lrp | Margin Manager

Halloween is a time of year when both kids and adults alike have fun being spooked but the hog market price action over the past month has been downright scary. December Lean Hog futures on the CME lost 18% in value over the second half of September, declining from $89 to $73/cwt. before recovering all of that lost value through October. As of this writing, the market has again turned down after facing resistance near the $90 level which has capped the contract on multiple occasions dating back to April. The feed markets by contrast have been steadier over the past couple months, although both corn and soybean meal continue to trade at historically elevated prices which has raised the cost of production and breakeven levels into 2023. From a margin standpoint, projected profitability in Q1 has seen an enormous swing with the recent hog market volatility, moving from a positive $5.00/cwt. around the 80^th percentile of the past 10 years to a negative $8.50 earlier this month before recovering to back above breakeven (Figure 1).

Fundamentally, there is a lot to be optimistic about for the hog market which helps justify the recent price recovery. The September Hogs and Pigs report confirmed lower inventories including a decline in the breeding herd and forward farrowing intentions that will tighten supplies moving into next year. Moreover, producers are current as evidenced by recent trends in both slaughter weights and spot prices paid in the cash hog market. The latest Cold Storage report featured a contra-seasonal decline in pork freezer inventories, led by hams which at 159.3 million pounds were down 3% from August and 18% below last year (Figure 2).

A September drawdown in ham stocks is rare. 2019 is the only other occurrence in the past 15 years in which frozen ham inventories declined from August to September. It is interesting to note that the pork cutout contra-seasonally increased into mid-November during 2019 (Figure 3).

Turkey supplies are extremely tight this year following the Avian Influenza outbreak that hit commercial breeding flocks, and while ham prices are historically high, they remain competitive with turkey and an attractive alternative for Thanksgiving and Christmas celebrations (Figure 4). Strong export sales and shipments to Mexico are likewise supporting ham values, as the Mexican peso has not lost value to the USD despite the aggressive pace of monetary tightening by the Federal Reserve which has strengthened the dollar significantly in forex markets. Recently, exports sales have even picked up to other markets such as Japan and South Korea, two countries whose currencies have lost considerable value to the USD this year. Meanwhile, recent strength in Chinese hog prices has raised speculation that they will be more active buyers of pork on the world market ahead of the Lunar New Year, although a recent plunge in DCE hog futures prices and a significant slowdown in their economy due to the ongoing zero-Covid policy are concerning.

While overall the fundamental backdrop of the hog market is supportive as we move through Q4, one should not lose sight of the risks. The winter months historically have not been favorable for hog prices and the risk of recession here in the U.S. has risen significantly with the aggressive pace of Fed tightening. The potential impact on consumer spending should not be overlooked, and there are already indications that spending habits have changed for food consumed both at and away from home. Moreover, ASF remains a big risk factor and history has demonstrated that market reaction tends to be sharp and swift when disease issues suddenly disrupt exports.

With the recent recovery in both hog prices and forward margins, it may be prudent to look at strategies to mitigate downside risk, particularly for those who may be light on coverage in 2023. Given the potentially supportive fundamental backdrop, strategies that retain flexibility to participate in higher hog prices and improved margins may be prudent to consider. Livestock Risk Protection (LRP) insurance may be a cost-effective way to put a floor under the market while allowing for the possibility to capture any further price advances. In addition to the reduced cost and cash flow advantages with this type of coverage, there may also be basis management applications that would be advantageous for Q1.

As an alternative to LRP, option strategies may likewise make sense to retain upside price flexibility while helping to put a floor under the market and protect against negative margin outcomes. While exchange-traded alternatives may be more costly than using LRP, the expense could be reduced by accepting a cap above the market which would correspond to historically high hog prices and strong margins should the market reach that threshold. As with any strategy, it is important to strike a balance between risk and opportunity that allows your operation to manage margin volatility and achieve long-term goals. The market has provided another opportunity to help mitigate forward exposure and it may be wise to take advantage of it.

Trading futures and options carries a risk of loss. Past performance is not indicative of future results. Insurance coverage cannot be bound or changed via phone or email. CIH is an equal opportunity employer and provider. © CIH. All rights reserved.

For many of us involved in the pork industry, the turn of the calendar to June means World Pork Expo is once again upon us. The event serves as the unofficial start to the summer season for many stakeholders and allows us all the opportunity to catch up in person with friends, colleagues, and industry professionals.

We most look forward to the conversations we will have—many of which will likely expound on topics such as domestic disease mitigation, Chinese demand, and tight global grain and oilseed balance sheets. Each of these areas are critically important and have been covered at length in trade publications over the past several years. But another topic that warrants discussion at this year’s gathering is the good work done on behalf of livestock producers by USDA’s Risk Management Agency and its Federal Crop Insurance Corporation (FCIC).

