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Cattle Risk Management. GEOFF BENSON, PhD Extension Economist Dept of Agricultural and Resource Economics North Carolina State University. Agenda. Introduction Price forecasting Price risk management Hedging with cattle futures USDA-RMA LRP Program Cattle futures options

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Cattle risk management l.jpg

Cattle Risk Management

GEOFF BENSON, PhD

Extension Economist

Dept of Agricultural and Resource Economics

North Carolina State University


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Agenda

  • Introduction

  • Price forecasting

  • Price risk management

    • Hedging with cattle futures

    • USDA-RMA LRP Program

    • Cattle futures options

    • Setting price targets & pulling the trigger

  • Summary

  • GEOFF BENSON, ARE, NCSU


    Slide3 l.jpg
    Risk

    • RISK -- the chance of loss or an unfavorable outcome or event

      • Anticipated or unexpected

      • Known probability or uncertain

    • RISK EXPOSURE -- The amount of a loss, if it occurs

    • The financial consequences for the business: cash flow, profit, solvency

    GEOFF BENSON, ARE, NCSU


    Sources of risk l.jpg
    Sources of Risk

    • Weather & other natural phenomena

      • Local variation in rain, temperature, etc.

      • Regional, national, global weather

      • Extreme (tornadoes, hurricanes, floods, etc.)

    • “Technology” and competitiveness

    • Changes in your customers’ ability or willingness to buy your product

    • Societies attitudes & preferences

    • Government and other institutions rule changes

    • Individual human behavior

    • Random accidents

    GEOFF BENSON, ARE, NCSU


    Managing risk l.jpg
    Managing Risk

    What are the most important risks your farm business is exposed to?

    How vulnerable is your farm business to these risks (exposure)?

    What cost-effective strategies are available to manage price risk?

    What is your attitude to risk?

    Do you have the time, knowledge and risk management skills?

    GEOFF BENSON, ARE, NCSU


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    Risk Management

    • Management strategies include:

      • Reducing the chance of an event

        • The management ability, knowledge and effectiveness of the producer is the key

      • Reducing the impact if an event occurs

        • Buying insurance

        • Self-insurance, which comes in many forms including carrying inventories, diversification, maintaining financial reserves, borrowing, off-farm income

    GEOFF BENSON, ARE, NCSU


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    Cost:Benefit

    • All risk management strategies involve costs, in money or time

    • Effectiveness varies among alternatives

      • Financial benefits & costs

      • Time, new knowledge and skills

      • Evaluate trade-offs

    GEOFF BENSON, ARE, NCSU


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    Agenda

    • Introduction

      • Price forecasting

  • Price risk management

    • Hedging with cattle futures

    • USDA-RMA LRP Program

    • Cattle futures options

    • Setting price targets & pulling the trigger

  • Summary

  • GEOFF BENSON, ARE, NCSU


    Price forecasting l.jpg
    Price Forecasting

    • Helpful for making marketing and business decisions

    • The futures market provides an industry consensus on prices as far as one year out

    • Takes account of known information

    • Changes daily as new information becomes available

    GEOFF BENSON, ARE, NCSU


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    Cattle Futures

    • The CME Group trades two types of cattle futures – data at www.cmegroup.com

    • Live (or finished or fat) cattle futures -- 40,000 pound lots of 55% Choice, 45% Select, Yield Grade 3 steers, physically delivered: Feb, Apr, Jun, Aug, Oct, Dec.

    • Feeder cattle futures are for 50,000 pound lots of 650-849 pound L&M 1&2 steers, cash settled: Jan, Mar, Apr, May, Aug, Sept, Oct, Nov.

    GEOFF BENSON, ARE, NCSU


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    Price Forecasting

    • Use “nearby” futures contract price for intended sale month

    • BUT

      • This is not the NC price

        “Basis” = futures price – local cash market price for similar cattle

      • If basis is predictable, then we can use the futures market to project local North Carolina prices and use this to make business decisions

    GEOFF BENSON, ARE, NCSU


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    Price Forecasting, cont.

    • The cattle futures contract may not match the cattle you have to sell –need to adjust the futures price

    • What market premiums & discounts affect the value of your cattle?

