups with full faith that car-cass price premiums already exist. One factupon which all producers can agree is that for-mula pricing systems, whether based on qualityor red meat yield, are constantly changing.Genetic change, however, does not happenquickly. The average producer will turn only sixor seven generations in his herd in his lifetime.Producers cannot be expected to constantlychange the genetics of their herds in hopes ofhitting some specification marketing programthat may or may not exist in the future.

Producers must maintain flexibility whiledeveloping the herd genetics that appears to bethe most economically viable in the short term.In short, producers might be best served bydeveloping cattle that can produce progeny foreither the high quality target or the red meatyield target, as situations dictate. This is notcontradictory. On the Great Plains, for example,a producer could develop a cowherd of moder-ate framed, Angus x Hereford Black Baldyfemales selected for maternal and fertility traits.On the Gulf Coast, a producer could develop aBrahman x Hereford or Brahman x Angus basedherd. If market trends indicate premiums forhigh quality targets, either producer could breedthose cows to British bulls with high marblingtraits. If the signals indicate premiums for cattlethat excel in lean, red meat production, the pro-ducers could breed the same cows to heavymuscled, Continental sires. With at least a 2-year lag between making breeding decisions andmarketing finished steers and heifers, it is appar-ent that a producer must have a sound under-standing of industry trends and directions.

Beef Carcass Alliances and RiskUnder grid pricing programs, performance

risk lies with the cattle feeder/seller. That is,premiums and discounts are not assessed untilthe live cattle have been processed and carcass-es evaluated. Sound risk management dictatesthat producers have some idea how their cattleare likely to perform, both in the feedlot and atthe carcass level, before enrolling a significantportion of their production in an alliance. Thereare Extension programs across the country thatcan help producers send sample calves throughfeedlots and get information on feeding perfor-mance and carcass quality. While no sample isperfect, many producers have learned a lotabout the cattle they produce through such pro-grams. This could be the first step in determin-ing whether you have the type of cattle to fitcertain alliance programs and their pricing grids.

When comparing different pricing structures,remember that different grids use different baseprices (for example, plant average prices versusUSDA-reported regional prices) and differentbase grades (for example, one grid uses USDAChoice as a base and discounts cattle that gradeUSDA Select, while another grid uses Select as abase and awards premiums to cattle that gradeChoice). Examine the pricing structures andmake sure you are making accurate compar-isons.

The same performance and financial risksfaced by a producer considering traditionalretained ownership programs also face a produc-er considering a BCA. Please consult “RetainedOwnership Strategies for Cattlemen,” RM1-3.0in this series, for more information.

Many breed associations and commercial enti-ties maintain listings of alliance program contactinformation on their web sites. One such site ishttp://www.beefshorthornusa.com/logo/beef.html.This is the official site of the AmercianShorthorn Association.

Page 78 of 104

Partial funding support has been provided by the Texas Wheat Producers Board, Texas Corn Producers Board,Texas Farm Bureau and the Houston Livestock Show and Rodeo.

Page 79 of 104

Retained Ownership Strategiesfor Cattlemen

Ernest E. Davis, James McGrann and James Mintert*

Market IntegrationMarket integration, or retained ownership, involves carrying over a production

activity into the next phase of preparation for the marketplace. There are certainadvantages associated with this production and marketing strategy. Retained own-ership through the stocker/feeder and finishing phase eliminates some tradingpoints, which can lower procurement, transportation and selling costs. Cattle orcalves may still be moved, but without the stress of being cycled through regularmarket channels. Such cattle can be shipped directly to the place where they willbe grazed, backgrounded or finished in a feedlot.

Retained ownership also allows producers to spread risk from one productionactivity to another and from one period of time to another. Cattle producersshould seriously investigate the possibilities of retained ownership and then electthe alternative that most closely meets their profit objectives. History reveals thatbetween birth and slaughter, someone will often profit from cattle before theyreach slaughter weight. One of the objectives of retained ownership is to takeadvantage of this tendency.

During certain periods and conditions, retaining ownership can be, and hasbeen, more profitable than selling calves at weaning. Ranchers must carefullyevaluate each decision period, because by retaining ownership they are assumingmore production and marketing risks. If the producer misjudges future marketconditions, or if the cattle are not properly contracted, retaining ownership cancause an accumulation of losses rather than profits.

There are other important conditions to consider when deciding whether toretain ownership. First, retaining ownership will increase management and deci-sion-making requirements. More capital will be required for the additional pro-duction expenses. The cattle producer’s cash flow will change because retainedownership delays income and adds production costs.

Producer SizeMany cattle producers do not have enough calves of similarkind at one time to use the retained ownership strategy. Usually

100 head are required for a pen at most commercial feedyards.But this should not deter you from using this strategy whentrying to make a profit. Producers can form marketing associa-tions, cooperatives or partnerships to put together the neces-sary cattle. In some cases, it may be feasible to sort and com-

mingle calves or feeder cattle into lots large enough to achievethis minimum size, thus making retained ownership a feasible

alternative.

L-5246RM1-3.0

5-99Risk

Management Education

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*Professors and Extension Economists, The Texas A&M University System; and Extension AgriculturalEconomist, Kansas State University Agricultural Experiment Station and Cooperative Extension Service.

The First Decision PointThe most important piece of information for

making marketing decisions comes from you,the producer. It’s important to know your indi-vidual production costs for each stage of produc-tion. Sometimes cattle producers pass up profitopportunities because they do not know theirown production costs and, as a result, areunable to project profitability accurately in thenext production phase. For example, if at wean-ing time a cow-calf producer determines that aprofit is not available on the cash market, norhas it been locked in by contracting calf sales,the logical strategy is to maximize returns fromthat point on. Although the initial productionphase, in this case the cow-calf stage, may notbe profitable, it’s possible the cattle enterprise’stotal profitability may be improved by retainingownership into the next production phase. Butto accurately assess profitability, you need to beable to project costs for the next productionphase.

Buy-Sell Price RelationshipsOne reason some cattle producers have not

used retained ownership strategies more often isto avoid the adverse buy-sell price situationsassociated with buying lighter calves and sellingheavier cattle. Generally, as cattle gain moreweight their price per pounds drops, or as aterm commonly used in the industry implies,the price “rolls-back.” This means that producerswill generally sell heavier weight feeder cattle ata price per hundredweight that is lower than theprice per hundredweight they are accustomed toreceiving for lighter weight calves.

Cost ConsiderationsEven with price roll-backs, retained owner-

ship programs can be profitable. An importantconsideration in determining whether or not toretain ownership of a group of cattle is the rela-tionship between calf prices and cost of gain.Knowing this enables you to determine therequired price relationship between the begin-ning and end of the production period. Forexample, if expected costs of gain exceedweaned calf prices, the sale price at the end ofthe production period will need to be above theweaned calf price at the program’s outset. Ifcosts of gain are less than weaned calf prices,some roll-back in prices of feeder cattle can beendured without suffering a loss.

Table 1 illustrates the effects of cost of gainand total pounds of gain on cattle break-evenprices. The table assumes you are grazing orbackgrounding a 500-pound stocker calf with avalue at the program’s outset of $80 per hun-dredweight. Costs of gain are given in units of$5 per hundredweight, beginning at $35 andincreasing to $55. If, for example, the stockergained 200 pounds during this period at a costof $40 per hundredweight, the break-even priceat the program’s end would be $70.29 per hun-dredweight, including interest charges on thecalf and other feeding costs. As one wouldexpect, the price per hundredweight required tobreak even is below the calf’s per hundred-weight price at the program’s outset because ofthe lower cost of gain. Also note that as the totalpounds of gain during the feeding programincrease, you can tolerate a larger price rollback.

Costs of gain $/cwt.Poundsgained 35 40 45 50 55

Break-even prices $/cwt.100 73.45 74.29 75.13 75.97 76.81150 70.96 72.13 73.29 74.46 75.63200 68.85 70.29 71.74 73.19 74.64250 67.03 68.72 70.42 72.11 73.81300 65.45 67.36 69.28 71.19 73.10

1500-pound calf at $80.00 per cwt.; costs of gain include allproduction, management, marketing, finance and transportationcosts.

Table 1. Break-even prices for a 500-poundcalf grazed to different endpoint weights atvarious costs of gain.1

Table 2 provides break-even prices for 750-pound feeders entering a feedlot at a price of$68 per hundredweight. Once again, costs ofgain and total weight gain are allowed to vary.Finishing a 750-pound animal to 1,150 poundsat $55 direct cost of gain would require a $65.45break-even price with interest. Interest ischarged on the full cost of the feeder and allother costs, adjusted for the time the cattle areon feed.

Information SourcesIt is essential that cattlemen have good infor-

mation on current conditions and trends in thelivestock, grain and meat sectors as they becomeinvolved with retained ownership strategies.They must also be current on consumer eatingtrends, as well as the general conditions of theU.S. and world economies.

Trends in domestic cattle numbers and pricesshould be considered before deciding whetheror not to retain ownership. Cattlemen should beaware of the size of the U.S. cow herd and thecalf crop and also have some knowledge of thecurrent cattle cycle. Perhaps the most importantpiece of market information to consider iswhether cattle prices are expected to rise or fall,as a function of the cattle cycle. Generally,retained ownership strategies will work bestwhen cattle prices are expected to rise cyclicallyover the course of the feeding period, althoughretained ownership can still be profitable evenwithout a significant rise in price level.

It may at first appear to be a difficult task toaccess such information, but it is not. Much ofthe information is available at little or no costthrough the U.S Department of Agriculture, theExtension Service or cattlemen’s associations.The next step is to determine what factors arehaving the most impact on the current marketand to watch those trends carefully.

One of the simplest ways to monitor marketconditions is to subscribe to weekly or monthlynewsletters with analyses of current trends andfactors that affect the markets. Such newslettersare available through Extension Services or vari-ous commercial consulting firms. Theseresources may help you fine-tune your marketawareness and decision-making skills. Examplesof these newsletters are the K-State Ag Updatefrom the Kansas State University CooperativeExtension Service (via subscription, or free onthe Internet at http://www.agecon.ksu.edu/livestock), and Texas Livestock Roundup(http://livestock-marketing.tamu.edu) from theTexas Agricultural Extension Service.

