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Adding another horse to the race

Pigs in a barn National Pork Board
Encourage pork producers to embrace the potential addition of a cutout settled contract and use it to your benefit.

The CME may be on the cusp of offering pork producers another vehicle to hedge risk with the pending introduction of a cutout settled hog contract. This is the revival of an idea that was considered in 2015 and shelved at that point. They have deemed that the timing is appropriate for its introduction.

The CME has actively assessed the needs of the industries that it serves in search of products that may fit. This ball is getting ready to go in the air. As a sidebar, the consideration of a bacon contract (very different specs than the delisted frozen belly contract that exited stage left in 2011) is taking a back seat to the cutout contract offering, but do not be surprised if you see this one resurrected at a later date.

I had written in this forum previously about the consideration of the cutout contract. At that time, the line of thinking was the replacement of the settlement procedures of the current contract to effectively transition what we currently know as the Lean Hog contract to a de facto cutout contract via the change in the settlement methodology.

The "problem" with that consideration is one of timing. Once a contract is open for trade and has open interest, you can't change the rules. That makes sense. We currently have trade on Lean Hogs through the February 2022 contract. The earliest we could have had a settlement under the cutout language would have been April of 2022 and I am not convinced that we wouldn't have winnowed the field of producers substantially by then. I am a fan of the new method.

LM-PK602 cutout versus LM-HG212 WCB negotiated cash hog price

Perhaps as soon as this fall, CME Group is giving serious consideration to the listing of a new contract for producers to hedge — the Pork Cutout Futures and Options. Because it would be introduced as a new listing, it could be listed soon. Perhaps even as quickly as the February 2021 contract.

That is important as it could make a real difference for those who have a component of cutout (PK602) in their pricing mechanism for their production. The chart below depicts the spread between the cutout and the cash market — huge.

I have often stated that success in the pork industry is comprised by three major factors. 1) having a lender that will hang with you 2) good production and 3) a pricing mechanism that has a cutout or basis component.

This last piece is the one that this new contract would address, and I think the timing is perfect. Consider this: we routinely experience higher prices in the summer relative to the cooler months for a myriad of reasons, seasonal production being the biggest component. Does this mean that demand, as measured by an economist of disappearance at a price, is higher in the summer? Nope. Demand is actually higher in the fall. It is normally overwhelmed by the increase in supply that generally leads to lower prices. See the chart below for the seasonal spread between the lean hogs and the pork cutout.

Chart: Seasonal index of price

This year is anything but usual and the constriction of harvest capacity will complicate our experience of normalcy. Instead of animal supply governing the weekly slaughter numbers, the pace of processing will dictate output — which could further exacerbate the spread between the cutout and the cash negotiated trade as we "starve" the product market while the production of live animals increases and backs up.

We already had a taste of this in mid-May when the cutout traded up to roughly $120 and the cash market stumbled along near $40, the spread maxed out at $85 on May 11. Ergo, the utilization of the cutout contract could come at a time when it may be needed the most. I encourage pork producers to embrace this potential addition and use it to your benefit.

Comments in this column are market commentary and are not to be construed as market advice. Trading is risky and not suitable for all individuals.
Source: Joseph Kerns, who is solely responsible for the information provided, and wholly owns the information. Informa Business Media and all its subsidiaries are not responsible for any of the content contained in this information asset. The opinions of this writer are not necessarily those of Farm Progress/Informa.
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