The all-time high and ensuing fall in cattle prices brought a sigh of relief, as it appeared the cattle top was in. We sincerely thought we saw it coming in June when we discussed the “Beginning of a Cattle Top.” The fundamentals of the increased demand via the global growth of the foreign middle class demographic remains fully in play as well as this year’s supply issues as nothing has occurred on either of these fronts to change the market’s current dynamic. Therefore, the only question to ask going forward this year has been, “How high is high?” Recent action in the live cattle futures spread between the current, October contract and the next active contract in December provides us with some clues as to what’s next.
There are a few issues worth updating on this front, most of which are bearish for cattle prices overall. The projected record harvest in most anything you can get a cow to eat may be the only thing that has kept cattle prices out of foie gras territory. However, in a similar vane, it is the expensive cuts of meat that continue to push the market higher at the packer level. No matter how cheap the feed inputs are or how big the animal is when it reaches the slaughterhouse, there are still only a few select cuts of premium beef and these cuts are increasingly being shipped overseas at prices and profit margins that American consumers are unwilling to pay or support.
This leads back to macro economic issues and the continuing strength in Asia. The entire Asia play currently hangs in Putin’s hands. The big picture he’s trying to create includes creating a free trading zone among a new block of persona non-grata countries that will allow them to process the needs of their own economies between Europe, Africa and Asia. This includes the construction of the world’s biggest pipeline from Siberia to China. This includes energy agreements with Syria, Palestine and Iran. Finally, this also includes an agricultural revolution currently taking place in Ukraine. All the oil in the world doesn’t feed a nation and we all know that the best way to suppress third world turmoil is to fill their bellies.
Trade sanctions via the banking sector from the EU and the US have already squashed Russian GDP and recent discussions about sanctioning Russia’s access to the SWIFT banking system would severely cripple their ability not just to do business outside the country but even to process domestic transactions. The SWIFT system, “Society for Worldwide Interbank Financial Telecommunication” is basically, a messenger system between banks that processes bank-to-bank transactions. Enacting these sanctions would be a game changer and bring with it a tremendous amount of turmoil in the financial system. Furthermore, handcuffing the Russian economy could bring retaliation from Putin that would increasingly polarize Russian friendly nations against Russian unfriendly nations. The end result would be significant and quantifiable slowdown in global GDP.
Shifting gears to the specifics of the current market setup there are two factors that need to be addressed. First, the recent price swings have been driven and will continue to be driven for the next week or so through the roll over from the October to December live cattle contracts. Index traders have made rolling their positions over into a micro trade of their own. Due to the creation of long only commodity index funds, commodity traders now have to be aware of when and how the Goldmans and the Black Rocks are trading. Due to the public nature of these funds, their roll dates are printed right in their prospectus. This allows smart traders to take advantage of the near month selling and the deferred month buying that is necessary to move the index positions from deliverable contract to the next.
This is the action that helped bring us to our current spot. Selling in the October contract caused the market to fall by a little more than 10%. This sell-off was exacerbated by long liquidation among trend following funds and speculators taking profits as well. Meanwhile, the deferred December contract that is currently becoming the front month, only declined by 8% because the index sellers in October were buying new December contracts to replace them. This means that a little more than 2% of the total decline was due to profit taking by speculators and trend followers. These actions can be seen on the October-December Live Cattle Spread chart.
Finally, analysis of the current situation shows us that the commercial traders are collectively banking on cheap feed prices to rebuild the herd. We’ve talked at length about the declining size of the US cattle herd, which has been bumbling around 50-year lows. Recently, we’ve finally seen the beginnings of herd rebuilding. This is evident in the slaughter numbers. This year, we’ve seen a steady increase in steer slaughter over heifers. Steers gain weight more quickly and their greater weight in general makes them a better product from a cattle producer’s point of view. What’s interesting is the change in the killing spread between steers and heifers this year as steer slaughter is down about 3% for the year while heifers are down 9% and cow slaughter is down more than 17%.
The decline in these numbers has kept prices high this year and I fully expect a new high to be set for the December contract but overall this is foreshadowing a turn. Packers chasing nearly marketable animals up to the point that their profit margins no longer justify it will push the December contract to new highs. So far, their margins have declined by about half as the price of beef has is about 20% higher than it began the year. The packers’ actions can be clearly seen in this Commitment of Traders chart plotted against the continuous futures contract price. Commercial traders have been net buyers in each of the last three weeks. This is the most concerted buying effort since the beginning of 2013. We believe that their purchases of more than 25,000 contracts will be more than enough to replace the open interest lost due to trend followers and speculators being taken out of the market on its recent decline.
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