Is the cash fed cattle market fixable?Is the cash fed cattle market fixable?
If participants in the fed cattle market want to keep a level of cash fed cattle trade sufficient enough to continue price discovery, are they willing to pony up to make that happen?
December 7, 2015
“When the music stops, nobody wants to be the one without a chair.”
That analogy by Stephen Koontz, professor of agricultural and resource economics at Colorado State University, sums up the current situation in the fed cattle market as well as any. And that situation is this: While the cash fed cattle market nationally is around 20%, there is a trend toward use of alternative marketing arrangements (AMAs) and away from a negotiated cash trade.
In some regions, like the Southern Plains, cash trade has all but disappeared. Nebraska still has robust cash trade, but it’s highly variable from week to week. Ditto for Kansas.
“There’s a lot of discussion about what packers are up to,” Koontz says. “And the bottom line — it’s not what packers are up to, it’s what producers are up to. They’ve really hammered cost and hammered this idea of supply chain management while trying to chase cost out of the system. We had corn go to $6, $7 and $8 per bushel. How can you continue to feed cattle in that kind of world? Well, you really manage your costs.”
Feed costs have moderated, only to be replaced the past several years by feeder cattle prices that pushed breakeven calculations to never-before-seen levels. “There’s just no slack there. Cattle feeders have to manage that operation very tightly. And the ones who are left are very successful at doing that.”
“If you have [those using formulas] willing to pay 50 cents a head, or something like that, then you pool that money and it goes to someone who is cash trading." Stephen Koontz
Part of managing costs is knowing not just the week, but the day that cattle will be harvested. That’s important for cattle feeders, and it’s important for packers.
Enter AMAs. And in the cattle industry these are formula cattle and forward contracts.
Among other things, these agreements between cattle feeders and packers let both parties know exactly when the cattle will be harvested. Koontz, who has been studying the thinning cash trade in the fed cattle market since 2012, says cattle feeders who have moved to marketing cattle with AMAs say they have no desire to go back to the cash market.
That’s because AMAs are simply more efficient. When he asked cattle feeders to put a value on the use of AMAs, they routinely constructed estimates of around $25 per head.
Those same businesses that use cash market price information estimate that it’s worth from $1 to $3 per head to them. “So formulas are worth $25 a head; cash is worth $1 to $3. The balance of the scale there is pretty clear. We’ll continue to use formulas and likely do more formula marketing.”
10 considerations with AMAs
But the rub is that AMAs use the cash price as the base point in establishing value. That means there’s good reason for the beef business as a whole to ensure that it maintains a viable cash market for fed cattle. “The individual incentive is to not use the cash market. But as a group, I’m not sure we don’t want to have a cash market. I believe maintaining a cash market is what’s best for the industry,” Koontz says. “So what will have to happen is, the industry will have to do something to incentivize that cash trade to bring it back.”
To that end, Koontz’s research yielded a list of 10 possible policy prescriptions and other actions the beef business can consider. “All have different probabilities of success. All require different amounts of work, commitment and change. Many overlap some. But the thinning cash market problem will not solve itself. Action by the industry is needed,” he says. The 10 considerations are:
1. Industry communication and voluntary leadership. The industry, through its associations, needs to meet, discuss the issue and assess what individuals are willing to do. Many public goods across the spectrum of common agricultural, fishery and environmental resources are managed through informal institutions. Industry members often value the common good, so that meeting, discussing the problem and agreeing to individual action will support the quality and quantity of the public good.
2. Work to increase flexibility of formal cash trade reporting. This work will be between the associations and government entities that report prices, such as the USDA Agricultural Marketing Service (AMS). The current structure of livestock mandatory price reporting provides substantial transparency. All transactions are reported or are considered for reporting.
However, the fed cattle industry has transitioned into using more basis pricing for cash trades, similar to the grains industry. This is currently being reported as forward contracts, even if delivery is within the cash window. Reporting the basis trades would, modestly and for the time being, thicken the reporting of cash trades.
3. New market reporting and trading technology. Substantial numbers of other commodity and financial asset markets trade through electronic means, and e-markets are common and accepted. But not for fed cattle trade.
A smaller cash market trade through e-markets may provide substantial price discovery. A substantial difficulty is the physical transportation and the transactions costs associated with trusting the trading partner that may be lost in e-systems.
