The feeder cattle market has experienced unprecedented volatility over the past couple of years. Steers averaging 600 pounds traded for over $300/cwt in September of 2015 but in February this year sold for $198. The erratic price action has caused cattle producers to take more interest in hedging feeder cattle and the Western Livestock Price Insurance Program. Therefore, I thought this would be a good time to discuss the feeder cattle futures market for North American feeder cattle. Whether you are using futures and options brokers or the Western Livestock Price Insurance program, understanding the market dynamics of the cash and futures markets is prudent when planning your risk management strategy.
The feeder cattle futures market (which trades on the CME Globex electronic platform) is the price discovery mechanism for North American feeder cattle. The contract is 50,000 pounds and is based on the CME feeder cattle index. Without going into detail, this feeder cattle price index is based upon a large sample of transactions in the 12 major feeder cattle-producing states for 700- to 899-pound medium and larger-frame feeder steers.
One of the most important factors for western Canadian cow-calf producers to understand is the basis. This is the difference between the CME feeder cattle futures price and the local price at the auction market. The local market price is referred to as the “cash price.”
Recently, the USDA cattle inventory report put the 2016 U.S. calf crop at 35.1 million head, which was a year-over-year increase of one million head. This is a supply factor that will influence the overall North American “cash” price of feeder cattle.
An example of basis risk, however, would be if there was a drought in central Alberta and cow-calf producers sold a larger number of feeder cattle earlier than usual during the fall.
Once a producer understands the difference between the cash and futures markets, there are three main characteristics of market behavior that are crucial to managing a successful risk management strategy.
During the fall of 2015, I had producers call me stating it was going to cost $80 per head to lock in a $200 loss using the price insurance program and they wanted to know why. Usually when the market is anticipating a surge in supplies, the feeder cattle futures market will lead the cash price lower. Often, the futures market can turn lower one to three months before the cash starts to follow. Remember, it is a futures market so the market is discovering prices in the future. If a producer is trying to buy price insurance or hedge production three to five months forward, the futures market will be trading lower in anticipation of the larger supplies coming into the market.
Second, feedlots will continue to aggressively bid up the price of feeder cattle even if they can’t lock in a positive margin by hedging or locking a price on the fed cattle. This makes it almost impossible for a cow-calf producer or backgrounding operator to use the feeder cattle futures to hedge profitably or set a floor price at reasonable levels. Usually, feedlots have to have negative margins for an extended period of time before they lower their bids on the replacement cattle thereby allowing the backgrounding operator to buy feeder cattle at a reasonable price.
This leads me to the third characteristic, which is called the constellation of prices. Feeder cattle futures will often behave like the nearby live cattle futures; however, in theory, the feeder cattle futures are the live cattle five months forward. For example, the April 2017 live cattle futures rallied by $20 since the lows in October 2016. At the same time, the May 2017 feeder cattle futures have strengthened by a similar amount. I’ve attached a chart including both the feeder and live cattle futures. If a producer bought feeder cattle during the price lows last October, it would be difficult to hedge or use the price insurance program at reasonable levels. However by waiting for the April live contract to rally, in essence, will also pull up the feeder market. Cow-calf producers and backgrounding operators need to have an idea of the market direction for fed cattle so that they can plan their hedging or insurance purchase.
In conclusion, understanding behaviour of the cash and futures markets is necessary for a successful risk management program. Whether producers use futures and options or the livestock insurance program, it’s important that they understand these characteristics and use this knowledge in their own market analysis.