Managing Today’s Downside Risk Is Critical

Business and markets are inherently related. However, strict focus on markets can prove misleading when trying to assess the realities of business. That contrast has been an important theme within the beef complex during the past 6-12 months; February was certainly no exception. The market surged in mid-February but margins remain tough all around.

Cattle feeders managed to hang tough and bump the fed market up to $129. That action was driven by renewed strength over on the wholesale side – the Choice cutout now encroaching $200. Higher prices always mean stronger profits – right? Nope. In fact, neither packers nor feeders are in desirable positions.

From strictly a market perspective, February’s market surge shouldn’t be interpreted as an “all-clear” signal. Much of it stemmed from slowing chain speed to create some room for margin; cattle feeders failed to exploit that strategy and gave all the benefit back to the packer. That just prolongs the string of bad weeks. It hasn’t happened yet, but at some point the packer has to push back. It’ll likely begin if or when downstream buyers abstain because of higher prices. That could prove very disruptive to the market.

Therein enters concerns about potential consumer warning signs within the economy. Most notably, when it comes to gas price volatility, John Eichberger, vice president of motor fuels for the National Association of Convenience Stores, explains that “…for the consumer it’s emotional, not necessarily a logical purchase. They go to extraordinary measures [to avoid higher prices].” That becomes especially important in the spring as we emerge from winter hibernation – we’re starting 2012 at already-high levels. So, rising gas prices may, or be perceived to, assert their bite on take-home income – and could potentially curb overall consumer spending.

That’s especially important given the backdrop of new reports about the state of the consumer. Bankrate reports that 27% of Americans possess a lower level of financial security compared to a year ago (vs. only 24% reporting better security); meanwhile, 38% indicate they’re less comfortable with their savings level vs. last year (only 14% reporting being more comfortable). That’s the macro view; now, let’s turn our attention to the internal drivers.

Higher prices don’t equal better profits. That’s true for the packer and also manifested in the feeding sector. The illustration below highlights steady erosion of margin at time of placement (not to be confused with closeouts). This results from excess feeding capacity chasing a diminishing supply of feeder cattle (the “feed truck premium”) coupled with higher feed prices. Clearly, some of that lost margin is made up in other areas (i.e., grid marketing, hedging strategies, etc.), but the trend is important – enduring margin squeeze.

Margin compression is especially important from an investment standpoint. Consider that during the first 13 weeks of 2007, the crush margin averaged about $140/head; the most recent 13 weeks has that value around $80/head. Now, put that in perspective of capital-at-risk (initial feeder cost plus corn): $990/head in 2007 vs. current outlay of about $1,495/head. The risk-reward equation is upside down. Where does that leave us?

Margin pressure manifests itself in business execution and potentially impacts the market. The packer slows down throughput. The cattle feeder willingly obliges because of stabilizing feed prices and limited replacement supply on the other side of the sale. However, the market is subject to unraveling fairly quickly if: 1) The consumer begins to push back and/or, 2) front-end supply becomes sufficiently large to erode feedyard bargaining leverage.   If those factors manifest themselves, the situation could be self-reinforcing.

Are spring highs potentially in place? That remains to be seen. Either way, the run of late is impressive. It’s the result of many years of hard work. Who would have guessed in 2009 that fed cattle would be priced at $130, or Choice product at $200?

But it also means increased capital requirements to maintain business operations and tighter working margins all around; in other words, routine, daily business decisions are less forgiving. Return OF capital becomes the driver (vs. return ON capital). With that said, careful management of downside risk becomes ever more important. Remain objective, stay informed!