Managing Your Feed Costs

5 December 2012, at 12:00am

An introduction to risk management on the feed market by Richard Veit of Market Intelligence at the UK Agricultural and Horticultural Development Board (AHDB).

Animal feed is the single largest expense in the production of a pig. In 2007, feed was roughly half of the total cost but by September 2012, it was estimated to have increased to as much as 66 per cent. Volatility in the commodity market, can cause large and unforeseen changes in the price of feed, which can have an almost immediate impact on livestock producers.

The unfortunate truth is that price volatility has been higher in the decade since 2000 than during the previous two decades, with the general consensus being that it is here to stay.

Managing risk has become crucial for all pig producers and the first step on that road is to determine the impact of price volatility on the overall costs of production. BPEX has developed a feed calculator, which can be used to help identify the impact of changes in the price of wheat and barley on costs of production. Using this tool together with knowledge of net margins, will allow users to see the net impact of changes in the price of feed to the overall profit (or loss).

It is important to note there are a great number of risk management strategies and there is no 'one size fits all' approach. A strategy will depend an individual's appetite for risk, the nature of that risk and the potential impact to a business. A strategy should ultimately be designed to meet specific needs. Factors to consider in developing a strategy include:

  • attitude to risk and exposure to market forces
  • desired level of flexibility in responding to unforeseen events
  • how much time can be devoted to monitoring the market
  • practical issues, such as storage facilities, and
  • any cash flow requirements during the year.

In terms of when to start developing a strategy to manage feed costs, it is possible to plan beyond the current year and production cycle. Futures markets allow for grains to be traded almost three years in advance. The November 2012 wheat futures contract, for instance, could potentially have been traded as far back as July 2010. The importance of this is that it is possible to 'lock in' a price for your grain and extend the length of time you have to plan your business model.

The direct benefits of using futures contracts are already being seen in the US. According to a report published by Rabobank in October 2012, many pig producers in the US have been able to reduce the impact of rising prices by buying forward their grain requirements, while also making forward hog sales. Market analysts have suggested that this may help the US pig industry avoid facing a large increase in costs until early 2013. In comparison, the increase in grain prices during 2012 impacted pig producers in the EU almost immediately. A summary of the report is available in Issue 12/38 of the Pig Market Weekly [click here]. There are a number of strategies that can be applied to mitigate the risk of rising feed costs. For the main strategies identified, Table 1 illustrates the impact of movements in the market price on each; movements of which correspond to price fluctuations experienced in the last year. The strategies are designed to illustrate the effect of a particular scenario but it is worth noting that many other strategies can be used, as well as combinations of each.

Table 1. Pricing strategies for feed wheat
Strategy Market Movement Ability to benefit from downward price movements Risk to upward price movements
-£60/t -£30/t Unchanged +£30/t +£60/t
Do nothing: buy all on spot market, as/when required
£90.00 £120.00 £150.00 £180.00 £210.00 100% 100%
Buy 50% forward now
£120.00 £135.00 £150.00 £165.00 £180.00 50% 50%
Buy 100% forward now
£150.00 £150.00 £150.00 £150.00 £150.00 0% 0%
Buy 50% forward now and cover with an Option*
£97.50 £127.50 £157.50 £172.50 £187.50 100% 50%
Buy 100% forward now and cover with an Option*
£105.00 £135.00 £165.00 £165.00 £165.00 100% 0%
*Based on a £150/t strike Put Option costing £15.00/t
Hypothetical prices used for illustrative purposes only
Source: AHDB

1. Do nothing

So long as this is part of a well thought-out plan, and not simply waiting for the market to move in your favour, buying your grain as and when required is a legitimate strategy. This is a commonly used practice and offers the greatest potential returns should the market price fall, as shown in strategy 1 in the table. However, it also presents the highest risks and offers no protection should the market price rise, leaving buyers of grain completely exposed to market movements.

2. Buying forward

Forward buying some or all of feed wheat requirements through the futures market, as shown in strategies 2 and 3, can provide greater certainty over purchase costs, although it may also limit opportunities to benefit from a fall in the market. In a strategy where all of the feed wheat is bought forward, as in strategy 3, the certainty of locking in a price for feed wheat is disadvantaged by the inability to benefit from any decrease in the market price during the year.

A development to the buying forward strategy is to buy forward a proportion of your grain requirements forward at regular intervals; a strategy referred to as 'averaging'. The concept of averaging is to reduce volatility in the market by taking the average price over the period.

Averaging removes the uncertainty in knowing when to react to price movements, allows the business to take the average market price during the year, and is relatively time-efficient. It may also help manage cash flow during the year, as it spreads grain purchases.

3. Forward buying and using an Option

Strategies 4 and 5 are also illustrations of forward-buying approaches, but with the additional use of an Option to provide the ability to benefit from any downward price movements. Options act as a form of price insurance, providing price certainty while leaving the opportunity to gain if the market price falls. They do, however, come at a cost, meaning that larger price movements are required before the benefits of using an Option can be realised. In strategy 4, it is only that part of the feed that is not covered by the Option that faces exposure from upward movements in market price. The grain covered by the Option can secure all the downside opportunities with none of the exposure to rising market prices.

The graph below illustrates the impact of using an Option based on historical data for the current year. In the example, an Option was taken out on 1 February 2012 for delivery in November at the prevailing market price (£150/t) and at a cost of £15 per tonne. With the additional cost of the Option, the feed would cost the buyer a maximum amount of £165 per tonne. However, it also allows the buyer to benefit from any downward movements in the market.

Price of wheat on spot market and under an option
(Source: AHDB)

The rapid increase in feed wheat since mid-June emphasises the potential benefits of using Options relative to buying on the spot market. At prices recorded in early October, the buyer would have made a saving of over £35 per tonne compared with buying on the day.

It is important to note that Options require considerable time management and careful monitoring of the futures market to determine when best to exercise the tool. An element of risk is still involved in determining when best to maximise returns which may be off-putting to some businesses.

For further information on using Options as a risk management tool, as well as a live example that tracks the use of an Option during the year, visit the Risk Management section of the BPEX web site.

Concluding Remarks

There are a number of strategies that can be applied to mitigate the risk of rising feed costs, depending on the needs and objectives of the individual business. It is always best to discuss any strategy with a merchant or vendor to understand all available choices, as well as having knowledge of the tools that are employed within each strategy. A strategy should be set to meet the individual needs and objectives of the business model.

To find out more about risk management from BPEX, click here.

December 2012