With a tip of the hat to Steve Meyer for introducing this topic last week, I wanted to expand on the topic of basis. Basis risk is an item that most pork producers acknowledge, understand and are completely perplexed regarding how to manage. We have recently been on a brutal run where the negotiated cash market and the futures market — two items we normally think of as correlated and moving somewhat in sync with one another — have been completely divergent in their patterns.
There are two basic tools to manage hog basis risk. The first is to have a packer contract with a fixed basis, $1 under the nearby futures, for instance. This allows a producer to hedge forward hogs with confidence that the effectiveness of the hedge is perfectly correlated with futures and basis risk is zero as long as we lift hedges in the same proportion as marketings. The packing community has been somewhat reluctant to offer this type of program given the market gyrations and the offers have been much wider than the historical basis. Read, the packers are taking some measurable protection before offering this vehicle. If you are fortunate enough to have a good basis contract, count yourself lucky among your peers, this one is treating you well right now.
The second tool we have used in the past to protect against basis is the bear spread where we sell the front month (December right now) and own a distant month (April of 2020, for instance). This strategy is generally less impacted in a market that is trending in one direction or another as our winning long is offset by our losing position in a 1:1 ratio.
Where it has traditionally helped is when the cash market is characterized by a heavy atmosphere and our front end short begins to converge with the cash as we approach settlement and the back end holds its ground — thus providing the pork producer a beneficial position to aid in the offset of a weaker cash market. This strategy has recently performed poorly as a hedge against basis movement as the cash negotiated market continues to fall in an environment of surplus pigs while the December contract has remained resilient. This argument can only be made with more than three weeks until expiration (more on this below).
Compound this lack of basis performance with the lack of correlation as a hedge and you have the opportunity to lose money on 1) the bear spread 2) your December hedge and 3) your live hog production. The insult to the production community of a sub-50 market in the midst of the biggest opportunity in the history of the hog market, African swine fever demand, is unexpected and unfortunate. Packer margins are sufficient to justify a few more Saturday hours to accommodate the added production that is on top of us, their choice to keep the proverbial thumb on the scale will provide us an opportunity to reciprocate the favor early in 2020 (more on that later).
For now, we need to learn a few lessons and change our behavior accordingly. The first thing we need to accept is the change in structure of how we settle the CME to the index. This has long been an imperfect science where two days in a traded month we get convergence. Our lack of 12 trading months in lean hogs means that we are often rolling 60 days of marketings with the only perfection of our hedges occurring in the final two days. Not exactly confidence inspiring.
This year in particular, we have a market that is hanging on to hope. Futures are holding their premiums for as long as possible before the longs roll out of the spot month and into the next contract, hoping to eventually capitalize on a similar rally that we saw in March. This optimism that is built into the deferred contracts is why we’ve seen spreads make counter-seasonal moves into expiration. Take a look at how the October-February spread acted as we expired the October.
This is not our first observation of this happening and it may not be the last. If exports don’t materialize as we end the fourthquarter, we are likely to see the short December-long February spread perform similar to the short October-February as the December contract succumbs to the lower cash and February holds its premium. This is how the bear spread can be effective; however, this move doesn’t happen until the last three to four weeks of the marketing period. Add to that frustration the lack of correlation and it is not a surprise that pork producers are frustrated at hemorrhaging money in the cash market and potentially the futures market at the same time.
Below is a copy of the USDA report commonly referred to as “the 201”. This is the report that represents settlement of futures at expiration and is the source of much confusion. Note the head count in the first column — a mere 7,838 head were openly negotiated in a bid-and-dicker environment. We used to think of this process as the price-determining factor to price the vast majority of the hogs moved on a daily basis. That is simply not the case any longer and we have to change our thinking, especially as it pertains to convergence. Next, take a look at the third column; the weighted average of these two observations (Column 1 and Column 3) are the determining factors for settlement. Note two things, here. The volume, nearly 113,000 hogs, completely overwhelms the negotiated values and is trading at a significantly higher value than those hogs. Simply put, hogs currently traded on the open market are getting smacked relative to other pricing alternatives.
Next, attached is a chart that depicts what I was referencing earlier. The Swine or Pork Market Formula is completely outperforming the negotiated component to a degree never before experienced. If you think we are in peculiar times, you are right. This aberration only has a couple of bumps in it relative to the December contract. The first was in March of this year and the other was in July. Recall, those were two periods where futures rallied and participation in the cash was beneficial in relation to other markers (December hog chart attached).
What do we make of all of this? Let's recognize the obvious. The packer has fantastic margins and is not sharing per anticipated market forces with the producer. We are not taxing kill capacity to a significant degree. Historically these types of margins would portend Saturday and even Sunday harvest schedules. The pork producer will have his opportunity to shine after the first of the year.
The last chart I am sharing may be the most important. Note that shortly after the first of the year, our anticipated supply of market-ready hogs declines for roughly six months before seasonal increases in slaughter kick in. It is in this environment of robust packer margins and declining hog numbers that the packer will be forced out of his oppressive stance and the pork producer will wield the upper hand.