Not adding up: Why are cattle futures so optimistic?

Recent reports of winter storms in the Great Plains rallied cattle futures prices to some very impressive levels. Futures-based forecasts of local cash cattle prices yield a rosy picture for 2007, with prices in every month projected to be similar to or higher than last year.
In particular, for the key spring months, futures-based forecasts are substantially higher (e.g., $5 to $10 higher) than last year. In short, my analysis is that these rallies have provided some great opportunities to hedge prices for the first half of 2006.
Particularly, I think that the April and June CME futures contracts are currently trading at levels that are highly optimistic given supply and demand conditions. I continue to think that recent February and August futures prices are also subject to some decline.
On Dec. 29, every maturity of the CME cattle futures market was trading at a price above $88 which, when translated using historical basis, suggests an average price around $90 during the 2007 calendar year.
Bullish prices. This is particularly impressive compared to the $85 average price in these markets during 2006. Why are 2007 futures prices so bullish compared to 2006? Let’s look at the possible causes for such optimism.
How about supply? Well, in December (well after the run up in corn prices was apparent), USDA projected 2007 beef production to be 2.5 percent higher than last year, with the specter of nearly 5 percent higher production during the first quarter alone.
Furthermore, pork production is also projected to increase by almost 4 percent. Granted, poultry production will only go up 1 percent, but it is still an increase.
What about those winter storms that rallied the markets in late December? These could cause some short-run reduction in supply due to death loss and weight loss.
However, even the most dire circumstances would only trim beef production by a couple percentage points, which still leaves at least a 3 percent increase in first quarter production and is unlikely to affect things for the rest of the year.
Corn prices. High corn prices will also discourage heavier cattle weights, though back in 1996 when corn prices soared to over $4, average cattle weights dropped only 15 pounds. Furthermore, cattle are better able than hogs and poultry to soak up the increasing flood of distiller’s grain being produced by the ethanol industry.
What about domestic demand? Well, retail demand was quite weak in 2006, with data from the first 3 quarters each revealing a fundamental downward shift of around 5 percent in retail demand for beef. This doesn’t necessarily translate to weaker demand for cattle, however. Indeed, for the first 3 quarters of 2006, the demand for live cattle was stronger than the previous year.
However, this slowed during the final months of the year with initial estimates suggesting that December 2006 cattle demand will be weaker than the previous year’s. Indeed, it is difficult for packers to bid aggressively for cattle when the beef they produce faces weak demand at the retail level, and it appears that this finally caught up with packers towards the end of the 2006.
Foreign markets. What about foreign demand? For the first 10 months of 2006, we shipped 78 percent more beef to foreign consumers. Virtually all of that increase was not from Japan or Korea, but rather from Mexico and Canada. One would expect, at most, modest gains in trade during 2007 from our two neighbors.
Japan is increasing demand at a painfully slow pace, while South Korea is thinking of reinstating the trade ban despite facing some of the highest prices for beef in the world.
In short, foreign demand may provide a modest boost in 2007, but cannot be the basis for the strong short-term prices we are observing on the CME.
So, given that the supply situation is bearish in general, that domestic demand is neutral at best and leaning toward bearish, and that trade is modestly bullish, why are the CME prices for cattle futures so high?
Comparison. I’m not sure, but let’s put the strength of these recent prices in context. Take April for example. The CME futures price traded above $93 Dec. 29. The Nebraska cash price in early April is historically about $1.60 above the futures price, though last year it was about even with the futures price.
That puts the cash price forecasts for April cattle in Nebraska between $93 to $94.60, depending on basis.
USDA projects that second quarter supplies will be 1.5 percent higher in 2007 than in 2006. Let’s suppose that, for whatever reason, supplies in April are not that heavy and, instead, are merely equal to last year. Last year’s average April price in Nebraska was only $81 – more than $10 below current projected cash prices.
In other words, even if current supply projections are overstated, the futures market is suggesting that cash prices will be 15 percent higher than last year. Well, what about the year before – perhaps last year was just a bad year for demand.
In 2005, prices did average $92 in Nebraska, but the supply of beef was 4.4 percent lower in April 2005 than in April 2006. The $81 for all the beef produced in 2006 actually reflected stronger cattle demand than did the $92 price in 2005.
In fact, the cattle demand observed last year was stronger than any other year since the Atkins-influenced demand of 2003.
In short, if April 2007 demand is exactly as strong as last year and supplies equal last year, it would imply that futures prices should be trading in the lower-$80s, not the lower $90s.
Justification. In order to justify futures prices around $93, we would have to be expecting demand tobe slightly stronger than the Atkins-era demand of 2003 or a massive beef shortage (i.e., 7 percent decline). A story with similar optimism can be told for the June futures price. Here the potential also exists for as much as an $8 decline unless demand exceeds last year’s very strong performance.
February and August futures prices are also optimistic when compared with the demand observed over the past three years, though in each case the degree of optimism in the futures market price is smaller. Neither of the distant contracts (October and December 2007) is trading at levels out of kilter with current supply projections and recent demand strength.
All this points to an opportunity to lock in prices for spring and perhaps summer fed cattle deliveries.
Insurance policies. For example, a producer could lock in a late April fed cattle delivery using a Livestock Risk Protection policy from USDA, which is sold by local agricultural insurance agents.
On Dec. 28 one could lock in $87.53/cwt. floor price for just under $2 per cwt., which effectively creates a price floor of $85.53 for April cattle.
Like any insurance product, the premium is paid up front and means that if cattle really do sell for $93 in April, you will effectively only receive $91 because the $2 premium has been paid.
However, if prices revert to last year and fall to $81, you will receive the $85.53 price as the insurance policy will pay out the difference between the cash price and the $87.53 price listed in the policy.
While these premium prices change with each day’s market, it provides a nice tool to guard against downside price risk without having to venture into the futures or options markets, plus the policy is written for exactly the number of animals you are marketing.
(Brian Roe is associate professor AED economics at the Ohio State University.)