For all of you feeling particularly giddy after last week’s markets, allow me to mention one thing to keep you grounded: H1N1. I mention it because there have been several outbreaks in the Southeast recently. And, it serves as an example of what can go wrong just when things are looking jolly good. Reality checks are part of the job. There is a good reason economics is called the dismal science.

What if H1N1 or foot-and-mouth disease or classical swine fever or any other swine disease that Russian or Chinese buyers could cite as a reason to stop imports of U.S. pork occurred? How would that affect the improvement in potential profitability that we saw last week as Chicago Mercantile Exchange (CME) Group Lean Hogs contracts rallied to contract life highs, corn futures fell to six-month lows and soybean meal futures lost $10/ton?

Don’t think for a minute that it cannot happen. It can.

I had an epiphany a few weeks ago when I saw a chart of threats to the U.S. pork industry. The chart was developed in early 2009 by a task force that was designing a new strategic plan for the National Pork Board. The chart had about 80 issues arrayed in a graph that had “impact” on one axis and “probability” on the other. The objective, of course, was to focus on the items that ranked high on both scales, ignore the ones that ranked low on both scales, and devise other strategies for the “trade-off” issues that were high on one scale and low on the other.

It was an impressive list of big and small challenges, put together by a group of really smart people who knew the pork industry and the business environment it faces. The interesting point is – a human virus that hurts pork demand was not on the list. The list did include “influenza,” but it was in the context of a seasonal flu that sickens pigs. Anything resembling the H1N1 scenario did not make the list only three months before the crisis hit.

Now, it’s not my intention to denigrate any of the people who worked on the Pork Board’s plan, the process they used, or the Pork Checkoff and the producers and staff who manage it. No one did anything wrong. I only offer it as proof that “stuff happens!” And it can happen at any time.

Consider the Options
Last week’s price changes pushed projected pork producers’ profits to over $40/head in June and July. My forecast of profits for the remainder of 2010 average over $24/head and bring the forecast profit level for all of 2010 to over $19/head (Figure 1) – a figure that includes losses in both January and February!

When I recommend hedging, I usually refer to using CME Group Lean Hog futures to lock in a specific expected price. Figure 2 shows the scenario where on the morning of April 2, a producer could sell a June Lean Hog (LH) contract at $85.25. If the expected basis (i.e. the expected difference between the cash price realized by a given producer and the futures price on the delivery date of the pigs) is $2.00 under (i.e. -$2.00), selling that futures contract will yield a net price of $83.25. It’s a done deal. The only thing that could change the realized price is the basis being something other than $2.00 under. But some producers don’t like ruling out a windfall if markets rise.

I have not recommended using LH Options much for two reasons: They tend to be expensive and they are pretty thinly traded if you are looking more than four to six months in advance. Considering put options for this summer’s marketings, though, solves both of these issues to some degree. Since we are only about four months away from the August expiration, the time value component of LH Option premiums is relatively small, which means that options are more affordable. In addition, being this close to the delivery period means that more traders are participating in this market, providing more liquidity and, thus, the opportunity to buy a decent number of puts without actually impacting the premium level.

So, this may be a wonderful time to use LH Put Options to put a floor under hog prices while leaving the upside gains in play. Figure 3 shows how that would work by buying a June $82 Put, which had a premium of $1.80 on Monday morning. Assuming our $2-under basis, this put would put a floor of $78.20 on hogs sold against the June contract (i.e. late May and early June deliveries), while allowing the price to rise should cash and futures markets rally between now and June 14 (the expiration date of June Lean Hogs futures). Yes, you will be out the $1.80 premium, but that premium represents only 2.2% of the strike price and 2.3% of the expected floor price.

The $78.20 floor price would be roughly $14/cwt. higher than my predicted breakeven cost for June-delivered market hogs. A floor profit of $28/head sounds pretty good when one considers it is virtually impossible to identify all of the risks producers’ face every day.

Click to view graphs.

Steve R. Meyer, Ph.D.
Paragon Economics, Inc.
e-mail: steve@paragoneconomics.com