Hog Market Contracting in Western Canada

 
 
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 Introduction | Direct packer contracts | Packer representatives | Evaluating and interpreting a forward contract price | Other types of forward pricing contracts | Summary | Return to Marketing Risk Management page | Return to Livestock Marketing page
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Introduction

Hog prices vary significantly over time as shown in Figure 1. The chart shows that producers face significant price risk. Sometimes producers have an opportunity to take advantage of attractive forward prices to protect against periods of low prices. There are a number of ways to lock in an attractive hog price well ahead of when the hogs will actually come to market. This article will provide information on one way to lock in an attractive forward price. By contracting the hog price directly with a buyer or an agent acting on behalf of the buyer of those hogs.

Figure 1: Alberta Index 100 Weekly Average Hog Price


Direct Packer Contracts

Many hog slaughter plants offer contracts to their suppliers. Some of these are supply contracts that do not contain a price guarantee. Supply contracts offer an outlet for a specific number of hogs per period. These contracts often contain carcass-based grade specifications that have bonuses and discounts relative to the cash hog price at the time of sale. In addition to supply contracts, many packers also offer forward pricing contracts that guarantee the base hog price in advance of delivery. When final settlement is made after delivery and slaughter, those base prices are adjusted by common industry indexes or other grading specifications. Sometimes referred to as a “pricing grid” for that plant. By using a grid, processing plants can send a financial message to producers about what hog characteristics they favour. Producers in turn have an incentive to meet those specifications that result in a premium price and which avoid price discounts. Some factors that result in those premiums or discounts relate to breed characteristics while others may relate to health, feeding, environment, or assembly and transportation management.

Packer Representatives

Some packers leave all or part of the hog acquisition arrangements for their business to another entity. In Alberta for example, the Western Hog Exchange (WHE), http://www.westernhogexchange. com/, will contract hogs on behalf of a packer. For a small fee per hog, a producer may contract through the WHE for delivery for a future time period and lock the price in advance on any number of hogs. The locked in price is a base price (e.g. Index 100), from which adjustments are made to arrive at a final price per kilogram for the dressed hogs. Some price adjustment factors are common between plants. Other adjustments may be specific to one slaughter facility. The grading differences between plants generally relate to the specific pork markets those plants are servicing. All grading is carried out by a government inspector.

Evaluating and Interpreting a Forward Contract Price

A hog producer that is offered a forward price contract should be able to assess the quality of that contract. The price aspect of the contract can be assessed by:
  1. knowing how that price compares to the producer’s breakeven price level,
  2. being aware of the historic range of prices for the time period being considered,
  3. following the hog market condition and price outlook, and
  4. being able to compare the basis level contained in that contract price with the historic basis level for the appropriate delivery period.

1. Evaluating price and breakeven
It is crucial that a producer know the costs per unit of production for their operation. Industry benchmarks may be available to help with this, but nothing is as useful as the producer’s individual costs. By knowing the costs per unit of production, the producer then knows their breakeven price per kilogram. Once this price is known, the producer can determine to what extent locking into a forward price contract will be profitable. The goal is not just to break even, but to sell hogs at an average price that is profitable over time.

2. Historic price analysis
The only futures exchange in North America for hogs is the Chicago Mercantile Exchange. As long as hogs can move between Canada and the US without restriction or tariffs, the US-based hog price should be correlated to our Canadian price. So, the factors affecting Canadian hog prices are the US hog prices, the Canadian/US exchange rate, and the basis. Basis is the difference between a cash and futures price and is made up to a great extent by transportation costs between Canada and a delivery point in the US. Variations in basis reflect the influence of supply-demand factors. Table 1 is an example of a basis calculation for our hog price.
Table 1. Example of Hog Basis Calculation
Alberta Index 100 Daily Cash Hog Price $/kg.
$2.287/kg.
Nearby US Lean Hog Futures Price $/lb.
$US1.304/lb.
Canadian $/US$
0.9307
Calculation:
Note: US dressing % = 74%.
Canadian. dressing % = 80%
(74/80 = adjustment factor of 0.925)
US futures in Canadian dollars per kilogram
$CN 2.858/kg
Basis = Alberta Index 100 Cash Price – futures in Canadian dollars per kilogram
Basis = $2.287 - $2.858 = $CN 0.57 under nearby futures

There is a seasonal pattern to basis levels as shown in the Figure 2 that must be considered when assessing the merits of a particular forward contract bid. Note that basis levels are typically a negative number, but can sometimes be positive. For example, a positive basis may result when the August hog futures contract expires, and the last half August cash price is relatively strong compared to the next futures contract in October. The nearby October contract is typically discounted in anticipation of seasonally lower cash hog prices in the fall.

