Cattle futures 101: Fundamentals of industry marketing tool explained
August 7, 2018
Today's cattlemen utilize a variety of different tools to be successful in the beef cattle business. From fencing pliers to genomic-enhanced EPDs for performance indicators, simple and complex tools of the trade help cattlemen complete the day's work and make decisions to increase profitability.
One not so simple marketing tool for cattlemen is the cattle futures market. Cattle futures contracts are legally binding agreements between a buyer and seller for the delivery of cattle at a set date. These contracts are negotiated at a futures exchange such the CME group or Chicago Mercantile Exchange, and this practice dates back to 1964.
Scott Varilek is a commodity broker for Kooima & Kaemingk Commodities in Sioux Center, Iowa. Varilek helps his customers place orders to trade based on a plan to manage risk and lock in a price that works for that individual producer.
"The bulk of our customers are farmers and ranchers who call in, and we act as the middleman to enact the trade," Varilek said. "We provide advice based on prices, what the producers' breakevens are, where their risks are and what protections we can put in place to mitigate that risk. Not every plan fits every producer, so we tailor a marketing strategy for the individual."
Cattle futures contracts, Varilek said, allow producers to lock down a price in advance instead of being at the mercy of where the prices are at the time of the sale. And for a small commission for each trade, a broker can help determine the best route for the producer to take.
There are two types of cattle futures contracts — Live Cattle and Feeder Cattle. Live Cattle consist of calves weighing 600-800 pounds, while Feeder Cattle are cattle fed to the point of harvest weight. A contract size is 40,000 pounds for Live Cattle or 50,000 pounds for Feeder Cattle, and they are priced in cents per pound. Live Cattle contracts come with physical delivery, there is no option for live delivery with Feeder Cattle contracts; they must be settled with cash.
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"When you have a product like cattle, and you have to buy a pen of them, that's a lot of dollars tied up," Varilek said. "Producers can calculate their breakevens and lock in a price on their commodities to manage the price now instead of waiting and getting whatever the price happens to be. It allows producers to mitigate risk to ensure they are still operating next year."
Producers can also choose Feeder Cattle options, which are option contracts where the underlying asset is a Feeder Cattle futures contract. In layman's terms, the holder of a Feeder Cattle option possesses the right to assume a long position (a call option) or a short position (a put option) in the underlying feeder cattle futures at a strike price. This right for an option contract is eliminated after the market closes on an expiration date.
"There are upside options and downside options, and you can be a buyer or seller either way," Varilek said. "In some strategies, we are selling options to lower the breakeven costs. In this case, the safest place to start is to buy a put, which puts a floor under your price and won't necessarily make money but will stop a loss. A call captures more of the upside. If you sell your commodity and feel like it might still go higher, you can try to capture that upside by utilizing a call option."
A more complex strategy implements "spreads," which combine both buying and selling options. Choosing options instead of outright purchasing the Feeder Cattle futures offers additional leverage while limiting potential losses, but the risk for the trader is the asset could expire and be worth nothing. "For these more complex strategies, that's where a broker can really help," Varilek said. "Puts and calls are just another tool that producers have access to. They can either lock in a straight price by hedging or use options that act as additional insurance. These are used to stop a loss if the market goes south, or they can be used to lower your break even by using those options. When you have a trade in the account and it goes in your favor, cash goes in, but when the market goes against you, you have to put more cash in your account. Basically, these options offer protection for a downside, but they also leave room for the upside.
"None of us know exactly what the market is going to do," he said. "When you take a position as a hedge, and you like the price, you should never look back. I tell my customers to plan your trade and then trade your plan."
Cattle feeders are currently feeling the market pinch with fats priced roughly $100 less than this time last year. Marlin Nilsson, owner of Nilsson Farms in Warner, S.D., said it's tough going right now.
"The calf market is strong, but fat cattle prices are tough largely due to the uptick in supply compared to last year," Nilsson said. "However, we are hopeful feed costs will stay down compared to what they have been. Corn prices are depressed and the anticipated 2018 crop looks like we'll have plenty of feed on hand. Hay supplies are on the short side, so we'll see higher prices there."
Kim Ulmer owner of Huron Continental Marketing in Huron, S.D., said the futures system was created to benefit producers but has been changed to benefit speculators and puts cattlemen at a disadvantage. He called it a primary problem in the industry. "The board of trade creates monthly instability with false valuation. It no longer represents the American producers, it is a globalized average."
"Speculators are really important to the market, but when the producer cannot challenge the money, it's too one sided," he said, explaining that speculators of feeder cattle don't ever have the concern of dealing with a live animal. "They buy a feeder contract that affects pricing on actual cattle but can't be challenged when a false valuation is created."
"Feeder cattle are a perishable product. The producer is taking care of the livestock. The speculators oversell and take it way below the market, never having to worry about receiving or delivering a perishable product."
