Ep. 3 Applied Risk Management in the Poultry Industry

[00:01] Introduction: Welcome to Relevant Risk from the fryer price risk management center of excellence, presenting conversations and analysis about risk and risk management for food and agriculture, supply chain decision makers from farmers to consumers and everyone in between. This is Relevant Risk.

[00:18] John Anderson: Hello, this is John Anderson with the Fryer Price Risk Management Center at the University of Arkansas here with the latest Relevant Risk podcast here with the Fryar Center associate director Andy Mackenzie. Andy, how are you doing today?

[00:31] Andy McKenzie: I’m doing good, John.

[00:32] John Anderson: Andy, I’m really excited about our guest today. We have a real treat in that our guest today is Dr. Ed Fryer, who is, let’s say, the founder of our Center and has had a very interesting professional life and personal, I’m sure, but we’ll stick with professional here.

[00:53] John Anderson: Ed, thank you for joining us today.

[00:55] Ed Fryar: Thanks, John. I’m really excited about being here.

[00:57] John Anderson: So, we’re going to get into some, I think some really interesting risk management topics applied risk management topics with you because you’ve got great experience with that, both as a, as an academic and as a practitioner, which is a really unique perspective, I think. But before we get to that, share with us a little bit of your bio, if you would.

[01:19] Ed Fryar: I grew Up in Arkansas and went to the University of Arkansas, have a degree in economics and then a bachelor’s degree in economics and a master’s in Ag Economics from the U of A.  Went up to Minnesota. Have a Ph.D. in agricultural and applied economics from the University of Minnesota. My first job was with USDA and the crops branch. I was a grain analyst in D.C. for a few years. A job opened up back on campus here at the U. Of A. I applied for it. I was fortunate enough to get it, so came back. My areas of research and teaching, for the most part, were grain marketing, poultry marketing and then hedging or price risk management. Joined the faculty in ‘82. Left at the end of ‘94. Went into the private sector, founded a small chicken trading company with another gentleman. That grew into a small processing company; sold my interest in that in 2000.  Opened up Ozark Mountain Poultry in April of ‘01. We had 25 employees at the time. We sold at the end of October and 2018, and we were somewhere between 18 hundred and 19 hundred employees at the time that we sold.

[02:36] John Anderson: So we’ll go through a little bit of the history of OMP because you, in about two seconds, you covered eighteen years roughly of history, and the company changed a lot over those 18 years.

[02:47] Ed Fryar: It changed dramatically over those 18 years.

[02:49] John Anderson: And I want to get into that because particularly, I think you manage the company through some of the more interesting times in grain markets that we’ve probably had in at least the last 50 years. I would say going back to the great grain robbery, which might be a podcast all on its own, but you manage that company through a really interesting time in the markets. And so I want to get into that in a little bit. Before we go there, though, I want to step back just a second. You talked about going to the University of Minnesota, so you were there in the late seventies. Who was your advisor in Minnesota?

[03:22] Ed Fryar: Jim Halk was my advisor. When I applied to several different places, but when I was looking around and trying to decide which place I really wanted to go to, I looked at the journal, American Journal of Ag Economics. I really enjoy price risk and, more importantly, enjoy price analysis. Jim had probably more publications than anybody over about a five or ten-year period in that field. So that was the reason I went to Minnesota.

[03:52] John Anderson: Very strong applied yes economics program at that time at Minnesota.

[03:57] Ed Fryar: Yeah, it was.

[03:58] John Anderson: And they still are, I think the probably less known in ag circles now than they were then, but very top-flight program at that time.

[04:06] Ed Fryar: Yes.

[04:08] John Anderson: So good. Good accomplishment for a farm kid from Arkansas to make it to Minnesota.

[04:12] Ed Fryar: Not bad. Yes.

[04:16] John Anderson: So let’s step a little bit now into OMP. OK? You’re teaching at the University of Arkansas. You’re very entrepreneurial, obviously. And so you begin OMP. And let’s talk about how that company started and specifically, maybe, what you were doing as a company at that time, where did you, how did you find your niche in that poultry space?

[04:43] Ed Fryar: The, OMP was actually the second chicken company that I started, so it might make it a little more sense to go back to the first one. The first company I started with a gentleman that was working at Tyson in their international division, and we started a trading company. It was called Anderson and Fryer Exports, or it’s better known in the industry as A and F Exports. It still exists. We, our first contracts, would buy chicken paws from chicken companies in the United States and export them to China. Chicken paw, if you’re not familiar with it, if you just think of the chicken’s foot, you’re technically you’re not correct, but you’re close enough for all practical purposes. So we were exporting chicken feet to China.

[05:25] John Anderson: Wow. OK.

[05:27] Ed Fryar: That that grew from that into a company when I sold my share of it, we had, I think, three 3 de-boning operations at the time.

[05:39] John Anderson: So let me interrupt just a second because I think a lot of listeners are going to hear, you know, we kind of take exports to China for granted now in the Ah world. You were kind of ahead of the curve in terms of exporting to China. I would say at that time.

[05:53] Ed Fryar: We, did a lot of exporting to China. We did, even more, export to Russia for a few years. And that was not long after the Wall had come down and the old Soviet Union had fallen apart. And I give Maynard Anderson my partner really the credit for that. He’s the one that really pushed that, and it worked very well for us.

