Seeking Alpha

African Swine Flu And The Chinese Hog Trade

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Includes: COW, SEB, TSN
by: COT Signals
Summary

China is both the world's largest hog producer and importer.

African Swine Fever (ASF) has induced a 20% culling in primary production centers.

Major production centers may only account for half of the Chinese hogs.

The anticipated protein shortfall makes this a long-term opportunity.

Reports of African swine flu infecting Chinese pigs began to break here in the States late last year. China has announced several measures implemented to contain the spreading of this extremely contagious disease, including a 20% cull. A story in Reuters in late July estimated that this would wipe out one-third of China's pork production this year. This follows a report from the USDA in March, which stated "African Swine Fever outbreaks continue in China, affecting all aspects of the swine and pork industry. China has reported 115 ASF outbreaks to the World Organization for Animal Health (OIE), covering all commercially significant swine producing regions."

It's been estimated that more than half of the Chinese pig population is held in back yards and off-grid farms across the nation's countryside. Likely, these operations have not adopted the stringent standards necessary to rid and prevent the spread of ASF within the communal agriculture industry. Porous borders and regional exchange suggests this situation will worsen. Therefore, I expect the contagion to spread since. As yet, there is no cure, and first-world agronomy practices are less likely to be followed.

Hogs are China's primary protein source. It is not only the world's largest pork-producing nation, but it's also the world's largest pork importer. The rise in the Chinese standard of living over the last 15 years has caused a surge in protein demand. A more fulfilling diet is one of the fundamental needs/wants to be met with newfound prosperity. Comfort food will also be one of the last things given up as an economy slows or food prices soar.

Trade wars have placed the commodity markets on the front lines. The Foreign Agricultural Service published a report in March stating that U.S. hog exports to China were nearly 50% lower in 2018 due to the 62% tariff imposed on U.S. pork. However, they've since snapped back to 4% higher than before the trade war.

The 4% roof is where the story gets interesting. China, along with 150+ other countries, does not allow the drug ractopamine to be given to its animals. Ractopamine causes animals to gain lean muscle more quickly and thus shortens the animal's time to market. Ractopamine is allowed here in the U.S., and it's given to about half of our animals. However, ractopamine, even at a trace level, makes them ineligible for export to China. China refused tainted shipments out of Canada's Frigo Royal Inc. just this past June. So far, the U.S. has been slow to jump through the hoops necessary to remove residual trace amounts from production facilities and bring them into Chinese compliance. Many U.S. operations seem unwilling to place much faith in the consistency of Chinese demand. Meanwhile, the E.U. and Brazil have increased exports to China to fill the void.

The culling of 20% of the Chinese pig herd puts a significant dent in the world's protein supply. We'll see if U.S. farmers change their ways or, fill the markets left behind by other hogs heading to China. Either way, there will still be an increase in protein demand. Of course, frozen pigs in Chinese storage will offset some of this, but the size of their reserves is unknown.

Weekly lean hog prices with Commitments of Traders report analysis.

There are a few ways to play the coming protein shortfall. First, it's essential to understand the current market's context. Lean hog futures rallied by more than a third in just a few weeks between mid-March and early April. The hog producers' collective response via the Commitments of Traders report was swift and decisive as farmers sold more than 83k forward contracts during that three- to four-week run. Their selling pushed the collective net short position of their forward hedges to its lowest level in five years. Furthermore, their selling was so swift and aggressive that it was three standard deviations beyond their normal week-to-week movement.

The flip side of hog producer selling was matched by speculative greed. We saw the large speculators move from just a bit short on March 15th to long nearly three to one in only three weeks. The last time speculators had become this bullish was in May of 2014 when hog prices were almost twice as high. That's also the highest the hog market has been, which provides us with a good transition into projections.

Like 2014, the speculators in the hog market have been wiped out. The December lean hog futures got moving this spring as they punched through price resistance at $.65 per/lb., before making a high in mid-April above $.90 per/lb. The market then sold off through early August before finally bouncing from an oversold level just under $.59 per/lb. We can now evaluate a hog market that is neutrally positioned and ready to be driven higher by tightening supplies.

Here in the U.S., Smithfield has the upper hand on ractopamine-free hog production. Remember, Shuanghui International Holdings, now W.H. Group, the largest Chinese pork producer, bought Smithfield about three years ago. It makes sense that Smithfield has been decreasing its ractopamine use ever since. Seaboard (SEB) is the second-largest pork producer in the U.S. However, I'm unable to determine the extent of ractopamine in its production lines. This leaves Tyson (TSN), which announced it was moving away from ractopamine three years ago, as the most viable publicly traded U.S. stock to capitalize on the domestic shift away from ractopamine and towards the global standard in hog production to meet the unexpected Chinese, and potentially Southeast Asian, supply shortage. Of course, the closer one remains to the lean hog futures market, the less derivative their investment will be. Those wishing to gain exposure without the leverage and expiration issues associated with holding futures could also look at an ETF like COW. This ETF is split about 70/30 between cattle and hogs, respectively.

We follow broad commodity and commodity-based ETF moves in our weekly Commitments of Traders newsletter.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in DECEMBER LEAN HOG FUTURES over 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.