Just last week the feeder cattle "board" (or futures price) for feeder cattle was $1.46 per pound while the market price at the local sale barn was $1.76 for the same weight of cattle. "You can't challenge the system. They can take it down as low as they want and oversell it and laugh at producers because they don't have to go anywhere on earth and find these animals valued that low. They are buying a piece of paper."
Ulmer also said that the value of feeder cattle futures is based on cattle commingled weighing 700-900 pounds, and of every flesh score — from fleshy to green and from gant to full. "Nobody on earth has ever sold or priced their cattle that way but for some reason the CME comingles the average of weight and flesh scores."
While the live cattle contracts do provide for a delivery option, the rules are so complex and fat cattle are so perishable, that delivery rarely happens.
"Fat cattle are the most delicate item in our industry. They can suffocate and die just on a hot day, who would we want to put up with an 18-page rulebook with specs that we can't hit, just to deliver them? Ninety nine percent of people won't use it."
Ulmer said most feeders don't utilize futures options, and those that do are forced into it by their bankers.
The futures system can provide feeders the ability to limit losses, he said, but the system is set up to benefit speculators, not cattle feeders.
Ulmer feeds cattle and has used the board of trade since the early 1980s off and on. He said 90 percent of the time it has cost him money and he has never felt like it was a protection tool, but rather a speculation game.
CATTLE ON FEED
According to the most recent USDA Cattle On Feed report, released July 20, 2018, "Cattle and calves on feed for the slaughter market in the United States for feedlots with capacity of 1,000 or more head totaled 11.3 million head on July 1, 2018. The inventory was 4 percent above July 1, 2017. This is the highest July 1 inventory since the series began in 1996. The inventory included 7.13 million steers and steer calves, up 2 percent from the previous year. This group accounted for 63 percent of the total inventory. Heifers and heifer calves accounted for 4.15 million head, up 8 percent from 2017."
"We currently have a larger supply of cattle; we are at the peak for the size of the U.S. cow herd," Varilek said. "We will soon start to enter the decreasing phase where we have the highest numbers of cattle on feed in the cattle cycle. Ranchers are keeping less heifers, so there will be more heifers on feed and more pounds of meat."
With more beef supplying the market, it would be natural to assume beef prices would drop; however, beef demand is robust. U.S. domestic beef consumption was a record 56.6 pounds per capita in 2017, and beef exports have increased by double digits for two consecutive years. USDA forecasts that Americans will eat a record 222 pounds of red meat and poultry in 2018, and cheap corn prices are contributing to the large supply of meat hitting retail shelves.
"We've got great demand for beef, both domestically and around the world," said Mark Preston, co-owner of Huron Continental Marketing. "This has been huge in beef prices, as well as helping to hold together prices the producers has received. Overall, I think we are actually holding together a lot better than I expected compared to last year."
Preston said in addition to cattle inventory being up by 4 percent compared to 2017, this spring's growing conditions have played a part in current market conditions, as well.
"We aren't getting those huge carcasses hitting the market this year," Preston said. "Due to snow and rain producers received this spring, we had mud to deal with in a lot of areas in April, May and June. As a result, I think cattle selling weights were less than many people had projected because the cattle were dealing with harder growing conditions. And we may have a larger supply, but producers have done a better job of marketing by advancing forward because the basis was in favor of the market. Cash has been higher, so people were wanting to pick up that basis improvement."
While it's been a tough market for feeders, Preston is hopeful beef markets will finish strong to end 2018.
"Just like every true cattleman, I'm optimistic that we'll have a better fourth quarter because of the numbers we've seen," Preston said. "As long as we keeping marketing well like we have been, things could improve for us to end the year on a good note."
It can be hard to predict just where the market will go, and brokers like Varilek are constantly watching various factors such as weather, disease, imports, exports and trade to better anticipate weaknesses in the market or opportunities for their clients to take advantage of. The U.S. accounts for just 10 percent of the world's cattle but produces nearly 35 percent of the world's beef, but events happening around the globe — particularly in the largest cattle producting countries India, Brazil, China and Africa — can have a great impact on the markets.
"One day we are looking at how a tsunami in Japan is impacting cattle prices and the next we are studying the implications of tariff wars," Varilek said. "These factors can change the market in ways we can't predict."
Some argue that outside speculators or computer trading programs who don't have vested interest in the cattle being bought and sold are unfairly manipulating the cattle futures market; however, Varilek said these traders play an important role in maintaining steady prices for producers.
"We need speculators in the market because without them, individual producers would be at the mercy of a very small handful of packers on the other side," Varilek said. "Without any other buyers placing orders, they would have the upper hand in dictating prices. Speculators provide more volume for us, and although we don't always agree with the direction they are shifting the market, they provide a more stable market for producers."
Ultimately, the cattle futures market is a tool for producers to lock in prices and have a level of protection to mitigate risk.
"Without it, our prices would be determined by the roll of a dice," Varilek said.