[06:13] John Anderson: OK, so the export business is up and going. How does that evolve then into OMP?

[06:19] Ed Fryar: Well, it never evolved into OMP. What happened was from that, we bought a small plant in Fort Smith, a very small facility.  15,000 square feet or something like that, it was not very big at all. And we began deboning thighs down.  We would buy truck load quantities of bone-in, skin-on thighs; debone those; so boneless, skinless thigh filets. And that’s what grew into became known as Twin Rivers Foods. Twin Rivers still exists today. We went from that plant to two other plants, so we grew in terms of our capacity around 2000. It was obvious that I had one vision of where I wanted to see the company go. I had three other partners. They have had a very different vision, so they bought me out and then we filed papers in, I think it was October of 2000 to form Ozark Mountain Poultry, but it was April of 2001 when we actually opened it up. And we opened it up as a dark meat, or thigh deboning operation.

[07:27] John Anderson: Now, by that point, you had left the university.

[07:29] Ed Fryar: Well, I left the university in back when we started Anderson and Fryar exports. Yeah.

[07:35] John Anderson: So. You talk about this, basically, a value-added operation, where you’re taking chicken thighs and deboning them. And again, I think a lot of people now listening to this now they sort of take boneless, skinless thighs for granted.

[07:49] Ed Fryar: Right.

[07:50] John Anderson: Very much on the leading edge of developing that product. I would say at that time, is that right?

[07:55] Ed Fryar: A little bit. Yeah, boneless, skinless thighs, thigh meat, had been around quite a while. It would … most Americans if they consumed it, they usually probably were not aware of the fact that they were consuming dark meat. America is primarily a white meat country, not a dark meat country. But if you go to a local, locally owned Hispanic restaurant or a locally owned Asian restaurant, the chicken items that you’ll find typically will be dark meat items. Anymore, you’ll find some breast items that are there. But if you’re finding anything that’s ground up or that’s breaded and battered when it’s cooked, it’s usually going to be dark meat.

[08:34] John Anderson: OK, so you are providing that market?

[08:36] Ed Fryar: That was mainly in the southwest and on the West Coast? Yes.

[08:39] John Anderson: Now let’s talk a little bit about risk management related to that. I mean, you’re essentially working on a buy/sell margin with that kind of product. What were your risk management challenges, and how did you, how did you address those?

[08:52] Ed Fryar: The risk management challenges then: there’s the old saying that you don’t make money taking risk, you make money knowing what risk to take. So any time you invest in a new piece of equipment or you’re looking at a new technology or maybe a new market that you’re going to move into, there’s risk associated with that and you have to decide whether or not that that risk is actually worth it. So a lot of the tools that you use for, say, hedging and hedge analysis are the same tools that you use to analyze those types of risks. You just don’t have the same hedging tools to use. You don’t have the futures market. There’s not a futures market for a new debone line in chicken.

[09:30] John Anderson: It’s not what we do to lay this risk off. It’s do we take this risk or not take this risk?

[09:35] Ed Fryar: That’s it.

[09:35] John Anderson: OK, that makes perfect sense. So then you get into OMP and tell us a little bit about OMP was sort of a continuation of what you had been doing with your previous company?

[09:49] Ed Fryar: To some extent it was. We open, we started off doing dark meat deboning. Our business plan was that we would buy, again, truckload quantities of thighs, debone them and sell them on the open market. There’s the old saying that I think General Eisenhower is credited with that. No business. No. No military plan. No battle plan — I’ll get it right here in a minute — no battle plan survives first contact with the enemy. Well, a business plan is the same way. You put together this beautiful business plan and two weeks, two months into it that’s out the door. And now you’re trying to figure out what’s really going to happen? How do you really survive? How do you win? How do you compete? And we made the transition in about four or five months from running what I would call our own chicken — where we would buy the product and we would own the product and we would sell it to our customers — to starting to do co-pack work for a couple of the larger poultry companies here in northwest Arkansas. And that transition turned us from being just a standalone independent deboner into being a co-pack contractor with, again, some of the larger chicken companies here.

[11:03] John Anderson: And was that, Ed, was that a risk management strategy, moving into that contract business instead of the margin business? Or was it just a good opportunity or what was kind of the thinking behind that transition?

[11:13] Ed Fryar: It was a combination of a good opportunity and a risk management strategy. When you’re buying meat on the open market, you can’t hedge chicken, you certainly can’t hedge thighs. There’s not an active contract for either one of those. So you’re kind of at the risk of the market with that. If you’re doing contract work or co-pack work, you don’t have to actually buy the product yourself. The company that has contracted with you, send you the chicken. You do what they want you to do to it. Then you either ship it back to them or you ship it to their customers. So it helped us in a couple of ways.  One, it helped us cash flow the company because now we weren’t having to buy the raw product upfront. So that was important for a startup. The second thing that it did was it eliminated a lot of the market risk for us. The risk that we had to deal with then was operational risk. If we put a number on the table, say we will debone this product for you for X cents a pound, we have to be able to hit that number. If we don’t hit that number, we lose money. If we hit that number, we make a little bit of money.

[12:16] John Anderson: So from a management standpoint, you could maybe shift some of your focus to worrying about that market risk to worrying about managing cost.

