Strategies for Low-Margin Environments


Although it is easier to strategize about protecting profitability when times are good, a sound risk management plan applies to all margin environments, and is especially important when the outlook is bad. When margins are low and opportunities are hard to find, producers may not consider it worthwhile to initiate margin coverage and may prefer to stay open to the market. While understandable, that tactic leaves operations vulnerable to further margin deterioration. For instance, many operations may now be in the situation where they don’t have adequate coverage in place for the current margin outlook because profitability projections over the past several marketing periods never presented a catalyst to trigger a risk management decision.

As an example, a crop producer may have set targets this past growing season to establish sales on expected production. Looking at CBOT December Corn futures, the producer may have picked $4.00/bushel as their first target to initiate sales, with a plan to scale up commitments in 10-cent increments. But unless the producer had started managing margins well in advance of this year’s marketing period, that plan would have led to only a couple of sales by early July, when the price reached $4.17. But after mid-summer, the price of corn proceeded to decline steadily and offered no further opportunities to capture attractive margins. (see Figure 1).

Figure 1: December 2017 Corn Futures (Year-to-Date)

Contingency Planning
The example of the crop producer’s marketing plan is a common one and may be thought of as “Plan A.” In a best-case scenario, the market will cooperate and allow the producer to scale into selling targets at incrementally higher prices, thus establishing favorable margins over time if all of their planned targets are triggered. A hog or dairy producer likewise may select thresholds of historical profitability to initiate strategies to protect forward margins, though these also rely on the market cooperating and delivering those opportunities such that the margin coverage is established.

While having Plan A is a good starting point for a sound margin management policy, all risk managers also need a Plan B. This plan addresses the possibility that the preferred course of action can’t be executed due to unfavorable market dynamics. While contingency planning is not exactly fun and no one wants to think about what they will do when things go wrong, a thoughtfully crafted backup plan can provide many benefits.

A good starting point for a backup plan might be addressing catastrophic risk. As an example, a producer could look at their margin history and determine some threshold level where they would absolutely want to have protection against a worst-case scenario. In the current environment where many producers are either at, or slightly below, breakeven levels, they might start by considering their cash flow situation. They could work with their lender to determine at what point they would no longer be able to afford a loss exceeding “x” amount of money for “y” period of time before things became problematic financially with their loan covenants. This could help to define that line in the sand.

As an example, following a $2.00/cwt. drop in the price of milk futures from earlier this summer, a dairy producer might opt to purchase out-of-the-money put options in deferred months to protect their revenue from any further declines. This strategy would help to mitigate catastrophic losses in the case of a market that moved sharply lower. A crop producer might likewise choose to purchase put options on deferred corn, soybean and wheat contracts for unpriced inventory they have in storage from this past year’s harvest.

One important component of this type of planning though is determining when to pull the trigger. Ideally, it would be best to wait for the market to provide opportunities to execute Plan A. While a producer is waiting however, it is necessary to consider whether that plan may need to be adjusted. A football analogy might be a quarterback calling an audible at the line of scrimmage because they don’t like the defensive setup against the play that was planned to be executed. This is when Plan B comes into play.

The producer may determine ahead of time, based on some sort of secondary trigger, when they will proceed with implementing their backup plan if their primary one can’t be executed. One example of this might be the dairy producer deciding that they won’t let their projected margins drop below a loss of $0.50/cwt. before deciding to act and purchase the defensive put options against their forward milk revenue.

Another example might be the crop producer choosing a point in time during the growing season, such as early to mid-summer, as a seasonal threshold to establish protection. The benefit in both cases is that the producer will know ahead of time that they will have some protection in place, regardless of how the market unfolds. This will also help to assure that a catastrophic event with extremely negative margins is avoided before it becomes a problem that needs to be managed under duress.

Be Ready to Adjust
A contingency plan is meant to address a worst-case scenario, but ideally the margin profile improves over time. If a producer is implementing Plan B, there should also be a corresponding strategy to adjust their position and protection to capture better margins. In the previous example, the dairy producer may purchase out-of-the money puts on milk to protect the catastrophic risk of prices declining further; however, they should also incorporate into that plan a strategy for capturing any improvement in forward margins in a recovering market.

For instance, if the dairy is purchasing Class III Milk put options at the 14.50 strike price, they might set up an alert to be notified if milk prices rise above a certain target price, such as 15.50/cwt. In this scenario, they could opt to roll their put options up to a higher strike price, and possibly pay for this increased cost by selling call options. Alternatively, they may simply decide to execute fixed sales if they are projecting a profit margin they consider acceptable for the operation.

To illustrate this example, consider a hog operation that was monitoring their risk on forward production looking at Q1. There has been much discussion recently about hog slaughter weights increasing and the possibility of larger supplies coming to market that may be getting backed up on farms. There is also concern about prospects for forward demand given intense competition from competing proteins. While projected forward Q1 margins have improved recently and are currently above the 80th percentile of the previous 10 years, they have mostly existed below breakeven until earlier this fall (see Figure 2).

Figure 2: Q1 2018 Hog Margin

While many operations took advantage of the strengthening margins during the month of October to scale into Q1 coverage, some became concerned as margins deteriorated into early November due to the aforementioned market dynamics. With perhaps no more than 50% coverage in place against Q1 amidst a questionable outlook, some operations may have chosen to implement a Plan B strategy in mid-November to increase coverage and offset more risk. With projected margins around $1.50/cwt. on November 17 and April Hog futures trading at $71.00/cwt., a hog producer may have opted to purchase a slightly out-of-the-money put option at the $68 strike price for a cost of around $2.50/cwt.

While the worst-case scenario in this example would equate to a loss on that portion of their production in a falling market, it would nonetheless be a defined loss and mitigated to some degree by the portion of the production that was protected at stronger margins. This may also have helped the producer in year-end discussions with their lender feel better about cash flow projections, particularly given that most operations are currently faced with negative spot margins in Q4.
As it turns out, hog prices and margins have recovered over the second half of November. With April Hog futures recently trading over $75.00, the producer would have been able to take advantage of the increase in price by strengthening their protection. For instance, they may have set an alert to trigger an adjustment if Q1 margins got back above, say, the 80th percentile, which they did recently on November 28.

As an example, they could have rolled up their floor from $68 to $74, and basically paid for that adjustment by selling the April $80 call option. For a very limited cost of around $0.50/cwt., this would have raised their hog price floor above the cost of production, thus preserving a positive margin on that portion of their risk. It also would have allowed the margin to continue strengthening above the 90th percentile before the operation would be obligated to a sale on that portion of their hogs.

Some other producers may have opted to simply liquidate their $68 puts, realizing a loss of around $1.00/cwt. against a fixed sale of futures or a commitment in the cash market with their packer. Regardless of how they may have reacted to the recent increase in hog prices and strengthening margins, it is important to have a plan in place to adjust Plan B protection into Plan A.