Animal Protein - Meats Second Quarter Review And The Outlook Q3

Summary

• The best-performing commodities sector of Q2.
• Live cattle fall 3.04% for the quarter.
• Feeder cattle move 10.43% higher.
• Lean hogs explode 38%to the upside.
• Backwardation in cattle and hogs as the 2017 grilling season gets underway.

The animal protein or meat sector moved 15.13% higher in Q2 after posting a 1.78% gain in Q1. Meats are up 16.87% through the first half of the year after falling 8.80% in 2016. Lean hogs led the sector and were the best performing commodity in all of the U.S. futures markets.

Meats were one of the best performing commodity sectors for 2014 rallying by 14.44%, but they moved lower in 2015 by 21.97% and 8.8% last year. After two straight years of losses, the hog and cattle markets came storming back over the first half of 2017.

Live Cattle Review

Live cattle futures moved 3.04% lower in Q2 and are up only 0.22% over the first six months of 2017 after falling 15.17% in 2016. Active month live cattle futures traded in a range between $1.0315 cents and $1.3890 per pound so far this year and continue to recover after trading below the $1 per pound level in October 2016 after the end of the 2016 grilling season. Live cattle closed the second quarter of the year at $1.1630 per pound basis the August futures contract on June 30, 2017.

Live cattle moved to all-time highs in the aftermath of the drought in 2012. When grain prices exploded to all-time highs that year, animal protein producers could not afford to feed their herds. As feed prices rose, producers sent the animals to processing plants early to avoid losses because of high feed costs. It takes 18 to 24 months to raise a head of cattle, thus began the great cattle bull market that reached highs in 2014. The population of planet Earth now stands at over 7.40 billion people. In Asia, diets have changed as wealth has grown. A traditional rice-based diet now includes more complex proteins, which has increased demand for beef and pork in the region. In 2015 and early 2016, ample supplies of grains lowered the input costs for producing cattle. It takes six pounds of feed for cattle to add each pound of weight. The average weight at the time of slaughter is between 1,200 and 1,400 pounds. Therefore, lower grain or feed prices filtered through and caused the price of live cattle to drop over the course of 2015, and this continued into 2016. When cattle dropped below $1 per pound last October, they seem to have found a low as demand increased and the price rebounded. Since then, grain prices have stabilized, and cattle have followed the trend in the feed markets.

Cattle and all animal protein prices are sensitive to price action in the grain sector as feed prices are a primary input in raising animal protein. Soybeans moved lower by 0.40% during Q2 while corn gained 1.72% and CBOT wheat posted a gain of 19.81%. The gains came in the final days of the quarter, so stable grain prices throughout the three-month period resulted in certainty for animal protein producers who let their herds grow to normal sizes and weights. The forward curve in live cattle is in a small backwardation from August to October and then moves back and forth between contango and backwardation based upon seasonal factors. The current backwardation represents slight tightness of supply at the beginning of the 2017 grilling season. Source: CME

There is lots of seasonality of this commodity, but it is highly sensitive to feed costs which are the critical input in raising cattle. Prices tend to peak before the grilling season in the U.S., which is the period between Memorial Day in late May, and Labor Day in early September. In October 2016 cattle fell to lows and have since recovered. However, since highs in late April and May cattle prices have been moving lower and the trend continues to be down.

Live Cattle Outlook for Q3 2017

In my Q1 report, I wrote,

“Consolidation in the food industry means that over 75% of all beef pricing now occurs outside the cash cattle market and that has caused producers to have to sell at prices that the few dominant buyers are willing to pay. Dominant buyers are dictating prices to sellers. As the cash market becomes less transparent, the utility of hedging in the futures market has diminished. Without a vibrant cash market, futures contracts become illiquid and subject to greater volatility that, at times, does not reflect actual transactions occurring in the cash market. The CME has been working with industry to come up with a fix for the problem.”

During the second quarter, volume and open interest in the live cattle futures market increased with the latter reaching a record high. Open interest or the total number of long and short positions in the futures market decreased from 389,457 contracts at the end of Q1 2017 to 381,158 contracts at the end of Q2. While open interest was down by 8,299 contracts, it reached an all-time high of 431,718 on May 2, and the decline since then is likely the result of hedges coming off as animals moved to processing plants to fulfill demand requirements during the peak season of the year.

The technical picture for live cattle indicates that the current correction could take prices lower over coming weeks and months. Source: CQG

The weekly chart shows that the slow stochastic, a momentum indicator, has crossed to the downside indicating a bearish trend. Both the slow stochastic and relative strength indicators are moving towards oversold territory, but neither has reached a level that indicates a bottom for the price of the beef futures. Source: CQG

On the longer-term monthly chart, the picture looks even less constructive as momentum is turning lower in overbought territory. The next level of technical support is at $1.13975 per pound the January 2017 lows and resistance is at $1.3890 per pound. The new active month August live cattle futures closed Q2 at $1.1630 per pound, they are closing in on the support level on the downside. I am neutral to slightly bearish for the price of live cattle futures given we are already in the season of peak demand for the year and futures markets tend to look further into the future. At this point, the markets are looking past the grilling season, and we could see seasonal weakness into the early fall like last year.

Feeder Cattle Review

While live cattle futures contracts have a physical delivery mechanism, feeder cattle contracts are cash-settled instruments. Feeder cattle futures tend to attract interest that is more speculative. Feeder cattle outperformed live cattle prices in Q2 and were up by 10.43% for the three months ending on June 30. The 2.68% gain in Q1 means feeder cattle are up by 13.4% so far in 2017 after moving 21.84% lower in 2016. Feeder cattle posted a decline of 23.2% in 2015, but in 2014 they gained 29.65% on the year. As feeder cattle outperformed live cattle in Q2, they made up for a lot of the divergence that developed in 2016. Over the course of 2017, the range of these contracts is from a low of $1.2050 to a high of $1.6090 per pound. The same fundamentals affecting the live cattle futures are at play in the feeder cattle futures contract. At times the Feeder cattle contract leads the live cattle contract as speculators can push the price of the cash settled contract because of less liquidity when it comes to volume and open interest. April feeder cattle closed on March 31, 2017, at $1.47925 per pound.