4. Develop and fund new trading institutions. Institutions are the rules and customs associated with trading fed cattle. Industry members could develop institutions associated with cash trading that improve the functioning of, and remove risks to, cash markets. This can be thought of as an updating of the “seven-day pickup.”
For example, an effective cash market institution would be for cash market cattle to be slaughtered early in the week. There could be agreed-to institutions that there are no delays to the scheduling or to picking up cash cattle, or that any delays will have compensation.
5. Develop and maintain industry standard business practices. In all interviews of cash market traders, there were examples of trades that were not perceived as reported that created price transparency problems, and that were not in the best interest of the industry.
All of these examples communicate a need for standardization of business practices. For example, in the grains industry, all trades are f.o.b. buyer’s location and the seller pays freight. Further, any modification of the terms by the buyer is paid for by the buyer. Many problems with the fed cattle trade would be eliminated by adopting the two sentences above in a trade bylaws document. Formalizing trading institutions can improve cash market function.
6. Provide new market information. Information removes risk. More information about the feeding industry’s inventory and timing of potential fed cattle marketings — and combining that with committed, but not delivered, information in mandatory price reporting — will remove some of the risk associated with using the cash market. While removing costs associated with the cash market, this information may also reveal competitive edges of a variety of market participants.
7. Employ market makers. All financial markets that function well employ market makers. Market makers are often directly compensated and/or derive some compensation from their trading.
This is a proven system. But it requires compensation. One method of compensating market makers would be to develop a system whereby businesses that use alternatives to the cash market and that make use of cash market price information would provide the compensation to market makers — for example, to a business entity that provides marketing services for feeding businesses for commission. This would create a cash market. But it is unknown if the volume would be sufficient or excessive for effective price discovery.
8. Develop permits or certificates. The critical economic issue with thin markets is that there is no market for price information. For example, if you think there is not enough price information, then there is no way to increase its availability by buying more.
Prices are simply reported by AMS, which addresses one aspect of the public good problem in that information is difficult to control once released. Permits or certificates would require some level of cash trade. Individuals who do not wish to cash-trade could trade them to individuals who do, and offer compensation. A market for cash information is thus developed.
Further, this permit market is not inflexible, like regulation or privatization. The market can be changed as needed — the volume of cash trade could be increased if certificates are too expensive, decreased if certificates are too cheap or folded if small numbers of certificates are worthless.
The market for price information provides and communicates its value. This is “cap and trade,” and it works where it has been tried. But it is very innovative and not tried before in any agricultural industry to facilitate price discovery.
9. Develop industry-supported legislative mandates. A traditional means of addressing public good problems is to use legislation to require certain behavior and prohibit other behaviors. However, almost no interviewees support this path. The question is also well-researched, and the clear answer is that this would cost the cattle and beef industry, and create regulation that is hard to change or undo.
10. Privatize price collection and reporting. This is another traditional method of solving public good problems. Allowing a private entity to own price reporting — change the public good to a private good — would result in users of price data paying subscription fees and would allow compensation to those providing the information and price discovery.
This is happening in other livestock industries. However, this does not recognize that many other upstream industries need economic information on fed cattle prices to make economic decisions. The owners of the information will also have to spend resources to protect against others sharing copyrighted price information.
Of those 10 considerations, Koontz advocates the market makers approach. “It should not be part of the checkoff, but the mechanics are exactly like the checkoff,” he says. “If you have [those using formulas] willing to pay 50 cents a head, or something like that, then you pool that money and it goes to someone who is cash-trading. You’re really paying somebody’s commission to get them to make a market.”
The bottom line, Koontz says, is if the industry did that, the problem would be solved. “If you’re not getting enough of something, chances are you’re not paying enough for it. If we set up a market and figured out what people are willing to pay for that information, is that enough to get what we need? I think it would flat-out solve the problem, and we could go on to something else.”
In Koontz’ mind, not solving the problem isn’t an option. If the beef industry does nothing, he says it’s just a matter of time before the cash market is substantially thin. So here’s the question: If participants in the fed cattle market want to keep a level of cash fed cattle trade sufficient enough to continue price discovery, are they willing to pony up to make that happen?
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