[12:25] Ed Fryar: Exactly that was it. It was, you shifted the market risk to operational risk and you could focus on that and you could become very focused and very, very good at what you’re doing and get that cost down.

[12:37] John Anderson: Your company became very much a specialist in this in this product line, I would guess.

[12:41] Ed Fryar: That’s right.

[12:42] John Anderson: So let’s move forward a little bit. And Andy, feel free to jump in here any time. I want to, I want to talk a little bit about what I alluded to earlier: this really interesting time in the grain market, starting at about 2007-08 as we’re getting into the financial crisis.  Let’s kind of go back. I’ve got to remember not everybody listening to this may be as old as we are. We’re getting into the financial crisis; there’s a lot of turmoil in markets. A number of factors converged during that time period to give us just a red-hot grain market. We had low global stocks. We had some weather disruptions around the world. We had high energy prices along with some policy interventions, the renewable fuel standard specifically, that were driving a lot of grain into biofuels production. And we had what was to that point, I think in real terms, unprecedented price levels in grain — again, maybe comparable to the early seventies period. But in a generation the toughest period of time to manage costs in the livestock sector that we’ve probably ever had. Again, at least in a generation. Now you were in that industry at that time, maybe not so much on the live production side where you were exposed to that, but you were certainly; you had, you at least had a ringside seat I would say to that. Tell us a little bit about that period of time and what that meant for your company. Good, bad or indifferent?

[14:11] Ed Fryar: We had a front-row seat, and in some ways, it was somewhat indifferent to us. In some ways.  It was, in the ways that it was indifferent is, again, our customers would ship us the product that they wanted us to debone or process. We would do that then which we would ship it out to their customers.

[14:32] John Anderson: Still working on margin at that point.

[14:33] Ed Fryar: We were still a co-packer at that point, so we didn’t have any grain risk directly. The companies that had contracted with us obviously had a lot of grain risk, but we didn’t have any grain risk. Where things began to change for us was around 2011. We knew that our largest customer was going to try and move a lot of the work that we were doing for them back in-house. We had known that for a couple of years. What we did not know was the time, the timeline or the time schedule, so we knew it was coming back in-house. We were looking around for other things to do. We had some ideas. We hadn’t really zeroed in on it yet. And starting in January of 2011, we were 90% co-pack, so 90% of the pounds that we ran were co-pack. By December of 2011, we were down to 10% of our pounds being co-pack. So they took almost, not all, but almost all of it back in-house over a twelve-month period. And that changed us and forced us to change as a company. And the way we dealt with that, we contracted with another vertically integrated chicken company that’s here in Arkansas, and we were buying — they are called wogs, but it’s basically a whole bird, if you think of it that way, you won’t be wrong. We were buying whole birds from them on a, not cost-plus basis but a cost-related basis. We agreed to take the grain risk. So it was whatever feed cost, or whatever grain cost were, and then you would translate that into feed cost. And they locked in some processing and some other cost. Those would adjust from one year to the next as the industry’s cost adjusted. But we ended up taking the real risk for that, and that started in 2011.

[16:25] John Anderson: So you’re in 2011 doing this?

[16:27] Ed Fryar: Yes.

[16:28] John Anderson: We’re rolling into 2012.

[16:29] Ed Fryar: Yes.

[16:30] John Anderson: Now, anybody who remembers that market remembers that 2012 was a serious drought year; probably the worst drought since ‘83,vmaybe the worst since ‘53 in the Midwest. And again coming off that period of time when we’d been through sort of the demand driven pull in those markets. Then we hit this supply side push when we when we had the drought. And 2012 was a ridiculous rollercoaster in the grain markets. So you’re on the cusp of that, and again, not to interrupt you, but just to set up for listeners who may not be as familiar with that history.  Whether you knew it or not at that time, and you can tell us when you became aware of it, you’re staring at a cliff. How did that play out?

[17:13] Ed Fryar: For everybody that’s listening at home, I hope you’ve been able to hear me shaking my head, Yes, to everything John has just been saying. If you go back to.  Well, first of all, in 2011, that transition from being a co-packer to no longer being a co-packer financially was very tough for us. We had a strong balance sheet. If we had not had a strong balance sheet, that probably would have been the end of us as a company.

[17:38] John Anderson: Now, sometime in that period, you got into live production. Is that correct?

[17:41] Ed Fryar: That was 2013.

[17:42] John Anderson: 2013. OK, I’m sorry, I’m getting ahead of myself.

[17:44] Ed Fryar: We were, we were in 2011 and twelve, I would call us semi-live production because of the contract that we had signed. So we had we accepted the grain risk. We didn’t take the other risk, but we did take the grain risk. And that made it fairly attractive to the company that was selling us those whole birds because that meant that they didn’t have to worry about the grain risk on at least that portion of their production. But we made that transition from being a co-packer to running the equivalent of a vertically integrated chicken company. It was a virtual, vertically integrated chicken company. 2011 we lost a lot of money through that conversion, and 2012 we had a business plan that we’d put on the table for the bank. It was a plan that in a normal year, we would have easily hit. It was, first of all, we were making money on the plan for 2012. We had to make money in 2012 after the losses we had sustained in 2011. About May of 2012, we were looking at the markets. And if you go back and look at the WASDE, the world of supply and demand estimates, the carryover that they were projecting for 2012, in May and June was a fairly large carryover. If you looked at all of the fundamentals in the marketplace, everything said, we’re going to have a big crop in the summer of 2012, and everything is going to be perfect for us.