Financial ConsiderationsRetained ownership increases capital require-

ments and delays income. This must be consid-ered and some adjustment to cash flow expecta-tions must be made if retained ownership isgoing to be successful. You may need to preparea balance sheet, projected income statement,cash flow, and a marketing plan before thelender will provide the additional capitalrequired for increased production costs anddelayed income. Some lenders may require thata portion of the cattle be hedged before lendingadditional capital.

Feeding ArrangementsIn today’s cattle industry, leased grazing and

custom feeding are options available to most cat-tlemen. In both options there are variousarrangements for assessing charges. The twomost common methods are a fixed charge basedon cost of gain, and the sale of feed and ser-vices. These two approaches differ primarily inthe way risk is shared between the feeder andcattle owner. Under a fixed cost of gain arrange-ment, the cattle owner shares in the risks ofdeath loss and assumes all the risks of fallingcattle prices, whereas the custom grazier orfeeder shares in the death risks and assumes allthe risks of poor cattle performance, bad weath-er, poor facilities, sickness, rising feed costs,

Costs of gain $/cwt.Poundsgained 50 55 60 65 70

Break-even prices $/cwt.300 64.38 65.83 67.28 68.73 70.18350 64.01 65.63 67.24 68.86 70.47400 63.68 65.45 67.22 68.99 70.76450 63.38 65.30 67.21 69.12 71.04500 63.12 65.17 67.21 69.26 71.30

1750-pound calf at $68.00 per cwt.; costs of gain include all pro-duction, management, marketing, finance and transportationcosts. Average daily gain of 3 lbs. per day assumed.

Table 2. Break-even prices for a 750-poundfeeder fed to different endpoint weights atdifferent costs.1

weight shrink and management. If the feedersimply sells feed and services to the cattleowner, virtually all of the risks are shifted awayfrom the feeder to the cattle owner. Very fewcommercial cattle feeders will feed cattle for afixed cost of gain, but it is not uncommon forcustom graziers or custom backgrounders tooffer a fixed cost of gain program. The relativemerits of the two approaches to custom feedingdepend on the individual situation, but be awareof the big difference in the risk profile under thetwo approaches.

Tax AdvantagesRetained ownership also offers cattle produc-

ers some flexibility in managing their annualincome tax liabilities. By retaining ownership, aproducer may transfer taxable income from oneyear to the next. This may be especially usefulin years when sales have been high. It is possi-ble that some sales can be carried over to thenext year at reduced risk by using futures oroptions contracts. It is important to discuss theseoptions with your financial advisor.

If cattle are being fed in one year and sold inthe next, prepayment of feed and productionexpenses, not to exceed 50 percent of the total,may be charged against income received duringthe year the cattle were placed on feed. Thisallows cattlemen some flexibility in planningtheir taxable income and tax liabilities from oneyear to the next.

Decision AidsThe Texas Agricultural Extension Service has

computer software that helps prepare financialstatements, set up retained ownership budget-ing, and summarize closeouts. This software canbe obtained from Extension livestock marketingand management economists or on the Internetat http://agecoext.tamu.edu/irm-spa/irm-spa.htm.

For estimating returns in a cattle feeding program, you may obtain a copy of publicationC-734, “Seasonality in Steer Feeding Profitability,Prices and Performance,” from the Kansas StateUniversity Cooperative Extension Service. It isavailable at county Extension offices in Kansasor on the Internet at http://www.agecon.ksu.edu/livestock.

Partial funding support has been provided by the Texas Wheat Producers Board, Texas Corn Producers Board,and the Texas Farm Bureau.

Produced by AgriLife Communications & Marketing, The Texas A&M System

Extension publications can be found on the Web at: http://AgriLifebookstore.org

Educational programs of the Texas AgriLife Extension Service are open to all citizens without regard to race, color, sex, disability, religion, age or national origin.

Issued in furtherance of Cooperative Extension Work in Agriculture and Home Economics, Acts of Congress of May 8, 1914, as amended, and June 30, 1914, incooperation with the United States Department of Agriculture. Texas AgriLife Extension Service, The Texas A&M System.1.5M, Reprint ECO

Grid Pricing of Fed Cattle Risk Management

*Assistant Professor and Extension Economist–Management, and Professor and ExtensionEconomist–Livestock and Food Marketing, The Texas A&M System; and Professor and Extension Economist, Kansas State University.

Grid prices, or value-based marketing, refers to pricing cattle on an individual animal basis. Prices differ according to the underlying value of the beef and by-products produced from each animal. Schroeder et al. have reported that pricing fed cattle on averages is detrimental to the industry because it does not send appropri-ate price signals to cattle feeders, stockers and, ultimately, cow-calf producers. However, incen-tives to sell cattle on averages and problems associated with identifying beef quality have inhibited the development of value-based pric-ing. Both cattle feeders and packers have been reluctant to change from a live animal pricing system to a carcass pricing system.

Opportunities to profit from better match-ing fed cattle prices to value have encour-aged packers, alliances and producers to use carcass-based pricing. Now, there are several value-based fed cattle pricing systems, includ-ing formula pricing, price grids and alliances. Is there one “best” pricing method? How are live weight, dressed weight and grid or formula prices related? The purpose of this publication is to help producers decide which form of fed cattle pricing may be most profitable for them.

Is Carcass Merit Pricing For You?Should you market your cattle on a carcass

merit basis? If so, does it matter which pricing system you use or which packer or alliance you

sell to? The answer to both questions is, “It depends.” The most critical factors that influ-ence the profitability of these decisions include: 1) the quality and dressing percent of the cattleyou produce; 2) the Choice-Select market price spread; 3) production and feeding cost dif-ferences associated with targeting your cattle to a particular price grid or packer; and most important 4) your knowledge about the price/quality distribution of your cattle and your (or the feeder’s) ability to sort your cattle to meet the criteria for a particular grid or formula. The following analyses focus on the price/cattle quality relationship, without consider-ing production costs. This is not to imply that production costs associated with attaining a particular quality-related price incentive are not important. They are critical to profitability. However, production costs differ with produc-ers and cattle types and are not explicitly evalu-ated here.

Cattle Pricing MethodsFed cattle usually are priced in one of three

ways: 1) live; 2) dressed weight or “in the beef;” or 3) carcass grade and yield or grid pricing.Live Cattle Pricing

When fed cattle are priced on a live basis, price is generally negotiated between the packer and the feedlot based upon the expected

Robert Hogan, Jr., David Anderson and Ted Schroeder*

E-557RM1-11.0

03-09

2

value of the cattle when processed (a 4 percent pencil shrink on the cattle from the feedlot to the packing plant is usually included). To establish a buy order, the packer starts with a base Choice carcass price and then adds or subtracts expected quality and yield grade premiums and discounts associated with quality traits the pen of cattle are expected to exhibit when processed. The adjusted carcass price is converted to a live animal price by multiplying it by the expected dressing percent-age. This live price is adjusted with by-product and hide values and further adjusted for slaughter costs, transportation costs, and the packer’s profit margin1 to establish an estimated live animal bid price. If packers can purchase a large number of cattle from one location at one time, they may increase their bid price to reflect reduced transac-tions and procurement costs.

Pricing cattle on a live basis is appealing to some cattle feeders who want to maintain com-plete flexibility in cattle pricing until the transac-tion price is established. Live pricing may also be preferred if the producer does not know the characteristics of the cattle or expects the dressing percentage, quality grade or yield grade to be be-low average. However, because meat quality and carcass dressing percentage are difficult to predict accurately on live animals, premiums and dis-counts paid on a live basis generally do not reflect the true value of the final product. In other words, high-quality cattle are often undervalued and low-quality cattle often overvalued. This gives producers no incentive to invest in better genetics and produce a better product.Dressed Weight Pricing

When cattle are marketed on a dressed-weight basis, the cattle seller assumes the risk of dressing percentage. Price is based upon the actual hot car-cass weight. The dressed price offered is similar to the live price bid in that the buyer starts with a base Choice carcass price and adjusts it for ex-

pected quality and yield grade, weight premiums and discounts, by-products, slaughter costs (seller generally pays transportation on dressed cattle sales), and the packer’s profit.

In principle, the dressed-weight price will be comparable to a live price adjusted for dressing percentage for the same pen of cattle. In practice, the dressed price (after transportation costs) may be higher or lower because there are no errors in estimating dressing percentage. Over time, across a large number of pens, the average dressed price should be greater than the average dressing percentage-adjusted live price, other things being equal.Grid Pricing

Pricing cattle on a grade and yield or grid basis is essentially the same as pricing on a dressed-weight basis, except that in addition to dressing percentage, the seller assumes the risk of the quality and yield grade of each animal in the pen. Many beef packers offer cattle producers the op-portunity to price cattle on a carcass grid basis. Most packer grids list a base price for a Choice, yield grade 3, 550- to 900-pound steer carcass. For example, a typical price premium and discount schedule offered by beef packers is shown in Table 1.

1 It’s important to note that the packer is not guaranteed a profit. The cattle market is a competitive market where packers still have to bid to get the cattle. That bidding sometimes is easier or harder. Packers do lose money, at times, when market conditions dictate that they pay more for the cattle than was profitable.

Table 1. Example grid, as presented by a packer ($/dressed cwt).

Choice YG3 550- to 900-lb Base price

Prime-Choice Premium 6.00

CAB-Choice Premium 1.00

Choice-Select Discount -9.00

Choice-Standard Discount -18.00

Yield Grade I 2.00

Yield Grade II 1.00

Yield Grade IV -15.00

Yield Grade V -20.00

Light Carcasses (<550 lb) -19.00

Heavy Carcasses (>900 lb) -19.00

Dark Cutters -25.00

Bullocks/Stags -25.00

3

The assorted premiums and discounts are then simply copied into the grid as shown in Table 2.

Table 2. Example of grid premiums and discounts.

Quality Yield gradegrades 1 2 3 4 5

($/cwt carcass)

Prime 6.00

CAB 1.00

Choice 2.00 1.00 Base -15.00 -20.00

Select -9.00

Standard -18.00

CARCASS WEIGHTS OTHER

550-900 lb Base(105.00)

Dark Cutter, etc.Bullock/Stags

-25.00-25.00

Less than 550 lb -19.00

More than 900 lb -19.00

The rest of the grid is now filled in typically by just adding premiums and discounts. For exam-ple, to get the premium for Prime-Yield Grade 1, add the $6.00 Prime premium and the $2.00 Yield Grade 1 premium to get $8.00. As another exam-ple, to compute the discount for Select-Yield Grade 5, add the $9.00 Select discount and the $20.00 Yield Grade 5 discount to get $-29.00. The entire grid is shown in Table 3.

