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Days of taking a passive role in deriving spot hog values are over. We must all take an active part in preserving and sustaining the open hog market and, with it, the underpinnings of price determination on the CME.
January 10, 2017
Use it or lose it.
This rule applies to muscle tone or market access. Recently, I was lucky enough to meet with some of the smartest people in the pig industry where the topic of conversation turned to the low volume of pigs traded on the open market and how to encourage an increase in these numbers. Unfortunately, there were no “aha” moments, but I wanted to unfold this one just a bit more to provide context to the gravity of the situation. More than a philosophical conversation to fill idle time, this is a genuine and immediate concern.
In the mid-’90s, over half of the pigs in the United States were traded on the open market. As an industry, we were accomplished at the bid-and-dicker negotiation and it was as much a part of the hog industry as loadout or power washing activities. But something changed.
We can argue whether the driver was the desire for further integration and the need for defined price discovery, banker demands or any other number of explanations, but the shackle space compression of 1998 was an inflection point in ushering in more long-term contracts that either indexed price to a negotiated market (“Western Corn belt plus two” or similar verbiage) or avoided it all together with cost plus or corn/soy matrices. I bring up this small history lesson to offer perspective and not to blame; it was simply an evolution at the time that — in hindsight — may have gone a bit too far. Our negotiated share of pigs on a routine basis has fallen from more than 50% to roughly 3% of animals marketed. Additionally, unless we see a substantial change in behavior, this percentage is going to fall even further based on the reporting rules, but more on that later.
Why is this important? In the simplest of terms, the entire function of the CME Lean Hog Futures depends on it. Each CME lean hog contract settles to a two-day weighted average of negotiated and market formula hogs. Imagine the chaos the industry would endure without a viable and transparent settlement process for the futures market. The chicken industry lacks such a pricing mechanism and look where they sit. Complete disarray and accusations of nefarious behavior surrounding the Georgia Dock price discovery tool and a recent ruling from the Department of Agriculture providing easier avenues to sue the production companies. (Note: this same legislation cascades over into the pork industry and is an area of concern, but the application of the law was driven largely by concerns in the poultry sector.)
Is that what we want for the pork industry? Of course not. But unless we do something to change our current trajectory, we may be headed toward a similar fate. Fortunately, our industry is characterized by a few features that the majority of industries would love to have at their avail. Consider this. We have virtually no Accounts Receivable (Packers and Stockyards Act requires your payment from the packer within 48 hours), there is very little in the way of needed advertising on an individual basis, and you have functional forward-looking risk mitigation vehicles in the way of futures and options for corn, soy and hogs. It is the very last that concerns me. Will our lack of negotiated volume and uneven convergence scare off the spec community? Will they take their money elsewhere based on their lack of confidence in the function of the hog market? It is sometimes tough enough sloughing off your hedges to a willing buyer in the distant months on the CME; we could be looking at reduced volume or potentially the dissolving of the contract if things follow the current trend. That would be bad.
So what is a pork producer to do? In my opinion, you have to wade back into the waters of negotiated hogs while you still have a chance to impact the direction of the industry. Commit 10% (or at bare minimum, 5%) of your production to the negotiated market. Have a talk with your packer of choice. There are varying opinions in the packing community of the value of increased negotiated hogs, some see the benefit of keeping a functional exchange, too, and understand the ramifications of its potential demise. If you do not want to take the time to negotiate the hogs yourself, hire someone to do it for you. There are several reputable firms that are willing and capable of performing this function for your account at a reasonable fee. We can do it for you from our office and I can assure you that those who participate every day have a better feel for the market and tend to make better decisions.
Anyone waiting for the all-clear signal before committing animals to the open market can come out of hiding. We had a legitimate threat to packing capacity in the fourth quarter of 2016 wherein producers ran the risk of not obtaining shackle space for uncommitted hogs. We made it through that period in better shape than I feared. Processor margins were huge which provided the incentive for the packer to run hard. We are now entering an era where packing capacity will likely not be challenged in a serious manner, possibly for the next few years, thanks to two new plants in 2017 and one announced facility in 2018.
