Chapter 15
Getting to the Meat of the Markets: Livestock and More
In This Chapter
Cashing in on meat-market supply and demand
Getting an inside look at the cattle and swine markets
Using meat-market technical and fundamental analyses
Knowing which reports to keep an eye out for
Seeing the effects of major reports and outside influences
If you’re like I was before I began trading, the first image of futures trading that comes to mind is something like pork bellies or orange juice. You probably start chuckling and shake your head, saying, “No way man . . . not for me . . . no sir.”
Then there’s the Hollywood take on commodities traders. They’re usually portrayed as not-too-smart, greedy fellows, looking for an edge and a quick buck.
In the movie Trading Places, Eddie Murphy and Dan Akroyd turn the tables on two old scoundrels played by Ralph Bellamy and Don Ameche, who are gaming the orange-juice market with inside information before the release of the monthly data hits the wires.
Although the movie is entertaining and the two old buggers get what they deserve, it unfortunately paints a lopsided picture of the futures market. Some traders in the futures markets might very well seriously consider trading on insider information. But given the tight surveillance of the markets and the potential for being caught, finding out just how the markets work and whether you’re cut out to trade probably is the best route for you to take.
Trading, after all, is a serious business, and the meat markets are basically about how much you and I have to pay to eat. If you look at it from that standpoint, you start taking it a bit more seriously.
Meat markets are as much about farmers, producers, and other industry-related traders using the markets to hedge their bets against potentially negative outside influences — weather, herds that catch plagues, and even fad diets like the low-carb craze that took hold in the last decade — as they are about people like you and me who look at charts and real-time quotes and try to make money by trading meat.
This chapter is meant to provide a good overview of basic trading strategies in the meat markets. Some excellent and more in-depth information can be found at these Web sites:
The Chicago Merchantile Exchange (CME) at www.cme.com/files/LivestockFund.pdf)
Ohio State University at www-agecon.ag.ohio-state.edu/people/roe.30/livehome.htm
Exploring Meat-Market Supply and Demand, Cycles, and Seasonality
Like all commodities markets, meat markets are based on supply. However, a more equitable relationship exists with demand in the meat markets than in other commodities markets where supply is key. The two major temporal factors to understand about the meat markets are the longer meat cycle, which is different for cattle than it is for hogs, and the more reliable — although not perfect by any means — aspect of seasonality.
The meat market goes through several phases where herds are built up and subsequently sold. When farmers increase the number of cattle in their herds, it’s called the accumulation phase, and when they thin the herd for selling, it’s called the liquidation phase. For hogs, the spectrum starts with expansion and ends with contraction.
The time that passes from accumulation to liquidation and from expansion to contraction is called the livestock cycle. Historically, the cycle for cattle usually lasted 10 to 12 years, and for hogs, it usually was around 4 years. The actual length of the cycle is measured either from one trough, or the low point in inventory, to the next, or from one peak, or high point in inventory, to the next. The time that it takes for female swine to reach breeding age has a direct effect on the hog expansion phase.
Seasonality, on the other hand, can be short term or have more of an intermediate duration. During summer months, the demand for certain cuts of beef that can be grilled outside tends to increase. The same is true of the demand for turkeys at Thanksgiving time. When consumers are flocking to one kind of meat at specific times, prices can be affected, and the market reacts and adjusts. For example, some specific times that affect specific meat markets include
January through March: These three months tend to be strong ones for feeder livestock prices because grain prices tend to be lower during the same period. Feeder cattle are steers, castrated males, and heifers, or females that have not calved. These animals weigh anywhere from 600 to 800 pounds when they arrive at the feedlot, with a goal of reaching 1,000 to 1,300 pounds before they’re slaughtered.
April through August: The spring and summer usually are weak months for feeder prices.
September through December: These four months are a second season of strength in feeder prices; however, the January through March period historically has been the stronger of the two periods.
Understanding Your Steak
Here’s a quick-and-dirty overview of the cattle business to get you rolling in the right direction.
Despite increasingly frequent scares about mad cow disease, the steak that everyone loves to eat starts off with a cow/calf operation, which in short is a cattle-breeding business that consists of a plot of land that holds a few bulls, some kind of feed, and an average of 42 cows, according to government statistics provided by the United States Department of Agriculture (USDA). The cow/calf operations are where natural or artificial insemination takes its course and calves are born.
