Where Should Feeder Cattle Futures Settlement Prices Be?

Not being sure whether our friend Bill has ever hedged any cattle, and given his recent reaction to an earlier post let’s return to basis talk for his edification.

You might recall the argument is whether the weights used for calculating feeder cattle futures settlement prices should be raised. Bill, you might also recall, had recently charged that his arch-nemesis, NCBA, had suggested that action simply to help cattle feeders and packers defraud cow calf producers out of millions or even “billions” of dollars.

My response—indeed the reason behind the suggested change—is that the most important thing for everybody concerned, both long and short sides of a futures market—is accuracy. My argument is that if I’m hedging cattle that are, say, fleshy, black baldy steers weighing 761.2 lbs per head  to be delivered at 6:35 a.m. Oct. 15,  9 miles from Poteau, OK, my ideal settlement situation is for a whole contract based on cattle of that exact description.

It is unlikely, of course, that CME would ever offer such a contract. There would be too few sellers and too few buyers to make a market.

So, if I want that exact deal, then I find a buyer willing to name a price. Such a buyer is most likely to use the board one way or another to protect his investment. Even if I personally don’t understand basis or trust the futures market—the difference in the settlement prices for October feeders and the value of my specific cattle—that buyer does. He will base his bid on his best guess about how much more or less value my cattle enjoy over the average.

The key word is “guess.” Basis varies day to day, month to month, year to year. The less certainty that buyer has in basis, the more risk he is going to price into what he pays me. In other words, the less accurate the futures settlement price, the less my cattle are worth to him. We both want an accurate settlement. The actual futures price doesn’t matter. The guy will pay $1.25 for my steers, whether futures are $1.20 and he calculates a 5 cent positive basis or futures are at $1.30 if he expects a negative 5 cent basis.

But the more doubt he has about that basis, the more “insurance” he’s going to buy by pricing my cattle lower. We could have an honest argument about the proper size for feeder cattle settlement. But we can’t have an honest—key word there—argument about that basis relationship.

In the interest of arriving at some agreement on the proper definition of a “feeder,” let me offer some web search results. Here is an old, but still relevant, explanation for how basis impacts contract prices: http://pods.dasnr.okstate.edu/docushare/dsweb/Get/Document-2000/AGEC-579web.pdf

Here is a graph showing how current placement weights are running far above 10-year averages.
  

And here is a graph showing the spread between calf and feeder prices. It’s hard to read, but UGA’s Curt Lacy offers some explanation:

“Back in 2008 when feed prices reached their historical highs, the spread between 500-600 pound steers and 700-800 pound steers narrowed to $3.52 per hundredweight a much smaller difference than the normal $13.50.  Currently the spread between calves and feeder cattle is actually at a 5-year high at roughly $24 per hundredweight. “

What my buyer doesn’t need when he tries to decide how much insurance he needs on my 750-lb. baldies is for the calf/feeder spread to provide extra risk.

Bill is right about one thing. There are still some <700 lb. calves placed on feed, and that is especially true this year when drought in much of the wheat pasture country has pushed cattle off early. Bill doesn’t need to tell me about it. The La Nina scared me into sending my own steer calves to town last fall.

But cattle wean larger today than they used to. That’s a trend with no end in sight. With ethanol and cotton both pushing corn prices upward, nobody wants to place little cattle. They eat too much corn. Much better to buy them and put them on grass—the same grass opened up by all the cows that aren’t there anymore—for some cheaper gains.

The more settlement prices reflect those evolving realities, the less “guess” my buyer has to price into what he offers me on that hypothetical cash offer.

You can certainly argue about the ideal size for the feeder cattle settlement. But to argue that there is something nefarious about suggesting an increase in the weight range is pure demagoguery.