Kentucky Ag News
UK economists weigh prospects for winter backgrounding
University of Kentucky College of Agriculture, Food and Environment
LEXINGTON, Ky. - After enjoying a phenomenal cattle market during 2014 and much of 2015, prices dropped considerably from summer to winter this year. The rapid market drop seemed to delay feedlot marketings of fed cattle, pushing weights upward. At the same time, reduced exports and growing pork and poultry supplies also pressured cattle markets. Last year, winter backgrounders were hesitant to place calves into winter programs due to the high price of calves.
This year, hesitancy seems to stem from uncertainty about sale prices for feeders in the spring given the recent market drop. The purpose of this article is to examine potential returns to backgrounding programs this winter.
At the time of this writing (mid-October 2015), spring 2016 feeder cattle futures were trading in the upper $170s. As winter backgrounders consider purchasing calves this fall, these spring futures prices provide market expectations for feeder cattle sale prices. A futures price in the upper 170s suggests a likely Kentucky price for 850-pound steers in the mid-$160s in the spring.
As an example, with spring feeder cattle futures at $179, and a -$14 basis, an 850-pound feeder steer in Kentucky would be expected to bring around $1,403 (850 pounds at $1.65 per pound) in the spring of 2016. Of course, actual basis is heavily impacted by local market conditions, lot size, cattle quality, location, and numerous other factors. The -$14 basis discussed previously is based on an expected basis for 750-pound steers around $6 under the board and an additional $8 for price slide from 750 to 850 pounds. Price slides tend to decrease as market prices decrease, so this slide component was slightly reduced from last year to account for the overall lower feeder cattle market. Regardless, producers considering winter backgrounding should make some estimate of spring sale price as they start to consider what can be paid for calves this fall. An excellent reference for predicting sale prices based on futures is AEC 2013-09, “Using the Futures Market to Predict Prices and Calculate Breakevens for Feeder Cattle” which can be found on the Agricultural Economics website.
The Kentucky Livestock and Grain Market Report for the week ending on Oct. 12 reported a state average price for 500- to 550-pound steers of $187 and a state average price for 550- to 600-pound steers of $179. If this range is used as a starting point, one might expect to place 550-pound steer calves for around $183 per cwt or something close to $1,007 per head. Larger groups of high-quality calves would certainly sell for more than this, so individuals are encouraged to apply this process to the type of calves they typically buy.
We also need cost estimates on wintering those calves and selling them in the spring. While we provide an estimate for a specific winter program, costs will vary greatly based on local conditions and the specific backgrounding program. Feed is the major cost, and producers should consider all potential feeding options including commodity feeds, corn, and corn silage. For this scenario, we will consider a single program where calves are fed 1.5% of their body weight per day of a 50/50 corn gluten/soy hull mix and another 1.5% of their body weight per day of grass hay. While performance will vary, we will assume a rate of gain of approximately 2.3 pounds per day, which would put on 300 pounds in approximately 130 days.
In terms of costs, we will value the corn gluten/soyhulls at $170 per ton and value the grass hay at $75 per ton. Health costs are assumed to be $25 per head, commission is set at $44 per head, and transportation is set at $15 per head. An interest charge of 5% is included, and death loss is assumed to be 2%. These costs will vary by location and operation, so readers are encouraged to come up with their own estimates.
Several of these cost estimates are worth careful consideration. For example, we have assumed sale expenses of roughly $9 per head, plus 2.5% of value. However, many yards offer considerable commission savings on larger groups, as do other marketing methods. Vet and medicine costs are also important. We have assumed $25 per head, which is likely sufficient to include mass medication of all calves. However, this is a decision that the individual producer should make. Finally, we would point out that our analysis largely assumes that calves are being purchased. If this was done for a cow-calf operator who was considering backgrounding their own calves, several costs would change. First, it is likely that vet, medicine, and death loss for raised calves would all be lower. Secondly, transportation and commission would be paid on the calves if they were sold after weaning, so the relevant costs become the difference in commission and transportation paid on the heavy feeder versus the calves, rather than the total costs. With these caveats in mind, the following table shows expected returns to the program described above.
As can be seen in table 1, projected returns are $77 per head this winter, based on the assumptions discussed previously. Producers are strongly encouraged to modify these assumptions for their individual programs to better reflect calf values and expected spring basis, as well as cost estimates and feed prices for their area. Labor, depreciation, and interest on owned capital are not included in the budget, so the return shown is a return to land, capital, and management. Producers should ask themselves if that return adequately compensates them for their time, capital investment, management, and risk.
The two key assumptions made in Table 1 include the cost of the calves being placed and the expected sale value in the spring. Changes in calf placement costs will greatly impact winter backgrounding returns. For every $5 per cwt decrease in the purchase price of the calves, the return to land, capital, and management increases by $27.50 per head. The second assumption, the sale price for the feeder steer, won’t be known with certainty until spring. Note that the assumed spring sale price in the analysis is $165 per cwt and the projected return is $77 per head. A $9 per cwt decrease in sale price would result in actual returns falling to $0.
Other assumptions can also have significant impacts on expected profitability. For example, a decrease in sale expenses from $44 to $16 if selling in large lots would bring the expected profit up to $105. The commission on small lot sizes has gone up dramatically in the current market, while the commission on larger groups has remained the same. This creates a significant cost disadvantage for small operators. A $25/ton decrease in price in corn-gluten/soyhulls would increase expected profit by $17 and vice versa.
Given the assumptions of the analysis in Table 1, expected returns to winter backgrounding are moderate given mid-October’s calf market and spring CME© Feeder Cattle Futures. However, given the importance of expected sale price on returns, winter backgrounders are encouraged to explore opportunities to manage downside price risk through contracting, futures and options, LRP insurance, and other strategies. The figure below depicts March CME© Feeder Cattle Futures from DTN over the last six months. Note that the March CME© Feeder Cattle Futures contract is down more than $30 per cwt from where it was in the spring and was down considerably more than that in early October. While it does appear that the market is offering some opportunity for winter backgrounding, the last few months have also provided a reminder as to how unpredictable these markets are. Therefore, some additional effort should be applied to manage downside price risk. Winter backgrounders should carefully calculate their breakeven purchase prices for calves and be opportunistic as they approach this fall.
This article was written by Kenny Burdine and Greg Halich, agriculture economists at the University of Kentucky College of Agriculture, Food and Environment. The article first appeared in the October 28 edition of Economic and Policy Update.