We previously covered general grain fundamentals to monitor during the summer, key reports to follow and the 2013 picture (“Quick and easy guide to summer grain trading,” June 2013). Here, we tackle the less-understood, but opportunity-rich, livestock markets, namely cattle and hogs. We’ll provide a breakdown of the complex and offer a general taste of fundamental analysis. A framework for finding true value in pricing will be given.
The value picture is drawn mostly by livestock balance sheets similar to those prevalent in the grain complex. However, instead of trying to estimate the amount left over, called ending stocks, the meat industry is priced off the amount left for the U.S. consumer in a given period. It is that measure, the supply left in the United States, that is the basis for price determination.
The implications of this discussion should be clear. Production decisions are made months in advance, without a perfect knowledge of demand for that period, and the market must find the right price to make that supply move through the system. This gives many opportunities for both sharp rallies and declines.
In “Balance sheet” (below), we see an example of the pork balance sheet for the coming fourth quarter. Separate numbers are used for cattle. We are not comparing these numbers against the first, second or third quarters because demand changes from season to season. Only a comparison against other fourth quarters is made.
In the meat world, analysts monitor pricing for the live animal, wholesale processed meat and retail levels using slightly different tools. The table shown here works well for finding true value at the live animal level for the general trader. Background tables of these per capita disappearance numbers can be found on the website for the U.S. Department of Agriculture (www.ers.usda.gov/data-products/livestock-meat-domestic-data.aspx#.UdcvwZys_Qh).
Traders also can get a feel for the USDA’s own viewpoint on future production and trade figures in the back tables of the monthly Livestock, Dairy & Poultry Report (available at www.ers.usda.gov/publications/ldpm-livestock,-dairy,-and-poultry-outlook/ldpm228.aspx#.UdrshZys_Qh).
For cash-settled lean hogs, you need to estimate the lean hog index on the expiration dates for futures. You either can compute where those dates typically fit into the quarterly average or move to a monthly format. Focusing on the current 2013 December contract, last year’s December 2012 price for the lean hog index was $82.59. Research suggests that we will see a slightly higher supply offered to the U.S. consumer this year. Excluding estimates of U.S. consumer financial health and competing meats, this would imply a slightly lower price for the 2013 contract.
Exports have a role
After supply estimates, the next real issue on the balance sheet is the trade picture. The economic health, food needs, currency values and trade relations with other countries all play a part. There are tremendous hopes for the long-term meat demand picture for the world (see “Purchasing power,” below).
As incomes improve, diets improve. Usage of vegetable oils, dairy products and eventually meats increases. The relative purchasing power of the two most populous nations has doubled over the past 10 years. Gains in many developing countries also have been impressive. At the start of this 10-year period, Japan, Canada and Mexico took 77% of our pork exports and 87% of our beef exports. Due to new markets for our product, those same figures are 52% and 58%, respectively.
This year has seen a number of export-related developments. Russia and China have discussed problems with our use of a popular animal feed additive in hogs and cattle. Canada and Mexico have raised concerns with a U.S. meat labeling law. They may eventually retaliate against our meat exports. A good example of the importance of these numbers was the recent announcement of the intended purchase of the largest U.S. pork processor by a Chinese firm.
Throughout the summer, we heard wildly inflated estimates of U.S. pork export growth from traders not familiar with actual numbers. Last year, China accounted for only 14% of our total exports. Before we even discuss increases over last year, we first have to fix our current sales problem. Exports to China in May (the latest data available at this time) were 14% lower than last year. While we don’t fight the initial move made from irrational hopes or fears, a fact-based approach to fundamental analysis can signal clear mispricing opportunities.
U.S. demand conundrum
Most discussions in the meat complex revolve around supply. There is a great deal of quality information for supply through daily, weekly and monthly slaughter reports. Future production levels can be computed from the various government surveys of producers.
The industry calls the last line of the balance sheet we have shown either per-capita disappearance or per-capita consumption. That is incorrect terminology. A much better term would be product supplied. Essentially, we put the meat on their plate whether they asked for it or not. Their method of telling us acceptance is through price.
