Livestock Markets: Cattle, Hogs, and the Meat Trade

Book: Commodities: Markets, Performance, and Strategies
Editors: H. Kent Baker, Greg Filbeck, Jeffrey H. Harris
Publisher: Oxford University Press, 2018
ISBN: 9780190656010

Chapter 10 is written by Xiaohu Deng, Andrew C. Spieler, and Desmond Tsang. It covers livestock markets: cattle and hogs, the two most financially important livestock types. The chapter walks through the entire production cycle, the financial instruments used to manage price risk, and the economics driving supply and demand.

From Calf to Steak: The Beef Production Pipeline

The beef industry has a multi-stage production process that takes about two years from birth to slaughter. Understanding this pipeline is essential for anyone trying to forecast cattle prices.

Stage 1: Cow-calf operations. Ranchers breed herds, typically in late summer to avoid harsh winter conditions for newborn calves. The average herd size is about 45 cows. Each cow has a nine-month gestation period and usually produces one calf per pregnancy. Cows that miss a pregnancy get culled from the herd. Calves are weaned at six months, weighing 500 to 600 pounds.

Stage 2: Stocker operations. Weaned calves are placed on land with harvest roughage like summer grass or winter wheat. They grow to 600 to 800 pounds, at which point they are classified as feeder cattle and ready for feedlots.

Stage 3: Feedlots. This is where the heavy fattening happens. Feeder cattle receive high-energy grain feed and gain about three pounds per day. They stay for 90 to 300 days, reaching 1,000 to 1,300 pounds. Feedlots are concentrated in Colorado, Nebraska, Kansas, Oklahoma, and Texas, with just 2,000 operations producing 85 percent of fed cattle.

Stage 4: Slaughter. At 1,000 to 1,300 pounds, cattle are classified as “live cattle” and sold to packers and processors. In 2012, the average live cattle weight was about 1,305 pounds, yielding an average carcass weight of 791 pounds.

The industry has shifted dramatically from small family ranches to large corporate operations. Operations with herds larger than 100 cows now make up just 9 percent of all calf-producing operations but account for 51 percent of cattle inventory.

Hog Production: Faster and More Concentrated

Hogs reach market weight much faster than cattle. The life cycle has three stages: producing baby pigs, fattening them, and slaughter.

Hog farms come in four types: farrow-to-finish (handles everything), finish-only (just fattening), farrow-to-feeder (birth to 40-60 pounds), and farrow-to-wean (birth to 10-15 pounds). The industry has moved heavily toward vertical integration. In 2012, farms producing more than 2,000 heads made up 87.5 percent of U.S. hog inventory. Most operations are concentrated in the western Corn Belt and North Carolina.

Sows and gilts give birth to litters of nine to ten piglets after a four-month gestation period. At six months, pigs weigh about 270 pounds and are ready for slaughter. The average carcass weight in 2012 was 205 pounds, yielding roughly 20 percent ham, 20 percent loin, 15 percent belly, and various other cuts.

The four largest hog slaughterhouses accounted for 64 percent of all U.S. hog slaughters in 2012. That level of concentration gives a few companies enormous influence over the market.

How Livestock Trades

The cash market for livestock involves local auction markets, electronic auctions, and direct sales. But the trend has moved away from cash market transactions toward Alternative Marketing Arrangements (AMAs), including forward contracts, marketing agreements, and formula pricing.

Formula pricing applies a mathematical formula that factors in spot prices, futures prices, and other inputs. Grid pricing sets a base price adjusted by premiums and discounts for quality characteristics. Both methods are more common now than simple cash transactions.

Futures Contracts: The Details Matter

Three main livestock futures contracts trade on the CME’s Globex platform:

Live cattle (LE): 40,000 pounds per contract. Physical delivery. Traded for February, April, June, August, October, and December expiration.

Feeder cattle (GF): 50,000 pounds per contract. Cash-settled. Traded for January, March, April, May, August, September, October, and November.

Lean hogs (HE): 40,000 pounds per contract. Cash-settled. Traded for February, April, May, June, July, August, October, and December.

All three have a minimum tick of $0.00025 per pound ($0.025 per hundredweight). Live cattle is the only one requiring physical delivery, and even then it happens on less than 1 percent of traded contracts. Nobody actually wants 40,000 pounds of cattle showing up at their door.

The Rise and Fall of Pork Belly Futures

This is one of the more colorful stories in the chapter. Pork belly futures launched in 1961 on the CME, originally to let meatpackers hedge seasonal price risk. Demand for bacon was highest in summer (alongside hamburgers), while slaughter happened year-round. So pork bellies were frozen in winter and processed later.

Over time, Americans started eating bacon year-round. Demand leveled out across all four seasons, eliminating the seasonal price risk that made the futures contract useful. Open interest dwindled, volatility became excessive, and in July 2011, the CME delisted pork belly futures. For decades it had been one of the most heavily traded contracts on the exchange. The change in consumer behavior killed it.

Basis: The Key to Effective Hedging

The chapter spends a lot of time on basis, which is the relationship between cash market prices and futures prices. This is the single most important concept for livestock hedgers.

Current basis equals the current spot price minus the nearest succeeding month’s futures price. Deferred basis uses a forward cash quote minus the futures contract in the nearest month after that quote.

The key insight: basis can strengthen or weaken regardless of whether overall prices go up or down. When prices rise but cash prices rise faster than futures prices, the basis strengthens. When prices fall but cash prices fall less than futures, the basis also strengthens. Short hedgers (sellers) benefit from a strengthening basis. Long hedgers (buyers) benefit from a weakening basis.

Hedgers need to track their basis in every cash market where they transact, since spot prices can vary between locations. This tracking helps determine whether to use futures or alternative hedging instruments, when to close positions, and where to buy or sell in the cash market.

Supply and Demand Drivers

The chapter distinguishes between changes in quantity supplied (movement along the supply curve) and changes in supply (shifts of the curve). Short-term price changes cause movement along the curve. External factors shift the curve.

For livestock supply, the most important inputs are feed prices and feeder animal prices. When feed prices rise, supply shifts left because it costs more to fatten animals. But in the short term, the effect can be reversed: if feed prices drop, producers might keep animals on feed longer to fatten them more rather than immediately increasing supply.

On the demand side, population growth, income changes, substitute goods, and consumer preferences all matter. The 2003 mad cow disease outbreak is given as an example of a sudden shift in consumer preferences that affected demand.

Going Global

The chapter closes by looking at international livestock markets. Brazil was the second largest cattle producer in 2015 at 9.4 million metric tons, trailing only the U.S. at 10.8 million. Australia is a major exporter, shipping about two-thirds of its production to Japan, South Korea, and the U.S. Ethiopia has one of the largest livestock populations in Africa but is held back by subsistence farming and limited access to financing.

The overall trend is clear: emerging markets are expanding their livestock industries, which will continue to change global supply and demand dynamics.

My Take

Two things stood out. First, the sheer level of vertical integration in both the cattle and hog industries. A handful of large operations control the majority of production. That concentration means supply-side changes can happen faster and more dramatically than in a fragmented market.

Second, the pork belly story is a great example of how changing consumer behavior can make an entire financial product obsolete. No amount of contract redesign could save pork belly futures once Americans decided they wanted bacon every day instead of just in summer.

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