The price received for each carcass is the base price plus the particular premiums and discounts. For example, if the Choice, yield grade 3, 550- to 900-pound carcass price is $105.00/cwt, a Select, yield grade 4, 700-pound carcass would receive a price of $81/cwt ($105.00/cwt - $24.00/cwt, the Select-yield grade 4 discount).

The USDA reports a weekly survey summariz-ing selected beef packer grid premium and dis-count schedules. This report is on the internet at http://www.ams.usda.gov/mnreports/lm_ct155.txt (Na-tional Weekly Direct Slaughter Cattle – Premiums and Discounts). The LM CT155 report is useful for understanding average grid price premiums and discounts being offered by packers, and for raising awareness of the range of discounts and premiums.

Table 3 illustrates how quickly net price can decrease with yield grades 4 and 5 and with qual-ity grades below Choice (Select and Standard). In this example, the discount from Choice to Select is a relatively severe $9/cwt. The discounts between Choice and Select quality grades typically range from $1.00/cwt to $12.00/cwt, depending on the supplies of Choice versus Select carcasses, the de-mand for each, and seasonal purchasing patterns and habits. (The weekly Choice-Select spread has been as large as $23.08 and as small as $0.68 over the past 5 years.) There are usually large discounts for Standard grade carcasses, dark cutter carcasses, and carcasses lighter than 550 pounds or heavier than 900 to 950 pounds. Some grids also offer pre-miums and discounts for hide quality.

For many packers’ grids, price premiums and discounts are additive. That is, the base price is adjusted in an additive manner for the associated characteristics of the carcass (as in our example above). For some packers, not all premiums and discounts in their price grid are additive. For example, some packers quote the same price for all Standard grade cattle regardless of yield grade. The USDA grid summary report assumes additive discounts and premiums. In addition, this report is not volume-weighted and includes only packer-stated grids, not actual purchases. As a result, the report does not represent market average grid prices. This is important to understand when interpreting the USDA price report and comparing it with any particular packers’ grids you may be considering.

Table 3. Example grid premiums and discounts.

Quality Yield gradegrades 1 2 3 4 5

($/cwt carcass)

Prime 8.00 7.00 6.00 -9.00 -14.00

CAB 3.00 2.00 1.00 N.A. N.A.

Choice 2.00 1.00 Base -15.00 -20.00

Select -7.00 -8.00 -9.00 -24.00 -29.00

Standard -16.00 -17.00 -18.00 -33.00 -38.00

CARCASS WEIGHTS OTHER

550-900 lb Base(105.00)

Dark Cutter, etc.Bullock/Stags

-25.00 -25.00

Less than 550 lb -19.00

More than 900 lb -19.00

4

Summary of Pricing MethodsTable 4 summarizes and compares issues as-

sociated with typical fed cattle pricing arrange-ments. Differences in the various methods are important because they use different kinds of information and cause prices to differ even for the same pen of cattle. The key is that as a producer moves from live cattle pricing to dressed-weight to grid pricing, it is increasingly important to understand the type of cattle being marketed and the pricing system being used, and to assess prob-able net price received.

Over time, average cattle or cattle with little background information may sell better with live pricing. A somewhat better class of cattle may sell better with dressed pricing. First rate classes of cattle whose characteristics are known by the producer may sell better by pricing on the grid.

Table 4. Assessing ways to sell fed cattle.

Cattle pricing method

Producer pricingattribute Live Dressed Grid

Pricing level pen level pen level animal level

Paid for quality No No Yes

Paid for yield No No Yes

Paid for dressing % No Yes Yes

Who pays trucking? Buyer Seller Seller

Formulas: Importance of Base PriceWhen fed cattle are priced on formula, an

important consideration, in addition to the premium/discount structure, is the base price. In interviews with packers and cattle feeders, Schroeder et al. discovered several different types of base prices being used. One was the average price of cattle purchased by the plant where the cattle were to be slaughtered. The average price of cattle was usually for the week prior to, or the week of, slaughter. Other base prices were specific market reports such as highest reported price for a specific market for the week prior to, or week of, slaughter. One base price was tied to live cattle futures prices. Some base prices were negotiated. Some base prices were on a carcass weight basis,

whereas others were on a live weight basis based upon yields of the cattle slaughtered.

Many packers have established base prices using plant average quality grades and dressing percentages of cattle slaughtered during the week. Before agreeing to deliver cattle to a particular packer on formula or grid, the producer should understand in detail how the base price is calcu-lated and obtain some base price quotes over time from several packers. The producer does not want any surprises at this point.

Importance of Grid Premium/Discounts

When selling cattle on price grids, in addition to considering base prices, cattle producers should carefully evaluate the price premium/discount structures of various packers’ grids and deter-mine which grid is most advantageous to them. Different grids may offer significantly different prices for the same quality of cattle. In addition, packers value traits differently. For example, one packer might not discount select cattle and an-other packer might not discount Yield Grade 4 as much as another packer.

Pens of cattle that are fairly uniform generally bring similar prices with different packer grids. However, pens with even small percentages of higher or lower grade carcasses, heavier or lighter animals, or more than the average number of “out” cattle (dark cutters, stags, bullocks, etc.) have much more variable prices. For this reason, it is important for cattle producers to know their cattle, sort their cattle carefully for uniformity, and target them for specific packers.

Grid Price Determinants over TimeIn addition to variability in prices across grids,

it is important that producers understand de-terminants of price differences over time. Small changes in dressing percentage alter the relative advantages of selling on either a live or dressed basis. For example, with a $65/cwt live steer price and a $102.50/cwt dressed carcass price, cattle dressing higher than 63.4 percent will receive a higher price per head if sold dressed than if sold live, and cattle with a lower dressing percentage will receive a higher price on a live basis. With

these prices, a 1200-pound live steer will gain $6/head in value for each 0.5 percent increase in dressing percentage.

Over time, one of the most important deter-minants of price grid premiums and discounts is the Choice-Select carcass price spread. The greater the Choice-Select spread, the greater the price discount for lower quality cattle. The Choice-Select price spread varies over time as the cattle supply and demand for specific qual-ity grades change.

There is a seasonal pattern to the Choice-Select spread. It typically is the widest in May-June and narrowest in February and again in August. The Choice-Select spread widens and

narrows based on seasonal patterns in relative supplies of Choice and Select cattle. Seasonal demand patterns for different cuts and qualities also affect the spread.

Yield grade premiums and discounts have remained relatively stable over time for all packer grids. Therefore, this pricing factor is expected to remain more predictable than the Choice-Select price spread.

ReferencesSchroeder, T.C., C.E. Ward, J. Mintert and D.S.

Peel. “Beef Industry Price Discovery: A Look Ahead.” Research Institute on Livestock Pricing, Research Bulletin 1-98, March 1998.

Educational programs of the Texas AgriLife Extension Service are open to all people without regard to race, color, sex, disability, religion, age, or national origin.

Issued in furtherance of Cooperative Extension Work in Agriculture and Home Economics, Acts of Congress of May 8, 1914, as amended, and June 30, 1914, in cooperation with the United States Department of Agriculture. Edward G. Smith, Director, Texas AgriLife Extension Service, The Texas A&M System.

Produced by AgriLife Communications, The Texas A&M SystemExtension publications can be found on the Web at: http://AgriLifeBookstore.org.

Visit Texas AgriLife Extension Service at http://AgriLifeExtension.tamu.edu.

Partial funding support has been provided by theTexas Corn Producers, Texas Farm Bureau, and

Cotton Inc.–Texas State Support Committee.

Selling cattle well in advance of their deliverydate, or forward contracting, is a marketingoption available to beef producers. Such a trans-action requires the seller to estimate the weightof the cattle prior to delivery. Weights estimatedat the time of sale and those recorded upondelivery often differ. Therefore, to ensure fairmarket value upon delivery, an adjustment ofthe sale price is often necessary.

The “slide” is a predetermined adjustment inthe sale price of cattle and is included in thecontract (forward contracting) or in the descrip-tion of the cattle (video or Internet marketing)being offered for sale. It is based on the differ-ence between the weight estimated prior to con-signment or contracting and the actual payweight. Pay weight is the actual live weight ofthe cattle upon delivery minus a “pencil” shrink.This pencil shrink is negotiable and normallyranges from 2 to 4 percent.

Three slides are used: up, down or both ways.The seller decides the magnitude and direction.Liveweight and the magnitude of the slide areinversely related; as liveweights increase, theslide will usually decrease. Calves (less than 600pounds) often are sold with a two-way slide.Sliding cattle both ways is particularly usefulwhen environmental conditions such as rainfalland forage availability can drastically affectweaning weights. The two-way slide protects thebuyer if the cattle deliver heavier than expected,and ensures the seller will receive a fair marketprice if the cattle are lighter than expected. Theweight of yearling cattle is more predictable;therefore, yearlings are usually offered with anup slide only.

Up SlideAn up slide is exercised when the weight of

the cattle upon delivery is heavier than expect-ed. Selling with an up slide locks in a maximumprice (dollars per hundredweight or $/cwt) thatwill be paid for the cattle.

Example AIn a mid-July sale, 600-pound calves con-

signed for November delivery sell for $80/cwt.The slide is $5/cwt. Calves will be weighed atthe ranch with a 2 percent shrink. Upon deliv-ery in November, the cattle average 630 poundsper head.

slide = $5/cwtslide weight = 600 lbs.

shrink = 2%sale price = $80/cwt

delivered weight = 630 lbs.

The slide will be exercised because the cattlewere heavier than expected at delivery.

shrink = 630 lbs. x 2% = 12.6 or 13 lbs.pay weight = 630 lbs. – 13 lbs. = 617 lbs.

weight subject to slide = 617 – 600 = 17 lbs.

17 lbs. = 0.17 cwt0.17 cwt x $5/cwt = $0.85/cwt

$80/cwt – $0.85/cwt = $79.15/cwt

The extra 17 pounds (expressed as cwt) ismultiplied by the slide, yielding $0.85/cwt. The$0.85/cwt is then subtracted from the sale priceof $80/cwt to yield the actual price of $79.15 perhundredweight. The actual price paid for thecattle under this agreement is $488.36 per head.

