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March 10, 2005
Meat Commodity Futures - Not Just a Load of Bull !!
Some of the most fascinating areas of trading are, to my mind, the commodities markets. Trading in commodity futures means trading in physical items – all well-known and all of which touch the lives of most of us. The commodity markets are also arguably the least understood by the majority of traders and therefore often avoided.
And within the commodity markets, perhaps the most arcane item to trade, at least by non-specialists, are the meats.
A recent article by veteran commodity trader Kevin Kerr in The Daily Reckoning gives us a rare insight into just what exactly are meat futures. Here are some extracts:
"Few markets conjure up as many images from investors as the meat futures markets do. Some people will think of Old West cattle auctions, with cowboys and ranchers bidding on prized bulls. Others know the meat markets are just like any other market, though they still hold on to the notion that it's exotic and full of risk …
Certainly meats are risky, the same as any market. But they're also a vital market filled with many opportunities for your portfolio. Of course, you're not likely to hear about them from your broker. The sad fact is, most analysts on Wall Street only know cattle as it's served up to them at a Morton's or Ruth's Chris Steak House.
Essentially, meats are traded on Chicago Mercantile Exchange. And as I said, all trading is done much the same as any other commodity. Of course, like all markets, meats have a very unique language. Traders concentrate on data that nobody else looks at …
Cattle are used in a variety of products - leather, soaps, animal feed, even camera film. But of course, when we talk cattle, we're mostly talking beef - everything from steaks to hamburgers.
As far as trading is concerned, cattle are broken up into two different categories: feeder cattle and live cattle …
Feeder cattle - sometimes called lean cattle - are just as alive as live cattle. They're simply calves that will be sent to feedlots to fatten up. Once they've gained enough weight, they can become "live cattle" - ironically, the ones that get shipped out for slaughter.
The slaughtered cattle meat is graded and sorted. If you've bought meat in a grocery store, you probably know a little something about that. The meat you buy is most likely labeled "Choice," "Select," or "Standard." In all, there are six categories of beef, and five yield grades, measuring how much beef came from the cow.
About 50 % of the meat is sold as steaks and roasts, 5% as stewing beef, and the rest becomes hamburger.
The butcher can then sell what's left of the cow to leather manufacturers and others that use cattle products.
Not surprisingly, cattle are raised all over the world. At last count, there were more cattle in India than in any other country. Brazil runs a distant second, with China, the United States and Europe rounding out the top five.
Beef doesn't have a very big import/export market - it's usually consumed in the country it's produced. Among exporters, Australia leads the way, followed by the United States. Most of the U.S. beef comes from just seven states - Arizona, California, Colorado, Iowa, Kansas, Nebraska, and Texas.
Like everything else, beef prices are a function of supply and demand. And like all commodities, a variety of factors can affect both.
You'd probably think weather doesn't play as big a role on cattle production as it does with other farm commodities. After all, with cattle there really isn't a planting, growing or harvesting season. Short of a severe drought or a major flood, the cows will always be there.
But the fact is, it takes a lot of money to raise a cow. Feeder cattle need a lot of pasture. And live cattle need a lot of feed. If there's too much or not enough rain, the pastures won't be able to support as many cattle, so ranchers will have to cut back on the number of cattle they raise. That'll limit the supply of feeder cattle, which in turn limits the number of live cattle.
Meanwhile, if grain prices are adversely affected by the weather, the feedlots may cut back on the number of cattle they buy. Again, this reduces the overall supply of cattle.
Demand, on the other hand, can fluctuate wildly. The main factor is usually personal income. The more money people make, the more they're willing to plunk down $50 or $75 at for a steak at Morton's. Usually increased paychecks translate into increased demand for high quality beef faster than most other foods.
If people are tightening their wallets, however, macaroni and cheese may be the meal of choice.
Other demand factors are less than economic. I'm talking about people's diet and preference. The mad cow disease scare pushed some people away from beef. (You might remember that some cattle ranchers blamed Oprah Winfrey for starting an anti-beef drive.)
More recently, diet fads like Atkins have brought people back. So if you're a beef trader, you have to keep an eye on pop culture. Keep track of what talk and tabloid shows are saying, what big celebrities say they're eating. You never know when a simple sound bite could lead to a big rise or drop in beef prices …
Now that we have the cows out of the way, let's look at the pigs. Lean hogs are the other major meats contract...
"Lean hog" may sound like an oxymoron. But as far as trading is concerned, it simply means a pig big enough to be slaughtered. So your pork chops, ham and even bacon come from lean hogs.
In fact, 20% of a pig's meat becomes ham. About 17% becomes pork loins and chops. And 15% - the hog's belly - is used for bacon. (Let's just say the rest of the meat falls under the category of "Other" and leave it at that.)
Just four states account for more than half of U.S. pork production - Iowa, Illinois, Indiana and Missouri. You may have noticed those are all Corn Belt states. That's not a coincidence... because farmers like to keep their pigs near their favorite food source. Yes, corn. So once again, weather plays a big factor in hog prices. If corn is expensive, farmers will feed their pigs less. In turn, it reduces the supply of lean hogs. And that drives prices up.
In fact, a key report to keep your eye on is the Hog/Corn price ratio. Simply put, it's the price of hogs versus the price of corn. Naturally, the higher the price of corn, the lower profits a pig farmer will see. So you can expect farmers to cut back on the number of pigs they raise.
The natural flip side is when corn prices are low compared to the price of hogs. More than likely, farmers will try to take advantage of the high prices to raise more pigs.
Weather plays a role on pigs another way. Pigs have a habit of becoming lethargic when the weather gets too hot - just like people do. Not only do they eat less, they also breed less. That ultimately means lighter pigs are sent to the butcher, while the number of baby pigs decreases. Colder weather makes for better breeding conditions (go figure...), increasing the next generation of piggies …
The demand for pork remains as strong as it ever was. Beef may be "what's for dinner," but pig farmers are busy reminding people that pork is "the other white meat." Meanwhile, the Atkins diet and other fads have reversed people's bacon aversion. In fact, since there's almost no market equivalent to bacon, demand has remained fairly constant."
Read the full article in the Daily Reckoning 03/01/2005.
For a good introduction to the fascinating world of commodity futures trading you can do no better than the Futures Trading Secrets course from Bill McCready: Commodity Futures Trading
Posted by Tony at March 10, 2005 07:53 PM