The breeding process
Producers breed cattle in the late summer or early fall because nine months are required to birth a calf. Most of the cattle production in the United States takes place in Kansas, Nebraska, Colorado, Oklahoma, Texas, Iowa, Minnesota, and Montana. Many of these areas of the country endure tough winters, so birthing calves in spring gives them a better chance for survival.
Calves spend six months or so with their mothers and then are either released into the feedlot or undergo backgrounding, a period where smaller animals catch up in size and weight, essentially a process by which they are fed until they grow to 600 to 800 pounds, which is considered large enough to enter the feedlot and become feeder cattle, the beef that humans consume.
Feedlots are where feeder cattle — calves, or steers and heifers — are fattened up. Cattle hotels are commercial feedlots that account for only about 5 percent of all lots that are involved in raising feeder cattle, but they produce 80 percent of the cattle sold. Feedlots sometimes buy cattle for their clientele or charge farmers a fee to custom feed their stock.
Commercial operations offer farmers convenient services, such as boarding and feeding cattle, and often serve as middlemen by setting up deals between farmers and slaughterhouses. In other words, commercial operations fatten up herds and use their industry contacts with packing plants to sell their client/farmer’s herds. Sometimes commercial operations combine smaller herds from several farms into one feedlot and then sell them to the slaughterhouses.
Feeder cattle are fed a high-energy diet consisting of grain, protein supplements, and roughage. Putting on weight fast is the idea. The grain portion these cattle are fed usually is made up of corn, milo, or wheat if the price is low enough. Usually, the protein supplement includes soybeans, cottonseed, or linseed meal. The roughage usually is alfalfa hay or even sugar beet pulp, depending on market prices.
The packing plant
When feedlot animals reach specific weights, they are sold to the packing plant. The packing plant is where live cattle and hogs are sent to be slaughtered. Packers sell the meat and byproducts, including the hides, bones, and glands, to different customers, including retailers, such as grocery stores and manufacturers of clothing and furniture.
The feeder cattle contract
Feeder cattle contracts are made up of feeder cattle, the precursor to live cattle, and are the province of the feedlot operator. See the previous section, “The breeding process,” for details about feeder cattle, and the next section for details on live cattle.
The prices of feeder cattle contracts are dependent on two major raw materials: the number of animals on the feedlot and the price of grain.
Feedlot operators increase the number of animals based on the demand for feeder cattle, which is dependent on the demand for live cattle. Corn and other grain prices influence the costs of maintaining an animal on the feedlot. Cheap grain prices usually correlate well with higher feeder cattle prices when you trade this contract. Low supplies of grain stocks, on the other hand, usually lead to weak feeder prices. Here are some of the specifics of feeder cattle contracts:
Composition: This contract holds 50,000 pounds of feeder cattle, with specifications calling for a 750-pound steer, such that each contract holds an average of 60 animals.
Valuation: Prices are quoted in either cents per pound or dollars per hundredweight.
Settlement: Delivery is cash settled and is based on an index, with the final price being the price of the index on the contract’s last day.
Price limits: The price limit is equal to the live contract limit, which is 300 points or 3 cents per pound, or $3 per hundredweight, above or below the closing price for the previous day.
The CME live cattle contract
The main difference between the live cattle contract and the feeder cattle contract is that the animals in the live cattle contract are ready for slaughter.
Buyers of live cattle usually are meat packers who sell the meat and byproducts. In general, prices for live cattle tend to rise from January to March, start falling in April, bottom out in July, and then remain below average until October.
This shifting of prices results from the pattern of cattle slaughter. According to USDA data, the number of cattle slaughtered peaks during the period from June through August, making a second but lower peak in October, and then declining into February, when the cycle starts rising again until the June/August top.
Live cattle contracts are much like feeder cattle contracts, with the same daily limits (300 points, 3 cents per pound, or $3 per hundredweight) above or below the previous day’s close, but each contract consists of 40,000 pounds of slaughter-ready animals.
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Understanding Your Pork Chop
The hog market is similar in many ways to the cattle market, but it has some important distinctions:
Pork demand rises in spring because of Easter and in winter because of the holiday season.
Hog prices tend to rise in January and peak in May and June, rolling over in July and falling into fall and the holiday season.
During the period of rising hog prices, the number of slaughters decreases.
Living a hog’s life
Similar to cattle, hogs being raised for the market go through significant stages that traders need to track. The two basic stages are pre-slaughter and post-slaughter. The pre-slaughter stage is known as the farrow-to-finish operation, which encompasses the entire process from breeding and rearing a hog to slaughter because the hog stays on the same farm from birth to finish.
