Measurement: The key to risk management in cattle operations

More money on the line means taking greater marketing risks for today’s cattle producers

Travis Hickey says there is probably going to be less variation in cattle prices than we’ve seen in the past two to three years. (File photo)

Producers need to remove emotion from the equation to manage risk in feeding cattle.

“When we talk about risk management, there are so many things that contribute to our risks as cattle feeders,” Travis Hickey, general manager of cattle strategies for Western Feedlots, said during a panel discussion at the recent Canfax Cattle Market Forum.

“Can we truly measure the risks we take as cattle feeders in a repeatable fashion that removes the emotion?”

His key yardsticks are volatility and variance, Hickey said.

“If we look at the actual realized volatility and compare that to projected or implied volatility over time, it’s a pretty interesting study.”

Hickey compared 2013 live cattle figures, representing an 11 per cent change in price, to figures from 1986 and 1996, where prices fluctuated up to 15 per cent.

“We like to think of the volatility we see in the marketplace today as exceptional and unprecedented,” he said. “I would argue it’s probably not.”

Tracking with options

One of the systems Hickey uses to project volatility is implied volatility using at-the-money option prices.

“Right now, that’s telling us we’re at about an eight per cent implied volatility. Three or four years ago, that implied volatility was like 19 per cent,” he said.

“The market’s telling us today, in a fashion that’s not based on emotion, we’re probably going to see less variation moving forward than what we’ve seen in the past two to three years.”

But that doesn’t mean there’s less risk.

“There might be less variance around that mean, but the value we have laid out there is higher, so the risk is actually higher.”

Today, a one per cent change in live cattle futures represents around $18 a head. A move of one cent in the Canadian dollar is about $20 a head — very different from even 10 years ago.

“Even though the variance isn’t different, the dollars that we have laid out there are so much greater that a small change hits home a lot harder than a small change did 10 or 15 years ago,” said Hickey.

Production risks

Production risk is another variable that can be difficult to quantify, but key to making money, he said.

“What we need to do is focus on the variables that have the biggest impact on our profitability and spend less time worrying about the things that don’t really impact the bottom line, even though they’re easy to quantify.”

Hickey cited average daily gain as an example. For one low-risk class of animals, an average daily gain between 3.44 and 3.78 pounds contributes almost $8 per hundredweight difference in cost of gain.

“If you incorporate the variation in daily dry matter intake and layer that on top of what the variation is in average daily gain, you just significantly increase the true risk you have in production,” he said.

“That’s looking at a variable like average daily gain, which I would argue probably has pretty little amount of sensitivity and contribution to the overall profitability of the yard.”

Producers assume buying quality cattle will reduce their production risk, but that doesn’t always happen, he said.

“It could, as long as we’re fairly valuing the attributes that are true predictors of yield grade and quality grade, which isn’t always the case.”

Hickey compared two animals from his tracking system. The first was a Canada AAA grade animal that had a yield grade of two on a five-point system and sold at $210 on the rail. In that animal, the actual value contribution of the yield grade and quality grade to Western’s bottom line was only about three per cent of the total value of the animal.

“How much are you willing to spend chasing that three per cent, and how much time and effort are you putting in to managing the 97 per cent?”

The second animal was Canada A grade, with a yield grade of five.

“On that animal, the yield grade and quality grade discounts, in this case, represent 13 per cent of the value. Again, what are we doing as cattle producers and where are we focusing our energy?”

Whether the risks are market based or production based, producers need to measure them effectively in order to manage them, he said.

“If we don’t measure risk, how can we manage it?”

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