For the last year or so,everyone has been telling you that hedging lean hog futures is a sound way to manage risk in your operation. Normally, that would be sage advice, but the future’s basis has been wide enough to mitigate much of the risks avoided on the live market.

There are two parts to a hedge, price risk and basis risk. The basis is the difference between the cash and futures prices when hedging. For the last two years or so, the basis price has been much wider than typical patterns, according to John Lawrence, Iowa State University livestock economist.

“Historically, the basis has been relatively narrow, in the $1- to $2-range per hundredweight,” says Lawrence. “But in the last 18 months, the basis for hog prices has in some cases been as wide as $10.”

For example, if the futures’ price was $56 per hundredweight and the basis for that month’s contract was normally around $1.50, you could expect to receive $54.50 for the contract. However, if the basis was $8, then you would receive $48 per hundredweight. You would make $16 less per head than you expected. That kind of basis fluctuation makes it difficult to use hedging to guarantee a breakeven.

“We have used forward pricing often, and in 1998 it saved our tails,” says Ron Homan, a Minnesota producer. “We’ve absolutely given up using forward pricing now because it is too unpredictable.”

Problems began to surface for producers when USDA began reporting carcass prices rather than live hog prices and the Chicago Mercantile Exchange changed its contracts accordingly. Low prices of late 1998 compounded the issue.

“When the market is in an up trend and prices on the board keep going up, the cash price is always behind the futures,” says Homan. “During last September, you just couldn’t win with the October contract.”

Homan believes better price discovery would help pork producers monitor the situation and says only about one-third of the hogs are being accurately tracked.

“The potential for basis volatility occurs because there’s no longer any threat of product delivery,” says Jon Caspers, a producer from Swaledale, Iowa, who chairs a National Pork Producers Council committee that’s investigating the basis problem.

Caspers also points out that most hog price reports are based on packers’ mid-day reports. This excludes hogs traded after 10:30 a.m., making it easier to manipulate the prices reported.

Cash market fluctuations are one potential cause for a wider basis, according to Paul Peterson, vice-president of commodity trading for the Chicago Mercantile Exchange. For example, on Feb. 17, cash prices on a 51 percent to 52 percent lean hog were running between $44.25 per hundredweight and $59.36 per hundredweight in the Western Corn Belt.

“We know where the futures price is,” says Peterson. “But when there’s a range of $15 in the cash price on a given day, the exchange can’t address the wide fluctuations seen in the cash market.”

Futures contracts and cash markets eventually have to move together as the contract’s expiration date approaches. That’s typically around the tenth business day of the contract month. The further you are from the expiration of the contract the wider the basis may be. For example, the October futures contract expires on Oct. 13, and the futures and cash prices begin reconciling about Oct. 5.

“The basis is really just a function of time, by definition,” says John Lawrence, Iowa State University agriculture economist.
The NPPC committee has written a letter to the Chicago Mercantile Exchange asking officials to add more contract months to the lean-hog futures offering. The reason is because the biggest basis problems occur in off-contract months. Also, current contracts reflect old industry production trends.
There are seven months in which lean-hog contracts are traded, February, April, June, July, August, October and December. Producer delegates at Pork Forum approved a resolution asking CMEto add May, September and January contracts. Ideally, NPPC’s committee would like to see contracts available for all 12 months.

“We have looked into adding contract months, but currently have no plans to do so,” says CME’s Peterson.
“We looked into possible gains and losses and it wasn’t advantageous to all market users. It could be possible in the future; the question is raised every year.”

Caspers says producers should express their frustrations to CME, to help the exchange better understand the problem.

Producers aren’t the only ones getting hung out to dry by basis risk. Packers have been hurt equally as badly. In a forward contract, the packer assumes the futures and basis risk, instead of the producer. Today, packers are taking extra precautions by passing some of the risk on to you by assuming a wider basis than the historical average because they have gotten burned.
“This could be a long-term problem if things don’t stabilize,” says Homan. “The only way I can see the situation improving is if CME offered a lean-hog contract for every month, because right now, the price outcome is too hard to predict.”

That doesn’t mean you can’t use forward pricing options, but you do need to consider more factors now.

“In order to hedge you need to understand the basis,” says Lawrence. “It’s not as predictable as it has been in the past. You need to start accounting for a wider basis when figuring break evens or other marketing plans.”