This was the view from Thomas Clark, Associate Director, Commodity Products, for the Chicago Mercantile Exchange Group during a discussion on how pork producers could manage risk, during the World Pork Expo in Des Moines, Iowa.

Hedgers like low volatility, while speculators like high volatility. Producers always hope the market will go higher.

In 2008, the US pork industry had total sales of $12 billion dollars. It's a big, and risky, business.

Mr Clark said producers should commit five to 10 per cent of their production to futures and options – not 100 per cent of it.

When the opportunity is there, take it and lock it in. But know that volatility will always be there. The days of just locking in production are gone.

As an example of volatility, he looked at grain prices: from 1980-2006, grain complexes went with 20 per cent volatility. In 2008 there was 40 per cent volatility. In 2009, there was 50 per cent volatility.

Producers should not be complacent, he said. The only time that is good is when the opportunity to make money presents itself.

In outlining some basic market definitions, he said that Futures are standardised, legally binding agreements to buy or sell a specific product in the future a (placeholder) whereas Options can be thought of as insurance policies. The option buyer pays a price for the right – but not the obligation – to buy or sell a futures contract within a stated period of time at a predetermined price. Options are a safety net on futures.

Marketing Plan

Mr Clark stressed that producers must develop a marketing plan.

"Without it, you are flying blind. You have to look at the numbers. Look at the big picture and see where you're vulnerable," he said.

Marketing plans add discipline to a hog operation. Budgeting adds critical break-even information. The producer gets a number. That number is a moving target, however, so one must add some plus or minus percentage on it.

Marketing plans are critical to success:

1. Know your costs of production - fixed and variable costs
2. Determine your break-even levels
3. Use sound market information - there is a large amount of information available, but not all of it is good)
4. Set target price(s) - you have to stick to your target price, and not wait until it goes higher; do not hedge; stick to the plan.
5. Evaluate pricing alternatives - use all marketing tools, not just futures. There are risks involved with all of these marketing options).
   • Cash sales - spot transactions, easy to do but price is what it is
   • Forward contract - make sure the person you are doing business with is OK financially
   • Futures and options hedging
   • Over the Counter, like insurance contracts
6. Execute when target prices are reached. (Do not speculate. Do not say: "I'll wait to see if the price goes up a bit more."
7. Review results to determine what works best for your operation - review it through the year; set a time: quarterly, semi-annually etc; do not just put it in a drawer and forget about it).

There also are big picture risks, including production, which is volatile and there are input costs, like feed, energy and transportation.

Financial considerations are also important, such as interest/credit and currency/exchange rates, which can create huge exposure. Risk management is a full-time job, said Mr Clark.

"Producers need to get some outside help, a consultant or a broker. Don't be a 'hedge-alator', a mix of hedger and speculator. That's a very bad idea," he said.

The actions that hedgers and speculators are looking at to determine prices include: supply, demand, political and psychological factors, including how to cope with price volatility.

Electronic Trading

Electronic trading has changed dramatically in the last five years.

In futures, 70 per cent of the hog market is traded electronically, while 85-90 per cent of grain market is traded electronically. In options, however, 40 per cent of hog market is traded electronically, while 50 per cent of cattle feeders are traded electronically.

In electronic trading, you get to see the best five bids and best five offers. Floor trading will always be around. The question is whether it will always have liquidity and value.

Electronic futures started trading started in January 2005, and nobody went for it. However, in 2007, it started to get busy and now it's the big deal.

Mr Clark presented a hedging summary:

• Know your costs
• Contract specifications
• Basis – difference between futures and cash price
• Performance bond requirements
• Hedging costs – commission, interest
• Knowledgeable broker
• Lender – very important. Need to talk to them and let them know your plan. Get them involved.

In conclusion, Mr Clark reiterated, "Get a marketing plan going."

June 2010