[19:17] John Anderson: So, so let me jump in if you don’t mind.  As I remember that period, if you think of, say, the the January WASDE, the February outlook conference that USDA does, March and April. The message — and I was probably saying this myself when I was doing outlook — the bull market’s over. 2012 ends the bull market. You look at the acreage, you look at how stocks are building: bull market’s over in 2012, and we’re back to a kind of a buyer’s market in the grain market. That’s the message that everybody had, and that’s the expectation everybody had — pretty strongly.

[19:52] Ed Fryar: And everybody was about a year premature.

[19:55] John Anderson: Yeah.

[19:55 ] Ed Fryar: Nobody saw the drought of 2012 hitting. And when it came, it hit and it hit hard. I talk about May and June and the projected carryover that USDA had at the time because even as late as May and June, it looked like the market was going to, the grain market was going to be exactly what you were talking about. We stood back and looked at our business plan and said, you know, if the market goes like that, we’re going to have a better year than what we told the bank. But one thing that we cannot afford is to let grain prices and our feed costs get away from us. So in May, we bought out of the money calls for both soybean meal and corn, enough to cover the fourth quarter of 2012 and the first two quarters of 2013.  When we stacked those later in the year, I think September, October — I forgot the trading months we actually used, but it was later in the year it was around harvest time. And when we bought them, we really thought that, OK, that’s money we’re just going to throw away. But I viewed it as, if you want to have an analogy to car insurance, it was buying a very high deductible car insurance policy for your teenage son that you just want to make sure that you don’t get sued if something goes wrong. And by the time, when the summer hit and it was obvious what was happening with the drought, the markets ran up, they ran up fast. We had already forward priced through the summer months, so that didn’t affect us. Once we got into the fourth quarter, those calls kicked in and the fourth quarter, the first quarter, and the second quarter — fourth quarter of twelve, the first and second quarter of ‘13 — the calls protected us from the marketplace. We made really good money in the last half of 2012 and the first half of 2013 because our feed cost, again with that contract that we had, our feed cost was way below our competitors’ feed cost. So in a way, if we had not been hedging, if we hadn’t bought those out of the money calls, we would have probably, that would have been our last year in business.

[22:16] Andy McKenzie: Ed, can I just say, so after that did you always buy call insurance from that point on?

[22:21] Ed Fryar: Yes. We did. And, but the logic for it was in May of 2012, when we were looking at the market, there was nothing that told us, you need to worry about the upside risk out here. Everything, it’s like John was talking about, everything everybody was saying, you know the high prices are behind us. We’re, we’re in a protracted bear market for grain. So, you know, every year after that, we continued to buy those out of the money calls just as drought protection.

[22:59] Andy McKenzie: And that makes sense. I mean, that’s what true risk management is. You’re not trying to beat the market. You’re trying to protect yourself against unexpected, unforeseen outcomes.

[23:08] Ed Fryar: Yes.

[23:09] Andy McKenzie: And I think that’s exactly what you did.

[23:12] Ed Fryar: And that’s exactly what we were trying to do. And for me, when I think about hedging, if the success or failure of your hedge position depends on the market moving a certain way or moving a certain amount, you’re really not hedging. If you’re truly hedging, then obviously with the out of the money calls, if the market had gone the way we thought it was going to go and had actually dropped, we would have made more money because they were out-of-the-money calls. We had to eat the first, I think it was on corn we had to eat the first $0.50 in the rise in the price. But the price shot up $3 a bushel. So we had to eat that first $0.50, but we were 2.50 a bushel below our competitors, and similar numbers on soybean meal. So it, but again, going back to the notion that if you have to sit here and if the market has to do certain things for your hedge to work, it’s not a hedge.

[24:05] Andy McKenzie: Right? So obviously, you talked about using options. Do you also use futures as well in the grain markets to protect your risk?

[24:13] Ed Fryar: We would use futures when, after harvest. I don’t think we… We may have used futures prior to harvest. And I’m talking about for the chicken operation, not for the elevators or anything, but for the chicken operation. I don’t think we ever used futures prior to harvest. There may have been a time or two when we did, but that that would have been rare. We would typically wait until after harvest. If it’s a normal year, you’re going to see some post-harvest lows set in August, September, October, November. We weren’t trying to call it a low in the market but there’s some, you know, well-established seasonal trends that are out there. So we might we might use futures to lock in, in September, say, a fourth of what we needed for next year, wait until October, lock in another fourth, wait till November. And like that. But we would only use the futures to hedge the portion of our sales where we did not have a forward contract. If we already had a forward contract in place, then we weren’t as worried about that. I mean, we would lock in…When I say we weren’t as worried, we would typically lock in, sometimes a couple of years in advance on forward contracts if we had a price, if we had a price contract for chicken that went out that far. If we could lock in our grain and lock in the price of chicken and see that we had a reasonable margin, then we would go ahead and do that.