USDA has offered two livestock insurance products for swine producers for nearly two decades. Livestock Risk Protection (LRP) is an insurance product designed to protect against a decline in market price. Livestock Gross Margin for Swine (LGM) provides protection against the loss of gross margin of swine (market value of livestock minus feed costs). Several rounds of LRP and LGM modifications approved by the FCIC over the past two years have made the insurance products a valuable component to many producers’ toolbox to manage risk. These changes have broadened the appeal to producers by increasing premium subsidies, increasing head limits, extending endorsement lengths, and easing the strain on producer cash flows. As a result, participation in the insurance programs has increased substantially.

Figure 1. Participation Growth in LGM and LRP

The most recent round of LRP revisions, announced in April 2022, continued to build upon recent improvements and will likely increase participation in these important programs. One modification increased both endorsement and crop year head limits beginning in Crop Year 2023, which runs from July 1, 2022 to June 30, 2023. Previously, the limit per swine endorsement was 40,000 head, or 150,000 head per producer for each crop year. Recent modifications increase those limits to 70,000 head per endorsement and 750,000 head per crop year. This amplified the number of animals that could be protected from future market price declines, substantially bolstering the safety net for hog producers. There has never been an annual head limit on LGM-Swine.

Several of the changes announced were designed to increase options at producers’ disposal. Whereas livestock producers previously had to choose between one program or the other, they can now use both. An insured may not, however, insure the same class of livestock with the same end month or have the same insured livestock insured under multiple policies. This allows for flexibility in decision making and lets producers make the best choice for their own financial situation and their own operation. LRP policies were also changed to allow any covered livestock to be “marketable” (meet a minimum weight requirement) by an endorsement’s end date. Previously, protected swine actually needed to be marketed within 60 days prior to the end date or maintain ownership on the end date.

Recent modifications also were geared toward allowing a wider array of ownership structures to participate in the program, better reflecting the diversity of participants in the pork production sector. Past policy language stated that only producers who owned sows under the same entity that owned and marketed the finished swine were able to purchase LRP for Unborn Swine. This limited the number of producers who could protect future swine marketing beyond 6 months out in time. This policy now states that the sows do not have to be owned in the same entity name as they are marketed. Proof of ownership prior to the issuance of an indemnity is also required, bolstering the integrity of LRP.

Additional changes to the programs include reducing the time limit for insurance companies to pay indemnities from 60 days to 30 days, clarifying how head limits are tracked when an insured entity has multiple owners, providing insured producers greater choices in how they receive indemnities, and modifying the endorsement length for swine to a minimum of 30 weeks for unborn swine and a maximum of 30 weeks for all other swine. These improvements to both the LRP and LGM programs have allowed for reduced costs and increased flexibility to the producer, taking two relatively unused programs and making them widely available across the industry to producers of all sizes.

We view these insurance products as important additions to producers’ toolbox to manage margins over time. It is important to note that the decision to use LRP is not an either/or decision with exchange-traded instruments. Many producers have also found utility in pairing the LRP coverage as the root of other futures and options strategies. With tremendous uncertainty and volatility proliferating throughout the equity and commodity markets today, establishing floors via subsidized insurance programs could make a lot of sense for many farmers.

A prime example of how one could implement LRP or LGM as part of a risk management strategy is looking at open market hog margins toward the end of the year. Despite multi-year highs in corn futures and elevated soybean meal prices resulting from conflict in Eastern Europe, dryness in South America, and a slower-than-normal domestic planting pace, open market margins for the 4^th quarter offer producers the chance to protect slightly better-than-average profitability. Looking at the chart below, there is a very strong seasonal tendency for both December lean hog futures as well as 4^th quarter margins to fall from early June into the first week of August.

Figure 2. December Lean Hog 10-Year Seasonality

Figure 3. Q4 Open Market Hog Margin 10-Year Seasonality

While many producers may not be willing to simply lock in these margin levels with straight futures purchases and sales, some may be willing to establish protection with floors and maintain opportunity to the upside using either of the insurance products. The seasonal charts above indicate it could be timely to do so over the next several weeks. On the one hand, the latest Hogs and Pigs report indicated a continued reduction in market hog availability compared to a year ago. On the other hand, continued lackluster export demand or crop production issues could squeeze the better-than-average open market margins being offered today. LRP or LGM could be a great start in establishing coverage given current margin levels and the seasonal tendency for margins to fall over the next two months.