When hogs reach 220 to 240 pounds, which takes about six months, they’re sent to market. Unlike beef, a significant amount of pork is processed into smoked, canned, or frozen ham.
Pork bellies
As a frustrated baseball announcer, I love a good slice of bacon, so I thought I’d do the next best thing by shouting out the title of this section as if it were Sammy Sosa striding up to the plate.
Pork bellies, though, are not a laughing matter. Indeed, they are the part of the hog from which bacon is derived. Hogs are cash settled, based on a USDA-calculated index.
Here are the basics of what you need to know about pork-belly contracts:
Contracts: Pork-belly contracts are traded in lots of 40,000 pounds, compared with 40,000 pounds for the live-hog contract.
Valuation: When trading hogs and pork bellies, a 1-cent move in hogs is worth plus or minus $400 per contract, while a 1-cent move in pork bellies is worth $400 per contract.
Market makeup: Speculators make up 85 percent of the trading volume in pork bellies.
Matching Technicals with Fundamentals
Figure 15-1 shows a fairly classic six-month chart for feeder cattle prices. Note how prices rallied in the early part of the year and started to roll over during the summer months.
As a speculator, you want to understand the market from a hedger’s point of view, but you need to focus on these keys to the cattle market:
Understanding the seasonal cycle: Livestock prices tend to be cyclical in nature, but more important, you want to confirm that the cycle is working the way it usually does. In the case of the chart in Figure 15-1, you’d be correct in playing the long side of the market during the early part of the year.
Using technical analysis: You’re not out on the farm, so you must trust the price action. Trend lines, moving averages, and oscillators are useful in trending markets, such as the one shown in Figure 15-1. See Chapter 7 for a full overview of technical analysis.
Keeping your strategies fluid: As with other contracts, you need to keep up with government reports that are scheduled for release and hedge your regular positions by buying options or by selling futures contracts if you’re long.
Following your trading rules: If you set a sell stop or a buy-to-cover stop on a short position, don’t change it other than to keep ratcheting it up or down as your position becomes more profitable. And when your rules say the time is right, don’t hesitate to take those profits.
If you get stopped out, you either saved yourself a lot of trouble or didn’t give yourself enough room. That dilemma is easily remedied. Go back and check the usual price range of the commodity for the specific time frame in which you’re trading. If you’re trading 15-minute bars and the commodity tends to move one to two ticks during that period, then set your stop just outside of or close to the normal movement. That way, if you get stopped out, it was because of an abnormal movement by the market against your position, and you’ve likely saved yourself from an even bigger loss.
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Figure 15-1: Feeder cattle futures for August 2005. |
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Watching for the Major Meat-Market Reports
As with virtually all other commodities markets, given their connection to supply and demand, meat-market traders need to keep an eye on their own distinct set of key reports. The CME and your broker have calendars that warn you when these key reports are going to be released. You need to take seriously the reports I describe in the sections that follow because they’re the most important inside influence on prices. Many times the information in one of them is enough to change the overall trend of the particular market for extended periods.
Of course, some reports are more important than others, but you’re asking for trouble if you either have an open position or you’re trying to set one up without knowing what to expect when one of these potential bombshells hits the street.
Counting cattle
Released every month by the USDA’s National Agricultural Statistics Service (NASS), the Cattle-on-Feed Report usually moves the market and is made up of these three parts:
Cattle on feed: This part of the report focuses on the actual number of cattle in the feedlots.
Placements: This part of the report focuses on the number of new animals placed into feedlots during the previous month. This number is an important predictor of future supply, because an animal placed in a feedlot can be market-ready in 120 to 160 days.
Marketings: This part of the report focuses on the number of animals taken out of the feedlots. This number is a hazier piece of data because it can be affected by an individual operator’s feeding methods and particular animal-specific idiosyncrasies.
For example, depending on demand and how well a particular animal grows, feedlot operators can vary their marketings from month to month.
Posting pig-related data
The Hogs and Pigs Survey, which is released quarterly by NASS, reports pig crop data from 16 major hog-producing states and is the most important report for the hog and pork-belly markets. Information in it can lead to limit moves that can last for several days whenever surprises are reported.
Here are the nuts and bolts of the Hogs and Pigs Survey:
Total numbers of pigs: This figure is the pig crop, and it shows where the market volume is at the time the report is released.
Breeding herd numbers: This figure tells you the total number of hogs not sent to slaughter that are to be kept for breeding purposes.