      • Weight

      • Sex

      • Frame

      • Muscle

      • Breed

      • Other, e.g., market channel, truckload

    GEOFF BENSON, ARE, NCSU


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    Price Worksheet

    GEOFF BENSON, ARE, NCSU


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    Feeder Cattle Futures, $/100 lb, 3/26/09

    GEOFF BENSON, ARE, NCSU


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    Historic Basis

    • The most useful comparison is the published NC weekly auction (cash or spot) prices for a particular week or month relative to the cattle futures price for the “nearby” month

    • Note

      • NC Auction prices are reported weekly in 50 or 100 lb./head increments for small lots

      • CME feeder cattle futures contract is for 650-849 lb. M&L1&2 steers in truckload lots

      • Contract months are Jan, Mar, Apr, May, Aug, Sept, Oct, & Nov.

    GEOFF BENSON, ARE, NCSU


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    NC Basis, Avg. 1990-2000

    GEOFF BENSON, ARE, NCSU


    Nc basis 1990 2000 l.jpg
    NC Basis, 1990-2000

    • Negative (transportation cost)

    • Varies by market, west to east

    • Seasonal:

      • Smaller discount in spring, high demand for cattle for summer grazing

      • Larger negative differences in fall as cattle are sold as grass runs out

    • Historic data on line at:

      http://www2.ncsu.edu/unity/lockers/

      project/arepublication/AREno32.pdf

    GEOFF BENSON, ARE, NCSU


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    “Quality” Differences

    • What are the characteristics of your cattle and how do they affect the price (value)?

      • Weight

      • Sex

      • Frame

      • Muscle

      • Breed

      • Other, e.g., market channel, truckload

    GEOFF BENSON, ARE, NCSU




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    Price Differences, Graded Sales, 500-599 lb. Steers, 1990-2001

    GEOFF BENSON, ARE, NCSU


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    Angus 1990-2001

    Braford

    Brahman

    Brangus

    Braunveih

    Charolais

    Chianina

    Devon

    Galloway

    Gelbveih

    Hereford

    Holstein (dairy)

    Jersey (dairy)

    Limousin

    Longhorn

    Maine Anjou

    Nellore

    Piedmontese

    Pinzgaur

    Polled Hereford

    Selected Breeds

    • Red Poll

    • Sahiwal

    • Salers

    • Santa Gertrudis

    • Shorthorn (dual)

    • Simmental

    • South Devon

    • Tarentais

    • Zebu

    • + Crosses &

    • Composites

    GEOFF BENSON, ARE, NCSU



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    Marketing Options 1991-2001

    • Regular auction = Base

    • Graded sale

    • Special programs, e.g., Southeast Pride, pre-conditioned sales

    • Direct farm sale (several options)

    • Retained ownership

    GEOFF BENSON, ARE, NCSU


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    Marketing Options 1991-2001

    • Farm situation determines opportunities and cost:

      • Size of herd

        • Number of cattle for sale

        • Uniformity of cattle

      • Market Premium offered

      • Marketing Cost

      • Risk

    GEOFF BENSON, ARE, NCSU


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    Price Worksheet 1991-2001

    GEOFF BENSON, ARE, NCSU


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    QUESTIONS OR COMMENTS 1991-2001

    ON PRICE FORECASTING?

    GEOFF BENSON, ARE, NCSU


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    Hedging Price Risk 1991-2001

    • Basics of futures & options

    • Hedging with futures examples

    • USDAs Livestock Risk Protection (LRP) Program

    • Hedging with Options

    • Is hedging for you?

      • How much do you have at risk?

      • Risk management strategies

    GEOFF BENSON, ARE, NCSU


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    Futures Contracts 1991-2001

    • Sell a Feeder Cattle contract for a specific month at a specific price -- Locks in a price!

    • “Off-set” your position in the futures market

      • By letting the contract expire

      • By buying back an identical contract (at or near the expiry date)

    • At the expiry date the futures price = the cash market (spot) price

    GEOFF BENSON, ARE, NCSU


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    Futures Contracts 1991-2001

    • Set up a trading account with a brokerage

    • Pay a small commission to the broker for the transaction

    • You may get margin calls to ensure you can cover your position -- Deposit cash in your trading account when the futures price moves above the price you locked in

    GEOFF BENSON, ARE, NCSU


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    Hedging: Example 1 1991-2001