The sign-up process for LRP and LGM is simple and program costs are uniform across all agencies. The value the agent brings is their expertise, tools, and analysis. Contact us or visit us at Booth V361 in the Varied Industries Building at this month’s World Pork Expo to discuss effective applications of these tools and how these programs could fit into your risk management approach.

The outlook for forward hog margins is less optimistic than it was even a month ago following the release of the USDA’s September Hogs & Pigs report. The surprising data indicating there were fewer pigs than what the market anticipated produced a bullish response in the futures market, although that soon faded as the calendar turned over to October. Spot December Lean Hog futures subsequently dropped about $13/cwt., and despite a recent bounce remain below the level we were trading prior to that quarterly report. Factors including a concern over labor shortages that could impact processor capacity in the winter months when it is needed the most as well as a significant slowdown in pork export sales to China recently have in part been attributed to the recent slump.

Meanwhile, feed costs have crept higher despite what generally have been better than expected yield results for both corn and soybeans as harvest winds down. Strong corn demand from the ethanol sector as margins swell to multi-year highs have supported the spot market, while concerns over South American weather and high fertilizer prices potentially reducing corn acreage in the U.S. next spring are adding premium further out on the curve. As a result of pressure from both lower hog prices and higher projected feed costs recently, forward margins have deteriorated over the past month and are only about average from a historical perspective looking back over the past 10 years. (Figure 1)

Figure 1 – Hog Margins (Q4 2021 – Q3 2022)

Focusing on either the spot Q4 or upcoming Q1 marketing periods, where margins are currently negative, there have been ample opportunities over the past several months to protect historically strong profitability and well above average margins. In fact, Q4 margins briefly breeched the 90th percentile of the past decade following the September Hogs and Pigs report, with projected profitability at $7.89/cwt. on September 30th (Figure 2). This followed a series of opportunities to protect at least 80th percentile margins going back to the middle of May. While it is obviously too late to do anything about protecting Q4 margins now that the marketing period is almost half over, there may be upcoming opportunities to address risk further out in 2022 if the margin landscape improves.

Figure 2 – Q4 2021 Hog Margin

In order to take advantage of these opportunities however, it is important to know where your margins are at. By taking account of your various input costs and expenses, and projecting hog sales revenue against those, you can begin tracking forward profitability and put that into a historical context. This will allow you to objectively determine favorable opportunities to initiate margin protection and shield your operation from either rising feed costs or declining hog prices.

While no one can know for certain what the markets will do as we move forward in time, it is probably safe to say that we can expect more volatility given increased uncertainties. Will China begin to see sow liquidation due to depressed prices and negative margins? Are there going to be less corn acres next spring because of high input costs? Is South America going to have a drought during their growing season? If strong demand continues from the ethanol sector, is it possible that the balance sheet may end up being much tighter than what the market expects?

Looking again at the graph of Q4 hog margins in Figure 2, you will notice that there has been quite a bit of volatility over the past six months. Margins have ranged from over $7.50/cwt. positive to about $5/cwt. negative since the middle of April. Swings in both hog prices and feed input costs have led to these changes in projected profitability, and this volatility creates opportunities. In addition to signaling beneficial times to initiate margin coverage, these price swings also allow for opportunities to improve existing margin protection. Examples of this include reducing cost in hedging strategies, creating more price flexibility in hedge positions, cutting exposure to performance bonds, and taking equity out of positions.

Moreover, with recent improvements to the LRP program and new alternatives like the CME’s pork cutout contract, there are now a variety of ways that margin protection can be established and more opportunities to create complimentary or supplemental positions once this protection is put in place. Regardless of the tools used, the main point is to have a plan and be disciplined with following through on that plan. Does your operation have triggers in place to establish coverage in forward time periods? Do you anticipate what types of supplemental strategies might allow you to improve on that coverage over time?

Figure 3 – Q4 Hog Margin 10-Year Seasonal

Figure 3 displays the seasonal tendency for Q4 margins over the past 10 years. The recent spike in margins to above the 90th percentile corresponds to a typical period of strength where margins seasonally peak at the 85th percentile by the first week of October. A secondary period of strength typically occurs from mid-January to mid-April (highlighted by the green bars), suggesting that producers be ready to execute on possible opportunities that may show up into that period. Similar approaches could be taken for other periods such as Q2 and Q3 2022.

Inventorying your costs and revenues to project forward margins and putting a plan together that will allow your operation to take advantage of opportunities once they arise can put your operation in a better position to be competitive. Now more than ever, it is important to be proactive in managing forward profitability. Please feel free to contact us with questions on how to create a margin management plan and take change of your bottom line.