Marketing Tactics in Volatile Times

Matthew Diersen, Ph.D.Department of Economics

South Dakota State UniversityMay 6 & 8, 2008

2

Outline

General observations Volatility discussion Wheat strategies

Synthetic puts Cattle strategies

Timing price & risk

3

What Has Changed

Disruptions have occurred Question rural legends about marketing Ability to price like never before

Fundamental drivers Speculative forces

Need to deal with credible partners

4

Marketing Plans

One plan per enterprise Get a handle on the big picture High stakes mean:

more to keep track of more room for error

Evaluation more important than ever Understand what did not work

Contingency plans important

5

Pricing

Know what you are trying to “beat” Lock in “high enough” up-front profit Pull trigger after prices move favorably Reduce transaction costs Done with:

1. Handshakes to forward contracts2. Futures contracts

6

Protection

Already realize profits Want to get higher returns Want to guard against wrecks Cover yourself prudently Done with:

1. Options contracts2. Insurance contracts

7

8

Buying Options A put option is the right, but not the obligation, to sell a

futures contract Cost is paid up front

$/cwt quoted times the cwt of the contract Premium made up of following parts

Intrinsic value (strike-futures) Time value (interest) Volatility in futures price (biggest driver today)

A call option is the right, but not the obligation, to buy a futures contract

9

Money Talk

In-the-money put Strike price is above the futures price Implies a positive intrinsic value Will cost the most

At-the-money put Strike price is near the futures price May be closest-to the futures price

Out-of-the-money put Strike price is below the futures price

10

Price and Volatility Patterns for November 2005 Feeder Cattle Contracts

88

96

104

112

120

3/1 3/15 4/1 4/15 5/1 5/15

Sources: CME & SDSU

Settl

emen

t Pric

e ($

/cw

t.)

4%

8%

12%

16%

20%

Impl

ied

Vola

tility

Futures Volatility

11

March 2004 Feeder Cattle Price Behavior

75

80

85

90

95

100

Aug Sep Oct Nov Dec Jan Feb Mar

Mid-month Observations

Pric

e ($

/cw

t.)

0%

5%

10%

15%

20%

25%

Impl

ied

Vola

tility

Futures Price Floor Price Volatility

12

Daily Close of Nearby Spring Wheat Contracts

0

400

800

1200

1600

2000

1/2 1/16 1/30 2/13 2/27 3/12 3/26 4/9

Source: MT.gov

cent

s pe

r bus

hel

Kansas City Minneapolis

13

Historical Volatility by Month in CBOT

0

5

10

15

20

25

30

J F M A M J J A S O N D

Source: CBOT

%

Wheat Corn

14

Wheat Tactics

15

WHEAT: World Ending Stocks (millon bushels)

0

2,000

4,000

6,000

8,000

10,000

1987 1992 1997 2002 2007-08Source: USDA - Economic Research Service & Foreign Ag Service

SDSU Economics Department - http://econ.sdstate.edu

16

Wheat Tactics for Today

Winter wheat Know your insurance Cover sales by buying calls Buy put options

Spring wheat Forward contract prudent % Buy put options Sell futures & buy OTM calls

17

2007 Wheat Coverage in Montana

0

300,000

600,000

900,000

1,200,000

1,500,000

50 55 60 65 70 75 80 85

Percent Coverage

Acr

es

MPCI CRC RA

18

Crop Insurance

Often buy Crop Revenue Coverage (CRC) Futures have exceeded upper limit Hedge losses could greatly exceed indemnity Can be managed with call options

Risk Calculator Available at http://econ.sdstate.edu/ What level can be prudently hedged?

19

Pricing and Protecting Wheat

Rely heavily on KC, MPLS markets Better hedging performance

Work with lender on margin account Margin costs are higher

Worst-case returns likely low given: Low loan rate Increased production costs Inadequate insurance

Prices have some support from corn (feed)

20

Basis Risk & Storage

Highlights local conditions Transportation concerns Price convergence still probable

