From the June 01, 2009 issue of Futures Magazine • Subscribe!

A crush on cattle, hogs and beans

The costs and potential profits from feeding livestock and processing soybeans can be approximated on paper by using price data on cattle, hog and soybean futures. Implied profits and losses on various spreads change with the viewpoint of the hedger or speculator, and whether the component futures contracts are held in long or short positions.

The cattle sequence begins with the feeder cattle that originate at the cow-calf level. Feeder cattle are grown primarily on grass and wheat pastures, and their costs are indirectly affected by the price of grain. Feeder cattle are sold to feedlots and are then fattened for sale as live cattle. In this final stage of production, grain prices (represented here by the cost of corn) contribute greatly to the total expense of raising cattle for sale.

Crush trades on cattle and hogs are based on the time required to feed an animal on grain, the total weight of cattle or hogs included in a futures contract, and the amount of feed necessary to produce the finished steer or hog. The table above shows the factors used to calculate results of intermarket spread trades involving cattle, hogs and corn.

Corn and feeder cattle are underlying costs for the operator of a feedlot, starting at the beginning point of the calculation of cost and profit for the crush spreads. After they are delivered to feedlots, it requires approximately five months to complete the feeding of steers (live cattle) and four months for a hog.

End-of-day prices for several delivery dates for feeder cattle, corn, live cattle and lean hogs from March 2 through April 9, 2009, provide the basis for several crush trade examples.

GET CRUSHED

As shown on “Cattle on call” on March 6, 2009, a crush spread using two October live cattle futures minus one July corn future and one May feeder cattle future had an implied profit of $4,125. The live cattle total price of 86¢ per pound on 80,000 pounds, or $68,800, was achieved at the combined cost of May feeder cattle futures at 92.25¢ per pound on 50,000 pounds, or $46,125 and July corn, 5,000 bushels at $3.71 per bushel, or $18,550.

The resulting profit on March 6 was the peak differential during the March 2 to April 9 period. Following that high point was a general decline. The cause of this decrease in spread profit is not difficult to locate. While live cattle and feeder cattle futures prices were relatively stable, July corn futures prices escalated from $3.71 on March 6 to $4.385 on April 9. The first chart in “Spread indexes” shows the futures prices as ratios to their 27-day averages. Live cattle and feeder cattle index numbers are never far above or below 1.00, while the index numbers for corn futures range from 0.92 to 1.08.

Because corn is moving while cattle prices are standing almost motionless, swings in the spread profits are inversely related to movements in the price of corn. Long and short positions shown in the cattle crush example are the reverse of those that may be used by the feedlot operator who takes long positions in feeder cattle and corn while selling live cattle short.

An 8-4-3 crush spread (eight October live cattle contracts, four May feeder contracts and three July corn contracts) improves the balance between live cattle futures and the corn and feeder cattle costs, but approximates the results of the 2-1-1 combination in “Cattle on call.” The modified spread shows that the more complex cattle crush spread continues to reflect a strong influence from the price of corn.

The lean hog crush, shown on “Bring on the bacon” and as one of the series in “Spread indexes,” has approximately the same profit pattern as spreads involving live cattle, feeder cattle and corn. On March 6, 2009, the October lean hog futures contract was valued at 68.075¢ per lb. The dollar value of two October lean hog futures, 2 x $0.68075 x 40,000 lbs, equals $54,460. Subtracting the cost of corn as shown by March 6 July futures, $18,550, produces an implied profit of $35,910.

With results similar to those shown above, one soybean meal contract could be added to the combined cost of grain, with soybean meal priced in cents per bushel for 5,000 bushels.

A soybean crush balances the cost of soybeans with the soybean products, oil and meal. For example, on April 9, 2009, soybean futures were $10.02 per bushel, soybean meal was $306.40 per ton, and soybean oil was $0.3571 per pound. The implied profit for the crush spread was $306.4 x 100 tons of meal + $0.3571 x 60,000 pounds of oil - $10.02 x 5,000 bushels of soybeans. Thus, the total value of meal and oil, $52,066, had a cost in beans of $50,100, for a spread difference of $1,966.

The soybean crush on April 9 may be compared with the spread on March 4, 2009, when soybeans were $8.676, soybean meal was $2.643, and soybean oil was $3.131. The dollar values of $43,380, $26,430, and $18,786, respectively, resulted in a spread of $1,836 on March 4. Without considering other costs and factors affecting crush profits, an increasing spread between soybeans, soybean meal and soybean oil should lead to expanded processing of soybeans, with soybean crushers offsetting risk of price declines by taking short futures positions in soybean meal and soybean oil.

VOLATILITY’S ROLE

The differences between implied profits at two dates for cattle, hogs and soybeans indicates significantly greater volatility for the cattle and hog crushes vs. the soybean crush. One reason for the difference is that the components in the soybean crush are all created from a single product, while the cattle and hog crushes depend on the major external cost of feed grain.

Analyses of call options for components of cattle and soybean crushes on April 9, 2009, are shown on “Cattle crush options” and “Soybean crush options” (right). Calls on July futures are shown for corn, soybean, soybean meal and soybean oil. Because live cattle futures do not have a July expiration, August is used as a near-term substitute. On both charts, data are standardized by dividing call premiums and futures prices by their related strike prices. This method permits the price curves to be compared to see both the relative heights of the curves, which indicate the market’s expectation for price change and volatility, and the space between price curves, which measures the differences in speeds at which time value is decaying for the call options.

The primary difference between the cattle crush and soybean crush option charts is the relative heights of the costs — corn and soybeans — compared with their respective products, cattle and soybean meal and oil. Measured as the height of the option price curve where the futures price equals the strike price, July corn futures on April 9 were 7.63% while the August live cattle option price curve had a height of 3.92%. The difference in this measure of futures price volatilities seems larger because of the times to expiration, which were 129 days for live cattle August options and 78 days for July corn.

On “Soybean crush options,” the price curves are closely related, which is not surprising because they all represent products from the same underlying commodity. The highest price curve, calls on July soybean futures, has a time premium value of 7.20%, slightly lower than the height of the July corn futures price curve but with the same 78-day time to expiration.

The soybean products have similar option price curves, although at declining heights — 6.24% for July soybean meal calls, and 5.11% for soybean oil. Soybean group options all expire in 78 days from April 9. With continuous trading by soybean crushers, growers and speculators, it is easy to see why the curves are kept in close contact.

For traders on both sides of the market, hedgers and speculators, it is helpful to have an option market assessment of price changes and volatilities. For example, will July corn call options pass by August cattle on their way to equal intrinsic value or zero, or (as implied by the cattle crush option chart) will August cattle be pushed to zero first by increases in the cost of corn?

Paul Cretien is an investment analyst and financial case writer. His e-mail is PaulDCretien@aol.com.

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