6.17 cwt (617 lbs.) x $79.15/cwt = $488.36

L-50638-98

Using a Slide in Beef Cattle MarketingRick Machen and Ronald Gill*

*Extension Livestock Specialists, The Texas A&M UniversitySystem.

Down SlideA down slide is exercised when the delivered

weight of the cattle is less than expected at thetime of sale (contract). Selling with a down slidelocks in the minimum price ($/cwt) to be paidfor the cattle.

Example BIn a mid-June sale, 500-pound calves con-

signed for October delivery sell at $90/cwt. Theslide is $10/cwt. Calves will be weighed at theranch with a 3 percent shrink. Upon delivery inOctober, the cattle average 480 pounds perhead.

slide = $10/cwtslide weight = 500 lbs.

shrink = 3 %sale price = $90/cwt

delivered weight = 480 lbs.

The down slide will be exercised because thecattle weighed less than expected upon delivery.

pay weight = 480 lbs. – 3% = 466 lbs.500 lbs. – 466 lbs. = 34 lbs.

This 34-pound (.34 cwt) difference is multi-plied by the slide ($10/cwt) to get $3.40/cwt,which is added to the sale price of $90/cwt toobtain the actual price of $93.40 per hundred-weight.

34 lbs. = 0.34 cwt0.34 cwt x $10/cwt = $3.40/cwt

$90/cwt + $3.40/cwt = $93.40/cwt$93.40/cwt x 4.66 cwt (466 lbs.) = $435.24

Therefore, the actual price received for thecattle is $435.24 per head.

Contract (Expected) Values

A. Expected weight _____lbs.

B. Price _____$/cwt

C. Pencil shrink _____%

D. Slide _____$/cwt

Expected value [(A/100) – C] x B _____$/hd

Actual Values

E. Scale weight (avg.) _____lbs.

F. Pay weight(E/100) – C _____cwt

G. Weight subject to slide (A/100) – F _____cwt

H. Slide adjustmentG x D _____$/cwt

J. Adjusted sale priceB + H _____$/cwt

K. Price receivedF x J _____$/head

To evaluate an up slide (line A is less thanline E), calculations in lines G and J change asshown.

G. Weight subject to slideF – (A/100) ______cwt

J. Adjusted sale priceB – H ______$/cwt

A worksheet for evaluating the use of a downslide (line A is greater than line E) follows.

Educational programs of the Texas Agricultural Extension Service are open to all people without regard to race, color, sex, disability, religion, ageor national origin.?????? ?? ??????????? ?? ??????????? ????????? ? ??? ?? ??????????? ??? ???? ?????????? ???? ?? ???????? ?? ??? ?? ????? ?? ???????? ??????? ??? ????? ?? ??????????? ???? ??? ?????? ?????? ?????????? ?? ???????????? ?????? ?? ????? ? ??????? ???????? ? ????? ???????????? ????????????????? ??? ????? ??? ?????????? ???????????? ??????? ???????? ?? ?

???????? ?? ???????????? ??????????????? ??? ????? ??? ?????????? ??????

Introduction To Futures MarketsRisk Management

E-496RM2-1.0

01-09

*Professor and Extension Agricultural Economist, Kansas State University AgriculturalExperiment Station and Cooperative Extension Service, and Assistant Professor and Extension Economist–Grain Marketing, The Texas A&M System.

Futures trading has a long history, both in the U.S. and around the world. Futures trading on a formal futures exchange in the U.S. originated with the formation of the Chicago Board of Trade (CBOT) in the middle of the 19th Century. Grain dealers in Illinois were having trouble financing their grain inventories. The risk of grain prices falling after harvest made lenders reluctant to extend grain dealers credit to pur-chase grain for subsequent sale in Chicago. To reduce their risk exposure, grain dealers began selling “To Arrive” contracts, which specified the future date (usually the month) a speci-fied quantity of grain would be delivered to a particular location at a price identified in the contract. Fixing the price in advance of deliv-ery reduced the grain dealer’s risk and made it easier to obtain credit to finance grain purchas-es from farmers. The “To Arrive” contracts were a forerunner of the futures contracts traded today. Although dealers found it advantageous to trade what essentially were forward cash con-tracts in various commodities, they soon found these forward cash contract markets inadequate and formed futures exchanges.

The first U.S. futures exchange was the Chi-cago Board of Trade (CBOT), formed in 1848. Other U.S. exchanges also began in the last half of the 1800s. For example, the Kansas City Board of Trade (KCBT) traces its roots to January 1876 when a precursor to today’s hard red wheat futures contract was first traded. Similarly, a forerunner of the Chicago Mercantile Exchange

(CME) was formed in 1874 when the Chicago Product Exchange was organized to trade butter. In each case the exchanges were formed because commercial dealers in corn, wheat and butter needed a way to reduce some of their price risk, which hampered the day-to-day management of their businesses. Sellers wanted to rid them-selves of the price risk associated with owning inventories of grain or butter and buyers wanted to establish prices for these products in advance of delivery. In recent years futures contracts have proliferated, particularly in the financial arena, as businesses become more aware of the price risks they face and seek ways to reduce them.

What Is A Futures Contract? A futures contract is a binding agreement be-

tween a seller and a buyer to make (seller) and to take (buyer) delivery of the underlying commod-ity (or financial instrument) at a specified future date with agreed upon payment terms. Most futures contracts don’t actually result in delivery of the underlying commodity. Instead, most trad-ers find it advantageous to settle their futures market obligation by selling the contract (in the case of a contract that was purchased initially) or by buying it back (in the case of a contract that was sold initially). The trader then completes the actual cash transaction in his or her local cash market.

Futures contracts are standardized with respect to the delivery month; the commodity’s quantity, quality, and delivery location; and the

James Mintert and Mark Welch*

2

payment terms. The fact that the terms of futures contracts are standardized is important because it enables traders to focus their attention on one variable, price. Standardization also makes it possible for traders anywhere in the world to trade in these markets and know exactly what they are trading. This is in sharp contrast to the cash forward contract market, in which changes in specifications from one contract to another might cause price changes from one transac-tion to another. One reason futures markets are considered a good source of commodity price information is because price changes are attrib-utable to changes in the commodity’s price level, not changes in contract terms.

Unlike the forward cash contract market, futures exchanges provide:

Rules of conduct that traders must follow • or risk expulsionAn organized market place with estab-•lished trading hours by which traders must abideStandardized trading through rigid con-•tract specifications, which ensure that the commodity being traded in every contract is virtually identicalA focal point for the collection and•dissemination of information about the commodity’s supply and demand, which helps ensure all traders have equal access to information A mechanism for settling disputes•among traders without resorting to the costly and often slow U.S. court system Guaranteed settlement of contractual•and financial obligations via the ex-change clearinghouse

The Purpose of Futures MarketsFutures markets serve two primary purposes.

The first is price discovery. Futures markets provide a central market place where buyers and sellers from all over the world can interact to determine prices. The second purpose is to transfer price risk. Futures give buyers and sell-ers of commodities the opportunity to establish prices for future delivery. This price risk transfer process is called hedging.

Changes in a Futures Contract’s Value

A futures contract’s value is simply the num-ber of units (bushels, hundredweight, etc.) in each contract times the current price. Each con-tract specifies the volume of grain or livestock it covers. Both Chicago and Kansas City Board of Trade grain and oilseed futures contracts cover 5,000 bushels. The CME’s live cattle futures con-tract covers 40,000 pounds (400 hundredweight) of live weight steers. The lean hogs futures con-tract covers 40,000 pounds (400 hundredweight) of carcass weight pork and the feeder cattle futures contract covers 50,000 pounds (500 hun-dredweight) of feeder steers. To determine both contract value and changes in contract value, examine the July KCBT wheat futures contract on a day when the settlement price is $6.00 per bushel. The total contract value would simply be 5,000 bushels times $6.00 or $30,000. If the July KCBT wheat futures price changes to $6.10 per bushel the next day, the new contract value is 5,000 bushels times $6.10 or $30,500. The change in contract value is $30,500 minus $30,000, or $500. Alternatively, you can compute the change in contract value by simply multiplying the price change per unit ($6.10-$6.00=$0.10/bushel) times the number of units in the contract ($0.10/bushel x 5,000 bushels= $500).

The effect of a change in contract value de-pends on whether you previously sold or pur-chased a futures contract. A decrease in contract value (a price decline) is a loss to anyone who previously purchased a futures contract, but a gain for a trader who previously sold a futures contract. Conversely, an increase in contract value (a price increase) is a gain to anyone who previously purchased a futures contract (i.e., is long), but is a loss for a trader who previously sold a futures contract (i.e., is short). One trader’s loss is another trader’s gain. For example, in the previous wheat futures example, a trader who purchased July KCBT wheat futures at $6.00/ bushel saw the value of his futures market ac-count increase by $500 when the price rose to $6.10; a trader who sold a futures contract at $6.00/bushel saw the value of his futures market

3

account decline by $500. The $500 gain earned by the futures contract buyer came from the fu-tures contract seller’s $500 loss via the exchange clearinghouse, as outlined in Figure 1.

Futures contract performance is guaranteed by the exchange through an institution known as the exchange clearinghouse, which tracks the value of each trader’s position and ensures that sufficient funds are available to cover each trader’s obligations. The exchange clearing-house requires that traders (via the futures

contract (typically less than 5 percent of contract value), traders of futures contracts are relieved of the responsibility of worrying that the trader on the other side of the contract will default on his or her financial obligations by the mark-to-mar-ket margin system and by a series of checks and balances put in place by the exchange to ensure that sufficient funds are available to cover each account’s risk exposure.

Futures Trading Terminology To trade futures contracts you must become

familiar with the terminology used in the trade. Here are some terms and definitions.

Figure 1. Marking-to-Market Buyer and Seller Accounts at Exchange Clearinghouse.

Buyer (Long)

Date Action Price

Day 1 Buy at $6.00/bu

Day 2 No action (but price increases)

$6.10/bu

$0.10/bu gain x 5,000 bu

$500 gain from day 1

Seller (Short)

Date Action Price

Day 1 Sell at $6.00/bu

Day 2 No action (but price increases)

$6.10/bu

$0.10/bu loss x 5,000 bu

$500 loss from day 1

Long A buyer of a futures contract. Someone who buys a futures contract is often referred to as being long that particular contract.

