The drought of 2012 now covers more than half of the continental United States. Temperatures have set records throughout 2012 leading to the warmest 12-month period since the National Oceanic and Atmospheric Administration (NOAA) began keeping records in 1895. When we combine these temperatures with the 10th driest June on record and consider that the rain we have seen has not made it to the Great Plains, it’s no wonder that grain prices have increased by 50% in the last month. Grain farmers are at least partially compensated for their lower output by higher prices on delivery as well as various insurance programs that kick in when output falls to pre-determined levels. The cattle industry faces an entirely different dilemma.
The price for beef and dairy in the U.S. changes very little at the grocery store. The competition between grocers as well as the availability of substitute goods to the shoppers make the livestock industry hold prices steady at the end point while withstanding the expense of higher feed costs on the front end. Their business plan is based on the two-year production cycle of cattle for beef, which places them in the position of absorbing losses this year while hoping to refill their coffers at higher prices two years down the road. How long can they afford to hold on to inventory while maintaining back stock for the coming year?
The cattle for beef industry is a two-step process. Individual farmers breed and raise cattle until they reach about 700lbs. These animals are then sent to feedlots to be fattened up for slaughter. Feeder cattle will nearly double in size for slaughter, ending up around 1,300lbs. The farmers and feedlots are in competition with each other. When feed costs are low, the feedlot operators can afford to fatten up the skinniest of animals. However, when costs are as high as they are now, feedlots are looking for heavier animals that have spent more time at the farms grazing. Iowa State published a paper two years ago on feed costs and determined that it takes 3,360 pounds of corn to increase fed cattle’s weight by 500lbs. This is the equivalent of 60 bushels of corn or, $420 per animal at today’s prices.
The upward pressure of grain prices forces farmers to determine how many cattle they can hold back and afford to feed versus how many they have to sell to generate more revenue to cover the higher input costs. These decisions show up in the World Agriculture Board’s forecast for greater cattle production through this fall. We will see cattle prices fall as a result of this through Halloween. The catch is that there will be fewer animals available next year and this will lead to competition among feedlots for placements because lower grain prices will increase feedlot operator margins as they finish the animals to send to the packinghouses.
These market forces will also show up in the dairy market. The relationship between feed costs and milk production are almost 1 to 1. It takes about 100lbs of feed made up of 75% corn and 25% soybean meal to produce 100lbs of milk. This equals input feed costs of $1.28 per gallon. Dairy farmers will be forced to cull their less productive cows to feed the animals that are producing well. This will add more beef cattle to the supply chain further depressing prices through this fall.
One of the best ways to determine if something is, “going on” in a market is by noticing when market relationships are out of kilter. Cattle and grains typically have a positive correlation. They tend to move in tandem. Moderately increase the price of corn and the cattle will follow suit. The opposite is also true as the cost of feed declines, so does the cost of production. However, when this relationship breaks down it’s because one market can’t keep pace or, pass on the costs of the other. That is exactly what we’re seeing between cattle and corn. The price of feed has exceeded the livestock market’s ability to pass on the costs. This brings more animals to slaughter now and will leave us with a smaller breeding herd heading into next year.
This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.
