Recalibrating Hedging Assumptions

Year-to-date, 2022 has continued to carry strong market volatility across the lean hogs, corn and soybean futures contracts. As of this writing on April 18, during the overnight trade, corn is posting life of contract highs putting July and December corn at $8.13 ¾ and $7.54, respectively. These highs expand the year-to-date contract trading range to an incredible $2.29 and $2.11 ½/bu. for July and December corn respectively. July soybean meal has had nearly a $100/ton trading range with December posting a $73.40/ton range. Realizing that the corn and soybean meal range extremes aren’t exactly aligned, the July trading range equates to a nearly $21/hd. higher cost of production.

Fortunately, lean hogs have posted impressive trading ranges with June boasting a $32/cwt range with a low of $95.30 back on January 11, and a recent high of $127.32 on March 31. This would create a nearly $68/hd. revenue swing. While December’s $13.78/cwt trading range is not nearly as impressive, it still drives a $29/hd. range with April 12 posting recent life of contract highs. Hedging a “crush margin” has helped alleviate producers from trying to pick the top of the market for hogs and the bottom of the market feed inputs. Today’s open market margin is roughly $58/pig for June Hogs while December would book close to a $7/hd. loss.   Average profits would be just over $20/pig across the next 12 months. Many of the pigs in the upfront months were hedged long before the $58/pig open market margins materialized. The challenge for producers is, how do I look at locking in profit margins for Q4 of 2022 and into 2023?

Risk management advisors and producers have a difficult responsibility of deciding when there is a “call to action.” Calls to action are typically identified by the percentile of profitability presented per pig given a certain time of year or by a return on investment formula. Traditionally the “fixed cost” portion of these formulas has been static as inflation has been relatively stable and interest rates actually trended down over the last few years.

The tide has changed on the fixed cost component over the past 12 months. Widespread PRRS events across the upper Midwest have caused an uptick in medication costs and unfortunately, in broader mortality costs. Other feed ingredients beyond corn and soybean meal like fat, amino acids, as well as key vitamins have seen increases in cost. Feed mills are facing higher labor and fuel costs, resulting in grind-mix-delivery rate notices for producers. These are all cost increases beyond the impact that corn and soybean meal have on cost of production.

CONFIDENCE IN COST OF PRODUCTION

Accurate, timely financials are key to having confidence that your true cost of production is reflected in the crush margin model. An individual farm that happened to break with PRRS last year could easily see a $12/hd. increase in the wean pig cost for 2021 vs. their original budget. A 10% increase in nursery mortality increases that wean pig cost by roughly $6/pig. The shortfall in pigs weaned is typically filled with open-market wean pigs which averaged roughly $65-70/pig for 2021 and can have a $3-$4/hd. added cost when spread out across the entire normal flow of pigs. Add a couple extra dollars of med costs and factor higher facility costs from lower throughput, and the actual “fixed cost” could be $25/pig higher for that flow than normal. In this example, if traditional fixed cost assumptions remained unchanged, an expected $20/pig profit will result in a $5 realized loss. The message here is not to forego hedging. Rather, continue to manage risk appropriately and have accurate information to best understand the true margins given your current circumstances.

Markets are not guaranteed to post wider margins to offset your particular increase in fixed costs. Understand the expected margin you intend to secure when locking in a margin. “Calls to action” may still be presented regardless of your margin being at historically desired levels or not. Working with your risk management advisor, you will be able to find the strategy that best fits your operation to appropriately mitigate risk, while pursuing profit margins for long term success.

Now is as important a time as ever to take on the difficult exercise of forecasting cost of production. Incorporate all the dynamic variables referenced above to ensure hedging decisions are made on sound assumptions. It is difficult, but necessary. Analyze how your actual performance is materializing each month in comparison to original budgets. Then revise accordingly to ensure your assumptions for hedging remain sound. This exercise also helps to better understand how cash and operating loan availability will be consumed with the broader increase in cost of production as you recalibrate your hedging models.

Daryl Timmerman is a senior swine lending specialist for Compeer Financial serving farm families and complex swine operations’ financing needs across the upper Midwest.