Should a pork producer measure the success of a biosecurity program by looking at the amount of money spent on vaccines? The latter is only one part of the former. Vaccines are important, but they certainly are not the definitive measure of success.
Similarly, should a pork producer measure the success of a risk management program by the price received? The answer is no – and the similarities between the two questions are clear.
Current discussions about price levels which could have, should have or would have been reached remind me of ongoing discussions about pork quality. In the 1980s and 1990s, the industry made great strides in making hogs leaner. At the same time, some real concerns arose about the quality of the lean in the new, high-efficiency hogs and their carcasses. Some of those concerns remain today. Selection for one trait, while improving the targeted trait causes improvement in that trait, but may have deleterious effects on another.
Can we have high lean and high quality hogs? Of course we can, but selecting for both traits simultaneously will not result in either the highest possible lean content or the highest quality muscle. Dual-trait selection seeks an optimal mix of lean and quality that provides production efficiencies and consumer acceptance.
Some producers are looking at this spring’s cash hog rally and ruing their decisions to hedge late spring and summer hog prices earlier this year. The prices they locked in are not bad prices. In fact, most of them are generating good profit margins. They just aren’t as good as they could have been had they waited and took their chances on the cash market. Some would say that means the strategy was a failure.
But it’s important to remember the objective. Was the goal to secure the highest possible price –akin to single-trait selection? Or, was the goal to manage risk by hedging hog and, in most cases, feed ingredient prices?
I cannot speak to producers’ individual motives, but I can safely say that if one’s goal is to manage risk, it is rare indeed that one will end up with the highest possible price in any give time period. Hitting the highest possible market price is not the goal. The goal of risk management is to ensure that the business survives by reducing the probability of adverse economic events.
Risk Tolerance
There is no doubt that many producers in the United States and Canada were in survival mode in 2009 and early 2010. Figure 1 shows a proxy for producers’ financial condition that I first saw used by Iowa State Agricultural Economist John Lawrence. It is simply the accumulated profits for an average Iowa farrow-to-finish producer that sells one pig per month beginning in January 1991. Feed and pigs are priced strictly off the cash market for these estimates.
Several key pork industry lenders confirm the accuracy of this proxy measure. The September 2007 peak coincides to a time when many producers had little or no operating debt and, in many cases, had significantly reduced long-term debt. Equity positions were 80% or higher for many, many firms. Bankers were complaining that no one wanted to borrow money – and they got absolutely no sympathy!
The $640 decline in accumulated profits from October 2007 through February 2010, took equity positions to 20% and below. It also easily eclipsed the $545 decline of December 1997 through January 2000, making 2008-2009 the worst two-year period ever for U.S. pork producers.
So, what was your goal this spring when equity positions were rock bottom? If it was to get the highest possible price, then history has almost always said you should be selling on the cash market and eschewing Lean Hogs futures. As Figure 2 and Table 1 show, using futures (i.e. Other Market Formula [OMF] in the graph and table) prior to June 2007, almost always meant lower realized prices. The variability of those OMF prices was significantly lower than were spot market (i.e., negotiated) prices, however, as can be seen by a lower standard deviation (7.09 vs. 10.98) and coefficient of variation (11.9% vs. 18%). The risk-reward trade-off was quite clear.
But since July 2007, the story is quite different. Even including the higher cash prices we’ve seen through the week of May 18, producers who have used futures markets over the past two years have done much better than those who did not. The average price received was $5.61 higher and the variability was 40% lower. Higher price and lower risk – nirvana for risk management!
Readers should note that these averages do not measure the results of all producers. They simply represent the behavior of those producers who locked in prices with packers based on Chicago Mercantile Exchange (CME) Lean Hogs futures contracts. Other producers very likely acted differently in terms of price levels and timing. The OMF prices are the only measure we have of what was possible. My bet is that it is reasonably representative of producers’ behavior as a whole.
Does all of this mean that one should always hedge? Of course not. That decision depends on the individual producers’ risk preferences, the business unit’s ability to handle risk (i.e. financial position) and the outlook for both prices and potential risks for those prices. All must be considered carefully. What was correct in September 2007, when balance sheets were flush was very well wrong in January 2010 when the wolves were at the door – and vice versa. But I think it underscores that your success should be judged relative to your objectives and not some wishful look backward.
Click to view graphs.
Steve R. Meyer, Ph.D.
Paragon Economics, Inc.
e-mail: steve@paragoneconomics.com