Hedging Feeders on the Hog Market?
Mar 21, 2011
Repeat after me: Futures prices don’t matter. It’s their relationship to cattle prices that matters. Ok, now, slower: Futures prices don’t matter. It’s their relationship to cattle prices that matters.
It’s the basis, not the level. (Basis is, of course, the difference between cash prices and futures prices.)
That’s what you need to remember if and when the CFTC and CME increase the weight range on the feeder cattle settlement index. At some point in the future, with the CME providing plenty of notice, the feeder cattle futures index—key word: Index—price could decrease slightly because heavier weights will be used to calculate the index. But that won’t make CASH feeder cattle cheaper, silly wabbit.
If you don’t understand that fundamental truth, you probably don’t understand the way the cattle market works.
I bring it up because we recently saw an embarrassing news release claiming that proposals to update feeder cattle weights for the cash index are “designed to break the feeder cattle board, causing direct financial harm to every U.S. cow/calf producer, backgrounder and stocker that markets feeder cattle,” and “would literally transfer millions, if not billions, of dollars away from feeder cattle producers and directly to the packers and their cattle feeding operations…at the expense of hundreds of thousands of U.S. cow/calf producers, backgrounders and stockers….”
It would have been much more helpful to tell their members to keep their eye on the situation and be aware that, perhaps in 2012, the CME will make the move and that if they are pricing feeder cattle off the futures price, they will need to get a bigger basis. I.e.: if you’ve got 600 lb. calves and you’re selling them par the futures market now, you will need to price them a few cents over the feeder board to get the same price after the index changes. That’s pretty simple.
A little more background is in order. At their annual convention, NCBA’s live cattle market committee recommended the removal of the 650-699 pound category from the calculation of the CME Feeder Cattle Futures Index, replacing it with an 850-899 pound category.
You’ll recall that feeder cattle are settled based on an index calculated from a 7-day moving average of cash feeder cattle prices.
Obviously, the lighter cattle bring more per pound than the larger cattle. So when you take them out of the numbers used to calculate the index, the index will be lower. So long as traders on both sides understand that, there is no problem. Since feedyards are buying larger cattle these days, in fact, the index will be more, not less, accurate.
“With record grain prices, more cattle are remaining on forage for as long as possible before going to the feedlot,” said NCBA President Bill Donald. “The realities of the marketplace vary year to year and as a producer, I respond to those changes. The intent is to adjust the index in order to more accurately reflect the realities of the marketplace. We need the CME Feeder Cattle Futures Index to adjust as well in order to serve as a viable risk management tool.
The idea behind a cash settlement—or any other form of settlement for that matter—is to base it as nearly as possible to the actual commodity. In the modern—or at least current—industry, there are far more 800 than 600 lb. calves going on feed. Moving the weight range would, thus, make the board more accurately track what feeders are actually buying.
That’s the whole idea behind having a feeder contract, for goodness’ sake. If you weren’t worried about basis swings you could just hedge feeders off hog or fed cattle futures. The basis unpredictability would probably scalp you, but there is usually a correlation, after all. It just isn’t good enough. You want to settle based on real world stuff. Otherwise, basis really would be a crap shoot.
It would be arguable that this is a temporary market, based on corn prices being so high and outside stocking pressure so low. Maybe someday CME will want to get rid of the 850 lbs and go back to the 600 lbs. we used to have. But the way things are now, an 800 lb. animal is a “feeder” and a 600-pounder is a “calf.” In a market where various pressures and inputs and rains often cause those two commodities to ride different ends of the see-saw, they might as well be apples and oranges.
To argue there is some sinister plot afoot just seems almost paranoid.
Anyhow, what cowmen need to remember is what I said before. If the change is made, remember that your basis will change with it. If you’ve traded off the board in the past, you know that the size of the cattle and your trading situation impact your basis. So price the cattle as if they were better next year than they are this year and you’ll be fine.
The risk would be letting it sneak up on you. The basis will change from one settlement month to the next in one move. We should be able to calculate the change months in advance by simply figuring the index with the bigger cattle instead of the smaller cattle. There is nothing to worry about here.