Modern agriculture has provided more opportunities for producers to manage their risk, which are welcome in an industry that has a substantial amount of it. The industry is also known for its rich history and traditions. In this age of world markets and new technologies, it can be hard to know when to move away from traditional practices and to adopt new ones. One traditional risk management tool that has been utilized in the industry for years is the practice of hedging in the commodities markets.
Hedging can be defined as “any technique designed to reduce or eliminate financial (or other) risk; for example, taking two positions that will offset each other if prices change.” Traditional hedging is the use of commodities trading as a tool to lock in profit. Really, you are locking in a certain profit margin. This can be on your product itself or on your inputs, such as feeds. Feedlots use this on both their cattle and many of their inputs. This allows a set margin to be locked in, regardless of which direction the markets go.
Most see hedging as something that is only available to larger operations or only applicable to those fattening cattle. In some ways, that is true. A feeder cattle contract in the futures market is 50,000 pounds. This makes it higher risk than necessary for smaller producers. In addition, the futures market can be volatile, and you must have funds in your account to maintain required margins to carry the contract – even if the value of your contract falls. In addition, hedging through the futures market does not provide appropriate options for those raising calves to weaning age. However, if we go back to the previous definition of hedging, we can see that there are many ways to hedge on ranching operations. That is why I promote a “hedging mentality” among producers.
Mitigate risk
A hedging mentality means that you look for ways to mitigate risk for your operation. There are many ways that individual operations can apply a hedging mentality to their business. The first step is to make sure you understand where your operation stands. This process starts with a clear financial picture of your ranch. Clear and organized finances can help you identify where certain pain points are and where risk could have the greatest impact. In addition, a strategic planning session might be in order. This will allow for a strengths, weaknesses, opportunities and threats (SWOT) analysis.
A SWOT analysis will help identify non-financial concerns as well. Some examples of risk areas that may need to be addressed in your hedging mentality are things like a high reliance on harvested forage or public land leases. Other concerns might be proximity to sale barn facilities or a lower-than-average local market when compared to more regional and national prices. Some non-financial concerns might be challenges in finding and retaining quality employees, the remote nature of your ranch or the interest and ability of upcoming generations to take over. Whatever they may be, identifying these areas is key.
Once these areas are acknowledged, you can begin to apply your hedging mentality. Insurance products are often a first step. There are USDA-backed products such as Livestock Risk Protection (LRP), Gross Margin Protection or Whole Farm Revenue that provide bottom-side protection without sacrificing top-side potential. The Pasture, Rangeland and Forage (PRF) program acts as a precipitation hedge. Mortality insurance on livestock, especially high-priced breeding stock, can help protect against losses there. Liability insurance is becoming increasingly important as well.
There are other ways to reduce financial risk. Diversification where possible spreads out market risk among multiple areas. Are you forward contracting cattle to lock in your price? If you are in an area with limited sales options or a depressed local market, have you considered one of the video auction services that provide the opportunity to reach a national audience? If you are reliant on harvested forages, can you raise more of your own or find additional grazing options?
What about your ability to reduce or eliminate non-financial risks? A broader hedging mentality can be beneficial here too. Good pay is important and can often help find and hire quality labor, but it is often not why people stay. Value can be added to an employee’s total package that is less directly tied to money. Is employee housing well maintained; would you live in it? Do you respect their home life and family time? Do you allow personal horses? Do you have a bonus structure tied to the profitability of the ranch? These are all examples of how you can hedge the risk of losing quality employees.
If remoteness is a challenge, can you leverage that through agro- or ecotourism options like wildlife tours, hunting or other recreational options?
Is the intellectual knowledge of the operation concentrated in the older generation? That risk can be hedged through educational opportunities, especially in an area the ranch could improve or that the individual has interest in or could improve on. Taking time to mentor and impart knowledge is also important.
Traditional hedging through the futures markets has long been a part of agriculture. However, many producers aren’t comfortable with or able to put it into practice. Every agricultural operation has risk. Taking the time to identify these risks is an important part of long-term success. By looking at the business with a hedging mentality, ranches can brainstorm options to counterposition those points of concern.
