Watch for wild cards when hedging market risks

Set-up


Here’s a good example of how a professional risk management specialist looks into a key window.

It’s a way to see the mental mathematics you need to be master of 
if you want to adequately address your market risk in any commodity.

Set-up

The fourth quarter of each year brings unique risk in hog markets. It’s when prices can collapse, as happened in 1998, when the price of market hogs fell to almost zero for a few weeks. This happens when hogs going to market exceed, even slightly, packer capacity.

It happens because of a combination of fewer days of slaughter due to holidays and increasing number and size of hogs going to market due to cooler weather in the fall. It’s not a problem most years because of lots of excess packer capacity, but in years near the end of the hog cycle, when market hog numbers are swelling, the numbers going to slaughter can approach packers’ capacity.

Producers become desperate to sell their pigs once packers hit capacity and an on-farm excess develops because they literally do not have the barn space to keep the animals.

Many will sell for whatever price they can get, even if that is far below cost of production.

Situation

North American packers could hit capacity this fall, fears Tyler Fulton of Hams Marketing. The industry will be on the verge of price collapse danger if today’s capacity is 2.45 to 2.46 million hogs per week and hog deliveries hit 2.4 million for a few weeks in a row.

Most likely

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The most likely situation is capacity being pressed but not exceeded, creating a decline in futures prices to around $55 per hundredweight.

Possible

However, it’s possible that something might cause pig supplies to exceed packer capacity, creating a “50 to 60 percent drop in price, or all of it, like ’98.”

Fulton pegs this possibility at 25 percent, which is the most it has been since 1998.

Wild card

There has been lots of chatter about an unexpected drop in hog numbers in the next few months because of problems with a semen extender that reduced farrowings in herds across North America a few months ago. If that suspected supply slip materializes, prices could rise this spring and summer.

Response

How does a producer respond to this mix of most likely and possible outcomes in the light of a wild card sitting there on the table?

Few hog producers hedge prices eight to 10 months ahead of sales because hogs take only a few months from farrowing to slaughter weight. Few are likely to want to lock in prices far ahead for pigs not born yet.

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However, Fulton said Hams has a contract that allows year-out hedging, which producers should consider for some future production because the risk this year is greater than usual.

They should also keep a keen eye on how the hog market develops in coming weeks and into late spring. If supply becomes short, cash prices would likely rise.

However, producers shouldn’t assume they are free from fourth quarter risk if prices rise into spring and early summer.

If the shortfall disappears and capacity gets pushed, “the price will plummet and the pricing opportunity will just disintegrate,” Fulton said.

A spring or summer rally would be a good opportunity to price for the fourth quarter.

Producers should be able to hedge their production before anything worrisome or catastrophic develops by understanding the situation, knowing the most likely outcome and being aware of the significant possibility of a much more severe development.

This is a good example of how producers need to think about hedging. It’s not just the most likely scenario that they need to be prepared for.

They also need to take into account significant risks when developing a hedging strategy.

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