    GEOFF BENSON, ARE, NCSU


    Hedging example 2 part 1 l.jpg
    Hedging: Example 2, Part 1 1991-2001

    GEOFF BENSON, ARE, NCSU


    Hedging ex 2 part 2 l.jpg
    Hedging: Ex 2, Part 2 1991-2001

    GEOFF BENSON, ARE, NCSU


    Hedging example 3 l.jpg
    Hedging: Example 3 1991-2001

    GEOFF BENSON, ARE, NCSU


    Usda s lrp program l.jpg
    USDA’s 1991-2001LRP Program

    • Price risk insurance, pay a premium

    • Can cover each year up to

      • 2,000 head of feeder cattle of up to 900 lb. – two weight categories, steers or heifers, 3 breeds – Brahman, Dairy, “all other”

      • 4,000 head of 1,000 to 1,400 lb fed cattle

    • Coverage can range from 70% to 100% of estimated ending value*

    • More flexible and more direct pricing than hedging with futures

    GEOFF BENSON, ARE, NCSU


    Example 1 nash co 3 30 09 l.jpg
    Example 1, Nash Co, 3/30/09 1991-2001

    GEOFF BENSON, ARE, NCSU


    Example 2 nash co 3 30 09 l.jpg
    Example 2, Nash Co, 3/30/09 1991-2001

    GEOFF BENSON, ARE, NCSU


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    Information on LRP 1991-2001

    Fact Sheets are available on line at http://www.rma.usda.gov/livestock/

    Examples of contracts are at http://www3.rma.usda.gov/apps/livestock_reports/main.aspx

    A premium calculator is available at http://www.rma.usda.gov/tools/premcalc.html

    A list of LRP insurance providers is at http://www3.rma.usda.gov/tools/agents/companies/2008/north_carolinaLPI.cfm. All are from out-of-state

    GEOFF BENSON, ARE, NCSU


    Options l.jpg
    Options 1991-2001

    • The right (but not the obligation) to buy or sell a futures contract.

    • Puts a floor under the price but not a ceiling – you get the upside

    • A “put”= right to sell & allows the producer to hedge

    • A “call”= right to buy & allows the buyer (e.g., the feedlot operator) to hedge

    GEOFF BENSON, ARE, NCSU


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    Options 1991-2001

    • An option is for a specific futures contract and a specific price

    • The agreed upon futures contract price is called the strike price

    • The cost of an option is called a premium

    • Premiums are established by public outcry pit trading and by electronic trading, similar to the way futures prices are established

    GEOFF BENSON, ARE, NCSU


    Options41 l.jpg
    Options 1991-2001

    • There is a range of strike prices for each futures contract

    • Premiums have 2 components:

      • Time value -- pay more for options on far off contracts, shrinks as the expiry date approaches

      • Intrinsic value -- related to the relationship between the strike and current price of the futures contract

    GEOFF BENSON, ARE, NCSU


    Options42 l.jpg
    Options 1991-2001

    • In-the-money -- Underlying futures price is favorable compared to the strike price

    • Out-of-the-money -- Futures price is unfavorable vs. strike price

    • At the money

    • Options automatically settle for cash at the time the underlying futures contract expires

    GEOFF BENSON, ARE, NCSU


    Feeder cattle options premiums may contract cwt 3 25 09 l.jpg
    Feeder Cattle Options Premiums, May Contract, $/cwt., 3/25/09

    *No brokers fee or cost of margin calls included

    GEOFF BENSON, ARE, NCSU


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    QUESTIONS OR COMMENTS 3/25/09

    ON HEDGING?

    GEOFF BENSON, ARE, NCSU


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    Is Hedging for You? 3/25/09

    • Things to consider

      • Size of your cattle operation

      • Financial importance of your cattle operation

      • Ability to handle price risk

      • Attitude to risk & expectations about hedging

    GEOFF BENSON, ARE, NCSU


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    Farm Structure, 2007 Census 3/25/09

    GEOFF BENSON, ARE, NCSU


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    Why Do You Have Cattle? 3/25/09

    OR

    FUN OR MONEY?

    GEOFF BENSON, ARE, NCSU


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    Hedging 3/25/09

    • It is not for everyone

      • Very small producers

      • Busy producers

      • Producers for whom beef cattle are a sideline

    • All risk management strategies involve costs and effectiveness varies among alternatives

      • Financial benefits & costs

      • Time, new knowledge and skills

      • Evaluate trade-offs in your situation

    GEOFF BENSON, ARE, NCSU


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    Hedging 3/25/09

    • How much do you have at risk?