Farrowing intentions: This number provides an indication of breeding levels expected in the future.
Market hogs: This number is the portion of the report that gives you the number of hogs that are being taken to market.
Other meat-market reports to watch
If you want your research to be complete, take note of these reports:
Cattle Inventory Report: This report is released in January and July and provides the number of mature animals and the number of calves in the annual crop.
Cold Storage Report: This report is a monthly release that tells you how much meat is stored in the freezers, including beef, chicken, and pork. It usually moves the pork-belly markets more than anything else.
Out of Town Report: This report is released after the markets close every Tuesday and, like the Cold Storage Report, is aimed mostly at pork-belly traders. It measures whether pork bellies were put into freezers or taken out of storage. Rising numbers of bellies going into freezers is bearish. Falling numbers of bellies in storage is bullish.
Daily Slaughter Levels: This report measures the daily activity of meat packers.
Interpreting Key Report Data
Reports in March and June 2005 affected the ebb and flow of the August 2005 pork-belly contract by starting a recovery in the market and pointing to two trading opportunities you can use to catch this kind of market bottom.
Figure 15-2 shows the pork-belly contract for August 2005 and how it broke above the first trend line and marked a trading bottom and how a second trend line marked a break in the downtrend. The first break in the market occurred soon after the release of the March Cold Storage Report from the USDA, usda.mannlib.cornell.edu/reports/nassr/other/pcs-bb/2005/, which contained the following line:
“Total red meat supplies in freezers were down 1 percent from last month, but up 4 percent from last year. Frozen pork supplies were up 9 percent from last month and up 14 percent from the previous year. Stocks of pork bellies were up 19 percent from last month and up 32 percent from last year.”
This reported glut of pork was not worked off until June when the government’s Cold Storage Report indicated:
“Frozen pork supplies were down 9 percent from May, but up 24 percent from the previous year. Stocks of pork bellies were down 9 percent from last month, but up 97 percent from last year.”
By July:
“Frozen pork supplies were down 4 percent from last month, but up 32 percent from the previous year. Stocks of pork bellies were down 14 percent from last month, but up 90 percent from last year.”
That was three months of sequential decreases in the amount of pork in storage, which was good enough for the market to make a bottom. The chart in Figure 15-2 clearly shows how a series of reports can influence the sensible, supply-and-demand driven pork-belly market.
Notice the following key technical developments on the charts in Figure 15-2:
Open interest (line on bottom of chart above volume bars) rose as selling accelerated, which is a bearish sign because it shows more people are selling.
Open interest declined as the pork-belly contract started to bottom, which is bullish because it shows selling is losing strength.
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Figure 15-2: Pork bellies respond to key reports. |
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Outside Influences that Affect Meat Prices
An important set of background factors can affect meat prices. Some are short-term influences, but others have been in the pipeline for some time and can suddenly be felt when a certain catalyst hits the news, such as an article that shows that beef is not as healthy for consumption as it was thought to be.
Some longer-term and softer influences on meat prices are
Population changes: If a demographic shift occurs in which more children are born, more baby food will be sold, which tends to be more vegetable based.
Income changes: The overall economy affects the kinds of food people buy and whether they will go out to a restaurant and order higher-priced items, such as steaks.
Prices of substitutes: Higher beef and pork prices are likely to lead to increased use of chicken; that is, until the price of chicken gets too high and the potential for a shift back to pork and beef increases.
Prices of complements: With a sudden increase in the price of barbecue sauce, you can see a decreased demand for beef or pork.
Changing consumer tastes: This anomaly can be described as the classic Atkins diet effect. Pork, beef, and chicken prices rose when the low-carb craze swept the United States. If a soybean-based diet was to catch on in the same way, you’d likely see a similar phenomenon in soybean prices, while you’d likely see the reverse in meat prices.
Some shorter-term but more constant influences on meat prices are
Weather: A tough winter can lead to big animal losses, which, in turn, can affect supply for extended periods of time. Cold winters also tend to make animals eat more but gain less weight. So even if no animal deaths occur, the time to market can be delayed because producers need more time to fatten up animals, in effect delaying their time to market. A glut in the market can then result at a later time, lowering prices after the initial rise caused by the short-term shortage.
Grain prices: Generally speaking, high feed prices result in liquidation, and low feed prices result in accumulation. The liquidation/accumulation ratio also is affected by the kind of prices producers get for their finished products. If meat prices are high, producers can spend more money on feed and pass along the added price.