We wrote here at Equities.com on June 30th that we thought cattle were finding support in, “Cattle Finding a Bottom into Summer.” Over the last six weeks however, commercial traders have come back to the market on the sell side. Based on the commercial traders’ deteriorating evaluation of the fundamental picture along with the clear technical signals, we’re not only exiting our longs; we’re going short October live cattle.
There are three markets in the meat futures sector with enough volume and liquidity to attract both hedging and speculative activity. These are the lean hog futures along with the feeder and live cattle markets. The live cattle market is best thought of as cattle on the farm while feeders are the cattle that have made the journey from the farm to the feedlot for fattening prior to slaughter. We’ve written extensively on the broad nature of global supply and demand fundamentals within these markets and included links to our previous research at the end. This week, however, these three markets appear to be setting up for a classic trading opportunity.
The outlook for cattle prices in 2013 appears to be even higher than 2012 due to declining herd sizes and an increasingly favorable export climate. The US cattle herd has been in decline over the last few years. The drought of 2012 has led to the culling of more animals including non-productive dairy cows and heavier steers that have managed to avoid the feedlots. The addition of these animals into the production mix did three things. First, it increased the average weight of cattle coming to market. Secondly, the increasingly tight supplies already pushed the April live cattle futures contract above the 2012 highs. Finally, it has led to the smallest U.S. starting herd since 1952.
The USDA’s January cattle inventory report shows a total U.S. cattle herd of 89.3 million head. This is the smallest calf crop since 1949 and is the 18th consecutively smaller calf crop. Producers and finishers appear to be coming to the consensus that it’s better to have fewer animals at heavier weights than more animals at lighter weights. The University of Missouri points out that steer weights are up over 34lbs from last year and December marked the 49th consecutive week of heavier steers on a year over year basis. There is an argument within the industry as to the real reason behind the growing weights between those who say weights are increasing due to better animals being culled versus the addition of the beta-agonist, ractopamine.
Politically, 2013 will see a good boost in demand due to Japan’s relaxation of the ban on U.S. beef following the mad cow episode of late 2003. This year, Japan will allow U.S. imports of cattle up to 30 months old. This relaxes the 20-month age limit rule that effectively crushed U.S. exports to Japan. Prior to mad cow, Japan was the number one destination for U.S. beef exports. In fact, Japan imported more than 500,000 tons of American beef as recently as 2000 in contrast to 2012’s total imports estimate of just over 200,000 tons. Many agribusiness insiders see the relaxation of the age limit as Japan’s recognition of globally tight supplies for the foreseeable future.
We’ve addressed the certainty of a declining cattle supply in 2013 as well as sourcing added demand in this marketing year due to freer trade, that leads us to the primary variable of input costs. This brings us to the feed vs. ethanol battle over the 2013 corn crop. Some of the blend tax incentives for ethanol producers were allowed to expire in 2012. Ethanol producers are still bound to the Renewable Fuels Standards mandate that shows 2013 as the first time that the mandate’s target is set beyond the blend wall. This year, 13.8 billion gallons of our fuel supply is supposed to come from ethanol. However due to our primary blend of 10% ethanol, we are unlikely to produce the 13.8 billion gallons to meet the mandate target.
The Renewable Fuels Standards face an application dilemma that must be sorted out by the bureaucrats to put the fundamental factors of the ethanol market back into equilibrium. Currently, unblended ethanol is trading around $2.37 per gallon while wholesale gas prices are about $2.65. The disequilibrium comes into focus when we realize that ethanol is about 25% less efficient than gasoline and should therefore, trade at a corresponding discount. Using the example above, ethanol should be trading at $1.99 per gallon. Ethanol blenders will have to push for either reenacting the expired ethanol blending subsidies or, governmental clarification of E85 liability and warranty issues that will allow the expansion of the E85 delivery infrastructure.
Finally, the cattle market will keep its eyes focused clearly on the skies. The drought of 2012 was genuinely historic with many ranchers still feeling the pinch through the high price of hay this winter. The run-up in grain prices was brutal to cattle ranchers, as crop insurance provides no relief for livestock ranchers. Therefore, this may be the most important weather year that I’ve been witness to as a steady and useful supply of rain will be necessary for both grazing and growing feed crops. The National Oceanic and Atmospheric Administration (NOAA) expects 2013 to be a normal year however, several universities’ grain forecasting models are leaving room for exceptional volatility with average December corn (2013 crop) prices expected to finish around $5.75 per bushel but, quickly tailing out to more than $6.50 per bushel without factoring in the rising tide of any additional volatility.
Cattle farmers appear to be taking proactive steps to managing their businesses in 2013. The Commitment of Traders Report clearly shows commercial buying both in the grain markets and the cattle futures market itself. Commercial traders have bought more than 11,000 contracts of corn below the $6.50 per bushel level in the December contract. This is evidence of cattle producers attempting to lock in their feed costs for the coming year at anything near normal feed prices. We’ve also seen commercial traders nearly double their long position in the cattle futures as they guarantee their ability to make future delivery. U.S. Cattle ranchers locking forward production costs at these levels shows that they’re projecting their profit margins based on growing global demand rather than declining input costs. Given the miniscule herd numbers, we could see prices really skyrocket in 2013 if the weather is decent and ranchers can hold back animals to re-grow the herd size on forage, rather than feed.
This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.
RJO Vantage has a tool called the “Market Book.” The Market Book provides live access to the resting bids and offers in the electronic market. The effectiveness of the Market Book becomes more and more apparent now that 90+ percent of total commodity volume is executed via electronic trading platforms. As a former pit trader in the S&P 500, I find myself used to looking at the depth of the market’s bids and offers to establish any strength or weakness biases the market may have at a given price level. I now use the market book as much as I do the Commitment of Traders Reports. This morning’s action in August live cattle was an excellent example of how the Market Book can increase the effectiveness of one’s trading strategies. Cattle have run up considerably for the month of June without any type of pullback. Over the last week, the market has consolidated just above the 103 level. Knowing that cattle prices tend to peak around Independence day and given the month’s run up, I felt like we could see extended selling on a penetration of the support at 103. I was watching the market as we neared the support this morning looking for the tell tale signs of a stop run to begin the decline. I expected to see standard volume on the available bids….maybe 2-6 contracts on every bid price under the lows, with an occasional 10 lot. Had I seen this, I would have been anxiously looking for a bid to hit to get my contracts sold. However, as the market declined to the support / breakout level, it was greeted with 10 – 85 contracts at each bid. This is an exceptionally large and supportive bid in the cattle market! Therefore, rather than rushing to get my contracts sold, I decided to wait. As I waited, the market climbed and climbed. The point is, had I placed an entry stop at the breakout level, I would have found myself stopped into a short position in a fully supported market. The beauty of the market book is that I was able to get a “read” on the market’s bias and avoid putting my accounts in harms way. If you haven’t spent any time with it, I highly recommend that you do. The market book can be a valuable tool in a trader’s arsenal.Any questions, please call.866-990-0777.Andy.