Short A seller of a futures contract. Someone who sells a futures contract is often referred to as being short that particular contract.

Bull A person who expects a commodity’s price to increase. If you are bullish about wheat prices you expect them to increase.

Bear A person who expects a commodity’s price to decline. If you are bearish about wheat prices you expect them to decline.

Market order

An order to buy or sell a futures contract at the best available price. A market order is executed by the broker immediately. “Sell one July KCBT wheat, at the market” is an example of a market order.

Limit order An order to buy or sell a futures contract at a specific price, or at a price that is more favorable than the price specified. For example, “Buy one March KCBT wheat at $6.30 limit” means buy one March KCBT wheat contract at $6.30 or less. In this example, the order will not be executed at a price higher than $6.30.

Stop order An order which becomes a market order if the market reaches a specified price. A stop order to buy a futures contract would be placed with the stop price set above the current futures price. Conversely, a stop order to sell a futures contract would be placed with the stop price set below the current futures price.

commission merchant or broker) deposit money before a trade to ensure contract performance. This deposit is usually referred to as the initial margin deposit. Each trader’s margin money is maintained in a separate margin account, which is adjusted daily to reflect the gain or loss in con-tract value that occurred that day. This process is sometimes referred to as “Marking-to-Market,” because the account is adjusted to reflect its cur-rent market value based on that day’s closing or settlement price. Although the margin require-ments are small relative to the total value of the

4

Using Futures Contracts in a Farm Marketing Program

There are a number of ways futures contracts can be used in a farm marketing program. Futures contracts can be useful when marketing grain or livestock because they can be a tempo-rary substitute for an intended transaction in the cash market that will occur at a later date. This is a working definition of hedging. For example, if you plan on selling wheat for cash at harvest, but would like to lock in the futures price ahead of harvest, you could sell a KCBT July wheat futures contract as a temporary substitute for the cash grain you plan to sell in the future. When you actually make the cash grain sale at harvest, you will no longer need the “temporary substi-tute,” which was your sale of the wheat futures contract. Thus, as soon as you sell the cash wheat you would exit your “temporary substitute contract” by buying a KCBT July wheat futures contract. Doing so means you no longer have an open position on the futures exchange. Your actual net sale price for the wheat would be the amount you received for the cash wheat at the elevator, plus any gain or minus any loss on the futures transaction.



Produced by AgriLife Communications, The Texas A&M System

Extension publications can be found on the Web at: http://AgriLifeBookstore.org.


Partial funding support has been provided by theTexas Corn Producers, Texas Farm Bureau, andCotton Inc.–Texas State Support Committee.

Futures contract prices also can be used as a source of price forecasts. A futures contract price represents today’s opinion of what a commod-ity’s value will be when the futures contract expires. If a history of the difference between a commodity’s futures contract and cash prices, for a particular grade and specific location of interest (known as the basis) is available, it can be used to estimate a futures market-based cash price forecast. For example, assume that on March 15 the KCBT July wheat futures contract is trading at $6.00 per bushel, and your local cash market price at harvest is generally $0.40 per bushel below the KCBT July wheat futures contract price (i.e., a basis of negative $0.40 per bushel). In this case, a futures-based local cash price forecast at harvest time would be $5.60/bushel. This forecast can be compared with price forecasts from other sources such as university Extension economists, market advisory services, and the U.S. Department of Agriculture when preparing budgets and making marketing deci-sions.

For more details on basis and how hedging works, see the following publications in this se-ries: Selling Hedge with Futures (E-497) and Buying Hedge with Futures (E-498).

Buying Hedge with FuturesRisk Management

E-498RM2-15.0

01-09

*Assistant Professor and Extension Economist–Grain Marketing, and Professor andExtension Economist–Livestock and Food Marketing and Policy, The Texas A&M System.

Many bulk purchasers of agricultural com-modities need price risk management tools to help stabilize input prices. Livestock feeders anticipating future feed needs or grain export-ers making commitments to sell grain are two users of agricultural commodities who could benefit from input price management strate-gies. A common tool is a buying, or long, hedge using futures. Producers concerned with price fluctuations for agricultural inputs can use a buying hedge with futures to manage that price risk.

What Is a Hedge? A buying hedge involves taking a position in

the futures market that is equal and opposite to the position one expects to take later in the cash market. The hedger is covered against input price increases during the intervening period. If prices rise while the hedge is in place, the higher cash price the producer must pay for his or her inputs is offset by a profit in the futures market. Conversely, if prices fall, losses in the futures market are offset by the lower cash price.

There are five steps to implementing a buying hedge that will likely meet your pricing objec-tives.

1. Analyze the expected profit of theenterprise in question. For example,a cattle feeder should analyze howexpected profits for fed cattle change

as corn price (the input in question) changes. Only then can the producer know if the corn price he could hedge would allow the cattle feeding enterprise to achieve its corn pricing goal for the period, holding all other input prices and animal performance constant.

2. Be sure to hedge the correct quantity.Check contract quantity specificationsand be sure the proper amount ofinputs is hedged. For example: Acattle feeder plans to feed 120 head ofsteers weighing 700 pounds each. Histargeted out-weight for the steers is1,150 pounds (140 days on feed x 3.2pounds average daily gain) and theprojected feed conversion (pounds offeed per pound of gain) is 7. The cattlefeeder’s projected feed requirementis 6,750 bushels (54,000 pounds totalgain x 7 pounds of feed per pound ofgain ÷ 56 pounds per bushel). Since oneChicago Board of Trade (CBOT) corncontract is specified as 5,000 bushels,the feeder would need to hedge twocontracts to fully cover the projectedfeed requirements.

3. Use the proper futures contract.Most widely produced agriculturalcommodities have a correspondingfutures contract. Fed and feeder cattle,

Mark Welch and David Anderson*

2

hogs, corn, wheat and soybeans are a few examples. A notable exception is grain sorghum. Because of grain sorghum’s close price relationship to corn, producers can use corn futures to manage grain sorghum price risk. Once the proper futures contract is selected, pay close attention to the contract month. Project the date of the anticipated cash market transaction and select the nearest futures contract month after the anticipated purchase in the cash market.

4. Understand basis and develop a basisforecast. Basis (which is covered indepth in another publication in thisseries) is the relationship betweenlocal cash prices and futures prices. Ifprojected basis and actual basis at thetime of cash purchase are the same,then the purchase price that was hedgedwill be achieved. Failure to account forbasis and basis risk could mean notmeeting the buying hedge pricing goal.

5. Be disciplined and maintain the hedgeuntil the commodity is purchased inthe cash market or the hedge is offsetby another price risk management tool.Producers should hedge only pricesthat are acceptable to them. Onceyou have initiated a hedge position,do not remove the hedge before thecash purchase date without carefullyconsidering the risk exposure.

Case Example: Buying Hedge for Feeder Steers

Joe has a pen of cattle on feed that he will sell in early October. He will need to purchase feeder cattle at that time to replace the fed cattle he sells. In June, Joe sees that November Chicago Mercantile Exchange (CME) Feeder Cattle fu-tures are trading at $105 per hundredweight. Joe knows the historical basis for 750-pound feeder cattle the first week of October is -$1 per hun-dredweight (i.e., cash price is $1 per hundred-weight less than futures price). Observation of

futures prices leads him to project a feeder steer purchase price of $104 per hundredweight ($105 - $1) for October 1. At that price, he projects a $20 per head profit under normal feeding conditions. Joe fears feeder cattle prices may increase be-tween June and October. He elects to implement a buying hedge to lock in the purchase price for 120 steers (120 steers x 750 pounds per steer ÷ 50,000 pounds per contract = two contracts) (Table 1).

Table 1.

Cash market Futures market

Basis

June 15 Objective: to realize a feeder cattle purchase price of $104/cwt

Buys two CME November Feeder Cattle contracts at $105/cwt

Projected at -$1/cwt

October 1 Buys 120 head of 750-lb feeder steers at $110/cwt

Sells two CME November Feeder Cattle contracts at $111/cwt

Actual basis, -$1/cwt ($110-$111)

Gain or loss in futures: Gain of $6/cwt ($111 - $105)

Results: Actual cash purchase price ................... $110.00Futures profit ........................................ - $ 6.00Realized purchase price.........................$104.00**Without commission and interest

How Did the Feeder Steer Buying Hedge Work?

Joe projected an October 1 purchase price of $104 per hundredweight on June 15. On Octo-ber 1, he purchased his feeder steers for $110 per hundredweight and liquidated his futures position at $111 per hundredweight, for a basis of -$1 per hundredweight. The increase in feeder cattle prices he feared occurred; thus, the cash price he paid for the steers was greater than his projection. However, Joe realized a $6 per hundredweight profit from the increase in the

3

CME November feeder cattle price. Applying the $6 per hundredweight futures profit to the cash purchase price, the realized (or net) purchase price was $104 per hundredweight, just as Joe projected.

Without Joe’s accurate basis forecast, the pro-jected purchase price and realized price would have been different. A favorable basis move (i.e., a widened basis) would have yielded a lower realized purchase price, while an unfavorable basis move would have increased the net buying price. In a hedged position, the producer trades price risk for basis risk. Once more, the basis forecast is a key to hedging with futures.

What if Joe’s Price Outlook Was Incorrect?

Let’s examine the effects of a price decline on the performance of Joe’s feeder steer buying hedge (Table 2).

Table 2.

Cash market

Futures market

Basis

June 15 Objective: to realize a feeder cattle purchase price of $104/cwt

Buys two CME November Feeder Cattle contracts at $105/cwt

Projected at -$1/cwt

October 1 Buys 120 head of 750-lb feeder steers at $100/cwt

Sells two CME November Feeder Cattle contracts at $101/cwt

Actual basis, -$1/cwt ($100-$101)

Gain or loss in Futures: Loss of $4/cwt ($101 - $105)

Results: Actual cash purchase price ...................$100.00Futures loss ........................................... + $ 4.00Realized purchase price.........................$104.00**Without commission and interest

Joe’s pricing objective of $104 per hundred-weight was achieved. This example illustrates the discipline necessary when hedging. Al-though Joe might be frustrated with the results of this buying hedge in a declining market, he should remember that the decision to hedge was made after careful analysis and his best price forecast. While Joe might not be happy about a net price of $104 per hundredweight, his plan was sound, he still made a profit feeding these cattle, and he will likely maintain, if not im-prove, his overall financial position.

