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XL Foods situation highlights hedging risks

XL Foods’ E. coli problems haven’t seemed to cause a massive slump in Canadian cash cattle markets.

However, the situation highlights the danger that can come from relying on continental prices for hedging livestock or grain that will be sold in the local cash market.

“There’s always a high, high risk factor on hedges in cattle, particularly feeder cattle,” said broker Ken Ball of Union Securities.

“The divergences can be quite significant.”

Farmers and feedlot operators who use futures and options contracts for hedging protect themselves against changes in the futures market price, although they also take on a small risk that the local market’s values may deviate from futures values.

However, the spread between continental and local Canadian prices can turn a sensible hedge into a money-losing proposition in ex-treme situations such as border closures and plant shutdowns.

The cash and futures markets always diverge slightly depending on local supply and demand issues. But many worry that the XL Foods situation could cause the Canadian cash market to become completely de-linked from the futures market until the company’s plant is back in business.

Fortunately for farmers, the market has been able to absorb and adjust to the short-term interruption of slaughter at XL Foods’ plant at Brooks, Alta., so a significant disruption in prices may not develop for most market animals.

“So far it’s not an unusual market difference,” said Canfax senior analyst Brian Perillat, noting that Alberta-U.S. price spreads are actually smaller now than they were a year ago, when there were no problems.

“(However), the more this prolongs, the more we’re going to feel it.”

In the short term, farmers can hold back cull cows, feedlots can hang onto fed cattle and some animals can be shipped to the United States.

Price spreads that act unpredictably are a great danger for hedgers of products they have to sell locally, so volatility is something commercial operators back away from.

The XL Foods problem is worrisome, but not nearly as damaging as a U.S. border closure. That happened when BSE was found in the Canadian herd and that caused Canadian and U.S. prices to surge in opposite directions.

The XL situation “is not devastating. The border’s still open,” said Perillat.

Ball said cattle hedging is a risky business for futures positions tied directly to actual shipments of animals. The U.S.-Canada border could close at any time and only two plants dominate the western Canadian industry.

However, he encouraged producers to be creative. His firm has helped farmers write out-of-the-money covered call options during extreme rallies as a way to gain a premium in the market. It’s not true hedging, but it’s an effective way to exploit market volatility rather than just being a victim of it.

“You’re daring the market to go up and exercise your option,” said Ball.

General hedging also works, in which an overall commercial position is protected through futures or options.

However, safe load-by-load hedging is impossible to guarantee.

“It’s much easier to get a localized disruption (in Canada) than in the U.S., where they’ve got more (slaughter plant) alternatives,” said Ball.

Farmers might escape significant damage from the XL Foods closure, so long as it doesn’t last too long.

“Obviously, we’re going to be backed up for a little while, but the impact won’t be nearly as bad (if the plant is soon back in operation),” said Perillat.

“It’s all a matter of timing.”

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