The pork producer is allowed a little more breathing room and should not be overly concerned that they will be raising an animal that will have to fight to find a willing packer. I think the contrary is the new reality. For a window of time, the pork producer will have an opportunity to negotiate from a position of relative strength and should exercise the privilege.
My last comments on this item: Per my conversation with the USDA Market News, if a pork producer owns more than 5% in a plant, the animals that he sells in the open market are considered “packer-owned”. This would potentially move some pigs that have been in the “open negotiated” category into the “packer owned” group if this 5% ownership threshold is met given the organizational structure of the two new plants in 2017. Recall, only “producer-sold negotiated” animals impact the CME calculation. The simple fact that more producers may find themselves categorized as owners in a packing plant could change their sales classification. This, by itself, can reduce the quantity of animals in the negotiated category and others in the industry would need to step up and fill this void – Right now!
The second substantial change is slated for the summer of 2018 when Prestage Farms, a longtime sponsor of the negotiated volume, will have a plant operational near Eagle Grove, Iowa. Same story here. All of these animals will also be labeled as packer owned rather than producer owned. By my estimate, the Prestage volume constitutes roughly one-quarter of the current negotiated volume. Their impending reclassification will have a huge impact on the number of negotiated animals.
Your take home: we are at an inflection point regarding the sustainability of the CME Lean Hog contract as we know it today. There is an opportunity to save it; the industry has the tools (live animals) and time to pull this one out of a death spiral, but the time to act in now. We must add volume to the negotiated category or we will be a victim of our own behavior.
It seems to me that agriculture is way underestimating the potential disruption to markets that are on the horizon with the new Trump presidency. I have shared in previous columns that I was a Trump voter, partially on account of the-lesser-of-two-evils thinking. Regardless of how you voted, you are faced with the reality of an incoming president that, via the power vested in his Twitter account, is already impacting markets from aircraft manufacturing to automobiles, and our diplomatic relationships from Russia to Taiwan. To think that ag will somehow go unscathed is probably misguided. China is firmly in the crosshairs and, with it, the fortunes of the pork and soybean export markets. Mexico has also been a hot topic and the primary sponsor of the cutout for the last several months as ham values have benefited us all. Ask yourself this question: If something were to change with the new administration, do you think there are greater odds that it will be beneficial or detrimental to a given commodity? This is how I think we are going to have to handicap the next several months of trade. It is not about whether you thought the Hogs and Pigs report was right or wrong, it is that we are in a politically charged era. In my opinion, volatility as expressed in statistical terms through agricultural board-traded options has not reflected this reality. I am a huge fan of options in the current environment as they seem to be undervalued given the potential risk.
Money flow is another arena where I think it would behoove us to pay better attention. Large commodity funds normally go through a rebalancing effort at least once per year and January sees the biggest shift. (Note II: these funds trade a specific dollar amount of a commodity — i.e. $1 million of wheat, $1 million of corn, $1 million of Lean Hogs, etc. If the value of a given commodity falls in relationship to another, the funds will buy more of the undervalued commodity to get the notional dollar amounts back in line) A month ago, it was predicted that commodity fund repositioning would usher in roughly 25,000 contracts of new buying in Lean Hogs beginning Jan. 9. Because of the strength in the market, that number has been whittled down to less than 5,000 contracts. Corn could see 60,000 contracts of buying, beans are anticipated to have 6,000 contracts or so of new buying. My point with this paragraph is two-fold. It seems to me that there was some front-running of the February contract in anticipation of the fund buying; this may end up in a thud. Corn and soy do not have much gumption on their own from a fundamental perspective. If we get a bounce, it may just be a money flow item and not a sustainable issue.
Bottom line: the days of taking a passive role in deriving spot hog values are over. We must all take an active part in preserving and sustaining the open hog market and, with it, the underpinnings of price determination on the CME.
Comments in this article are market commentary and are not to be construed as market advice. Trading is risky and not suitable for all individuals.
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