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Understanding the forward curve in the futures market

Market Talk with Jerry Klassen

I’ve received many calls from backgrounding operators and feedlot managers in regard to the feeder cattle market. Prices have strengthened throughout the fall period and it now appears that potential margins will be quite snug for all weight categories. The futures market for live and feeder cattle is reflecting two distinct price structures. Discerning the variation between the two is vital to determining your marketing or hedging strategy. Ask these two helpful questions when conducting your analysis: What is the market trying to tell us and what is it trying to accomplish? In this issue I will discuss the forward curve in the futures market which will provide an idea for price direction over the next six to eight months.

First, I want readers to consider the closing prices on the live and feeder cattle futures as of December 1, 2017. Remember that the feeder cattle futures are actually the live cattle five to seven months forward, depending on the weight. The feeder cattle purchased in March will be sold in August through October for slaughter. Notice the March and September feeder cattle are relatively the same price; however, the October live cattle futures are trading at $10.525 discount to the April contract. Notice the sharp inverse between the April and October live cattle futures but the feeder cattle futures are relatively flat. The March corn futures are at $3.58 and the December corn futures are at $3.90 so the feeder cattle prices seem out of line relative to the live cattle futures.

Feedlots in Canada and the U.S. have experienced a prolonged period of healthy margins from February through September of 2017. To simplify the situation, consider this analogy. If there are three cattle feeders feeding 100 head each and margins are $200, each cattle feeder will want to feed 125 cattle on the next round. Therefore, in Canada we have stronger demand but relatively the same amount of feeder cattle which causes prices to strengthen. To a lesser extent, we’ve seen the same situation in the U.S., although the 2016 calf crop was 1.3 million head above 2015. A similar year-over-year increase is expected in 2017. In any case, the nearby feeder cattle market is quite strong because of the recent period of healthy margins for backgrounding and finishing operations.

Given the current live cattle futures market, feedlots will experience profitable margins during the first quarter of 2018. This will keep the nearby feeder cattle market quite strong for the reason mentioned in the previous paragraph. This bodes well for backgrounding operators. Given the price of calves in Western Canada during November 2017 and the March feeder cattle futures, it appears that backgrounding operators should have a margin of $50 to $80 per head. In the spring of 2018, if backgrounding operators buy grassers or calves, they’ll want to be very aggressive on their hedges or when buying their price insurance.

Finishing operators are facing a different story. Feeding margins will be profitable in the first quarter of 2018 but fed cattle prices will start to drop in the second quarter so that feeding margins move into negative territory. Feedlot margins in the latter half of 2018 will be in negative territory by $150 to $200 per head based on the current cash market for feeder cattle and the August and October live cattle futures.

In October of 2018, finishing feedlots will have experienced about six months of negative margins. At the same time, the U.S. will be contending with a sizeable year-over-year increase in the calf crop. This will result in sharp drop in feeder cattle prices for the fall period. In the final quarter of 2018, the price of a 600-pound calf could be about $30 below current levels.

Notice the April 2019 cattle futures are only at $114.250 while the November feeder cattle are at $147.15. The November feeder cattle are too high priced. One has to consider after a prolonged period of negative margins, a sizable year-over-year increase in the calf crop and finally a flat live cattle futures market from October 2018 through April 2019.

In conclusion, the feeder cattle futures appear to be overvalued relative to the October 2018 through April 2019 live cattle futures market. This is an opportunity for backgrounding operators, or those buying grass cattle in the spring, to take price insurance on their fall 2018 yearling marketings. Finishing feedlots need to be aware of the risks because it appears there will be a prolonged period of negative margins from May 2018 through December 2018.

About the author

Columnist

Jerry Klassen manages the Canadian office of Swiss-based grain 
trader GAP SA Grains and Produits Ltd., and is president and founder 
of Resilient Capital specializing in proprietary commodity futures trading and market analysis. Klassen consults with feedlots on risk management and writes a weekly cattle market commentary. 
He can be reached at 204-504-8339.

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