[25:51] John Anderson: So you were using basically a portfolio of futures products and forward contracting to manage, to manage risk. Across those, let’s say, those two major instruments, what, what proportion, what percentage of your needs for a given year were you trying to lock in and how much did you leave open?

[26:11] Ed Fryar: We would leave open very, very little. By the time we got. By the time you get to say December of one year, most of your pricing is already in place for the following year — the pricing on the chicken products. So once we had those prices locked down for the following year, we wanted to have our grain locked down also. We weren’t…

[26:36] John Anderson: By extension, you had your gross margin that effectively locked in.

[26:39] Ed Fryar: Yes. And that’s a really good point. Because when we would do our quote unquote hedge analysis — and I call it price risk, everybody else does, and you talked about hedging the price. It really was not the price that we were hedging. What we would be hedging was our profit. We would start with, say, the price where it is today. For, I’ll stick with corn and then go up to what I would think would be a high price and then go up to an Oh-my-god-I-can’t-believe-it’s-this-high type of price – a really, really high price.  Which in 2012 we blew through that oh-my-god price. Then we would go back to where the price is today. We would go down to a low price and then a, oh-it’ll-never-get-that-low price. Unfortunately, it never got to. It blew through the Oh-my-god, but it never got to the it’ll-never-get-to-that-low-price price. That would give us five different price points. We would use those five different price points, then run that through a planning model that we had for the company. See what our profit was, for example, if we wait: if we wait and it goes high, if it goes low; what’s our profit in each one of those situations? Then we would stand back and say, Right, let’s forward — let’s, on paper — forward price 100% today. So that gives you another set of profits that you’re looking at out there. Then we would look at buying say an at-the-money call, and that would turn into a set of five different profits if you buy an at-the-money call. We’d look at an out-of-the-money call. Then maybe look at forward pricing an out-of-the-money put. And then once you get those basic strategies or scenarios laid out, you can start playing What-if games? OK, what if we wait on half of it and what if we forward price on half of it? What if we buy an at-the-money call for half of it and we forward price the other half or do a, wait on a third do an at-the-money call on a third and forward price on a third. So you can start to put together a matrix of potential outcomes. What we would do then, was we would take that matrix and we would go through and say, All right, these, we would have maybe 20 different scenarios; of these 20 different scenarios. If the price goes up to the Oh-my-god level, if it’s that high, which of these outcomes can we not live with? And whatever scenario had an outcome that we couldn’t live with, we would eliminate this.

[29:08] John Anderson: You would take that off the table with your risk management strategy.

[29:11] Ed Fryar: That was gone. That was not something that we were going to do. With the way we looked at it, we got to pick the game we were going to play. And the game would be forward price or wait or at-the-money call or some combinations. So we would get to pick the game that we were going to play. The market was going to pick what the outcome of that game was. So we knew we had no control at all over the outcome. So we would look at the outcomes we couldn’t live with. Then we would go to the next highest price and say, All right, we’ve already ruled some out, of the ones that are left are there any of these that we can’t live with? And we might rule out another one or two? Then we would go down to that lowest price and say, OK, which of these, which of the strategies that were still on the table? Which of these can we not live with? And by the time you finish that, you’re down to two or three strategies that — they’re not the best strategy; I mean, the best strategy is, you know what the market’s … you know, you have next summer’s Wall Street Journal, you know what the market’s going to do. So you go out and do exactly what you should do. It really puts you in a speculative position. But we had strategies that we knew we could live with. We weren’t out to make the most money that we can make in any given year, but we also wanted to rule out losing the most money.

[30:32] John Anderson: Catastrophic loss.

[30:33] Ed Fryar: Yeah, that’s it.

[30:35] Andy McKenzie: So Ed, really, you had your strategy in place, months in advance on the price risk side, really.

[30:41] Ed Fryar: We knew what our strategy was in that April, May, June period. That’s that’s when we would buy or out-of-the money calls. And then as we got to August and September, you have a much better, you know what the weather was. And you’ve got a much better feel for what the yields are going to be. So now, you know if you’re dealing with a big crop or small crop or what it is. So that’s when we would sit down and go through what I just described where we would talk about, all right, let’s look at our profit for next year and these different situations, these different scenarios. We would do that once, twice, maybe three different times as we were moving through the fall, and sometimes our strategies would change from September to October and November. A lot of times they didn’t really change. We were following the same strategy all the way.

[31:28] Andy McKenzie: So you talk about we. Is this, a very select group of individuals in the company that are making these decisions.

[31:33] Ed Fryar: Yes. The individual that was the VP of our grain division, our CFO, a gentleman that would, that ran one of our country elevators, another gentleman that did a, did the grain buying for the feed mills. We would get together. Typically it was the VP of grain and myself, but a lot of times we would call in those other people just to take a look at it and see, does this make sense? What? What mistakes that were made? We know we’ve made them. Just what are they?

[32:11] Andy McKenzie: So, you know, in our first podcast episode, we talked about price risk and basis risk. And really what you were talking about is real price risk here. Is basis risk or was it even a concern for you?

[32:24] Ed Fryar: Basis risk was not a concern until we bought our first country elevator. And once we bought the elevator, then basis risk for the elevator was a huge concern.

[32:34] John Anderson: So Ed, let me interrupt again. Before you go into that, tell us. Let’s put put that in place in time. When did you pick up the first elevator?

