Crushing the ag markets

November 3, 2015 09:00 AM

Agriculture futures, options and exchange-traded funds (ETFs) present trading possibilities in a number of ways, including spreads between ETFs and related futures contracts and crush spreads created from futures contracts on livestock and grains.

“COW and COMBO” (below) shows the cumulative percentage price movements for the exchange-traded note (ETN) known as COW (the iPath Bloomberg Livestock Subindex Total Return ETN) and an artificial asset called COMBO. The value of COMBO is the approximate combination of market prices included in COW, about 61% live cattle near-term futures and 39% lean hog futures. A trade in the COW vs. COMBO spread would involve long or short futures in live cattle and lean hogs at the 61-39% ratio, which would be offset by a position in COW. 

The COW vs. COMBO spread is termed a “shadow trade” because COMBO is a virtual image of COW, and COW is expected to ultimately follow the price movements in COMBO. Nevertheless, reality does not always do what it should, and deviations are common. Price changes for the two series from March 1, 2015, through the first week of August show several opportunities for spread trading as the prices separate temporarily then come back together. 

There are several other iPath Bloomberg Subindex ETNs with prices that are based on combinations of energy futures, industrial metals, precious metals and grains. Their index formulas are more complicated than the two-way basis for COW, but we can imagine a trader experimenting with trades built with these different combinations in an attempt to match the ETN price movements. This is the financial equivalent of working in your own kitchen to develop a recipe that copies the taste of Kentucky Fried Chicken or Coca Cola. 

One major benefit of most ETNs and ETFs is their pricing of shares in a reasonably low dollar range for ease in trading. Obviously, matching ETN share prices against the price movements of related futures contracts included in the COMBO vs. COW spread would be somewhat demanding.

For this reason, another approach using the two-price series would be to forecast COW price changes based on movements in COMBO. The success of this method would depend on COW following the futures prices included in COMBO. As we see in the chart, this plays out several times with the COW vs. COMBO spread, as the ETN share price rises following an increasing COMBO price, or falls faster after COMBO establishes a declining price trend.

Getting crushed

A crush—buying or selling soybeans versus their products, meal and oil—is a type of spread that allows a trader whose business is not agricultural to engage in selling the commodities on paper and possibly profit from futures price movements. Livestock spread trades include their own crush spreads on cattle and hogs. 

Although the prices and cash flows of the paper trade do not include all of the real costs of raising and selling livestock, they do contain the largest elements of cost and income, thereby giving a reasonably accurate idea of actual profit or loss of the business over time. 

Feeder cattle are the basic—and currently the largest—proportion of the cost of producing steers ready for the “live cattle” market. Calves raised by the original cow-calf farmer or rancher are sold as feeder cattle when they approach a weight of 750 pounds. Before feeders are sold as live cattle, they will add another 500 pounds. To accomplish this weight gain, corn is the next big cost to consider. The three variables: Feeder cattle, corn and live cattle, represent two negative cash flows and one positive cash flow that constitute the cattle crush.

“Crushing cattle” (below) shows the prospective profit and loss from one spread trade from 
March 2 through Aug. 6, 2015, based on futures contracts expiring in December 2015. On April 20, the crush includes six live cattle contracts sold for $1.4755 per pound for 40,000 pounds per contract (or $354,120). Costs include three feeder cattle contracts at $2.06475 per pound for 50,000 pounds for each contract (or $309,712.50) and two December corn futures at $3.92 per bushel for 5,000 bushels for each contract (or $39,200). The resulting profit shown by December futures on April 20 is $5,207.50.

During the five-month period, feeder cattle are not only the major expense, but they are more variable than the selling price of live cattle. “Cattle crush without feeders” (below) shows the relatively smooth increase in profit through the middle of June followed by a decline to the end of July. There are two periods of higher feeder cattle costs that cause losses on live cattle sales: March and April.

This is not to say that the cattle business can get by without feeder cattle, but the charts show that during this period the variations in the cost of feeders determined the changes in profit or loss.

Spread variations

Cattle feeding spreads can be arranged differently in an attempt to control the variations in prices of cattle and feed. The 6-3-2 spread (shown in “Crushing cattle”) increases the number of live cattle vs. feeder cattle to dampen the effect of higher feeder cattle prices.

At times a trader may find that higher corn prices need to be offset by using a different spread model. A cattle crush spread used previously was 2-1-1 (see, “A crush on cattle, hogs and beans,” June 2009). Although the 2-1-1 spread was profitable in March 2009, it would have produced negative results in 2015. Cattle spreads consider the number of animals per futures contract (32 live cattle or 66 feeder cattle based on the average weight of each animal in 40,000 lb. and 50,000 lb. contracts respectively, and approximately 3,300 bushels of corn to increase the weight of one contract of feeder cattle to the final weight for sale).

A hog feeding spread may be created by selling lean hog futures and buying futures on corn and soymeal. “Hogging the profits” (below) shows the profit resulting from seven December 2015 lean hog futures minus three September corn futures and one September soymeal contract. The differences in expirations approximate the time needed to increase the weight of young pigs to the sale weight of lean hogs.

The input cost of young pigs is not a part of the hog feeding spread shown in “Hogging the profits“; this chart is similar to “Crushing cattle.” The lower weight for hogs vs. cattle is reflected in the total profit difference, but the timing of highs and lows in the two charts are closely related because of the hedging of costs and the similarity of market price movements for the finished products. 

For the 7-3-1 hog feeding spread on April 20, 2015, seven 40,000 pound December lean hog futures contracts are sold at 6.7475 per pound for $188,930, three 5,000 bushel September corn futures are bought at $3.92 for $58,800 and one 100-ton September soymeal contract at $314.7 is bought for $31,470. The projected profit from the hog feeding spread on April 20 is $98.660.

A picture of the options market forecast price variations for live cattle, feeder cattle, lean hogs, corn and soymeal is shown on “Likeable options” (beloq). Several significant differences exist between the results on this chart and the experience of cattle and hog feeding spreads from March through July 2015. 

Volatility play

“Cattle crush without feeders” and “Crushing cattle” indicate that most of the volatility in the cattle crush is caused by feeder cattle price volatility. Twice during the five-month period, the spread showed losses because of surges in the feeder cattle price. This feeder cattle volatility is at odds with what is indicated by calls on feeder cattle in “Likeable options.” 

The options data show calls on feeder futures at the bottom of the chart measured by the options price-to-strike price curve. The options market is looking forward to price variations through year-end and not expecting much volatility, while feeder price changes through the past five months have caused occasional losses for the cattle feeding operation.

Lean hog calls have the highest options price curve, with volatility measured to 7.55% vs. 2.89% for feeder cattle. This is another anomaly. “Hogging the profits” shows a relatively smooth trail of price differences led by seven hog futures contracts. The differences in the two charts are again because of the options market forecast of a wide spread in hog futures prices through December 2015, while the past five months of the hog feeding spread show little effect from volatility.

A trader might ponder the differences described above between the options forecast of price variations and the experience of price spreads during the past five months. Will lean hog futures really be that volatile, and will feeder cattle futures remain that flat? This may be a good reason to continue studying both sides of the market—past price experience and forecasts of future price spreads.

About the Author

Paul Cretien is an investment analyst and financial case writer. His e-mail is