Just don’t get killed in the stampede

Livestock futures were originally developed by the Chicago Mercantile Exchange in the late 1960’s and indeed the exchange is often referred to as the ‘exchange that pork bellies built’. Like soft commodities, live cattle was a cornerstone of the early markets, allowing farmers to fix the sale price of their stock several months in advance of bringing the cattle to market. Indeed livestock futures were initially considered to be a novelty when first introduced, since virtually every other commodity traded on the exchange can be stored with no degradation, and at no extra cost to the buyer.

Livestock are very different. First, if not well cared for they will degrade, and ultimately die, and secondly, they require feeding, an ongoing cost, and once at the market weight, then further feeding may make the cattle uneconomical. As a result, the dynamics and fundamentals which affect the price of livestock futures are very different from those influencing other commodities. So when looking at the market prices for these contracts, we have to use a different approach in order to analyse the market.

The most popular livestock futures contracts at the CME (the largest exchange) include live cattle, lean hogs and feeder cattle. So let’s start with live cattle and the supply and demand relationship which drives prices.

Live cattle

As already outlined above, the live cattle future is very different from that of a soft or hard commodity in terms of the supply and demand relationship, purely because the product is a living animal, which requires feeding and watering, and which cannot simply be stored away or stockpiled. There are no live cattle silos, as for wheat or grain. In addition, live cattle require constant attention, and therefore are costly to keep. Finally of course, live cattle are not subject to the weather like a crop, nor are they generally destroyed by natural disasters. So in the case of live cattle we use something called the cattle pipeline, which tries to forecast and predict the supply chain from live cattle through to the slaughterhouse and then into the retail market.

All of this normally starts in the US, with the US Department of Agriculture ( USDA) , which monitors the numbers of cattle on feed, both monthly and quarterly, generally referred to as ‘feedlots’. The feedlots are where cattle are placed on feed, before finally being moved on in the supply chain to slaughter.

In addition to monitoring the live cattle on feed, the USDA also report on the numbers of cattle being slaughtered. So by cross referencing the cattle on feed with the numbers of cattle being slaughtered, the live cattle trader begins to build a picture of the current supply chain. In addition to considering the above reports, the USDA also issue an average weights report which is another useful tool to check whether the flow of cattle from feed to slaughter is on target.

It is also possible to cross check beef production by simply multiplying the number of heads of cattle by the average weight, and then to compare these with the red meat and total meat supplies to give a clue as to future pricing moves for the futures contract

On the other side of the equation we have demand, and here we see the influences of everything from consumer tastes, political pressure, the prices of alternative meats and meat products, and even any health scares which may result in changes in longer term trends, away from red meat to white meat or fish.

The primary driver for demand is disposable incomes, and in this case the broader economy becomes a key measure, along with the growth in emerging economies around the world, where red meat has become the food which defines social status.

The live cattle market price is derived from the price of beef, and therefore changes in either the wholesale price of beef or sales by the meat packers may cause cattle prices to fluctuate in parallel. This is reported by the USDA in another release which analyses the true value of packed beef cuts and gives yet another view on the market price of live cattle, and the future potential price direction.

In addition to the above factors, there is one other which has a direct impact on the costs associated with live cattle, and that’s cattle feed. Typically what we see here is a relationship between the price of feed grains and the price for live cattle. After all, if the feed grains are rising in price generally, then this will filter through to higher costs for the farmer in feeding his cattle, and ultimately higher prices for live cattle as a result. So this relationship is always one to watch when trading in any live markets where the cost of feed is an issue.

Live cattle futures contracts

The CME live cattle futures contract has an underlying value of 40,000 pounds of cattle, and the contract is specified for delivery in February, April, June, August, October and December. The minimum price move per contract is $0.00025 per pound. In other words, 40,000 x 0.00025, or $10 per contract.

As an example the live cattle quote often appears as a number like 84.60. This simply means that the the price of live cattle is being quoted at $0.84600 per pound.

Lean hogs

Lean hogs are of course pork and the terminology here simply means that a pig is a young animal, whilst a hog is an older animal – an old pig!  The primary regions for rearing pigs and hogs in the US is in Minnesota, Iowa and North Carolina. As with live cattle there are several stages in the supply process from the farm to the table which include farrowing, growing and finishing and finally slaughter, before packing and distribution to the retail market. Once again it is the USDA which provides the central source of information, statics and analysis for the futures trader in lean hogs, and the supply pipeline is a key component. This starts with the farrowing report, which details the number of pigs produced over the time of the report. It is  followed by detailed statistics on the numbers of hogs and pigs in the system, in particular those retained for breeding, and those intended for the market. They are  further classified by weight, thereby giving a clear indication of the overall supply pipeline.

Less Volatility

Whilst there are many similarities between live cattle and lean hogs, one major difference is in the supply chain after slaughter. Live cattle generally move quickly through packing and dispatch into the retail market. Lean hogs on the other hand do not, and a significant percentage is frozen and not sold fresh, which results in a buffer being created in the supply chain. So the stock of frozen products makes up for any temporary shortfall in supple and smooths out any volatile price action, which would normally have occurred in other markets when there is a fall in supply. This is one of the reasons that lean hogs tend to be less volatile than other commodity markets.

The USDA provides the Cold Storage report, allowing futures traders to cross check these numbers and draw any conclusions as a result.

In terms of demand, the same factors apply, and these include disposable income, the price of other white and red meats, consumer tastes, health scares, and trends in consumer consumption.

Lean hogs futures contract

Unlike the live cattle contracts, the CME lean hogs contract is cash settled, so there is no chance of taking delivery of the physical products. It is based on the CME lean hog index. This index is constructed using data sampled over a two day period which ends on the last trading day of the futures contract. The dats is taken from the USDA daily report for the price of hog carcasses. The futures contract is based on an underlying of 40,000 pounds, just like cattle, and settles in February, April, May, June, July, August, October and December, and is quoted in exactly the same increments as for live cattle, so a $10 per contract minimum price movement.

Who trades livestock?

It is certainly true to say that trading in the livestock markets is a little more specialized that in either softs, metals or energy which tend to attract the headlines in the mainstream news, and generally relegating livestock prices off the front page. Nevertheless, livestock constitute a key component both of everyday life as well as contributing to the longer terms effects of price increases and inflation. However, that said, this is a market, just like any other, and provided you understand the futures contract you are trading, and also have Hawkeye on hand, then there is money to be made, just like any other.

Why trade livestock?

Rather like the soft commodities, livestock is a fascinating market, and one with plenty of potential for the adventurous commodity trader. So here are some tips if you are keen to move into trading livestock futures or options. First, cattle futures and prices tend top move in a seasonal way, generally moving higher between November and January, and then starting to fall again from February through to May, which generally reflects the higher costs associated with feeding and sheltering cattle over the winter months. As we have already seen, the price of feed is a key determinant, and generally if the feed costs are higher, then cattle are then sent to market early and at a lower weight, which in turn tends to lower the prices for cattle futures. One of the  biggest market movers in the cattle futures sector is the cattle on feed report.