[32:43] Ed Fryar: All right, but let me work on the time line a little bit more. The fall of 2013 is when we bought the live operations from Pilgrim’s Pride over in Batesville, so that put us in live production the very first time. We still had that contract that I described to you where we were buying on a cost-related, on a grain-related basis. That ran through, I believe, the end of 2015. Maybe the end of 2010, I think it was the end of 2015, so we had a couple of years where we had our own live production, but we were still bringing in a lot of birds from another chicken company. But our, the hedging problem we faced in both of those situations now was was the same. We face grain risk in both of those. We bought the first elevator. I don’t remember if it was ‘14 or ‘15 and then we bought the second elevator, the next I believe it was ‘15, we bought the second elevator the next year.

[33:40] John Anderson: So just let me recap real quick because I think this is an important point. 2012, you faced the potentially catastrophic grain market that very well could have been, Hey, we’re locking up the doors and sending everybody home.

[33:54] Ed Fryar: If we had not bought those out-of-the-money calls, I wouldn’t be here talking to you right now.

[34:00] John Anderson: So from that to 2013, you were able to pick up live production operations again. I think that underscores the significance of your effective risk management. If you had not had that in place. You’re going home with that in place you not only survive to fight another day, but you’re able to expand in that into different enterprises in fairly short order. And to me, that’s a pretty remarkable outcome of your risk management strategy.

[34:24] Ed Fryar: It changed the company in a very, very fundamental way. I mean, it’s one thing to be a dark meat deboner contract, dark meat deboner. It’s something else to have your own live operations. Now you have a feed mill, a hatchery, you have broiler growers, you have breeder growers or breeders, you have pullet growers. So you have all the the live operations that you had.

[34:47] John Anderson: And that was just to be clear, that was a Pilgrim’s operation and Pilgrim’s had not survived the 2008-09 period. Is that right? I’m trying to remember exactly what their timeline was. So that facility was available because of the catastrophe of 2007, eight, nine, ten.

[35:06] Ed Fryar: It, Pilgrim’s is still running it. It was not one of the facilities that they closed. They closed Clinton, Arkansas, and they closed El Dorado, Arkansas, and then they closed some other facilities around the country. But they had they left Batesville running. But when we when we bought Batesville, they were ready — I think they were on the verge of saying, That’s it; it doesn’t make a lot of sense for us. It was an older plant. It did not have modern equipment and it did not have the modern high speed lines, and they had struggled to find something to do with Batesville that made sense. They had a really good management team. They actually… In any acquisition or any startup, there’s always some surprises, and I’ve told lots of people by far the biggest surprise out of the Batesville acquisition was the quality of the leadership team that was in place. They were excellent, and when we came in, they hit the ground running and never looked back.

[36:08] John Anderson: Fun personal fact the family farm. I grew up on supplied chickens to that plant.

[36:13] Ed Fryar: Oh, really? Okay.

[36:15] John Anderson: It was a Banquet plant. Yeah, my earliest recollection. Yeah, that goes back a ways.

[36:20] Ed Fryar: That does go back a ways. The Banquet building; ConAgra still owned the Banquet building in Batesville in 2012.

[36:27] John Anderson: Okay. Wow, I didn’t know that.

[36:28] Ed Fryar: We bought the complex, so we bought the slaughter plant. We bought the feed mill and we bought the two hatcheries. And so we own kind of a small horseshoe around that massive Conag building, the Banquet building.

[36:41] John Anderson: OK.

[36:41] Ed Fryar: And we bought the Banquet building a few years later and actually shut down the small kill plant that we had and moved all of that into the Banquet building. So it transitioned from being a cook facility for ConAgra to being a live operation for us.

[36:56] John Anderson: OK. I didn’t realize that history. That’s interesting. ConAgra held that a long time.

[37:02] Ed Fryar: So yeah, that that started back in the in the sixties.

[37:06] John Anderson: I think so. Well, I interrupted Andy’s question about basis risk to get that timeline. So pardon that interruption. But, Ed, if you want to pick up back up on Andy’s thread about basis risk in the elevators.

[37:19] Ed Fryar: Yeah, when once we bought the elevators; if you own an elevator, your, the hedging problem that you face is fundamentally different from the hedging problem that you face if you own a chicken company or if you’re a grain farmer. Andy, we’ve talked before about the notion of an open hedge and a closed hedge. With an open hedge, you’re can have an open output hedge, and that’s where you can hedge your output but you cannot hedge your inputs. A corn farmer is a classic example of that. They cannot hedge the price of the land, the price of the tractors, all the other inputs that they have. But they can hedge corn. So they can hedge half of it, but not the other half. If you’re a chicken company, you can hedge corn, you can hedge soybean meal, but you can’t hedge whole legs, boneless/skinless thighs, chicken tenders, necks all the other things that you sell. There’s just not futures contracts for that. So if you’re a chicken company, you have an open input hedge. Your hedge is open; you can only hedge one side of the transaction, and it’s the input side that you can hedge. If you have an elevator, you’re buying something that you can hedge (corn) and you’re selling something that you can hedge, which also is corn. So you have a closed hedge. If you have a closed hedge, price is not the issue if you’re fully hedged. What is the issue is the basis. If if you talk to an elevator operator and say, how much do you have in your corn? And they tell you, we’ve got it in for probably five, 525 a bushel this year. I’d I’d be a little worried about who they were. Now if you ask them, what have you got in your corn and they say, we got it in at 35 under? OK? They’re looking at the world through basis eyes, and that’s the only thing that that’s important with an elevator. I will tell you, though, and you run into these things all the time where you keep relearning the fact that accountants really do rule the world. A closed hedge in the accounting world is called a value hedge. An open hedge in the accounting world is a cash flow hedge. So if you talk to a lot of people around the country, if you talk about a value hedge versus a cash flows hedge, they will know what you’re talking about as opposed to an open or closed hedge. It’s the same situation, just different terminology.

