Most estimates are that upward of 80% or more of the fed cattle sold in the U.S. trade outside of the cash market. That’s because alternative marketing arrangements (AMAs) — formulas, forward contracts and such — offer a variety of comparative benefits, including lower cost and increased value differentiation.
As Stephen Koontz, agricultural economist at Colorado State University, notes in the executive summary to the multiyear Price Discovery Research Project (PDRP), “No formula operation expressed any interest in returning to the cash market or in marketing any animals through cash markets. The cash market had value in terms of price information, but not in terms of opportunity.”
The potential problem is that price discovery of fed cattle — the prices central to many AMAs — occurs in the cash market. So, the price discovered via fewer and fewer cattle helps establish the value for more and more.
Likewise, cash fed cattle prices are a critical component to price discovery and validation across a wide swath of beef and cattle markets. As an example, Koontz notes, forward contracts can require historical information on cash prices to construct basis estimates.
“Fed cattle, futures and beef values all move together,” Koontz explains. “There are strong equilibrium relationships. Knowing any one price provides strong knowledge about all of the other prices.”
Although various research suggests futures prices lead cash prices, the futures market is busted unless cash prices of the underlying commodity converge with the futures price at contract expiration.
In his extensive interviews of cattle feeders and beef packers for PDRP research, Koontz says, “All recognized that the value of cash is clearly and directly limited by the fact that there is a futures market, and it will simply do more of the price discovery work. They also recognized that the performance of the futures market would be at issue with a thin cash market to which it is tied.”
“Cash fed cattle prices are critically important, but not necessarily in obvious ways,” sums up Glynn Tonsor, agricultural economist at Kansas State University.
For clarity, there are distinct differences between price discovery and price determination.
“Price discovery is the process of buyers and sellers arriving at a transaction price for a given quality and quantity of a product at a given time and place” say Ted Schroeder, agricultural economist at Kansas State University, and Clem Ward, agricultural economist at Oklahoma State University, in their publication Price Determination Versus Price Discovery.
“Price determination is the interaction of the broad forces of supply and demand that determine the market price level,” Ward and Schroeder explain. “It shows the interaction of a supply curve and a demand curve to determine the general price level.”
Other than lots of chatter and hand-wringing for at least a couple of decades, the industry has done little to bolster price discovery in cash markets as more fed cattle trade outside of that market.
The simplest explanation is that, by and large, price discovery remains effective. “Nothing is wrong with it until we lose the last critical trade,” Tonsor says. No one knows when or where that is likely to occur.
In his PDRP research, Koontz says no one was concerned that thin cash markets had negatively affected business profitability over a significant time period.
Cash market traders wanted to see 30% to 50% of trade in a regional market as cash trade. Formula traders were comfortable with 10%. Nationally, about 20% of fed cattle are traded in the cash market.
Based on his objective price discovery modeling, Koontz says, “The national market is substantially thick, and there are no concerns. It is only some regions where there are concerns, mainly the Southern Plains … Cash fed cattle price discovery in 2015 was effectively conducted in the Northern Plains. There is some price discovery in Kansas and arguably none in Texas. As important as the Southern Plains are in the production of fed cattle, there is relatively little work conducted there to determine the value of those fed cattle.”
Specifically, Koontz says cash trade of less than 5% appears to be too thin for Texas, and that occurred in all of 2014.
“Below 10% to 15% is too thin for Kansas — this occurred in the latter half of 2014,” Koontz says. “Colorado is too thin below 8% to 10% cash trade. Nebraska and Iowa have grown in importance in terms of feeding, and in the contribution to price discovery. They have not been thin enough to be concerned or to know how thin is too thin … The results appear to suggest that policy and association efforts would be best spent on maintaining cash trade in Nebraska and returning cash trade to the Texas region.”
It’s worth noting that Koontz found no evidence of price discovery improving with less cash trade.
There’s also no way for the study to get at another concern expressed by some market participants. They wonder how thin markets can become before the government shows up to help by mandating negotiated trade.
“The thinning cash market problem will not solve itself,” Koontz says. “Action by the industry is needed.”
Cash price discovery of fed cattle is similar to public roads, if you never paid taxes. You use them regularly without giving much thought to how they got there or what you’d do without them. In this case, participants in the cash fed cattle market pay for the price discovery that others use.
“To date, the thin markets discussion has not recognized the public good aspect,” Koontz explains. “Price discovery is work. It is the work of market participants in discovering how changing market conditions and anticipated changing market conditions impact price. Price discovery is the process of gathering information on current and expected future supply and demand, formulating bids and offers in negotiation, and incorporating new and changing economic information.”
Such work comes at a cost.
“Formula and forward-contracting operations use information provided through the efforts of negotiated cash market participants,” Koontz explains. “Cash market price information is used in many formula operations and is decision support information for forward-contracting operations.”
The extent of the using but not providing information has become problematic in some regional markets — in particular, the Southern Plains, he says. “The solution involves selective or some combinations of: communication, institution development, technology, information, market-making or legislation. But to date, only legislation has been proposed, and that solution is most opposed by industry members.”
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