      • Number of head

      • Possible change in price

      • Total financial losses

      • Impact of those losses on farm and family finances

    • Example,

      • I truckload of feeder cattle = 50,000 pounds (~65 head)

      • A $10 per cwt. price drop = - $5,000

    GEOFF BENSON, ARE, NCSU


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    Price Risk Management Strategies 3/25/09

    • Ride it out – “self-insure”

      • Draw on savings or borrow

      • Restructure debt payments

      • Adjust expenses, especially maintenance & new investments

      • Add off-farm income or cut family living expenses

    • Prevent unacceptably low prices with futures contracts, options, LRP – “buy insurance”

    GEOFF BENSON, ARE, NCSU


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    Hedging 3/25/09

    • Attitude & Expectations

      • Futures, options & LRP are tools to manage downside price risk and prevent or moderate the financial problems lower prices would cause

      • It is unrealistic to expect that using futures and options will increase your average or long run profit but using them may help keep you in business!

      • Using them may help you sleep better!

    GEOFF BENSON, ARE, NCSU


    Attitude to risk l.jpg
    Attitude to Risk 3/25/09

    • Attitude to risk affects an individual’s decision in a given risk situation

      • Are you risk averse?

        • Willing pay to reduce risk (insurance)

        • Willing to accept a somewhat lower expected profit to avoid downside risk

      • Are you a “risk preferer” – NOT willing to pay for risk reduction and possibly accept lower average profit

    GEOFF BENSON, ARE, NCSU


    Setting hedging price targets l.jpg
    Setting Hedging Price Targets 3/25/09

    • A minimum profit

      • Full cost of production + margin

      • Break even

    • Cash flow protection

      • Stocker purchase price

      • + or - debt service

      • + or - cash production costs

      • + or - $$ for family living

    GEOFF BENSON, ARE, NCSU


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    Do you know your cost of production & profit margin? 3/25/09

    • Operating cost - Out of pocket expenses, e.g. forage, other feed, fertilizer, vet, repairs,

    • Investment (fixed) costs—Depreciation, interest, property taxes & insurance (DITI)

    • Opportunity cost – charge for your time and equity capital invested

    GEOFF BENSON, ARE, NCSU


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    MN Cow-calf Cost & Returns, 2007 3/25/09

    Source: MN Farm Business Management database

    GEOFF BENSON, ARE, NCSU

    55


    Mn stocker cost returns 2007 l.jpg
    MN Stocker Cost & Returns, 2007 3/25/09

    Source: MN Farm Business Management database

    GEOFF BENSON, ARE, NCSU


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    NCSU beef & forage budgets 3/25/09

    • Beef: cow-calf, backgrounding, summer grazing, pasture finishing, conventional finishing, pre-conditioning

    • Forages: perennials, annuals, hay making, silages

    • Available on line at:

      http://www.ag-econ.ncsu.edu/ extension/Ag_budgets.html

    GEOFF BENSON, ARE, NCSU


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    Costs in the Budgets 3/25/09

    • Operating inputs -- fuel, fertilizer, chemicals, labor, seed, interest

    • Fixed costs -- depreciation, interest, taxes, insurance on machinery and buildings

    • Full labor and interest costs and charges

    • Forage budgets

      • Do not include storage, feeding or pasture management costs

      • Some include harvesting costs

      • Include yield estimates and “unit costs”

    • NO farm overhead cost

    • NO land charges

    GEOFF BENSON, ARE, NCSU


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    Cash Flow 3/25/09

    • Budgets include full economic costs

    • For cash flow price targets, evaluate the revenue needed to cover

      • Out of pocket production expenses, including cattle purchases

      • + or - Debt payments

      • + or - Family living

    • Remember, the purpose is to lock in or set a floor price at an acceptable level to insure against a financial disaster

    GEOFF BENSON, ARE, NCSU


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    Pulling the Trigger 3/25/09

    • Futures price volatility means pricing opportunities come and go

    • Futures prices respond to:

      • Market fundamentals, so track key economic factors and understand their impact on prices

        • Supply factors

        • Demand factors

      • Technical trading driven by market psychology, so following price moves and interpreting trading patterns can help

    GEOFF BENSON, ARE, NCSU


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    Demand & Supply Factors 3/25/09

    • Consumer Demand

      • General economy – income, unemployment, exchange rates

      • Competition from other meats

      • Demographic changes – age, race, pop.

