Does the risk-reward ratio favor cow herd expansion?

Does the risk-reward ratio favor cow herd expansion?

Despite summer doldrums, beef producers are willing to take on more risk to expand their cow herds.

Summer is right on schedule and so is all that comes with it, including hot weather and market weakness. The beef complex had exhibited surprisingly solid resilience through most of the spring. But that all changed in earnest after the lead-up to Memorial Day, the unofficial start of summer for the beef complex. 

Since May, prices have generally been caught in a slump. While fed cattle trade finished July on a favorable note, trade jumped $2 per cwt to $147 and spurred a strong rally at the CME as August opened for business. July followed a mostly normal seasonal pattern with softer trade occurring during the previous three weeks.  

The negative pressure stems from spillover on the wholesale side. There again, in line with normal seasonality, the cutout has experienced some sharp setbacks during the past six to eight weeks, in distinct contrast with last year. The downward move was especially harsh in July, with the Choice cutout giving up nearly $20 per cwt in the past four weeks. Cutout values are now trading around $230, their lowest levels since last June.   

Meanwhile, hide and offal values are also pressuring the fed market. The U.S. dollar’s strength has severely squeezed drop value. The byproduct market has retreated nearly $4 per cwt or 25% thus far in 2015, and finished July around $11.80 per cwt. 

Since mid-May, cutout and drop values have receded approximately $250 per head and $25 per head, respectively. That influence has directly impacted fed cattle pricing on a weekly basis. And the fed market’s decline has occurred in a fairly steady, systematic fashion.  

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Early May was the last time the market saw some follow-through strength week over week; fed trade gained about $3 during a two-week period in late April and early May, moving the market to $161-$162. May then trickled along, giving most of that back during the remainder of the month, closing at $159. June then gave up another $11 and July followed through with $3 more, hitting a low of $145. Moreover, the market has taken a negative hit 10 of the last 12 weeks. As such, the four-week moving average turned sub-$150 in July for the first time since the end of June, 2014. 

Those fundamental indicators have also influenced action at the CME. Most notably, the deferred live cattle contracts also retreated in July. The December and February contracts slipped about $7 during the past month—the equivalent of about $95 per head. As mentioned earlier, futures markets rallied during the first trading day of August, following better cash trade at the end of July. However, buying replacements against those contracts ultimately means feeder cattle prices will subsequently experience some adjustment. 

In accordance to the move on the futures side, the CME Feeder Cattle Index has slid $13-$15 per cwt, or about $100 per head, since its near-term peak in mid-June. From a longer-term perspective, yearling prices at $215-$220 per cwt are right in line with levels established last year at this time. Nevertheless, behind the incredible surge in 2014, the market appears to be consolidating and chopping to establish a narrower, more predictable trading range, assuming live cattle prices and corn do the same. And since the second half of January, the feeder cattle market has been essentially flat (Figure 1).  

weekly cme trends

Shifting gears to the cow-calf sector, “risk-on” has seemingly been the general sentiment among producers. Such indicators have been in place for some time. However, USDA’s July Cattle Inventory and Cattle on Feed reports provided definitive evidence that restocking the cow herd is underway in earnest.  

First, the cattle inventory report pegged the mid-year beef cow inventory at 30.5 million cows, up 750,000 versus 2014 and the largest count since 2011. Beef producers have sharply curtailed culling (see Implications of Declining Culling Rates). Second, and more importantly, the replacement heifer inventory equaled 4.9 million head; 2006 marks the last time the industry saw a heifer number that big—and that occurred against an inventory of 3 million additional cows. Simultaneously, the Cattle on Feed report further confirmed that shift; feedyard heifer inventory continues to decline over time (Figure 2). 

heifers on feed

So, rebuilding is occurring on both sides—cows and heifers. It’s one thing to simply not cull a cow and run her an additional year. The risk associated with that strategy is fairly minimal. Within the current price structure, the marginal profit potential generally outweighs the marginal investment, which is mostly an additional year’s worth of production costs. 

Heifers are another matter. Given the comparatively high investment cost and long payoff associated with developing heifers, it’s clear that market optimism and subsequent risk appetite among beef producers has definitively turned the corner to the upside.    

That’s an important development. Keep that in mind when you recall how the market struggled along in February. Given the action during the past several months, and the intent to rebuild the cowherd, the summary that followed in March seems appropriate to include here once again:

All of this discussion can seem somewhat gloomy, especially on the heels of 2014. That said, two things are important to point out. One, commodity markets are inherently challenging. Corrections are inevitable and many seasoned industry veterans will likely tell you they’re not surprised; they’ve weathered some big swings in the market, albeit, never at these levels of capital at risk. Two, it doesn’t mean 2014 was a fluke. There were key reasons for 2014’s success—the surge was partially supply driven, but was fundamentally underpinned by solid beef demand both domestically and internationally

And ultimately it’s the demand picture that’s driving producer optimism—and rightfully so.

Therefore, the business finds itself in uncharted territory. The demand curve has seemingly experienced a positive, long-term shift. That’s the direct result of hard work and commitment to improved quality and increased consistency over time. However, now the complex will also have to begin dealing with increased supply in the foreseeable future—that will feel like a new dynamic, considering the enduring pressure of shrinking supply over the past 10 to 15 years.  

Those shifts, along with a host of other persistent considerations including corn supply, interest rates, energy costs and others, highlight the persistent challenge associated with making strategic business decisions. Moreover, there’s a new risk level across all segments of production stemming from the increased levels of capital required to operate the beef business.

Therefore, as noted each month, it’s imperative to introduce some form of risk management. Such implementation may be non-traditional, depending on the operation, but important nonetheless. And to be effective, those efforts should include access to accurate, data-driven, objective information and establishing time to adequately absorb and analyze that information. Both components are essential to being successful over the long run.  

Nevil Speer is based in Bowling Green, Ky., and serves as vice president of U.S. operations for AgriClear, Inc. – a wholly-owned subsidiary of TMX Group Limited.  The views and opinions of the author expressed herein do not necessarily state or reflect those of the TMX Group Limited and Natural Gas Exchange Inc.

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