Don’t leave risk management to luck and chance

More Perfect Union

The previous column referenced a video from More Perfect Union entitled, We Went to Nebraska: The Beef Crisis Will Shock You . The discussion highlighted several key points from the video, but one of them deserves some more delineation because it's inherently misleading about how the business works.

Namely, the video includes comments from Bill Bullard (CEO, R-CALF USA) who explains: “…the problem with cattle futures market is it is highly susceptible to manipulation and to news, whether true or false. And so, producers are harmed. One could describe it as a playground for speculators.”

Futures Markets

The caricature gives rise to several considerations as it relates to futures markets and producers:

1. How futures work: My futures-class professor said it over and over, “For every buyer, there must be a seller; and for every seller, there must be a buyer.” That principle underpins the creation of a contract – and subsequent elimination of such. The first chart illustrates the premise: the number of respective positions – buyers (long) and sellers (short) – is perfectly balanced.

2. The role of the speculator: And it’s the speculator who provides an opening for the hedger. In the case of live cattle, the speculator generally takes a long futures position with the expectation that the price in the future will exceed the current price. The hedger on the sell side wants to avoid downside risk; he/she is buying insurance from, and transferring risk to, the speculator. As such, the short hedger must be willing to sell a futures contract at some level below the expected future price of the commodity (otherwise the hedger cannot induce the speculator to assume a long position – the discount being what the hedger pays the speculator for assuming risk). And thus, the ebb and flow of net-long vs. net-short among the non-commercial versus commercial traders, respectively (see Chart 2).

3. Transfer of risk: Given that reality, let’s return to the observation that futures markets are nothing more than “a playground for speculators.” Speculators (like packers) are always the favored villains when it comes to futures markets. Dr. Scott Irwin, University of Illinois, and his book, Back To The Futures, explains the distrust occurs, “Because speculators buy and sell contracts for products they don’t own nor have a hand in producing, they have a reputation as rogues, trying to make a bundle at others’ expense in the market.” He subsequently asks the rhetorical question, “How do you trade something you don’t physically own?” But as mentioned above, it’s that very trade that allows the TRANSFER OF RISK . As such, we don’t hear hedgers complain (much) about speculators; they’re the insurance provider.

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Luck and Chance

IF futures markets are just a “playground,” THEN where does that leave us? Primarily, it relegates producers to simply being price takers. The marketing plan is nothing more than “a wing and a prayer” – relying on luck when it comes time to physically sell livestock.

That’s a weak, undependable, and disempowering strategy. Do futures markets possess some complexity? Sure. They require some understanding of volatility, basis, and margin. But the effort to that end is a far better strategy than simply leaving it to chance.

Risk management empowers producers. Futures markets (or options or LRP) enable them to protect the equity tied to their business. Instead of being price takers, they can be indifferent to market fluctuations (as they best see fit) and thus become better business managers. And given the equity at risk in this environment, that’s more important than ever.