Table 3. Advantages and disadvantages of a buying hedge with futures.

Advantages Disadvantages

Reduces risk of price increases

Gains from price declines are limited

Could make it easier to obtain credit

Risk that actual basis will differ from projection

Establishing a price aids in management decisions

Futures position requires a margin deposit and margin calls are possible

Easier to cancel than a forward contract arrangement

Contract quantity is standardized and may not match cash quantity







Selling Hedge with FuturesRisk Management

E-497RM2-14.0

01-09

*Assistant Professor and Extension Economist–Grain Marketing, The Texas A&M System.

When a commodity price is acceptable prior to the time the commodity will be sold in the cash market, a producer can use a selling hedge to reduce the risk of declining prices.

What Is a Hedge? A selling hedge involves taking a position in

the futures market that is equal and opposite to the position one expects to have in the cash market, so one is covered (subject to basis risk) against price declines during the intervening period. If futures and cash prices decrease while the hedge is in place, the lower cash price the producer realizes for his production is offset by a profit in the futures market. Conversely, if prices increase, losses in the futures market are offset by the improved cash price.

There are five steps to implementing a selling hedge that will likely meet your pricing objec-tives.

1. Analyze the expected profit of theenterprise in question. Whether ornot you decide to implement a sellinghedge will depend somewhat on thecost of production for the enterpriseand on having an acceptable profitexpectation. However, protecting anacceptable profit might not always bepossible. A prudent manager mightalso use a selling hedge to limit losseswhen market conditions dictate.

2. Be sure to hedge the correct quantity.Check contract quantity specificationsand be sure the proper amount of acommodity is hedged. For example: Acattle feeder has 100 head of steers onfeed that have a projected out-weightof 1,200 pounds each. The total poundsof fed cattle produced divided by theChicago Mercantile Exchange (CME)Live Cattle contract weight specificationyields the number of contractsnecessary to fully hedge the cattle (100head x 1,200 pounds per head ÷ 40,000pounds per contract = three contracts).Similarly, a producer who wants tohedge 100 percent of an expected 10,000bushels of corn would use two futurescontracts (one Chicago Board of Trade,or CBOT, corn futures contract is for5,000 bushels).

3. Use the proper futures contract.Most widely produced agriculturalcommodities have a correspondingfutures contract. Fed and feeder cattle,hogs, corn, wheat and soybeans area few examples. A notable exceptionis grain sorghum. Because of grainsorghum’s close price relationship tocorn, producers can use corn futures tomanage grain sorghum price risk.Once the proper futures contract isselected, pay close attention to the

Mark Welch*

2

contract month. Project the date of the anticipated cash market transaction and select the nearest contract month after the anticipated sale in the cash market. Futures contracts expire before the end of the month and this ensures that all cash sales will take place before futures contracts expire. For example, an expected September corn sale would be hedged against December CBOT corn futures, since there are no contracts available for October or November.

4. Understand basis and develop anaccurate basis forecast. Basis (which iscovered in depth in another publicationin this series) is the relationshipbetween local cash prices and futuresprices. Basis is defined as cash minusfutures. If projected basis and actualbasis at the time of purchase are thesame, then the selling price that washedged will be achieved. Failure toaccount for basis and basis risk couldmean not meeting your selling hedgepricing goals.

5. Be disciplined and hold the hedge untilthe cash sale of the commodity or untilthe hedge is offset by another price riskmanagement tool. Producers shouldhedge only prices that are acceptableto them. Once you have initiated ahedge position, do not remove thehedge before the cash sale date withoutcarefully considering the risk exposure.

Case Example: Selling Hedge for Corn

Bill is a corn farmer in the Texas Panhandle. He has a 10-year average corn production of 24,000 bushels and at no time in the past 5 years has that production dropped below 15,000 bush-els. In March, Bill notices that December CBOT corn futures are trading at $5.65 per bushel. He knows the historical harvest time basis for corn in his county is -$0.05 per bushel relative to fu-tures (i.e., cash price is $0.05 per bushel less than futures price). Based on futures information, he

projects a harvest time price of $5.60 per bushel ($5.65 - $0.05), which is acceptable to him. Be-cause Bill fears a possible price decline between March and harvest, he elects to implement a selling hedge on 15,000 bushels (three contracts at 5,000 each) because he has a reasonable expec-tation of producing this quantity based on his production history (Table 1).

Table 1.


Basis

March 5 Objective: to realize a corn sales price of $5.60/bu

Sells three CBOT December corn contracts at $5.65/bu

Projected at -$0.05/bu

October 10

Sells 15,000 bu of corn at $5.40/bu

Buys three CBOT December corn contracts at $5.45/bu

Actual basis, -$0.05/bu ($5.40-$5.45)

Gain or loss in futures: Gain of $0.20 ($5.65 - $5.45)

Results: Actual cash sales price .....................................$5.40 Futures profit ................................................ + $0.20 Realized sales price ..........................................$5.60* *Without commission and interest

How Did the Corn Selling Hedge Work?

On March 5 Bill projected a harvest-time sell-ing price of $5.60 per bushel. On October 10, he sold his corn for $5.40 per bushel and liquidated his futures position. The decrease in corn prices he had feared did occur, and the cash price he received for his corn was less than his projec-tion. However, Bill realized a $0.20 per bushel profit from the decrease in the CBOT December corn futures price. Applying the $0.20 per bushel futures profit to the cash price, the realized (or net) selling price for the 15,000 bushels he hedged was $5.60 per bushel, just as he had projected.

3

Without Bill’s accurate basis forecast, the projected selling price and realized selling price would have been different. A favorable basis move (i.e., a narrowed basis) would have yielded a higher realized sales price, while an unfavor-able basis move would have decreased the net selling price. In a hedged position, the producer trades price risk for basis risk. Once more, the basis forecast is a key to hedging with futures.

Did Bill receive $5.60 per bushel for his en-tire crop? The answer depends on the quantity produced. If he produced his historical average of 24,000 bushels, he was protected at $5.60 per bushel for the 15,000 bushels he hedged and received a price at harvest of $5.40 per bushel for the unhedged 9,000 bushels. This yields a weight-ed average price of $5.525 per bushel. Had he produced more than his historical average yield, the weighted average price would have been less than $5.525 per bushel. If he produced less than his historical average yield, the weighted average price would have been higher than $5.525 per bushel. Actual production determines the final average price per bushel.

What if Bill’s Price Outlook Was Incorrect?Let’s examine the effects of a price increase

on the performance of Bill’s corn selling hedge (Table 2).

Table 2.


Basis

March 5 Objective: to realize a corn sales price of $5.60/bu

Sells three CBOT December corn contracts at $5.65/bu

Projected at -$0.05/bu

October 10

Sells 15,000 bu of corn at $5.85/bu

Buys three CBOT December corn contracts at $5.90/bu

Actual basis, -$0.05/bu ($5.85-$5.90)

Gain or loss in futures: Loss of $0.25 ($5.65 - $5.90)

Results: Actual cash sales price .....................................$5.85Futures loss ..................................................... - $0.25Realized sales price ..........................................$5.60**Without commission and interest

Bill’s pricing objective of $5.60 per bushel was achieved for the 15,000 bushels hedged. This example illustrates the discipline necessary when hedging. Although Bill might be frustrated with the results of this selling hedge in a rising market, he should remember that the decision to hedge was made after careful analysis and his best price forecast. While Bill might not be happy about a net price of $5.60 per bushel, his plan was sound, he still made his desired profit for this part of his corn crop, and he will likely maintain, if not improve, his overall financial position.

Table 3. Advantages and disadvantages of a buying hedge with futures.

Advantages Disadvantages

Reduces risk of price increases

Gains from price increases are limited

Could make it easier to obtain credit

Risk that actual basis will differ from projection

Establishing a price aids in management decisions and can help stabilize crop income within a crop year

Year-to-year income fluctuations may not be reduced with hedging

Easier to cancel than a forward contract arrangement

Contract quantity is standardized and may not match cash quantity

Futures position requires a margin deposit and margin calls are possible







Commodity Options as Price Insurance for Cattlemen R. Curt Lacy1, Andrew P. Griffith2 and John C. McKissick3

Adapted from “Managing For Today’s Cattle Market and Beyond”

1 Associate Professor and Extension Economist-Livestock, University of Georgia2 Assistant Professor and Extension Economist-Livestock, University of Tennessee3 Professor Emeritus and Distinguished Marketing Professor, University of Georgia4 Cattle producers can purchase Livestock Risk Protection (LRP) through crop insurance agents. A good reference on LRP for feeder cattle producers is “Livestock Risk Protection Insurance (LRP): How It Works for Feeder Cattle,” publication number W 312, available through the University of Tennessee at http://economics.ag.utk.edu/riskmgmt.html.

IntroductionMost cattlemen are familiar with insurance. Examples include insuring buildings against fire, equipment against accidents and lives against death or injury. Purchasing insurance trades the possibility of a large but uncertain loss for a small but certain cost: the insurance premium.

One of the greatest risks cattle producers face is price risk. Price changes can come in the form of declining cattle pric-es for sellers, increasing cattle prices for buyers or increas-ing feed prices for feed users.

Because of this risk, producers might want to “insure” feed-er cattle, fed cattle or feed against unfavorable price move-ments, while still being able to take advantage of favorable price movements. Cattlemen have this opportunity by using the commodity options market4. What is the Commodity Options Market? The commodity options market is a market in which producers may purchase the opportunity to sell or buy a commodity futures contract at a specified price. Purchasers in options markets have the “opportunity” or “right” but not the “obligation” to exercise their agreement. Therefore, the markets are appropriately named “options markets” since they deal in an option, not an obligation.

Just as a cattleman may purchase the right from an insur-ance firm to collect on a policy if a building burns, he can purchase the right to sell commodities at a specific price in case prices drop below the specified price. A separate op-tions market also exists to allow the purchase of commodi-ties at a specified price in case prices increase.