Feeder Cattle Outlook for Q3 2017

The outlook for feeder cattle in Q3 is the same as in the live cattle futures market. One thing to consider when watching these markets for clues on price direction is always to be sensitive to deviations between the two traded cattle contracts that often develop on a short-term basis. The weekly chart in feeder cattle futures has crossed to the downside as we head into the final months of the 2017 grilling season in the beef market reflecting a potential of a continuation of the recent price correction over the coming months.

Lean Hogs Review

Lean hog futures were a big winner as they posted a 38% gain in Q2 after declining by 0.72% during the first quarter of 2017. So far in 2017, lean hogs are up 37%. Lean hogs moved 10.62% higher in 2016. In 2015, lean hogs shed 26.35% of value. Lean hog futures were the worst performer in the animal protein sector in Q1 after being the best performer in Q4 of 2016; they returned to winning the gold medal for performance in Q2 and are leading the herd in 2017. The range in this market was a low of 62.55 to a high of 90.85 cents per pound over the first six months of the year. The forward curve in lean hogs out to December 2018 flips back and forth between contango and backwardation depending on seasonal factors. Source: CME

The price spread between the nearby active July futures contract and the October 2017 lean hog futures highlights a backwardation of 20.175 cents. Hogs are in backwardation out to February 2018 and then prices out to 2018 reflect seasonal factors or weakness in winter months and strength during the grilling season. Hog production is a year-by-year affair, and it is possible that a production issue could present problems in 2018 as those pigs have not yet been born. In 2014, the outbreak of PED virus that killed 7 million suckling pigs was an example of the unexpected events that can influence pork prices.

China is the world’s largest pork producer, but at the same time, the nation is the world’s biggest consumer of the meat. China bought the United States’ largest hog producer and processor, Smithfield Foods (SFD), in 2013. The next time there is a pork shortage like seen in 2014, a lot of Smithfield’s production could potentially head to China. Given the current administration’s posture on trade with China and other nations around the world, we could see changes when it comes to food supplies raised, grown, and manufactured in the U.S. even when ownership is by foreign entities. Food supplies are a matter of national security interest.

Meanwhile, the technical position of the lean hog futures markets at the end of 2016 highlights a bull market that has risen into overbought territory. Source: CQG

As the weekly chart highlights, the bullish trend has pushed the slow stochastic into an overbought condition where the odds of a downside correction are rising. During the final week of Q2, hogs began to run out of bullish steam on the deferred October futures contract which could be a sign of a top in the market price. Relative strength on the weekly pictorial was in overbought territory at the end of Q2, and open interest has been rising, which is not a bearish sign for the pork futures market. Source: CQG

The monthly chart of lean hog futures shows that the recovery from October 2016 lows caused the momentum indicator to cross to the upside in December of last year and the trend has matured as the slow stochastic is now in overbought territory.

Lean Hogs Outlook for Q3 2017

Technically and fundamentally lean hogs seem to have found a long-term bottom in October 2016. July lean hog futures closed on June 30, 2017, at 90.625 cents with the August futures at 83.75 cents per pound. The backwardation out to December indicates that the market expects lower prices after the current grilling season, the time of the year for peak demand. However, it is also a sign of tight pork supplies. I believe that the price of hogs will likely correct to the downside over the weeks and months ahead and that the best performing commodity of Q2 will post a loss during Q3. Technical resistance on the July contract is at the June 30 high of 90.85 cents per pound. Last year, hogs peaked at the same time, and by October they were trading at half the level when they found a low at 40.7 cents. The reason for the big rally at the end of last week could be an overabundance of shorts in the hog market looking for a downside correction.

The bottom line on animal protein for Q3

The pork-beef spread is an inter-commodity spread that tells us if the price of one of the meats is cheap or expensive on a historical basis when compared to the other. The long-term historical norm for this price relationship is 1.4:1, or 1.4 pounds of pork value in each pound of beef value. Based on closing prices at the end of Q2, the August spread was at 1.28:1 and the October spread stood at 1.64:1. In August, the spread tells us that pork is historically expensive when compared to beef prices. However, in October, lean hogs are historically cheap when compared to live cattle. Keep your eyes on the live cattle-lean hog spread, as it could provide clues for future action and pivot points in both cattle and hog markets over the course of 2017. These time spreads often provide clues as to the direction of nearby nominal prices when extensions and deviations from the norm present themselves.

As we move into Q3, the price of cattle has been correcting lower while hog prices are sitting near highs on the nearby futures contract. At the end of Q4 2016, I wrote,

“As we move into 2017, I am a cautious buyer on price weakness in both meats, but I will trade with tight stops and take profits when they are on the table. Trading rather than investing in the animal protein sector is likely to continue to yield optimal results.”

The strategy worked well over the course of Q2, but for the next three months, we are likely to see more volatility as the futures begin to reflect the fundamentals that will follow the season of peak demand. Additionally, any changes in trade policy under the new administration could cause some dislocations and volatility in meat prices. For those who do not venture into the futures markets, ETN vehicles such as the iPath Bloomberg Livestock Total Return Sub-Index ETN (COW) or Market Vectors Agribusiness (MOO) products tend to replicate price action in the animal protein markets.

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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.