Risk Management Tool May Cause Cattle Market Price Fluctuations

The fourth quarter of 2023 brought considerable price fluctuation for both feeder cattle and fat cattle, leading many to question if a risk-management tool was behind the abrupt changes. For some cattle producers, Livestock Risk Protection (LRP) helped save their operations, while others may be playing the system on both sides.

An LRP policy is set up to reduce losses from price declines. But, recent changes have added flexibility and incentive to use it, similarly to how crop farmers buy crop insurance to insure against a declining market.

Northwest Iowa farmer Craig Moss began using LRP in his hog operation in 2008. After the program was overhauled in 2019, he used it more and eventually took out policies on the cattle side of his business.

"The guy who markets our hogs wanted to meet with us and our lender at the same time to discuss using LRP. That's how we got into using it in our hogs and now in our cattle, too," he says. For the past two years, Moss has used LRP mostly for basis management on cattle. He says it has worked especially well when the actual ending value is below the coverage price. However, using the LRP program does not guarantee a profit if the livestock is not insured at a high enough coverage price.

"Our lender and us have an understanding if we are going to use a lot of futures and options, we need to have a structured line of credit for that. LRP gave us the option to use it as margin management to guarantee ourselves on our fat cattle. It helps ensure we can see where we will be in the end," Moss explains.

REASONS FOR MARKET DECLINE

Lance Zimmerman, senior beef and cattle market analyst for Rabobank, points out prices in the live and feeder cattle futures markets have gone through a significant correction lower over the last several months. "Looking specifically at the April 2024 live cattle contract, prices have declined $34 per cwt. from the September highs to the recent lows. That is a $500-per-head decline in prices in roughly three months (end of September through the end of November). That magnitude of a price move causes all participants to take pause and assess what is happening in the marketplace," he says.

Zimmerman adds risk managers have left some margin on the table by simply selling live cattle futures as they procured feeder cattle. "You likely miss out on some of the market upside potential in exchange for avoiding some of the downside market risk," he says.

The risk managers had to look for more than one way to prevent a larger loss because of the fluctuating markets. Zimmerman explains one strategy would be selling a put option below the market, and as the market started to break, the risk managers may have needed to manage those positions, adding to some of the downside potential. Some have discussed whether the increase in the use of USDA's LRP program added to some of the recent downside.

Though the program has been around for 20 years, it had a slow start and, as recently as 2017, less than 100,000 head of cattle were enrolled, Zimmerman explains. In 2023, volume had increased to more than 5 million cattle. "The program absolutely has benefits to cattle producers, and it can serve as a valuable risk-management tool for producers, especially smaller producers where futures or options markets are not always the best tool for price protection," he adds.

A CLOSER LOOK

Brad Kooima, president of Kooima Kooima Varilek Trading, in Sioux Center, Iowa, has been a cattle marketer for more than 40 years. He says several of his customers are using LRP as a marketing tool, and when it's used for its intended purpose, it works well.

"The LRP contract is basically a put option. Fairly recently, the government decided to increase the subsidy much like they do with crop insurance. They have increased the subsidy by 35%. This is very attractive to smaller producers or cow/calf producers looking for some protection," Kooima points out.

However, some have been covering the cattle twice. Kooima describes it this way: "Some entities who have taken advantage of the program and have taken a $9 put option, which is covered 35% by the government subsidy, and then sell the exact same option back to the commodity broker for $9, thus collecting $3 with no risk no matter what happens."

Kooima says his partners, who are licensed to sell LRP, alerted USDA's Risk Management Agency (RMA) to the issue. The RMA called it subsidy harvesting but didn't think it was a widespread practice. Kooima's partners told RMA differently.

"Why should we care about the subsidy harvesting? For me, it doesn't pass the smell test and isn't an ethical use of taxpayers' money. If it's used for the intended purpose, no problem, but this is not it's intended purpose," Kooima stresses. He also points out another problem is people can spend more on feeder cattle because of their lower breakeven, which could have extended and accelerated the recent break in the market.

Kooima contends the oddness of what happened when the market went down dramatically hard and fast like it did in November means a solution is needed to prevent it in the future. A simple revision of rules could help prevent these problems.

Moss hopes the LRP continues to be available for producers like himself, even during market dips such as they recently experienced, which resulted in writing a check back to the LRP. "We've never traded any options along with it, mostly because that's another thing to manage, and time is something we have the least of. The dollar amount per head we spend on LRP is sometimes sizable, but it's a guaranteed return, and we know it's going to be there."

HOW LRP WORKS (supplemental information by Chris Clayton, DTN Senior Ag Policy Editor):

Livestock Risk Protection (LRP) policies go back 20 years. USDA's Risk Management Agency increased the premium subsidies in 2019 and continued to adjust them in 2020, creating tiered rates based on coverage levels. Policies can range from 70 to 100% with the premium subsidies at 55% for policies up to 79% protection levels, and subsidies declining to 25% for the 95% and higher coverage levels.

Producers can cover up to 12,000 head at one time and 25,000 in one crop year, and they can purchase LRP contracts for both feeder cattle and fed cattle. Coverage periods can stretch from as little as 13 weeks to as long as 52 weeks. Producers also must indicate their ownership interests in the cattle that are covered.

LRP operates like a put option, except the government is subsidizing 35% of the cost of the put. Unlike crop insurance, contracts actually change daily. Prices for new contracts are posted in the late afternoons on weekdays and are available until 8:25 a.m. Central time the next day.

At the end of a policy, an indemnity is generated if the regional/national cash price average is below the insured coverage price. If the cattle are sold more than 60 days before the end of the contract date, producers can't collect an indemnity or get their premium back unless their share of the cattle is properly transferred.

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-- USDA RMA website for livestock reports:

https://www.rma.usda.gov/…

-- Follow Jennifer on X (formerly Twitter) @JennCattleGal

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