Cost of Production 2009: The End of Points and the Beginning of Distributions
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For years, modern swine producers thought about cost of production as a point or single number. For almost a decade, a cost of production of 38 cents a pound was consider standard, high efficiency cost control. Those days are gone and I don't mean just that number. There is no new number which is or will be the normal cost of production for all of us who love to live by rules of thumb. The cost of production for meat animals is largely determined by the cost of the underlying feed ingredients which have entered a phase of volatilty that is not likely to abate. The continued mandates for ethanol production which will absorb four billion bushels of US corn production will keep key feed ingredient prices on a perpetual "stocks-to-use" razor and provide another source of price volatility here-to-fore reserved for weather events alone. The combined impact of weather and reduced stocks-to-use values will force the volatility of the grain sector into the cost of production for poultry, pigs and to some extent beef production.
I have forecasted the cost of production for pigs in the US using a simulation technique which is based on the last three years corn and soybean meal price distributions to give you a new look at how you must conceive of your costs now and in the future. The pattern of the distributions of corn and soybean meal bleed through to the shape of the distribution of the cost of production estimate. In the graph which follows, the height of the histogram bars is the probability of a given average cost prevailing in 2009. The average cost of production: $67.72/cwt is not the outcome with the highest probability due to the skewness of the distribution but you should learn to look at this as the pattern of likely outcomes rather than our nice, tidy, single cost rule of thumb. Doing so will give you certain key understandings which will help protect you from big mistakes. The graph follows:
The long tail to the right reflects the fact that crop price volatility push a greater danger of very high costs into your system than they do of dramatically lowering your cost. This is based on the last three years but a similar pattern is observed in the last couple of decades since droughts and other crop killing disasters happen from time to time and mega-bumper crops (such as doubling the five year average) are non-existent.
By coming to visualize your cost of production in this way you will avoid some important traps of the single point mindset. First, you will avoid the temptation to average price self-sufficiency. By that I mean, you believe because you are a low cost producer, you can simply take the average price offered in the market for pigs and in the long run beat the competition. That notion only works in price stable environments, in other words, "the old days". The new days require risk management rather than the safe haven of "cost-control only" as a strategy.
Second, you will be relieved of at least some of the fear, that when high prices come, they will last a long time or occur frequently. Very, very high prices are rare (as illustrated in the graph), which is to say, they have a low probability. Since "high prices cure high prices" through substitution and use conservation, you will be guided to make better decisions about locking long term current high prices in an environment when bubbles and other price drivers have everyone thinking prices could go even higher. Such as when commentators where talking about $12 corn last summer.
Lastly, this new envisioning of prices and therefore costs, will give you guidance regarding locking margins, which is the only way to go at this stage of the game when meat prices and input costs are subject to wide and unpredictable swings. By visualizing the patterns of corn and soybean meal prices coming into your cost of production and realizing the impact their distributions (rather than their levels) have on your distribution of costs will help you avoid liquidity disasters by choosing margin locking opportunities with better skill and ingenuity.
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Dennis,
Explain this comment to me further: "By coming to visualize your cost of production in this way you will avoid some important traps of the single point mindset. First, you will avoid the temptation to average price self-sufficiency. By that I mean, you believe because you are a low cost producer, you can simply take the average price offered in the market for pigs and in the long run beat the competition. That notion only works in price stable environments, in other words, "the old days". The new days require risk management rather than the safe haven of "cost-control only" as a strategy. "
You seem to make the assertion that being a low cost producer with adequate equity to weather the unlikely catastrophic cost scenarios, is an antequated risk managemnt strategy, and will lose out to "hedgers of risk" yielding a lower return over time. Exactly what has changed except for the volatility of input costs and perhaps revenue? This will only lead to the hedgers being "more right" or "more wrong" on their "risk managment program" or further ahead or behind at any one point in time. What I hear you saying is that somehow because cost volatility is high people who actively manage risk will "win" more than they "lose", thus beating the "take the average price of inputs (and outputs)" model.
Is this what you are saying or am I missing it? How will active risk managment, given the same 50/50 chance of being right, yield any better results than it ever has? Only if you are under the delusion that you are smarter that the market over the long haul, will you make these assumptions. If you are so dilusioned, why go the bother of produceing pigs. Just be a trader.
Help me understand what you mean.
Thanks Dennis,
Rod Leman
Thanks for the comment Rod. In 1982 I co-authored a textbook for college level Farm Management classes with the title: "Farm Business Mangement: Successful Decisions in a Changing Environment". I always think of that right before I say something like "We are in a new phase which requires us to change this...or that..." But of course, we are in a new set of challenges (as always) and believe me, this one is just one of the many being teed up for you.
First, the goal of hedging is not to beat the average market price. In general, since you are supposed to be passing off risk when a hedge is properly placed, you should expect a lower than average outcome, especially if you do it frequently, since you have to pay a "risk premium" to off load risk.
I was talking about selective hedging (hedging under certain pre-defined and well thought out criteria) which attempts to avoid liquidity disasters, especially after months of "death by a thousand cuts" losses. You can "hedge" in a variety of ways including using options and forward contracting where you establish a fixed basis and can lock in a known price for both inputs and output.
If you establish a basis history for hogs and for corn and bean meal, you can every day, produce a future set of target "or possible" locking prices for both pigs and the major feed ingredients for months ahead. These target prices, when taken together allow you to calculate a kind of target gross margin. This "predicted gross margin" for months ahead, changes every day the markets change and has a variance of outcome from your prediction (since basis is variable) but it should be less than the variance of the three market prices if you are totally open to the market. The hog basis this spring has been very wide since cash has been unusually depressed compared to futures.
If you do this, you can look at your predicted gross margin (return over feed cost) today for the 4th quarter (for instance) and compare the gross margin you could establish today with your ability to preserve capital and pass a strong liquidity challenge should it occur.
So you may find yourself willing to "lock in" small losses and or small gains today for the fourth quarter to make sure you have staying power. You wouldn't typically hedge everything this way but by having some rules and targets, you can scale up the amount you hedge as opportunities present themselves in line with your pre-determined goals. So lock 5% of production at this target outcome, 10% more if that price goal is met, etc. I say predetermined because if you just look at things every day without a strategy you will be blown around by the infamous fear and greed cycle.
So in short, you are not trying to "beat the average", you are trying to produce an outcome which may be slightly below the average but is not subject to the same extreme highs or lows. This smoothing is a real benefit in times like this when everyday brings a new random shock. This is not for the "typical" producer who wants to jump in and out based on watching his price screen from time to time as it takes a real dedication to developing a strategy that makes sense and then almost "automatically" executing it so you don't wind up second guessing every move.
Lastly, the focus is on locking a gross margin rather than just shooting for locking what appears to be a "high" hog price offered by the futures market since there is no such thing without reference to feed costs.
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