Time to consider hedging as part of your market strategy?
Wednesday, August 1, 2012
Some insiders are suggesting forward contracting as a defense against falling prices and the Farm Credit Corporation considers it a useful tool. But not all lenders are comfortable with the idea
by DON STONEMAN
If the pork price downturn this spring slammed your operation's income because you didn't have pigs hedged to cover your costs, you are not alone.
"Generally speaking, when the markets fall off, the majority of hogs aren't hedged," says Patrick O'Neil, manager of Ontario Pork's Marketing Division. Prices in mid-May made a strong case for forward contracting, he says.
O'Neil says only two to five per cent of all hogs in Ontario are locked in through Ontario Pork's forward pricing program, which sells roughly a quarter of the hogs in the province. Other pigs sold in Ontario may be contracted through a program such as that offered by Quality Meat Packers, or fixed with a broker taking a position at the Chicago Mercantile Exchange (CME).
But, if Ontario independent pork producers follow the pattern in the United States, use of the Chicago futures isn't likely. Based on the May 16 USDA Market News report, only about 25,000 of 258,852 producer-owned hogs are sold that way, O'Neil says. That's about 10 per cent of producer-owned hogs selling through forward contract deals.
"People who are delivering against hedges are doing it at very profitable levels," he says, probably $20 a pig more than they would have if they had not forward-contracted. The range was $5 to $30 a pig in mid-May. And producers who did hedge "may wish they had booked more pigs," he adds.
A relatively low level of hedging among independent hog producers is a feature of the U.S. hog industry as well. AgStar Financial Services, based in Mankato, Minn., is one of the largest lenders to the American pork industry, with a US$1.5 billion swine portfolio.
Justin Roelofs, AgStar's financial services officer, says the swine industry "has a special ability" to lock in feed costs and hog revenue at the same time. He estimates probably 65 per cent of U.S. hog producers are either integrated with packers or are doing some "crush hedging," trapping profit by locking in costs of feed and a price for their pigs at the same time. Crush hedging eliminates pricing risk, Roelofs explains. All of the risk is on the production side.
Why is it that slightly less than a third of the American pork industry appears to be doing nothing to hedge? Roelofs thinks those producers are older, have a lot of equity and are willing to take the risk. Or they may be scared of hedging.
"You need a good advisor," Roelofs says, either in Chicago or a local office. An advisor who was tracking markets would have told a producer in February that prices were at the highest levels seen in nine of the last 10 years and likely to fall. "It was a no-brainer to lock in" pig prices at those levels, he says.
Seasonally, hog prices trend downwards in the spring. This year, the price just went down more than normal, he says.
Roelofs spoke at the London Swine Conference in March last year and talked extensively to producers afterwards. Some Ontario producers feel they are too small to hedge, he says. Others are discouraged by dealing with a "basis" factor in pork as well. Basis is a cost of transportation factor to packing plants.
Typical American hog producers deal with a basis that averages US$1-2 a hundredweight compared to the nearby CME lean hog futures. For Ontario producers, that basis is $5 higher. Roelofs says the basis is worse in Canada because there are fewer packing plants and they are further apart. He thinks the basis can be managed through a hedging program. The higher basis probably needs to be viewed as "a cost of doing business."
Roelofs thinks operations with 400 to 600 sows producing 15,000 hogs a year can make futures contracts work to their benefit. Every futures contract covers 200 head. Smaller producers may feel that is a problem because it is a larger percentage of their production that they must guarantee to deliver to any given contract. But, in Roelofs' view, for a producer selling 15,000 hogs a year, 200 pigs per contract isn't a huge commitment.
That leaves producers with another concern – that they can't get their lenders to go along with them. Roelofs cites a large, unnamed Canadian pork producing company which said its banker "is absolutely scared" of futures. Smaller producers attending the London conference told him their lenders were uneasy also. "Getting your banker trained may be an issue," Roelofs allows.
AgStar backs producers who hedge on the Chicago Mercantile Exchange, but with a caveat. "We are all for it as long as there is discipline," Roelofs says.
Farmers still need to strive to be low-cost producers, he says. Still, a higher cost producer who locks in a corn price and a pig price could make twice the margin as a lower cost producer who lets the cash markets determine his costs and his pig return.
Hedging encouraged
Perry Wilson, London District director for Farm Credit Canada (FCC), finds Roelofs' comments "interesting," and says FCC isn't afraid of hedging and margin calls. He says hedging commodities is one of the marketing tools that the lender encourages, along with any sort of forward contracting that takes the risk out of market fluctuations. FCC offers training programs in hedging to both clients and non-clients. It doesn't require its lending clients to hedge, however.
Orangeville pork producer Steve Illick says that farmers can only hedge on the price if they also lock in their key production costs well in advance and can cover them by taking a price position on their pigs. "No one wants to give up possible profit by locking in a return," he says.