[39:40] Andy McKenzie: Mm-Hmm. So in a sense, in your business, though, you you treated your elevator as a separate entity to the chicken business. Is that right in terms of how you deemed risk management?

[39:53] Ed Fryar: The risk that we faced with the elevator? Yes, we we would basis trade everything that we purchased at the elevator and the. We viewed the elevator as it was a — we had two of them. They were captive elevators for our feed mill. We sold a little bit of grain out of those two elevators to other entities. But it was it was very, very little. And usually we were doing a favor for another company or something like that. It wasn’t, it wasn’t our business model.

[40:28] Andy McKenzie: Right. So I mean, you alluded to the fact that there isn’t a futures contract in chicken or chicken parts. So somebody who’s not familiar with commodities might ask, Well, why not? Do you have an answer for that?

[40:42] Ed Fryar: There was a contract that existed for quite a while for chicken, but I think I’m trying to think back. There was a textbook on the commodity futures trading by an author named Hieronymus. And he listed four or five criteria for a successful futures market. One of those was the product had to be a commodity. U.S. number two yellow corn is U.S. number two yellow corn. It doesn’t matter whether it came from your farm or mine. That is, it is a commodity. Chicken tenders, whether they come from a small bird or a big bird, are not a commodity. If you have wings, chicken wings, I mean, the chicken industry sells lots of different parts and they’re just, they’re not commodities. People will refer to them as commodities, but they’re commodities on a very, very small basis. I can’t imagine there being a small bird chicken tender futures contract. You would have to get down to that type of granularity in order to get something that’s close to a commodity.

[41:50] John Anderson: And the more granularity you have, the less liquidity that you would have in that market.

[41:55] Ed Fryar: That that’s it exactly. And see, that’s another thing where Hieronymus his list falls apart because you have to have a relatively large number of, sort of, customers and producers.  And you have, with chicken, you do not have a large number of producers. We’re down to just a little over 20 commercially viable, vertically integrated chicken companies in the U.S. right now. 20 in the U.S. is not a large number. I don’t know how many thousands of corn farmers that there are. That’s a large number. When you look at the customers for chicken, that’s also a small number. When you look at the role that Kroger or McDonald’s, a Walmart, Costco, several of those those customers play you just, you’re not going to have a chicken market — a futures market for chicken or chicken parts.

[42:51] John Anderson: Well, and I would think back to Hieronymus list, and I vaguely remember that list. Hieronymus is well known in the futures world. I think he would probably be discussing those conditions as necessary, but not sufficient, even if they had, even even if everything were ideal there’s still no guarantee that the contract works. There’s no surefire formula, at least, that I’ve heard, and I think there have been a lot of contracts that have been tried that the fit specs pretty well that still don’t work.

[43:23] Ed Fryar: Yeah. Yeah. And I agree that was a list of necessary conditions, not sufficient.

[43:29] Andy McKenzie: This makes me think of rice, actually, as well. Although we have a rice futures contract in the U.S., if you look to Asia, there’s so many different varieties and types of rice. What would you base the contract actually on? I think that’s one of the reasons why it’s never taken off in Asia.

[43:44] John Anderson: I think also of a few years ago, I’ll say a few. It’s probably been a lot more than a few now. CME launched a stocker cattle contract some years ago. If don’t know f you all remember that, and they maintained it for a couple of years, but it just never generated the volume to work. And I think, you know, by… If you think about the conditions in that market, that would seem to be a product that would have a real chance and it didn’t, it just didn’t pan out.

[44:13] Andy McKenzie: I think the economists that the CME would tell you, they do try to launch different products every year and somewhat, it’s trial by error. They’re guided along the principles that you mentioned, Ed, but they do try a lot of different products, and a lot of them actually do fail.

[44:26] John Anderson: Absolutely.

[44:27] Ed Fryar: But a lot of them do work, I mean, if you look at the financials that are out there, the volume in the financials just dominate anything that we’ve ever seen in the Ag’s. And you go back 30, 40 years ago, the financials didn’t exist at all.

[44:39] John Anderson: It’s a great point.

[44:40] Andy McKenzie: I think I think one of the stories that we’ve got from what we heard from you’ve said so far for my students, the take-home message would be how important price risk management is and being able to understand what call options even are and how you use them in a business context. These are very, very key principles to learn.

[44:59] John Anderson: You know, I think and the other thing I would add, Andy, thinking about what students would pick up from this conversation: the importance of discipline in a risk management program? You know, in my experience with a lot of producers in different markets, it’s easy to put a strategy on once and then, well, it doesn’t work. Or I would have been better off doing nothing. So next time I’m going to do nothing. You know, it’s hard to be disciplined consistently with the strategy. And I think your your experience demonstrates the value of that very well, Ed.

