Skinning the Futures market, or being skinned

By Tim Kalinowski, Staff Writer

Volatility in the Live Cattle Futures market has kept many producers and investors from putting their hedges in this year. The traditionally stable and slow-moving market has been weaving like a drunken sailor since last year when cattle prices saw a precipitous drop from an historic high of $165 U.S. per hundredweight to start 2015 to just over $100 per hundredweight today. The market has continued to be unsettled even after the major drop concluded and prices stabilized above $100, leaving producers, feedlots, investors and analysts alike stumped by ongoing developments.

Dr. Ted Schroeder, an agricultural economist with Kansas State University, says the reason analysts are having such trouble pinpointing the source of the instability is because there is just too little information to work with. Schroeder is one of the most respected experts on the Live Cattle Futures markets in North America, and he has trouble on that score himself. However, he says there are likely causes which each represent one peel of the onion.

First and foremost volatility in others areas of the marketplace is permeating into the Futures market.

“The Futures market is trying to discover and capture what is happening with the trade in the Cash market,” explains Schroeder. “When there are days when there is no trade at all, what is that Futures going to trade off of? It’s going to trade off of rumours, and other kinds of unconfirmed information.

“So this market is kind of sitting there, hedgers pulling away a little bit, trying to figure out where the information that it sells on is. We have used the term before where we say occasionally markets gets starved for information, and I have a feeling Live Cattle Futures is a little bit that way.”

Schroeder says there are also new players in the Futures market getting in on the action, and they have some high tech algorithmic equipment to play with.

“Look who is all involved in that market,” he emphasizes. “It isn’t the same players or same composition of market participants that it was maybe five years ago. That there is more algorithmic trading activity going on; speculators have always been around, but there has been a little more of a concern there has been more of these high-frequency type trade systems that might be trading in the market… There is evidence they add to day to day volatility. It doesn’t mean the market is broken. They just increase market volatility in that day to day market.”

Another reason is there is less cattle in the market to speculate on.

“With cattle right now 50-60 per cent are formula priced; that’s 50-60 per cent of cattle in the United States not even coming into the negotiated market,” states Schroeder. “There’s 10-15 per cent going into forward contracting, and a little bit of Negotiated Grid going on as well. That means 70 per cent aren’t even showing up in the negotiated market (Futures).”

According to Schroeder this also means localized markets like Nebraska and Iowa, which have high participation in the Live Cattle Futures market in the United States, can jam up the whole marketplace if something happens in those states with their cattle supply.

“If Iowa gets behind that’s killing everybody because it’s dropping their cash price, and that’s the price the Futures market participants are seeing,” explains Schroeder. “So Iowa has their back against the wall, the packer has the leverage and you start getting those volatile, almost emotionally-driven markets. We saw that last fall. That’s what happened to us.

“But those are just some of the day to day, month to month, dynamics that swings leverage in these markets. Someone looking on and participating in that thinks something’s wrong, something’s broke… Some of this is just the ebb and flow of markets and players.”

Schroeder acknowledges that the Futures market has taken a beating this year. He understands why a producer looking on might decide to keep himself out. However, there’s a big catch; a Catch-22, in fact.

“There are whole bunch of reasons people might stay out of a market for hedging purpose,” says Schroeder. “In time of rapid price decline people might be hedging in a loss, and people don’t like doing that. So sometimes people just kind of hang out when markets are tanking quickly. There is tendency psychologically to see a stepping away for a bit.

“However, if the hedgers all leave, if all the producers quit hedging and all the packers quit hedging, then that market would go away. If a lot of them leave, and what you got left is speculative and algorithmic trading, you still have a problem. When hedgers leave volatility may increase, but they got to get back in to help stabilize and get that market back to equilibrium.”

Schroeder says the Chicago Mercantile Exchange, (which manages the Live Cattle Futures), is also making additional attempts to correct itself; the most significant being the banning of the trading Futures beyond October 2017.

“That’s a pretty significant event,” states Schroeder. “If you are saying I can’t even right now physically place a hedge beyond there, we’re not going to let you. We have added a discount to one particular delivery location to try and re-align Futures and Cash across the rest of the sector… There has always been an ongoing challenge with maintaining animal weights that match the contract specifications for delivery… They are making some modifications and they will continue to, I think.”

Schroeder says if volatility continues, and hedgers continue to stay away, it may eventually open the door for another historic change.

“I ultimately think, and I am getting real speculative here, at some point we will move away from a physical animal delivery system in our Futures market and move toward some kind of a Settlement Index. There are a lot of reasons we will probably go in that direction, and that might help retie the Futures to the live cattle market out in the country.”

However, it’s a long way to go before we get there, says Schroeder. In the short term, hedgers have to be more vigilant than ever.

“What this does say is one has to be a little more diligent about placing hedges when using that market right now. So my advice has always been if you are going to be a real margin hedger in the cattle feeding business, when you buy feeders you are also locking in the sale price on the feds. You are locking in your corn costs. You are locking in your margin. Because if you don’t, you really are rolling the dice in a volatile, risky market. So be a little more vigilant about it, and get that hedge placed quickly. Because this market is going to move around on us.”

Schroeder believes the Live Cattle Futures market, even with its recent problems, remains one of the most essential risk management tools for the North American cattle industry.

“That Live Cattle Futures market is absolutely critical for our industry,” asserts Schroeder. “I have been hearing some suggest ‘Oh, the dang thing don’t work anymore; shut ‘er down.’ That’s a really reckless position. That market provides, even with reduction in the numbers hedging, the critical risk management tool for our industry. I can’t imagine what would happen if it weren’t there.”