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Market Madness

When the year began, plenty of the beef industry saw the cattle markets as resplendent in potential, promising succulent, low-hanging fruit to everyone. By April, those same markets were ghastly: higher placements than expected; fed prices $10/cwt. lower than anticipated; live cattle futures losing $10 in 30 days; allegations of market manipulation, and on and on. What happened? It's easy and often

When the year began, plenty of the beef industry saw the cattle markets as resplendent in potential, promising succulent, low-hanging fruit to everyone. By April, those same markets were ghastly: higher placements than expected; fed prices $10/cwt. lower than anticipated; live cattle futures losing $10 in 30 days; allegations of market manipulation, and on and on.

What happened?

“It's easy and often more convenient to point a finger at something and say it needs to be modified,” says Bill Helming of Helming Consulting Services, Olathe, KS. “I believe the overall fundamentals of the marketplace are working. It boils down to supply and demand.”

Helming says the overwhelming reality is that among some cow/calf operators, stockers, cattle feeders and market analysts, there's been an incredibly high level of excess optimism for a long time. “A lot of people honestly believed we'd be trading fed cattle for $70-$80/cwt. today (in April when feds were trading at $64),” he says.

The giddiness at the start of the year was based in part on last year's historically high feeder prices and the spreads between feeder and fed cattle. The widespread belief that cyclical liquidation was ending also promised fewer cattle numbers to place, and thus less beef and stronger prices.

The predictions, however, turned out horrifically wrong, or at least late in coming.

“We, as much as anyone, anticipated that carcass weights would moderate to the point of relief,” explains Dave Weaber, market analyst at Cattle-Fax.

Weaber says many read the lower cattle-on-feed placements of last fall and January as harbingers of expansion. Unexpectedly, a staggering 16% more cattle went on feed in February than a year ago, followed by more increases in March and April.

Besides more near-term harvest to manage, and partly because of it, carcass weights climbed to record levels, fanned by an open winter, cheap grain and the economic incentive to push weight when selling cattle away from the live market. Weaber says that as more fed cattle trade away from the live market, some cattle feeders are negotiating and receiving higher, non-discounted thresholds for carcass weight, as high as 950-1,000 lbs.

Cattle-Fax says average carcass weights have increased 5.9 lbs./year since 1975. With 29 million fed cattle harvested last year, that's the equivalent of 228,000 more cattle, basis a 750-lb. carcass.

The crux, says Chuck Lambert, chief economist for the National Cattlemen's Beef Association (NCBA) is “We have again produced more beef with fewer cattle.”

Most analysts now project a beef production increase for 2002. Cattle-Fax expects a 2-2½% jump from 2001; Helming estimates a 1-2% increase. Bottom line: beef production in 2002 could top the record 26.8 billion lbs. produced in 2000.

Exacerbating the situation are anticipated increases in poultry and pork. Helming expects a record for combined levels of red and white meat supplies in 2002 and 2003.

He pegs the overall increase at 2½-3% this year. That adds up to a per-capita supply of 205 lbs. of meat, which Helming says is “getting close to the point of saturation on per-capita consumption of protein.” That in mind, he expects competing protein supplies to pressure cattle and beef prices for the remainder of 2002 and 2003.

That's the supply side.

Demand's Where You Find It

Domestically, demand remains strong. Lambert says, “We've seen relatively stable retail prices that are relatively large on a historical basis.” That means consumers so far are paying basically the same money to consume more beef.

From a retail featuring perspective, Weaber says beef's market share of ad space increased 4.2% the first quarter of 2002 compared to last year. That means retailers are using beef to get consumers in the door.

This is where it starts to get dicey, though. While more positive than some had predicted, beef exports are down 10% so far this year. Much of the reduction is due to a 25-30% decline in exports to Japan, the largest U.S export market.

Russia added to the bad news when it imposed a ban on U.S. poultry imports in March. Though lifted a month later, at the end of April Russia still hadn't issued new import certificates. So what?