[45:30] Ed Fryar: Discipline across years and disciplined within years. Is, the whole thing of hedge accounting, where you may have a loss on the cash side but you have this tremendous gain on the futures. And so there’s, there could be a real temptation to close out those futures positions, lock in those quote unquote profits. But if the market on the cash side moves against you, then you’re stuck.

[45:58] John Anderson: And I like how you’ve laid this out, Ed. And one thing, maybe a summary statement about this to kind of draw out a couple of points you’ve made: the line between hedging and speculating can get a lot grayer than I think people realize. When, you know when you’re in the moment, that line becomes very blurry sometimes. And and again, that speaks to the discipline, can you maintain the discipline to stay in a hedge position and avoid? I’ve got $0.12 made on this deal, I’m taking it and you’re basically speculating at that point.

[46:33] Ed Fryar: Yeah. Yes. And that discipline, that really, I think, starts at the top of an organization. If, if you have a CEO that tells, in a chicken company, that tells the grain buyer, all I want is for you to stay on top of the market and beat our competition by a nickel a bushel. You’ve put that person into a speculative position. The only way you can beat, consistently, your competition if you’re buying corn is to take speculative positions and guess, and guess right, all the time.

[47:15] John Anderson: And that’s a question of incentives within the company.

[47:18] Ed Fryar: Within the company. And policies within the company, you know, written and unwritten policies.

[47:23] John Anderson: Interesting. Ed, I think I told you we would talk for an hour. I think we could probably go two or three. I know Andy and I could, just picking your brain about this. Andy, any last questions?

[47:35] Andy McKenzie: You know, would you have any thoughts for somebody who wants to get into a risk management type career path? What sort of classes they should be taking at university? What what internships should they be looking for?

[47:49] Ed Fryar: The internships, obviously, would be with companies that that are currently actively involved in risk management. Price risk management, that sort of thing. In terms of the classes. Clearly, as you pointed out a little while ago, you need to take at least a basic futures class and maybe another class beyond that so that if somebody is talking to you about buying an out-of-the-money call or an in-the-money put, you have some idea of what they’re talking about. So you need to understand what the tools of the trade are that you have to work with. And I know when I was on campus, I started and you’ve continued — actually, you’ve improved it a lot from what I hear — the class on applied price risk management.  A course like that can also help a student a great deal.

[48:36] Andy McKenzie: Yeah. Well, thanks for saying that. You know, I think as well, just like you alluded to here, the terminology, the understanding the terminology. Even if you’re not in the company making these decisions, you might be in sales or marketing, but you might have a meeting with somebody in the risk management side just to understand even what they’re talking about is important.

[48:55] Ed Fryar: Yeah.

[48:57] John Anderson: Ed, any last thoughts you’d like to share, I’ll give you the last word. To be respectful of your time, I’ll try to keep you at an hour. Any last parting shots?

[49:08] Ed Fryar: I just go back to that old notion that you don’t make money taking risk, you make money knowing what risk to take. If you’re in business, you’re going to end up taking risks. That’s part of business. So make sure you’re taking a risk that you understand and that you can live with.

[49:24] John Anderson: I appreciate that quote. I’m glad we’ve got that recorded now. Maybe I’ll I’ll listen to that a few times and maybe it’ll stick with me.  Ed, I just want to thank you. Thank you for your support of the Fryar Center. Thank you for your vision for that center and the direction that you continue to give to not only to Andy and I, but the rest of the faculty in Ag Econ and Agribusiness. We’re certainly proud to have you as an alum and a benefactor and a friend and really appreciate you being generous with your time to join us. And I hope you’ll come back and do this again. I think this has been really productive, and we’ve really loved having you.

[49:56] Ed Fryar: Yeah, I’ve enjoyed it. And before we go, I think it’s really important that I point out that Fryar is the name on the center, but it’s Ed and Michelle.

[50:07] John Anderson: Your lovely wife.

[50:08] Ed Fryar: And Michelle is also an alum of the department. And if she had not agreed to this, there would not have been a donation. So.

[50:17] John Anderson: Absolutely. And I appreciate you pointing that out. It is the Ed and Michelle Fryar Center.

[50:21] Ed Fryar: Absolutely, yeah.

[50:23] John Anderson: All right, Ed, thank you. We really appreciate your time.

[50:25] Ed Fryar: Thanks, John. Thanks, Andy.

[50:26] Andy McKenzie: Yeah. Thanks, Ed.

[50:27] John Anderson: Thank you for joining us for this Relevant Risk podcast. We’ll see you next time.

[50:33] Conclusion: Thanks for listening to the relevant risk podcast. A production of the Fryer Price Risk Management Center of Excellence in the Department of Agricultural Economics and Agribusiness within the University of Arkansas system. The Fryer Price Risk Management Center of Excellence carries out teaching activities through the Dale Bumpers College of Agricultural Food and Life Sciences at the University of Arkansas in Fayetteville, and research and extension activities through the University of Arkansas System Division of Agriculture. Visit Fryer, Dash Risk Dash Center, USDA Edu. For more information. Thanks for listening!