| | 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
,
Introduction
Hog prices vary significantly over time as shown in Figure 1, below. 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. That is by contracting the hog price directly with a buyer or an agent acting on behalf of the buyer of those hogs.
Figure 1
Direct Packer Contracts
Many hog slaughter plants offer contracts to their hog suppliers. Some of these are supply contracts that do not contain a price guarantee. Instead, 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 settlements are made after delivery and slaughter, those base prices are adjusted by common industry indexes or other grading specifications, sometimes known 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 favor. Producers in turn have an incentive to meet those specifications that result in a premium price and which avoid price discount factors. 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. For example, in Alberta, the Western Hog Exchange, 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, but other adjustments may be quite 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:
- knowing how that price compares to the producer’s breakeven price level,
- being aware of the historic range of prices for the time period being considered,
- following the hog market condition and price outlook, and
- 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, then the producer can determine to what extent locking into a forward price contract will be profitable. Of course, 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/U.S. 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 U.S. 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. | $1.40/kg. |
Nearby U.S. Lean Hog Futures Price cents/lb. | US$.6940 cents/lb. |
Canadian $/U.S.$ | $.8879 |
 | |
Calculation: | |
Note: U.S. dressing % = 74%.
Canadian. dressing % = 80%
(74/80 = adjustment factor of 0.925) | |
U.S. Lean Hog Futures X 0.925 X 2.205 =
Canadian $ Exchange Rate | U.S. futures in Canadian dollars per kilogram |
.6940 X .925 X 2.205 =
.879 | 1.594/kg. Canadian |
Basis = Alberta Index 100 Cash Price – futures in Canadian dollars per kilogram | Basis = $1.594 - $1.40 = $0.194Cdn under nearby futures |
There is a seasonal pattern to basis levels as shown in the Figure 2 below, and that must be considered in 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 of October, which is typically discounted in anticipation of seasonally lower cash hog prices in October.
Figure 2
For example, in August, a hog packer is offering a forward price of $1.22/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 into the fall. After studying his market analysis information, is concerned that, when September arrives, cash hog prices will be lower yet. Assuming that the US and Canadian hog prices are well correlated, then the analysis may come down to an assessment of the basis level in the $1.22 contract price. Table 2 below shows how the producer would calculate the basis within that $1.22/kg bid. Calculating the basis allows the producer to compare it to the historic average and range of cash basis levels for September.
| Table 2: Hog Basis Calculation | |
Alberta Index 100 Daily Cash Hog Price $/kg. | $1.22/kg. |
Nearby U.S. Lean Hog Futures Price cents/lb. | US$0.6170 cents/lb. |
Canadian $/U.S.$ | $.8920 |
Note: U.S. dressing % = 74%.
Canadian. dressing % = 80%
(74/80 = adjustment factor of 0.925) | |
Calculation: | |
U.S. Lean Hog Futures X 0.925 X 2.205 =
Canadian $ Exchange Rate | U.S. futures in Canadian dollars per kilogram |
.6170 X .925 X 2.205
.8920 | U. S Futures = $1.41/kg. Canadian |
Basis = Alberta Index 100 Cash Price – futures in Canadian dollars per kilogram | Basis = $1.41 - $1.22 = $0.19Cdn under nearby futures |
Historic basis information for the September period shows that the five year average cash basis level is $(0.1953)/kg. or $0.1953/kg. under the nearby futures, very close to the basis level offered in the contract. The 15 year cash basis range for September is from zero to $(0.27)/kg. It appears that the basis being offered is within the range of a fair offer. If the hog producer decided that the basis being offered in the contract was weaker than acceptable, but still wanted price protection, the producer could elect to hedge the futures price via 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 more fully explained in the “Hedging Hogs by the Farm Manager” module.
Other Types of Forward Pricing Contracts
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 that the price guarantee is a minimum price only. Should cash prices at the time of delivery be higher than the minimum price, then 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, then the producer is paid the minimum price. Typically, in comparing the minimum price contract to the alternative of a 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, and the cost of using the options market is incorporated into the minimum price being offered.
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 that the minimum price is higher. Once again, to offer such a contract, the buyer is usually using the options market on hogs.
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 the hog sales part of 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. |
|