U.S. beef producers quickly learned that 10% of all U.S. broilers go to Russia. Thus, the ban sent 44 million lbs. of chicken looking for a new home each week. Prices were slashed to move more domestically, but that crashed the pork market by $20/cwt. in a single month, which pressured beef prices.

The U.S. beef industry still earns more than $1 billion from net international trade. But Lambert points out that as other countries re-entered the market this year, U.S. producers lost the $2/cwt. on fed cattle they picked up last year when foreign animal health concerns made the U.S. a primary exporter of hide and offal.

“Where would we be now if we wouldn't have had the upturn in demand we've had?” explains Helming.

That's the demand side.

Negative Thinking

Now, throw in a host of other dynamics — Sept. 11, a faltering economy, 2002 Farm Bill uncertainty and wide-scale drought. Add to them a handful of cattle with lesions that showed up March 12 at a Kansas sale barn and were routinely tested by USDA for foot-and-mouth disease (FMD).

Though tests confirmed within 24 hours that it wasn't FMD, word about the tests created a firestorm of rumor that crashed the live cattle futures contract the next day. The reaction was so sudden and complete that NCBA and others asked the Commodity Futures Trading Commission to investigate possible market manipulation. None has been found so far.

All told, Lambert says, “Fundamentals are a big part of it, but there's also been negative market psychology at work.”

Keep in mind this comes during some of the worst bloodletting the cattle feeding industry's ever seen. Cattle-Fax estimates cattle feeders lost $1.14 billion in equity from October to mid April and a net loss of $2.6 billion over the past five years. Helming estimates that from January 2000 to June of 2002, cattle feeders will have lost a record $3.3 billion.

Bottom line, Lambert says, “The market has absorbed a lot of shocks. Whether it's lost equity or the perception of increased risk, we've seen more fragility in the futures market than in the past.”

The futures market, which is supposed to remove volatility from the cash marketplace by predicting and evening out production, started heading south. It then turned negative to cash and sidelined buyers.

“It's not a matter of manipulation; it's a matter of who's willing to be long in the market,” says Weaber. “Why do you want to buy the board if cash is moving lower?”

Even without market manipulation, few are saying that futures are working as effectively as desired. All the analysts in this article mention the need to determine whether the risk management tools available today match the reality of the cattle the contracts were designed to protect.

“We know it's not working. We hear that from the largest cattle feeding organizations to the smallest farmer-feeders even when the basis is positive,” says Lambert.

Future Market Shock

Work the beads on this abacus, and Helming says, “The cow/calf operator is in for a rude awakening between now and fall.”

Cattle-Fax expects “Given current market sentiments for the late 2002 and early 2003 cattle market, cattle feeders will look to buy breakevens in the low to mid $60s, which would put feeder prices (basis 750 lbs.) at the low to mid $70s.”

Compare that to the nearly $86/cwt. average paid for feeders last year. Cattle-Fax expects calf prices (basis 500 lbs.), which averaged about $105.50 last year, to average $90-$95/cwt. the next couple of years.

Helming is slightly more conservative, expecting feeder cattle (basis 700-850 lbs.) to trade for $5-$10 more than the average fed cattle prices of $64-$66 he anticipates this year and next. He expects calves (basis 500-600 lbs.) to trade at $12-$15 ahead of feds.

Moreover, Helming says, “Cash fed cattle prices can and likely will reach lows of $55-$59/cwt. between now and October.” More broadly, Helming believes that compared to 2000-2001, the price spread between feds and feeder calves and cattle will narrow substantially through 2006. The narrowing will be due to declining prices paid for feeder calves and cattle, not by fed cattle increasing in price, he says.

All of the above forecasts assume corn prices will remain at $2/bu. or less.

Nonetheless, the analysts say profitability can remain in the cow/calf sector.

The number of heifers going into feed yards indicates expansion isn't yet underway, Weaber says. “While peak calf prices are probably behind us in this cycle, there should be an opportunity for cow/calf producers to make a profit for the next four to five years,” he adds.