For instance, if a cattleman wanted to buy the right to sell feeder cattle for $175/cwt., the feeder cattle options market might provide the opportunity. By paying the market-de-termined premium, the cattleman could then collect on the option if prices fell below $175/cwt. when the cattle were actually sold. If prices are higher than $175/cwt., the cattle are sold for the higher price, and the cost of the premium is absorbed.

While this is a simplified version of the actual way in which producers might operate in the options market, the reality behind this concept is not much different. Just as with other types of insurance, by paying a premium, insurance can be purchased against price declines or increases. Collecting on the insurance would be an option if the price moves in an unfavorable direction. The “Ins” and “Outs” of Options: Puts and Calls There are two types of commodity options: a put option and a call option. The put option gives the holder (usually a commodity seller) the right -- but not the obligation -- to sell the underlying commodity contract to the option writer at a specified price on or before the commodity expiration date. The call option gives the holder (usually a commodity pur-chaser) the right -- but not the obligation -- to buy the under-lying commodity contract from the option writer (seller) at a specified price on or before the option expiration date.

The put option and the call option are two different and distinct contracts. A call option is not the opposite of a put option. Distinguish between the two types of options by remembering that the holder of the put option can choose to “put-it-to-them”; that is, sell the product, while the holder of the call option can “call-upon-‘em” to provide the product.

Commodity Options as Price Insurance for Cattlemen UGA Extension Bulletin 14052

Buyers and Sellers In the option market, as in every other market, transactions require both buyers and sellers. The buyer of an option is referred to as an option holder. Holders of options may be either seekers of price insurance or speculators.

The seller of an option is sometimes referred to as an option writer. The seller may also be either a speculator or some-one who desires partial price protection. The choice to buy (hold) or sell (write) an option depends primarily upon one’s objectives.

Buyers and sellers of cattle options “meet” on the Chicago Mercantile Exchange. Rather than physically meeting, all transactions are carried out through brokerage firms that act as the buyer’s and seller’s representative at the exchange. For this service, the brokerage firm charges a commission. The exchange has no part in the transaction other than to insure its financial integrity. In effect, the exchange offers a place for option buyers and sellers to get together under organized rules of trade.

Strike Price The “specified price” in the option is referred to as the exercise price or strike price. This is the price at which the underlying commodity contract can be bought or sold and is fixed for any given option, put or call. There could be several options with different strike prices traded during any period of time. If the price of the underlying commod-ity changes over time, then additional strike prices may be listed for trade.

Underlying CommodityThe “underlying commodity” for the commodity option is not the commodity itself but rather a futures contract for that commodity. For example, an October feeder cattle op-tion is an option to obtain an October feeder cattle futures contract. In this sense, options are the right to buy or sell a futures contract and not the physical com-modity.

Because options have futures contracts as their underly-ing commodity, each option contract represents the same quantity as the underlying futures contract. That is, most grain options represent 5,000 bushels, while the live cattle option represents 40,000 pounds of fed cattle. The feeder cattle option represents 50,000 pounds of feeder cattle. Options are traded for each of the futures contract months in each of these commodities. A table

A more extensive explanation of

futures contracts is available in UGA

Extension Bulle-tin 1404, “Using

Futures Markets to Manage Price Risk

in Feeder Cattle Operations.”

showing the option contract specifications for feeder cattle and live cattle is shown at the end of this bulletin (Table 1).

Expiration Futures contracts have a definite predetermined matu-rity date during the delivery month. Likewise, options have a date at which they mature and expire. The specific date of expiration for the feeder cattle option contract is the same as its underlying futures contract – the last Thursday of each month, with the exception of November and any month when a holiday falls on the last Thursday or any of the four weekdays prior to that Thursday.

Because fed cattle futures contracts can be settled by physically delivering the cattle, the fed cattle option contract expires the first Friday of the futures contract month, prior to the futures contract expiration around the 20th of the month. For example, a $175/cwt. October fed cattle put option is an opportunity to sell one October live cattle futures contract at $175/cwt. The holder can execute this option on any business day until the first Friday in October.

Option Premiums The option writer is willing to incur an obligation in return for some compensation. The compensation is called the option premium. Using the insurance anal-ogy, a premium is paid on an insurance policy to gain the coverage it provides. Similarly, an option premium is paid to gain the rights granted in the option. The option premium is determined either by public outcry and acceptance in an exchange trading pit or electron-ically through a “virtual” trading pit. Like all commod-ity prices, option premiums can be expected to change not only daily but often by the minute.

While the interaction of supply and demand for op-tions will ultimately determine the option premium, two major factors will interact to affect the level of premiums. The first factor is the difference between the strike price of the option and the futures price of the underlying commodity.

This differential in prices may give the option “intrin-sic” or exercise value. For example, consider an Octo-ber feeder cattle put option with a strike price of $175/cwt. and the underlying October feeder cattle futures with a current price of $172/cwt. The option could be


sold for at least $3/cwt. since anyone would be willing to purchase the right to sell at $175 when the market is currently $172. This $3 is said to be the intrinsic value. As long as the market price on the option’s underlying futures contract is below the strike price on a put op-tion, the option has intrinsic value. The converse of the price relationship is true for a call option. A call option has intrinsic value when the futures market price is above the strike price.

Any option that has intrinsic value is said to be “in-the-money.” An “in-the-money” option has value to others because the futures market price is below the put or above the call strike price. An option is said to be “out-of-the-money” and has no intrinsic value if the current futures market price is above the put or below the call strike price. When the futures market price of the commodity and the strike price are equal, the op-tion is said to be “at-the-money,” and has no intrinsic value.

A second factor influencing the option premium is the length of time to expiration of the option. Assuming all else is held constant, option premiums usually decline in value as the time to expiration decreases. This phe-nomenon reflects the time value of an option. For ex-ample, in August the time premium on a $175 Septem-ber feeder cattle option will be less than the premium on a $175 November option. The option with a longer time to expiration has a greater probability of moving “in-the-money” than the option with less time. There-fore, it is worth more on that factor alone. The longer the time period, the greater the chance that events will occur that could cause substantial movement in futures prices and change the value of the option. As a result, the option writer requires a greater premium to assume the risk of writing a longer-term option.

“Out-of-the-money” options have a value that reflects time value. “In-the-money” options possess both time value and intrinsic value. The total cost of a premium minus the intrinsic value yields the time value of an option (Time Value = Premium – Intrinsic Value). Offsetting an Option The method by which most holders of “in-the-mon-ey” options realize accrued profit is by resale of the option. This is referred to as “offsetting” an option position and completing a round turn (the buy and sell or the sell and buy of an option). Options can be offset

anytime between their purchase and expiration date if the holder so desires. Most option buyers will offset their position rather than exercise the option to avoid losing any remaining time premium and (or) assuming a futures market position and its resultant decisions, margin deposits and commissions. In most situations, the option can be resold to another trader at a premi-um at least equivalent to the intrinsic value that results from an “in-the-money” price relationship.

Another method by which the holder of an option could realize accrued profits is by “exercising” the option. Options are only exercised at the direction of the owner or if there is intrinsic value at expiration. The opportunity to exercise the option means the option buyer can always get the intrinsic value of the option premium even if there is little or no trading in the option being held. It also provides for a means of continuing price protection after the option expires.

If the decision is made to exercise, the following proce-dures are followed. For a put, the holder is assigned a short (sell) position in the futures market equal to the strike price. At the same time, the option writer is obli-gated to take a long (buy) futures position at the same price. Both positions are then adjusted to reflect the current settlement price. It is rational to exercise a put option only when the futures market price is below the strike price, so the holder’s futures position will show a profit. The futures position of the writer will show an equivalent loss. At this point the option contract has been fulfilled and both parties are free to trade their futures contracts as they see fit. Evaluating and Using Options Markets Now that the mechanics of options trading have been explored, it is time to consider two critical questions: 1) What do varying strike prices mean in terms of price insurance? and 2) How does a producer actually obtain this insurance?

There are three steps to consider in evaluating option prices.

1. Select the appropriate option contract month. To do this, select the option whose underlying futures will expire closest to, but not before, the time the physical commodity will be sold or purchased.


For example, if a group of feeder calves were to be sold in early October, the October option would be appropriate.

2. Select the appropriate type of option. To insure products for sale at a later time against price de-clines, the producer would be interested in buying a put (the right to sell). If the producer’s motive is to insure future commodity purchases against cost increases (for instance, corn needed to feed cattle), then purchasing a call would be an appropriate strategy. To continue the example: If the cattleman wishes to insure the feeders he will be selling in early Oc-tober, then he will be interested in purchasing an October put option.

3. Calculate the minimum cash selling price being offered by the put option selected. For a call option, the maximum purchase price would need to be calculated. These calculations can be accomplished in five steps:

1. Select a strike price within the option month. For instance, a $175/cwt. October feeder cattle put.

2. Subtract the premium from the strike price for a put or add the premium for a call. For example, if a $175 October put costs $2.75/cwt., the result is $175 - $2.75 = $172.25/cwt.

3. Subtract (for a put) or add (for a call) the “op-portunity cost” of paying the premium for the period it will be outstanding. For example, if the option premium of $2.75/cwt. is paid in June and the option is expected to be liquidated by an offsetting resale in early October, an interest cost for the three-month period needs to be added. If borrowed funds are used and the interest rate is 9 percent, then the interest (opportunity) cost would be .75 percent per month, or 2.25 percent for three months. The interest cost associated with a $2.75/cwt. put option premium would be $0.06/cwt. This leaves a net price of $172.25 - $0.06 = $172.19/cwt.

4. Subtract (for a put) or add (for a call) the com-mission fee for both buying and offsetting the op-tion. Assume the brokerage firm charges $75 per round turn for handling each option contract. The commission fee would be $0.15/cwt. ($75

for 50,000 lbs., $75/500 cwt.). The net price is now $172.19 - $0.15 = $172.04/cwt.

5. One final adjustment must be made to these prices. The option strike price must be localized to reflect the difference between prices in the local markets where the cat-tle will be sold or grains

purchased, and the futures market price. This difference is called basis (Basis = Local Cash Price – Futures Price). The basis differs for cattle at different weights, sex, location and time of year across the country. See UGA Extension Bulletin 1406, “Understanding and Using Cattle Basis in Managing Price Risk” for some of the factors that affect cattle basis. Many state Extension offic-es have historical basis estimates for cattle and inputs that may be helpful in determining the appropriate basis.

