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The Future Of Cash

Cash markets in the beef business are becoming a thing of the past. So what will be the foundation of new-era cattle pricing?Daily cash transactions in the cattle trade are riding off into the sunset. With the proliferation of innovative marketing agreements, alliances, formula pricing and forward contracts, cash transactions are fewer and becoming less representative of the cattle trade.With nothing

Cash markets in the beef business are becoming a thing of the past. So what will be the foundation of new-era cattle pricing?

Daily cash transactions in the cattle trade are riding off into the sunset. With the proliferation of innovative marketing agreements, alliances, formula pricing and forward contracts, cash transactions are fewer and becoming less representative of the cattle trade.

With nothing on the horizon to reverse the trend, what are the alternatives to the cash market quotes that have served as the foundation of cattle pricing?

"For years the livestock industry relied on cash price quotes as the barometer of the market," says Ted Schroeder, Kansas State University (KSU) agricultural economist. "But fewer animals every day are sold via simple cash market negotiation."

Schroeder says new-era marketing, especially formula pricing, can offer advantages to both buyer and seller. These agreements, however, mean fewer cash trades and less public price information.

"The situation is complicated further by the fact that many formula-priced cattle sales rely on an external reference price for establishing a base price," explains Schroeder. "Many of those external prices are built upon cash market prices - the very prices that are becoming more thinly quoted."

With cash prices less indicative of trade - particularly in fed cattle - market participants are often left searching for other external pricing references. Suggested choices for these "transfer" prices include: average dressed or live prices from beef processing plants, retail beef prices, live-cattle futures prices and prices of wholesale boxed beef and beef by-products.

- Prices from processing plants are poor candidates for use as external reference prices, says Schroeder. They reflect varying quality levels over time and can lead to perverse pricing results.

- Retail prices might yield the same perverse results because of the vast difference in the product form from farm to retail levels.

- Futures prices are appealing because they rapidly reflect a large volume of new information. "They also are a viable source of price expectations, provide readily available price quotes and are closely monitored to avoid manipulation," says James Mintert, KSU Extension agricultural economist.

In addition, futures price-based formulas fix the basis level, which greatly reduces the risk of hedging.

But, there are concerns about using futures prices as external reference prices.

"Futures have a `time-matching' problem - they represent specific delivery or expiration dates that don't necessarily match the cash market transaction date," emphasizes Mintert. Basis (cash price, minus futures price) variability needs to be accounted for if futures prices are to be used as a reference price source.

Schroeder says futures markets must have a viable underlying cash market. "If viable cash market prices disappear, futures markets will also struggle to survive."

- Wholesale boxed beef and by-product prices are another possible source of external reference prices as they reflect the prices meat processors are receiving for beef products from retail, food service and export markets. However, using wholesale prices as a cash price alternative has its drawbacks.

"Direct wholesale cash trade is diminishing much like cash livestock trade, and meat sales are increasingly done on a non-cash basis," says Mintert. Consequently, the USDA wholesale beef prices are based on a small percentage of all beef traded and may not represent the animal's true wholesale value."

Also, as slaughter and processing costs change, the relationship between wholesale and farm level prices also changes, he adds.

Long-Term Implications The long-term trend in the relationship between wholesale and live cattle values may have more implications to the price discovery process than short-term fluctuations. In the early 1990s, the fed steer value typically averaged 90-95% of the wholesale value. However, this ratio has trended downward and increased in variability. By the late 1990s, the live animal value ranged from 80-90% of the wholesale value, Schroeder says.

"This doesn't necessarily indicate that packer margins are increasing," he points out. "Rather, cash fed-cattle markets could be representing progressively lower-quality cattle, as higher-quality cattle get marketed using grids and marketing agreements."

The key here, according to Schroeder, is that using wholesale beef prices as external reference prices will result in lower fed-cattle prices today than would a similar formula just a few years ago.

Jim Holzer, vice president of Chicago-based Frontier Risk Management, says there's no question "transfer pricing" gives market power to the middlemen, primarily meat packers.

"Whether they use that power to the detriment of the beef industry is up for debate," he says. "But, non-cash pricing is the direction the industry is going, and there's really not a whole lot that can be done about it."

Holzer adds that large cattle feeders who are selling cattle every week can maintain a say in how the cash market is established, but it involves some added risk.

"If you have five lots of cattle ready to sell, take one lot and negotiate it on the open market," he says. "Odds are you're sending the bulk of your cattle to the same plant anyway. At least then you can test the validity of the cash market and still sell the bulk of your production on the formula. Otherwise, when you're not in the cash market, how do you know how valid or representative the reported markets are for your cattle?"

Holzer adds that the reason the industry is moving to formulas at the expense of cash markets is the consolidation in every beef production sector, as well as in retailing. "These guys want their supplies guaranteed nationwide, consistently and a year in advance," he says.

Is There A Panacea? So, there looks to be no panacea for replacing cash prices in the real world of today's cattle marketing picture. In a world of spotty price quotes, scanty trade volume and fewer buyers and sellers, Schroeder says the negotiation of the formula should not be taken lightly.

"Be careful of settling for a formula based on plant averages," he advises. "In the long run, formulas using wholesale and/or live cattle futures prices as a reference appear to hold the most promise."

To address livestock pricing problems and force more pricing information into the system, some segments of the livestock industry have pushed through mandatory price reporting (MPR) laws. Proponents believe MPR has the potential to reduce variability in prices between transactions.

"Some producers believe MPR will mean a significant difference in the amount they're paid for their animals, but it's doubtful this will do much to change price levels," says Ted Schroeder, Kansas State University agricultural economist. "It will not shift either the livestock supply or demand, which are the underlying driving forces in determining prices."

Schroeder says he's an advocate for price transparency and believes more pricing information is better. But, he says it has to be meaningful information - information that's somehow going to influence a producer's ability to negotiate a particular transaction.

"The cash trade is still `thin and lumpy,' with or without MPR," Schroeder says. He just doesn't see MPR doing much to change the trading environment.

Especially as the industry moves into value-based pricing, the vast mixture of transactions in the cattle industry will tend to complicate and confuse the market reporting system.

"Some transactions are long-run joint ventures, some are forward price contracts set months previous, some are marketing agreements with formula prices," he says. "Each transaction may contain pricing attributes that we'll never see in a price report."

To make price reporting truly transparent, a whole paragraph will have to be written explaining the parameters and pricing details of each transaction, according to Schroeder. "Otherwise, we're prone to a lot of misinformation."

Schroeder says it will take quite an effort for USDA to come up with a meaningful and timely price reporting system. Providing such a vast array of data in a condensed form that is useful to buyers and sellers in a cost-effective manner may be nearly impossible.

"It's clear this will be a very costly activity for the industry," says Schroeder, adding that the on-going costs will be passed back and forward from the packers. "It will be reflected in slightly lower fed cattle prices and possibly slightly higher beef prices," he says.

His other concern is that such public information could benefit processors more than producers.

"It reveals to them more clearly what each other is doing. As soon as a packer does something innovative with an alliance, for example, it will be reported. Suddenly, other packers will know what the competition has done.

"It's almost like we are mandating that packers get together and share price information," he says.

Jim Holzer, vice president of Chicago-based Frontier Risk Management, isn't sure MPR will offer much to the industry. He says it might be useful in capturing any discrepancies there may be in premiums and discounts.

"It may allow a formula seller to evaluate whether he's getting what his competitor is getting as far as premium structures," he says. "That's the only benefit I see.