For perspective, a Cattle-Fax member survey found 83% of cow/calf operators were profitable last year. Two-thirds of them made more than $50/head on calves sold at weaning; a third made more than $100.

With the near-term outlook in mind, Helming says he's hearing stockers and cow/calf operators say they'll feed their cattle themselves rather than take lower bids. He doesn't recommend it.

“In this market, you're better off selling your calves to someone else then buying back cattle to feed cheaper,” he says.

As a means of risk management, all these analysts say cow/calf producers may want to consider any forward contracting opportunities that arise this summer. And, Lambert suggests seeking opportunities to reduce risk by working cooperatively with other producers and segments.

Fundamental Shift

Depending on how you decipher the future, markets the rest of this year may be similar to markets for the next several.

“The cattle market today, in large measure, will trade within whatever range it trades in because of fundamental supply and demand forces,” emphasizes Helming, “But there are also other much broader forces at work that must be accounted for.”

Helming points to domestic and global economies that have been impacted by “disinflation” for the past 21 years. While inflation pushes prices higher each year, disinflation occurs when prices rise less rapidly, remain fairly static from year to year or at times even move lower (deflation). Disinflation, he says, makes it harder to assume and service debt.

“In that environment, you have lots of capital at risk, and you're forced to figure out how to become more productive, which in turn feeds on itself,” he says.

Increasing technology and more global supply than demand are driving this prolonged disinflation, he says. Since 1980 the world has been in a position where the tendency is for more supply than demand. This is partly due to poor countries utilizing commodity production as a means of garnering international currency, which provides incentive to maximize production.

As for technology, by its definition, Helming says it's the ability to produce something better, faster and cheaper.

That brings us back to now.

Helming isn't suggesting the cattle cycle is dead, but he believes the forces described above set the stage for the current and future cycles being fundamentally different than previous ones. The overriding trend for at least the next two to four years will be continued cowherd liquidation, he believes.

“We don't need as many cows as we now have, let alone more cows, due to the increased efficiency per cow,” he says. “We're producing as many pounds today as we did in 1976, but with 26% fewer cows.”

That would push the total liquidation phase of this cycle to at least eight to 10 years, the longest in recent memory. And, once liquidation ends, Helming isn't convinced that expansion will immediately follow.

“My guess is that we won't expand but remain flat until such time that domestic and export market demand warrants the possible beginning of a new cycle,” he says.

Another reality, Helming says, is that the cattle feeding business is overbuilt, having increased pen space 20-25% on a net basis since 1990. In sum, that excess capacity, coupled with a dwindling cattle supply and driven by disinflation, underscores the need for cattle producers to further increase production and cost efficiencies, he adds.

“It will place excruciating pressure on cow/calf producers to reduce costs and increase productivity,” Helming says.

Many producers are weary of hearing about cost reduction. But, Weaber points out the market will be very efficient at deciding which producers survive.

“The one guarantee is that high-cost, low-return producers will be pushed out of the system. That's one reason we've lost 200,000 beef producers since the mid 1970s,” he says.

So, do these shifting fundamentals mean the market itself is broken?

Predictions Are Coming True

“We're at a juncture every bit as big as when we changed from terminal and river markets to direct selling on the High Plains,” says Lambert.

In the past 20 years, consolidation increased in all production segments and at retail; vertically coordinated production and marketing systems have proliferated; cattle traded away from spot cash grew to 50%; brandable beef caused a divergence in the traditional commodity marketplace; a revolution from boxed-beef to case-ready products looms close on the horizon.

What's more, none is a surprise. Fundamentally, the industry has seen these developments coming in some form for more than two decades. Some folks took them seriously; some didn't. Economics and politics sped the development of some and delayed others.

The difference this time may be that shifting fundamentals and market forces have finally achieved critical mass, like a rain-swollen river that grows until it moves beyond its previous constraints.

“Some producers are still missing the fact that things have changed. Some are still hoping that we'll roll back the clock, and that's not the case,” says Lambert.