Risk management tools needed for beef industry to grow to its potential, says white paper

Risk management tools needed for beef industry to grow to its potential, says white paper

THE development of risk management tools should be a priority if the Australian red meat industry is to fulfil its future growth potential, a recently published industry white paper suggests.

A recently released industry white paper commissioned by Meat & Livestock Australia explores the Australian cattle industry’s awareness, willingness to change and appetite for improved price risk management, with a focus on relevant benchmarks and the viability of a derivatives market to allow for risk transfer.

The white paper was developed to provide an independent assessment of the Australian cattle industry’s approach towards price data and benchmarks, as it relates to livestock price risk management and the potential value of benchmarks and risk transfer to the sector.

In gathering information for the report, a series of ‘roundtable’ discussions were convened via video links, with strong participation from all red meat supply chain sectors and industry service sectors, including finance, industry groups and professional services.

The paper’s author, John Reeve, from AgRee Commodities, has had a 25 year career in agri commodities, advisory, finance and venture building. He has held senior roles in Sydney and Singapore in agri trade, risk management and finance at CBA, UBS, Standard Chartered and Goldman Sachs. Earlier, he was involved in term debt (Rabobank) and commodity hedge advisory in Australia and the US.

Price risk management in the Australian cattle industry

While cattle futures and other risk management tools are commonly used overseas, the Australian beef industry has twice tried, and failed, to establish a cash-settled cattle futures mechanism through the Australian Stock Exchange. Lack of liquidity was a key problem, on both occasions.

However the white paper argues that the beef cattle sector has grown and changed significantly in the 20 years since the development of the Eastern Young Cattle Indicator and associated earlier price risk management initiatives.

The key changes have been the increase in notional value and the geographic concentration of risk, it says. Major changes over the last 20 years outlined in the report included:

  • Export-driven growth – substantial increase in beef exports
  • Tripling of the feedlot sector – 88pc concentrated in southern Queensland and northern NSW
  • Greater reliance on individual international markets – market access is an increasing risk
  • Ever-increasing biosecurity risks
  • Stronger regulatory and ESG expectations of global consumers and investors
  • Further concentration of processing capacity accentuating the ‘wine glass’ industry structure, where there are many producers, few processors and many consumers.

“Considering these major changes and trends, it is clear that appropriate resource allocation should be assigned to risk management in the cattle sector to ensure the industry is prepared for future challenges and more generally for continual improvement,” the white paper argues. Stronger, more resilient supply chains would allow for increased likelihood of achieving national, industry and individual farm objectives, it says.

Discussions around industry benchmarks and price risk management in the white paper focus around four central themes:

  • Consensus: “Does industry consensus exist around the value of benchmarks and price risk management?”
  • Obstacles: Where does the industry see obstacles to the creation of benchmarks and the adoption of derivative-based price risk management? Would the industry contribute to overcoming these obstacles?
  • Preconditions: Under what conditions would the industry actively engage in a livestock pricing derivative market?
  • Expectations: Given MLA’s areas of expertise and competency, and role in the red meat and livestock industry, what expectations does the industry have in MLA supporting the creation of benchmarks and facilitating the development of a livestock pricing derivative market?

The white paper says while there is a wide range of awareness in industry circles around risk management, the general sentiment was that there is industry-wide value to improved understanding of risk management, price transparency and associated price-risk transfer tools and close-out mechanisms.

“Participants recognised that risk factors, such as drought, dependency on export markets and biosecurity are increasing in the beef sector, and that benchmarks and risk transfer tools could help mitigate against such risk factors,” the paper says.

Participant contributions were used to substantiate alignment between the red meat and livestock industry’s strategic goals and industry growth objectives stated in the White Paper.

Structural and cultural obstacles that needed to be addressed were identified, including improved knowledge and application of new business models – as they relate to physical sales and supply agreements that observe benchmarks, and the concept of price risk transfer (hedging).

A critical starting point to capture the value on offer to the industry should be the creation of benchmarks that reflect prices paid across all sales channels, particularly latter stage cattle transactions, the paper said.

Data visualisation innovations and risk transfer examples from adjacent agricultural industries were ‘well received’ and illustrated to participants the value of innovation, price transparency and risk transfer.

“This value stems from more predictable and stable earnings, enterprise value uplift and wider access to capital, as well as the wider benefits of a more collaborative, modern and orderly market system, such as environmental, social, mutual obligation, innovation and market access benefits,” the report said.

International experts emphasised the important role of government to ensure trust, but the consensus amongst domestic participants providing feedback was that ideally progress, in this area, should be driven by commercial operators.

Participants indicated that MLA should act as a facilitator by further improving industry awareness of risk and the inter-relationship between supply, demand and price metrics and how this may translate into new physical supply agreements and demand for price transfer tools.

MLA’s existing role in publishing market indices could be leveraged to support any benchmark/indicator required, the report suggested.