In a former life, Illick was a professional commodity trader in Toronto and in England. Illick expects that volatile prices and instability in markets will plague producers for some time to come. He brought lessons about markets and what he calls "market psychology" home to the farm. He's not surprised that pork prices slipped in the spring for no discernible reason.
For all of the challenges that pork producers have faced here – rising currency values, high corn prices, and even Country-of-Origin Labelling – the North American pork market has been riding a four to five year boom linked to commodities in general.
Pork exports from the United States, the world's largest exporter, have never been stronger than in the early part of this year. (The value of pork exports in January and February exceeded US$1 billion for the first time and exports took nearly 28 per cent of the pork produced, including offals, out of the country.) While sales to Mexico declined, it remains America's biggest customer, but China and other Asian countries have happily purchased American pork as well. Canada imported nearly US$130 million worth of American pork in January and February, up 36 per cent from a year before, according to the U.S. Meat Export Federation.
Rick Anderson, executive vice-president of Informa Economics Inc. based in Memphis, Tenn., describes the demand factor as "huge." Strong export shipments, which keep the domestic supply tight, result in stronger prices in Ontario as "the U.S. tide raises all boats." But that increased demand is a double-edged sword. "The linkage between the two markets and the stronger dependence of U.S. pricing on export demand does create additional vulnerability to pricing in both markets," says Anderson.
‘Market glitch' fears
That dependence upon out-of-country sales is a concern. Exports haven't been a major feature affecting pork demand in the United States until these past few years, Illick says.
Farmers like Curtiss Littlejohn of Paris, an Ontario director on the Canadian Pork Council, worry that a market glitch in the United States might lead to lower prices in markets that are dependent upon exports.
For an example of a "market glitch," think about the H1N1 crisis here in 2009 that turned a promising year into a terrible one, says Kevin Grier of the George Morris Centre in Guelph, writing in the highly respected Canadian Pork Market Review newsletter. Nobody saw that coming. "That is the nature of it," he says grimly. He agrees that pork producers have a lot at stake. Producers have more liquidity and more working capital available than ever before, he says.
"As long as the Asians have an insatiable appetite for everything we are OK," Illick says. "If China or Japan closes the door, it will hurt. We will have fire sale prices for pork."
There was no crisis similar to the H1N1 one that hurt prices in the spring of 2012. Illick thinks it likely that the "market psychology" factor took its toll and that the commodity boom might be getting stale. "It's late in the party and people are starting to leave," he says.
The reduced emphasis on commodities might also be linked to the strengthening American dollar, as traders go back to dealing in currencies rather than commodities. The commodity sector is generally showing signs of weakness.
Futures prices point towards a mediocre summer and an unprofitable fall. A predicted average loss of $8 a pig won't be so bad for some producers and will be worse for some others. Some, of course, won't lose money at all, Illick says.
The only saving grace at the time of writing was that the corn market was dropping too, but just not as fast as the pigs.
Risk management has become a big part of what we have to do, Illick says.
It may be unnerving that the United States exports 25 per cent or more of its pork. But, at 60 per cent, Canada is even more dependent upon exports, notes Jacques Pomerleau, president of Canada Pork International, which represents pork exporters. Pomerleau cites a number of reasons why he believes pork prices dampened off in the spring. Export markets are sluggish all over. Russia is about to join the World Trade Organization and buyers are reluctant to build up pork stocks until they see what that means. The Philippines had issues with imports. (There have been widespread complaints that millions of kilograms were smuggled into the country last year.) China isn't buying as much pork as it did a year ago. In the United States, consumption is not what it was. Canada forgets that other countries face a difficult economic situation, he points out.
Pomerleau says there are very few big export markets. The major buyers are Russia, Japan and Korea, followed by the Philippines, Taiwan, and Australia and, for the Americans, Mexico. Other markets "are bits and pieces here and there," Pomerleau says.
According to the U.S. Department of Agriculture's World Markets and Trade report in April, nearly all of the major producers increased their contribution to world production, with most of the growth coming from China, the European Union (EU) and the United States. While the world production of pig meat is expected to reach 104.4 million tonnes, up close to one million tonnes, exports represent only about seven million tonnes.
However, there is room for optimism that export opportunities for Canadian producers will improve. The EU is a major pork exporter on its own, but less than 50,000 tonnes of pork goes into the EU annually because of a "very complex import regime." Pomerleau says Canada is negotiating a trade agreement with the EU that could be finished by the end of the year and is entering into an enhanced trade agreement with Japan that may be completed in "the near future." If those agreements go well, Canada would have an advantage over the United States in European and Japanese markets. It is, however, losing ground in Korea because of the latter's recently inked preferential agreement with the United States.
The EU's ability to compete in export markets may be compromised next year. Pomerleau points to European farm business news reports indicating great uncertainty about the ability of pork producing countries to meet a new standard for animal care banning gestation stalls by January of 2013. Many countries appear unable to comply.
If they are forced to do so, Pomerleau thinks pork production may fall, as did egg production when battery cages were banned in January of this year. BP