Building Blocks for Risk Management
Create a plan and stay the course.
How do you define risk management? That was the question Tony Drake with the CME Group posed to attendees at a Learning Lounge educational session during the 2017 Cattle Industry Convention & NCBA Trade Show in Nashville, Tenn., Feb. 3. Drake, who has spent more than three decades on the trading floor — and 22 of those years with Cargill — says a simple definition he has used through the years to define risk management is essentially having a plan in place “so you are able to sleep at night.”
Drake noted that throughout history, markets have moved up and down. However, in recent decades that volatility within markets for all ag commodities has had sharper peaks and valleys. He cited a variety of events that impact price — from drought and other weather events, government regulations, recalls and dock strikes to more unanticipated events like the terrorist attacks of Sept. 11 and industry issues like bovine spongiform encephalopathy (BSE); H1N1 flu; or lean, finely textured beef (LFTB).
“All of this plays a role in driving price, and as we become more of a world market, these become more important factors to watch regarding their impact on price,” he stated.
He added, “It’s tough enough raising cattle and making money — and then throw these things at it and that adds risk.”
He suggested producers ask themselves, “What allows me to have one of those unanticipated events happen that doesn’t crush my business?”
Answering that question is essentially developing a risk management plan, Drake said, explaining, “Risk management is a structured approach to managing uncertainty.” Strategies include transferring the risk to another party, avoiding the risk, reducing the negative effect of the risk and accepting some or all of the consequences of a particular risk.
To begin the risk management process, he suggested taking a “big picture” view to evaluate the overall business for financial exposure and risk. Examine where you are vulnerable within production stages; within inputs such as feed, energy or transportation; and with regard to interest rates. Drake suggests considering, “If the worst thing happens [within any of these sectors], how will you get through it?”
Additionally, as producers work to create one cohesive big-picture marketing plan, Drake advised, “Know your cost of production, determine your breakeven levels, set target prices, and evaluate pricing alternatives within cash sales, forwards, futures and options.”
He explained that “hedging” means taking an opposite position in the futures market from your present cash position. Drake also noted that futures and options offer tools to lock in or cap input costs, to protect inventory, and offer customers fixed-price contracts to reduce risk of regular seasonal moves, minimize damage from long-term cyclical moves, cover opportunity losses from forward pricing, or control risks in other parts of the business.
Restaurants hedge all the time, said Drake. “They want to set one menu price for the year, so they are actively hedging to lock their costs in so they know where they are well in advance. It may not be the low or high price of the year, but it allows continuity.”
Drake suggested cattle producers approach their businesses in a similar manner.
“You’ve got to smooth the volatility out,” he said.
Once a plan is in place, Drake said, it is of utmost importance to continue to review the plan and monitor marketplace changes that occur, but also to execute when the target prices are hit. He shared one of his favorite sayings from a seasoned trader: “Plan to trade, trade to plan.”
Drake elaborated, “That means plan what you’ve got to do, then stay the course.”
He concluded, “Risk management is really about locking in a breakeven or profit, so you can sleep at night.”
Learn more about the CME Group’s agricultural services at www.cmegroup.com/trading/agricultural/.
Editor’s Note: Field Editor Kindra Gordon is a freelance writer and cattlewoman from Whitewood, S.D. This article was written as part of Angus Media’s coverage of the 2017 Cattle Industry Convention. For further coverage, read the Angus Journal or visit www.angus.media.