The white paper recommended three steps in the next phase:

  • Risk awareness: The creation and adoption of a series of risk frameworks, standards and scorecards by which the industry might improve risk culture and accountability
  • Data: Active engagement with existing (and future) MLA initiatives to address market transparency issues in the latter stage cattle market, primarily through data-sharing
  • Risk transfer: Feeder futures contract design and implementation.

The willingness of key players in the industry to contribute to overcoming obstacles to data sharing and adoption of risk transfer strategies was addressed in the report, along with potential ways to resolve these obstacles, including the use of technology.

“MLA recognises that any changes to price data collection, benchmark creation and risk transfer development must be commercially driven and this paper, specifically, does not provide any expert opinion, direction or recommendation around the specific design, development and adoption of more sophisticated risk management tools. Such efforts must be industry-led and recommendations are made to assist this process,” the report said.

Price risk management: an introduction

The white paper defined price risk management, or ‘hedging’, as the process of protecting the value of a business from the impact of commodity price fluctuations.

“By planning for future scenarios, it can help to minimise any adverse changes in prices, and so capitalise on positive movements. In doing so, price risk management can help with long-term business planning and investment, decisions relating to production/herd management and managing day-to-day cash flow,” it said.

“Less risk means more resilience and peace of mind for stakeholders. Beef production is a complex and risky activity – heightened climate variability, increased dependence on volatile international markets, the ever-present biosecurity risks and many other risk factors mean a focus on risk management and resilience is becoming a critical matter for the industry to consider.”

Whilst Australia possessed a comparative natural advantage in breeding and fattening cattle, it also had a range of structural competitive advantages that could be leveraged to help achieve further global competitiveness relative to South American producers, for example.

“Proactive use of our strong property rights/legal system, stable banks, market makers, education, technology and communication offer the industry an opportunity for appropriate wider adoption of risk management to deliver the associated positive impacts around enterprise value, access to capital and ESG,” the report said.

“Domestically, the industry is under scrutiny around market transparency, particularly given the growth in the industry over the last 20 years relative to the overall economy and its potential for further economic contribution.”

The deregulation of the cotton, wheat and sugar markets (see trend graph lines above) was a ‘sudden change’ that had resulted in primary producers in those industries facing more choice in marketing and price risk management decisions over the last 30 years, the report said.

“This deregulation triggered the development of more farm-level risk management understanding and has benefited industry resilience.”

In contrast, the beef cattle sector has not undergone any significant regulation or structural change, and is consequently more vulnerable to issues related to poor price signals and transparency, such as difficulty in making informed drought feeding decisions, lack of forward price signals exacerbating herd volatility, access to capital and risk management products, and increasingly large margin swings between producer and processor, with associated processing plant shutdowns.”

Price risk management and international livestock markets

Price data recording and futures contracts were generally seen as one of the cornerstones of a strong industry by leading international participants in the white paper’s webinar series. However, an obstacle identified by webinar participants was the challenges the US industry is facing despite plentiful data and two liquid futures contracts.

“The market in the US has evolved, for very understandable reasons, towards an increase in contractual vertical integration between feed yards and packers, which has significantly reduced the amount of negotiated cattle trade,” it said. “The industry now recognises this and is trying to find a way to voluntarily increase the percentage of negotiated trade; and at the same time some groups are trying to get the government to mandate a minimum level of negotiated trade.”

“Futures need cash trade data as a feedback loop to help keep the market in line (converge) as they come to final settlement (feeders) or delivery (fat cattle).”

A second problem the US had seen recently is a misunderstanding of the role of futures. There had been some feedback that futures were not tracking the cash market, but in most cases this was based on a flawed understanding of how futures work, the report said.

Key lessons from the US were:

  • Convergence: Need industry to set minimum level (~30%) of negotiated cattle trade and get closer to the customer to ensure buyside interest – leading to convergence between cattle and beef prices at delivery.
  • Data: Set a critical minimum percentage of benchmark cattle to be appropriately reported/recorded to ensure benchmark is representative e.g. 30%+ arm’s-length cash sales, such as saleyard transactions or other negotiated cattle trade sales.
  • Education: It took many years for the futures and options market to reach appropriate liquidity and, as per international risk standards, continuous improvement is integral to ensure the system can cope with current and future industry risks factors.

Price risk management and inward investment

The report also raised the potential value seen in risk transfer mechanisms in attracting capital.

“Data availability and risk transfer are major influences in attracting foreign investment into any industry. Investors will always be drawn to opportunities that offer the greatest likelihood of return and will avoid placing funds into scenarios of ‘known risk and unknown reward’, it said

Many studies, including those by the likes of Deloitte and ANZ bank, had identified a capital gap in the Australian agriculture sector.

“There is a clear need to diversify the sources of capital supporting Australian agriculture, including attracting international investors; this need would be well-supported by price transparency and a wider adoption of price risk management,” the report said.

Click here to read the full White Paper report.

Article credit www.beefcentral.com