Figure 2: Alberta Lean Hog Basis Levels


For example, in August a hog packer is offering a forward price of $1.81/kg for hogs delivered in September. The producer knows that this price is not great, and may be below the breakeven price point. However, the producer also knows that hog prices typically weaken in the fall. After studying some market analysis information, the concern is that by the time September arrives cash hog prices will be lower still. Assuming the US and Canadian hog prices are well correlated, the analysis may come down to an assessment of the basis level in the $1.81/kg contract price. Table 2 shows how the producer would calculate the basis within that $1.81/kg bid. Calculating the basis allows the producer to compare it to the historic average and range of cash basis levels for September.

Historic basis information for the September period shows that the five year average cash basis level is $0.19/kg under the nearby futures. The 15 year cash basis range for September is from $0.04 to $0.37/kg under the nearby futures. The basis being offered is not within the range of a long run basis average. If the hog producer decided that the basis being offered in the contract was weak and not acceptable, but still wanted price protection, the producer could elect to hedge using futures contracts with the help of a commodity futures broker and leave the basis portion of the price open.

Other considerations in making the decision to sign the packer contract or hedge using the futures market are that, unlike the futures hedge, the packer contract requires no margin money, locks both the futures and basis, and also locks the hog price in Canadian dollars. The use of the futures market in hedging the hog price is explained more fully in the “Hedging Hogs by the Farm Manager” module.

Other Types of Forward Pricing Contracts

Fixed Price Contract: The fixed price contract is the most commonly available type of forward cash contract for hogs. Some buyers may offer other alternative contracts that may be interesting to hog producers. One of these is a minimum price contract. This contract is the same in all respects as the fixed price contract, except the price guarantee is a minimum price only. Should cash prices at the time of delivery be higher than the minimum price, the producer would be paid the prevailing higher cash price. If the cash price at the time of delivery is lower than the minimum price, the producer is paid the minimum price. Typically when comparing the minimum price contract to the alternative fixed price contract for the same delivery period, the minimum price will be lower than the fixed price. In order to offer a minimum price contract, a buyer will usually use the options market to manage their risk. The cost of using the options market is incorporated into the minimum price being offered.

Window Contract: A variation on the minimum price contract is a window contract. A window contract locks in both a minimum and maximum price, or price range. If the cash price at the time of delivery is between the minimum price and the maximum price of the contract, then the producer would be paid the current cash price. If the cash price at the time of delivery is lower than the minimum price, then the producer is paid the minimum price. If the cash price at the time of delivery is higher than the maximum price, then the producer is paid the maximum price of the contract. Although the window price contract caps the price upside, an attraction of the window contract compared to the minimum price contract is the minimum price is higher. Once again, the buyers are usually using the options market on hogs to cover their risk of offering the contract.

Extended Flat Price Contract: Some buyers offer an extended flat price contract. This type of contract may be attractive to a hog producer who wants to lock in a fixed price for all hogs contracted during a six month or even a one year period. If the extended fixed price is a profitable one, such a contract removes the price uncertainty of hog sales in their business. If the hog producer also locked in the price of the major cost of feed, then, depending on changes in other costs and production performance, the producer has moved a long way toward locking in a profit on his or her operation.

Summary

This article has provided an overview of deferred delivery contracts available to hog producers. Hog producers need to investigate the various pricing alternatives available and know how their hogs grade to make an informed decision on what buyers to deal with.
 
 
 
 
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For more information about the content of this document, contact Jason Wood.
This document is maintained by Erminia Guercio.
This information published to the web on August 29, 2006.
Last Reviewed/Revised on September 29, 2017.