Crop insurance of no help Weigh basis improvement against carry

Tough to store with inverted markets Monitor interest opportunity cost

Some research supports some “speculative” storage behavior

21

Cover by Buying Calls

Before: forward contracted winter wheat for $9.00

Now: buy KC Sep $9.00 call for $0.75

Contract 9.00- Premium - 0.75+/- Basis n/a= Floor 8.25

* No ceiling *

Now: sell MPLS wheat futures for $9.00

Now: buy MPLS Sep $11.00 call for $0.40

Futures 9.00- Premium - 0.40+/- Basis - 0.80= Floor 7.80

* No ceiling *

22

Current Prices

23

Feeder Cattle Tactics

24

CHANGE IN BEEF COW NUMBERSJANUARY 1, 2007 TO JANUARY 1, 2008

(1000 Head)

2 to 141 (13)1 to 2 (3)

-6 to 1 (13)-25 to -6 (11)-74 to -25 (10)

Alaska

Hawaii

US Total

C-N-2802/01/08

-40-1

-10 22

-455

CT -1

DE 0

-14

-32

-3

-13

0 0-55

11 -48

23

1

MD -6

MA 2

-2

-8

1

-66

141

-57-15

1

NJ 1

20

-8

-20

-17

-4

30

8RI -0

-6

-25

-74

-63

21

0

-18

7

-10

5

-30

-339

Livestock Marketing Information CenterData Source: USDA/NASS

53

25

Feeder Cattle Tactics for Today

Sell futures or forward contract Know the relevant basis

Buy put options Buy Livestock Risk Protection Build wide fences

26

Feeder Cattle Contracts

Contract is for 50,000 pounds of steers Contract months: January, March, April, May,

August, September, October, and November Futures settle on the last Thursday of the contract

month (except November) Cash settled to the CME Feeder Cattle Index

650-849 lbs Medium and Large #1, #1-2

27

Feeder Cattle Futures and Projections

90

95

100

105

110

115

A M J J A S O N D J F M

Sources: CME & USDA-ERS, April 17, 2008

$/cw

t.

Projection Range Futures Price

28

November Feeder Cattle Futures Change from March to Expiration

-20

-15

-10

-5

0

5

10

15

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

$/cw

t

29

Average Monthly Basis 5 - 6 Cwt Steers, BillingsPlus and Minus 2 Standard Deviations

-$5

$0

$5

$10

$15

$20

$25

$30

$35

$40

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Bas

is

Average Basis (00-07) Plus 2 STD (00-07) Minus 2 STD (00-07)

30

MED. & LRG. #1 STEER CALF PRICES500-600 Pounds, Billings, Weekly

75

90

105

120

135

150$ Per Cwt.

2004 2005 2006 2007 2008

Livestock Marketing Information Center 04/21/08

31

MED. & LRG. #1 STEER CALF PRICES500-600 Pounds, Billings, Weekly

75

90

105

120

135

150$ Per Cwt.

2004 2005 2006 2007 2008

Livestock Marketing Information Center 04/21/08

Seasonal Price

Increase

High Corn Volatility

32

Buy a Put

Oct Feeder Cattle trade at $110:Out At In

Strike 104 110 114- Premium - 3 - 5 - 9+/- Basis + 8 + 10 +12= Floor 109 115 117

33

Current Prices

34

LRP vs. Other Tools

LRP has Price Adjustment Factors Fixed percent up front and at settlement For Steer calves: 110%

Forward contracts likely give the best basis Synthetic put strategies need broker’s help LPR designed for spot sales in final 30 days

of coverage (transferable on earlier sales)

35

Typical Marketing Plan

Cow-calf producer with 140 steers & 100 heifers to sell on October 15, 2008

Buy 2 Oct puts (200 head), 108 strike, for $3.00 per cwt. or better

Buy LRP on 40 steers if floor exceeds $115 and cost is $4.00 per cwt. or better

Sell 1 Oct futures (100 head) if $115 or better (assume $10 cwt. basis)

36

For More Information

Commodity Exchanges CME, MGEX, KCBOT

USDA’s Risk Management Agency http://www.rma.usda.gov/

SDSU Department of Economics http://econ.sdstate.edu/ Extension / Current Market Analysis FS 929 – Writing a Commodity Marketing Plan ExEx 5055 – How to Capture High Calf Prices

37

Some Thoughts

“Put all your eggs in one basket, then watch that basket.” – Mark Twain

Active risk management means doing things 1) when prices are high, 2) when volatility is low, and 3) before its too late

Any Questions?