By adjusting the option price for basis, a minimum selling price can be obtained for a put or a maximum purchase price obtained for a call. For the example, if in early October, 600 lb. feeder steers normally bring $10/cwt. less than the feeder cattle futures market, then the likely minimum local cash price becomes $172.04- $10 = $162.04/cwt. In the end, the only thing that will change this price is the fluctuation in the basis.

More or less price insurance can be purchased by buy-ing options with different strike prices. To determine the minimum selling price suggested by each strike price, repeat steps one through five for the various strike prices and their associated premiums.

Options Arithmetic: Two ExamplesOnce the relevant options prices have been evaluat-ed, the next question is, how would the producer go about obtaining a certain level of price insurance? Two examples, one using a put to establish a price floor (an expected minimum selling price) and one using a call to establish a price ceiling (an expected maximum pur-chase price), will help illustrate the total process.

Basis estimation is a critical component in estimating the expected net purchase or sale price. Interested readers should also consult UGA Extension Bulletin 1406, “Understanding and Us-ing Cattle Basis in Man-aging Price Risk” to help them better understand the various factors that can affect basis.


Put Option ExampleIn the following put option example (Figures 1 and 2), we discuss a cat-tleman who will be sell-ing a load of feeder cattle in early October. In our example, he checks the options quotes in June and finds he could pur-chase an October feeder cattle put option to sell at $175/cwt. at a premium of $2.75/cwt. To further localize this strike price, he subtracts $10/cwt. basis since he normally sells 600 lb. steer calves for a somewhat lower lo-cal cash price in October than the October futures price. Commission ($75 per contract) and inter-est on the premium cost will be about $0.25/cwt., so the $175 put would provide an expected minimum selling price of $175 - $10 - $2.75 - $0.25, or $162/cwt. By compar-ing this with his other pricing alternatives and his production cost, he decides that purchasing this put would be an appropriate strategy for the 83 steers he plans to sell in October. He advises his broker that he wants to purchase one “$175 October feeder cattle put at $2.75.” He then forwards a check for $1,450 (500 cwt. X $2.75/cwt. plus $75 brokerage fee) to his broker.

As October approaches, one of three things will hap-pen: prices will stay relatively unchanged, rise above the option strike price (thus making the option worth-less) or fall below the strike price (thus making the producer’s option valuable). Remember that for a put option, if the current futures price is above the strike price, the option is said to be “out-of-the-money.” If futures are below the strike price, it is “in-the-money.”

First, assume the futures market prices in early Octo-ber are $185/cwt. -- well above the put option strike price of $175/cwt. This makes the producer’s option

“out-of-the-money.” Since no one is willing to pay for an option to sell at $175/cwt. when they could sell current-ly for $185/cwt., the option expires as worthless (Figure 1). In this case, the cattleman sells the load of feeders and does not use the option. The net price would be the cash price received less the net premium cost originally paid. Assuming the basis did not change (-$10/cwt.) and the cattle brought $175/cwt., the actual net received would be $172/cwt. ($185 - $10 basis - $2.75 premium - $0.25 commission and interest).

In this case, the insurance policy was not needed. Had this been known in advance, the cattleman could have saved the premium. However, just as fire or other disas-ters can’t be predicted, price movements can’t be pre-dicted with accuracy either. For this reason, the cattle-man was willing to substitute the known loss (premium) for the possibility of a larger unknown loss.

Figure 1. Put Option Example. Feeder cattle pricing example where the option expires as worthless.


What happens if the cattleman does need to collect on his option position? The mechanics of this instance are shown in Figure 2. Assume the futures market price at the first of October is $170/cwt. In this case, the option to sell does have value, because others are willing to purchase the right to sell at $175 when they are cur-rently only able to sell at $170/cwt. Remember, this means the option is “in-the-money.” One way to collect on an options policy (offset) is very much like collect-ing on insurance. Since the value of the loss is $5/cwt., the cattleman should be able to sell the option back for at least this amount. He calls his broker and tells him to sell the October put at $5 or better. The sale of a previously bought put cancels the option, and the bro-ker sends a check for $5 per cwt. X 500 cwt. or $2,500. Since he paid a premium of $2.75/cwt. plus the $0.25/cwt. option trading cost, he really netted $2/cwt. on the option trade. The producer sells his calves for $160/cwt. on the cash market and adds the $2/cwt. gained

on the option market to get the net price of $162/cwt. Thus, the option was successful in assuring the minimum price when he bought it in June.

In this case, the producer collected on his option (policy). Just as with insurance, he collects to the extent of his loss. In options terminology, we are talking about the strike price (the face amount of the policy) less the current futures price of feeder cattle.

A second way in which the “insurance” could have been recovered would be to exercise the option, converting it into a sell (short) position in the futures market. If the futures position were then immediately closed out with a purchased October futures (long), the $5/cwt. difference would be real-ized ($175 - $170 current

futures) with only an additional commission for the futures purchase. Since fed cattle options expire before the underlying futures, this may be the route to com-pleting the options “insurance” if the cattle were not sold until after the option had expired. With feeder cat-tle, however, this is not a problem, because the futures and options expire together.

Figure 3 summarizes the resulting net price from purchasing an October put for $2.75/cwt. with $0.25/cwt. trading cost under several futures market prices in October and a realized -$10/cwt. basis. It also makes clear why put option purchases are sometimes referred to as “floor pricing.”

In reality, the producer will only be able to estimate what his basis will be when he sells the cattle. If the ac-tual basis is better (stronger) than anticipated, then the

Figure 2. Put Option Example. Feeder Cattle Pricing Example where market declines and option is sold.


realized net price from the options will be higher. If the actual basis is worse (weaker) than anticipated, then the realized net price from the options will be lower. In either case, the actual net price will vary by the differ-ence in forecast and actual basis.

Buying More or Less Insurance Figure 4 shows the net futures floor prices achieved at various strike prices. Basis would still need to be sub-tracted to arrive at an estimated cash price.

The crosshatched area indicates the amount of the premium paid. For instance, a $180 put could have been purchased for $6.70/cwt. This would have provid-ed a higher floor price but at an unreasonable expense. Alternatively, a $170 put could be purchased for $3/cwt., providing a net futures price of $169. Finally, a $166 put would have cost only $1.30/cwt. but provid-ed a futures floor of only $164.70/cwt. Again, readers are reminded that these prices are calculated before any basis adjustment. So, if the basis is -$10/cwt., as

has been used throughout this publica-tion, then net cash prices will range from $164.70 to $175.90/cwt.

This graphic illustrates the impacts of strike prices and premiums on net futures prices. Selecting the “right” strike price involves knowing not only what level of protection is afforded, but also how much the protection costs.

Call Option ExampleAs mentioned previously, call options can be used to establish an expected maximum purchase price. Call options may be use-

ful for stocker operators or feedlots to set a maximum purchase price of incoming cattle. Likewise, livestock producers can use corn or soybean meal options to set a maximum purchase price for feed ingredients. Similar to a put option establishing a price floor, call options establish a price ceiling.

Call options give the holder the right but not the obliga-tion to BUY a futures contract at a given price. The same terms (strike price, premium, etc.) apply for call options

as they do with put options except the objective is to set a maximum purchase price for feeder cattle, live cattle or feed ingredients as opposed to a minimum price. As a result, premiums and other transaction costs are added to the strike price in calculating the net price paid, where with put options they were subtract-ed. In either instance, the result is the same. The holder experiences a small but known loss in exchange for mitigating the risk of upward price movements in the market.

To illustrate a call option, consider the feeder cattle ex-ample presented for the put option (Figure 5) except that a feeder cattle buyer wants to set a maximum purchase price of $168/cwt.

In this instance, prices increased enough to make the call option “in-the-money.” As result, the owner offset the option for the intrinsic value and reduced his net pur-chase price to $168/cwt.

Figure 4. Net futures prices for put option at various strike levels. Nov FC contract. Prices quoted in June.

Figure 3.

Table 1. Comparison of Options Specifications

Item Feeder Cattle Live CattleUnderlying Contract Size

50,000 pounds 40,000 pounds

Delivery Cash settled Physically delivered

Months traded

Jan, Mar, Apr, May, Aug, Sep, Oct and Nov

Feb, Apr, Jun, Aug, Oct, Dec

Last day of trading1

Last Thursday of the con-tract month with exceptions for November and other months when a holiday falls on the last Thursday or any of the four weekdays prior to that Thursday, 12:00 p.m.

See CME Rule 102A01.I.

First Friday of the contract month, 1:00 p.m.

See CME Rule 101A01.I.

1 Source CME website – accessed May 27, 2014http://www.cmegroup.com/trading/agricultural/livestock/feeder-cat-tle_contractSpecs_options.html http://www.cmegroup.com/trading/agricultural/livestock/live-cattle_con-tractSpecs_options.html

If the futures market had gone down to, say, $165/cwt., the cattleman would have purchased the cattle for $155/cwt. ($165 - $10 basis) and let his call expire as worthless. Because his total purchase price (premium + commission + interest) was $3/cwt., his net purchase price would have been $158/cwt.

Summary Purchasing options for price insurance is a way cattlemen can use the futures markets as a pricing alternative. This alternative should be care-fully compared to all other pricing alternatives in light of the producer’s objectives and risk-bearing ability. Options purchased for price insurance provide a “hybrid” market with characteristics of both doing nothing (cash market pricing) and hedg-ing or forward-contracting. That is, the producer who purchases an option for price insurance has some of the same price protection offered through a hedge or forward contract. On the other hand, options are not as protective against unfavorable price movements as hedging or forward contracting or as attractive as the open cash market if prices become more favorable. In fact, option purchases will always be, at best, second to either of the other two pricing alterna-tives when evaluated after the fact. However, cattlemen do not have the luxury of making pricing decision after the fact. Because of this, many cattlemen may find a place in their pricing plans for the kind of “hybrid vigor” offered through the option market.

Bulletin 1405 June 2014

The University of Georgia, Fort Valley State University, the U.S. Department of Agriculture and counties of the state cooperating. UGA Extension offers edu-cational programs, assistance and materials to all people without regard to race, color, national origin, age, gender or disability.

The University of Georgia is committed to principles of equal opportunity and affirmative action.

Figure 5. Call Option Example. Feeder Cattle Price Increase Example.

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