Q&A: Market Prices and LRP-Lamb
By DAVID P. ANDERSON
Professor and Extension Economist
Texas AgriLife Extension Service
(November 1, 2008) As any new product gets up and running, questions arise about how it works and how it could work better. Livestock Risk Protection (LRP) for lamb prices (LRP-Lamb) is no exception. Further, this price-insurance product is a “pilot project,” so input from producers, insurance agents, the U.S. Department of Agriculture’s (USDA) Risk Management Agency staff and other experts are all important. After just more than a year of experience with the project, a number of questions have come up. This article will examine some of these common questions and look at how LRP works in the broader lamb market.
It is probably useful to start with some definitions. There are a number of lamb prices reported by USDA’s Agricultural Marketing Service (AMS). The formula live price is the average price for slaughter lambs sold in direct trade in the United States and was used in the research, etc., to set up this program. That price is only for lambs sold live and on a formula basis, which is only one of many ways slaughter lambs are sold. Increasingly, in recent years, producers also have sold slaughter lambs on a formula carcass-price basis, which reflects pricing based on carcass (after slaughter) characteristics-based formulas. The negotiated lamb-price series represents sales that occur through a negotiated (spot-market) price rather than a formula. National average prices for formula live, formula carcass and negotiated slaughter lambs are reported to AMS by packers under Mandatory Price Reporting legislation. That legislation was supported by livestock organizations largely because getting relevant prices was difficult given changing marketing practices. Some local prices, often reported by AMS, represent local auction sales. All of these prices represent different markets and different ways in which producers sell their lambs.
A common question is how these markets can have prices move in different directions in the same week. It might best be answered by going back to the classic marketing-class answer of a product’s form, function, time and location. It is not unusual for different market prices to move in different directions during the same week. The formula live-carcass and local auction-market prices reflect different types, quantities and sales conditions (time of delivery, transportation, etc.) of lambs sold. And different types or qualities of lambs may be going through different market channels.
Location can affect prices. The number of buyers and sellers on a given day can move prices up or down. Sharply higher fuel prices have forced prices lower the greater the distance from the packing plant location.
Another explanation for price differences is the data series themselves. For example, the formula live price represents all lambs sold in the United States on a formula. So, the price is an average price paid across all of those lambs in the country processed by all the larger packers. A local market price is the price at that sale that day. The process of averaging across many locations can reduce the variability in the prices that are averaged when compared to a single local market.
Lamb markets moving in different directions in the same week can happen in the short term. Longer-term markets do move together due to opportunity to arbitrage those markets. If prices in two different markets get too far apart in price, a person could buy lambs and transport them to the other market, bringing prices back together.
LRP-Lamb was initially designed based on the formula live-price series. The price was chosen as the reference point because a national representative price was needed. Local prices are sometimes not reported due to a lack of sales and more seasonal markets. Local conditions may vary widely across the country so that one local market does not reflect another local market. Of course, for slaughter lambs where transport to packers often involves movement across several states, price differences are rather likely, especially when seasonally large numbers of animals are being sold. Producers have actually faced these situations for many years. Attention to fundamental market factors influencing local slaughter-lamb prices and how quickly reported market prices come together has become more focused upon since LRP-Lamb began.
Due to the absence of a futures market, LRP-Lamb needed a price that could be projected by a statistical, or econometric, model. The absence of sales or prices in some weeks and varying local price differences precluded the use of a local auction-price series. For LRP to work, one of the nationally reported price series had to be modeled and future prices projected. One reason the formula-type prices were chosen over the negotiated price is due to larger volume of sales. Over the last three months, almost three times as many lambs have been sold by formula than on the negotiated price. Even then, there have been weeks where ‘few’ lamb sales on a formula live basis have been reported, meaning that the LRP reference price was based on relatively smaller number of animals than was in the formula carcass market. However, the formula live and formula carcass markets have been moving together, but in some weeks recently, the smaller “negotiated market” has not.
Other LRP or crop insurance products use the futures market as the reference price.
The futures often move in directions that differ from local markets for short periods of time.
A couple of practical considerations come up in choosing a reference price, as well. One is that if a local market was chosen, it would reflect the type and quality of lambs in one region and not all regions of the country. Few producers would like that solution if it was not their region, especially if the selected market was, for example, experiencing drought-forced sales and animal characteristics. A second reason is that local markets have more price volatility. More volatility would translate to higher LRP- purchase prices and more volatility in contract-settlement prices.
A key question becomes whether or not LRP can be an effective tool for producers if the formula live price is not exactly the same as a local market price or the price every producer gets.
To shed light on this question, we examined the price relationship between reported San Angelo, Texas, prices and the formula live-price series.
Several things are highlighted graphically. One is that it can be seen that there are instances where the two price series move in opposite directions. But, those instances are short lived as over longer time periods, the two series move together. It is also noticeable that there are times when formula-price declines would cause an indemnity.
Another important consideration is what might be termed the ‘basis’ or the price difference between a local market price and the formula price. This basis is noticeable in the chart showing formula and San Angelo lamb prices as the difference in these prices get larger over time.
Several events have caused this basis relationship to change. One is the loss of a local lamb slaughter plant. The loss of the plant means that lambs have to be shipped to Colorado for slaughter. Over the same time period, transportation costs have skyrocketed further eroding the basis given the transportation distance. LRP-Lamb does not have a mechanism to protect producers from those types of events.
It is interesting to point out that even with the underlying basis changes, the seasonal pattern of basis has continued. The basis continues to widen to its largest level in the middle of the year. Even though the difference between the two price series has widened, there continues to be some consistencies in the markets. That fact suggests that LRP can continue to provide some protection from price declines, but it can not increase revenue to make up for the structural changes in the market area.
It is certainly possible that over time, some LRP changes could be implemented. Monitoring how producers market lambs is important. It is also important to remember that insurance does not always pay off. Sometimes, prices may increase or not decline enough to trigger indemnities, but that does not mean that the price risk-management decision was not a good one.
There may be times that the local sale method may result in a higher lamb price than the week before, while the formula price declines resulting in indemnification through LRP-Lamb. In those cases, a producer has benefited from a price risk-management strategy that protected the lamb price from a decline in the overall market, and the producer happened to get a better lamb price in the market than may have been anticipated.
Perhaps the best strategy for producers is to view LRP-Lamb in the light of their overall marketing strategy. LRP-Lamb is not dependent on a single market, method of sale or single LRP-Lamb contract week. Overall, LRP-Lamb does provide price risk-management protection against unexpected declines in national prices or the overall lamb market.