In the example above, let’s say we project a 16.46 lbs. per-capita consumption (product supplied). Depending on consumer demand for it, that could trigger a price from $62 to $102. Though the majority of price changes in livestock come from supply, we cannot forget about the year-to-year changes in consumer demand. Consumer income/employment and the economy/asset appreciation are all factors to consider. For 2013, specifically, consumer spending on meats is up slightly over last year.
Lean hog futures
The CME Group lean hog futures contract, symbol HE, calls for 40,000 lbs. of hogs on a lean (carcass) basis. Today, a 270 lb. live hog produces a 203 lb. carcass. Pricing is quoted on a dollar-per-hundred-weight (cwt.) basis. Therefore, a quote on the screen of 85000 is called $85 per cwt. The minimum tick size is 2.5 cents per cwt. A minimum tick move from 85000 to 85025 would represent a change in value of $10 per contract. (Take note that some quote systems do not quote the last digit.) The contract is cash-settled against a two-day weighted average of the cash market called the Lean Hog Index, symbol IHX. Contract expiration is generally around the 12th of each contract month.
Supply projections are pretty straightforward for lean hogs. It takes just six months from birth (farrowing) to slaughter. When you add in a 114-day pregnancy period, you have a relatively modest 10-month delay from a decision to expand or contract to when those numbers hit the packing plant and affect prices.
The main long-term supply picture comes from the USDA’s quarterly survey of producers called the Hogs & Pigs Report (which can be downloaded at http://usda.mannlib.cornell.edu/MannUsda/viewDocumentInfo.do?documentID=1086). The general trader can get a quick idea of supply for the next six months out by looking at the weight breakdowns in the “kept for marketing” numbers. With slightly more effort, the farrowing intention numbers can help provide a map of supply for the next full year out. For 2013, with sharply lower grain prices, the question in the industry is not if producers will expand, but when and by how much.
The CME Group live cattle futures contract, symbol LE, also is traded in a 40,000 lb. allotment. Though packers buy on a carcass- and live-animal basis, this contract is based off the live animal pricing. It also is different from hogs in that it can be physically delivered. Keep that in mind as first notice day approaches. Pricing is quoted as dollars per cwt. A price of 127000 on your screen is therefore $127 per cwt.
Supply projections are a little different for cattle because there is a two-stage production process. The base producer in the industry carries a herd of mothers (cows) and sells the offspring in the form of 400-500 lb. calves or later as 600-900 lb. feeder cattle. Those offspring are fed out in feedlots from three to eight months, depending on various factors, until they are 1,100 to 1,400 lbs. Profitability in the feedlot phase is dependent on the purchase price of feeder cattle, feed costs and selling price of live cattle.
Important for us for the long term is that the base producer has a separate concern as well: Quality pastures. With drought a lingering concern in the Plains, the breeding herd has been in liquidation for eight years. As there is a three-year lag between a decision to expand and when that expansion hits the packing plant, the long-term supply picture is clear here.
The report that the industry gauges to determine monthly supply is the USDA’s Cattle on Feed Report. It can be accessed at http://usda.mannlib.cornell.edu/MannUsda/viewDocumentInfo.do?documentID=1020. A supply picture for the coming months can be made by following the number of new calves and feeders starting their feeding period, called “placements.” We can gauge whether feedlots are actively selling market-ready animals on time by monitoring the marketing numbers.
Though there is no longer an active U.S. futures contract for chicken, this is the industry powerhouse. Although most traders will not need to have a full working knowledge of chicken fundamentals, it is important to know the general trends of both production and prices and how they can affect cattle and hogs. The story into 2014 is increased production because of lower feed costs (see “Meat breakdown,” below). This will help temper some of the shortfall in beef production expected next year.
Almost as popular as outright trades in individual contracts are spreads. Spread trades involve two opposing positions in related contracts or different months of the same contract.
Popular spreads play off seasonal supply changes. For hogs, we are heading into the period with heavy supplies, so many traders sell the winter contracts and buy the spring. Cattle traders often buy the period with tight supplies, such as December and February, and sell the June against it. Another trade to consider, as cattle and hogs are entering opposite supply periods into winter, is simply to buy the cattle and sell the hogs.
Rich Nelson is the chief strategist for Allendale Inc. He has more than 15 years of experience as an analyst and broker covering agricultural futures. His daily analysis can be accessed at www.allendale-inc.com.