    • Supply

      • Availability of cattle – stage of cycle

      • Feedlot costs

      • Transportation costs

      • Trade

    GEOFF BENSON, ARE, NCSU


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    . 3/25/09

    GEOFF BENSON, ARE, NCSU


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    Cattle cycles 3/25/09

    • Low prices force liquidation of breeding stock, adding to beef supplies and reducing prices further

    • Reduced production leads to higher prices encouraging heifer retention for breeding, reducing beef supplies and raising prices further

    • Lags

      • Decision making takes time

      • 15 months to raise a heifer to breeding age

      • Seasonality in breeding & 9-month gestation

      • 14-18 month production period

    GEOFF BENSON, ARE, NCSU


    Beef product flows l.jpg

    $ CONSUMER $ 3/25/09

    Beef Product & $$ Flows

    RETAILER

    PROCESSOR

    WHOLESALER

    FEEDLOT

    PACKER

    COW-CALF

    STOCKER

    GEOFF BENSON, ARE, NCSU


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    Price Volatility 3/25/09

    • Unexpected changes in significant supply & demand factors

    • “Known unknowns”

      • Weather

        • Crop prices & feed costs

        • Forage supplies & quality

        • Cattle supplies

    • “Unknown unknowns”

      • Disease outbreaks, e.g., BSE

      • Economic crises

    GEOFF BENSON, ARE, NCSU


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    Feeder Cattle October Contract Price History 3/25/09

    GEOFF BENSON, ARE, NCSU


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    Hedging 3/25/09

    • Takes time to learn to follow market conditions

      • Marketing club?

      • Paper trading

      • Finding a market adviser and/or broker you trust

    • Takes confidence to learn when to “pull the trigger”

    GEOFF BENSON, ARE, NCSU


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    Summary 3/25/09

    • All producers can use futures and other price information to project prices for their cattle as part of marketing and business decisions

    • Benefits of hedging

      • Protecting yourself from unfavorable price movements that would cause you serious financial problems

      • For the seller -- protection from price drops

      • For the buyer – protection from price increases

    GEOFF BENSON, ARE, NCSU


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    Summary 3/25/09

    • Several factors affect profits

      • For cow-calf

        • Prices & premiums related to selling weight, frame, breed/color, season, choice of market etc.

        • Animal performance

        • Cost of production

      • Base hedging decisions on feeder cattle futures prices, adjusted for basis, weight, other cattle characteristics, and market choice

    GEOFF BENSON, ARE, NCSU


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    Summary 3/25/09

    • For Stockers, key factors:

      • Purchase price

      • Selling price

      • Feed costs

      • Average daily gain & change in body condition

    • Use feeder cattle futures prices as the basis for profit projections

    • Base hedging decisions on feeder cattle futures prices, adjusted for basis, weight, other cattle characteristics, and market choice

    GEOFF BENSON, ARE, NCSU


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    Summary 3/25/09

    • Price risk management tools include futures, options and LRP

    • Set price targets based on your own cost of production or cash flow needs

    • Track market conditions to time your actions

    • Producers need good financial records to set price targets, and monitor performance, costs & profit margins

    • No $imple or ea$y an$wer$!!

    GEOFF BENSON, ARE, NCSU


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    “If it’s easy, fun or can be done from the seat of a tractor, there ain’t no money in it”

    Anonymous Cowboy

    GEOFF BENSON, ARE, NCSU


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    What Next? tractor, there ain’t no money in it”

    • What more assistance do you want or need, if any?

    • Topics

      • Price forecasting

      • Hedging with futures

      • USDA’s Livestock Risk Protection Program

    • How would you like this help delivered?

      • One-on-one with an adviser & broker

      • Group meetings

      • Materials, publications, etc.

    GEOFF BENSON, ARE, NCSU


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    Geoff Benson tractor, there ain’t no money in it”

    • Phone: (919) 515-5184

    • Fax: (919) 515-6268

    • E-mail: [email protected]

    • Web page:

      http://www.ag-econ.ncsu.edu/ faculty/benson/benson.html

    GEOFF BENSON, ARE, NCSU


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