Cattle Markets: Why Cash and Futures Need to Converge  

At a Glance

  • Proposed Live Cattle futures discount in Worthing, SD highlights need for cash, futures alignment
  • A discount to the futures price does not change the cash price

Futures markets are designed for price discovery and risk management. They are based on an underlying cash market for a commodity at a future date. When that future date arrives, the futures and cash markets must converge on price, otherwise the futures contract is not an effective hedging tool for the industry it is intended to protect.

When it comes to commodities where the delivery locations are geographically spread out, in many cases the values at different locations vary. That means they need to be adjusted with premiums or discounts. Examples of delivery location differentials include Corn and Soybean futures where Chicago is the par location and zones on the Illinois river are deliverable at premiums (4.75 cents/bushel for Lockport-Seneca, IL; 6.25 cents/bushel for Ottawa-Chillicothe, IL and 8.75 cents/bushel for Peoria-Pekin, IL).

After several years of observing a consistent seasonal cash market discount in the Iowa/Minnesota region of our  Live Cattle futures delivery territory, we recently took a step to realign the contract with the cash market by proposing a discount of $1.50 per hundredweight (cwt) on cattle delivered against the contract during the month of October at our Worthing, South Dakota delivery location.

Based on the feedback we’ve received to date and according to some media reports, it is clear there is some confusion about what this proposed discount would mean for both the cash and futures markets. Some producers in the region have suggested that the change would put them at a disadvantage. To the contrary, the proposal seeks to level the playing field for producers delivering cattle at each of the 13 delivery points for our contract, which are spread from Texas/Oklahoma to South Dakota.  The proposed discount is not intended to disadvantage producers who are near the Worthing delivery point, but to bring cash and futures into convergence throughout the delivery territory.

Here is how the futures and cash markets have diverged at Worthing: Over the last ten years, USDA data shows that the Iowa/Minnesota regional cash market price (which is representative of cash market prices at Worthing) is, on average, $1.50/cwt lower in October than the price range in the rest of the five area regions in the USDA survey. This chart shows the difference between average prices at Worthing and other delivery points:

 

Worthing Cash market

 

In addition, since 2009 more than 70 percent of cattle delivered on our October contract were originally tendered to Worthing. With 13 delivery points, the contract should experience a broader distribution of deliveries than what we have seen since 2009. Geographically dispersed deliveries help ensure that expiring month prices reflect supply and demand factors across all delivery regions during contract months. This is as true for other commodities like corn and soybeans as it is for cattle.

In recent years, the region that includes Worthing experienced a supply/demand disconnect. Livestock production became cheaper with less expensive input costs, like feed, while demand remained flat. This makes the area a growing region for cattle production and Worthing an extremely efficient delivery point. As a result, cash market prices have been lower on average than in other regions, at times much more than the $1.50 adjustment being proposed, as the seasonal production overwhelms demand in the area.

To be clear, assigning a discount to the futures price does not change the cash price at all. Packers need to pay a price for the cattle they need to operate their plants. A discount in the futures doesn’t mean those same packers can pay a lower price. It simply means the cash price in the region now will be higher relative to the futures price than it was before. Only the price of cattle delivered against the futures contract will be lower.   In fact, only a small number of cattle actually go to market through physical delivery against our futures contracts. In October 2015, for example, only 6,500 out of 2.6 million cattle slaughtered were delivered against our Live Cattle contract across all 13 delivery points.

Though a futures discount does not affect the cash price, it will affect is something called the basis. The basis is the premium or discount to the future price a buyer needs to pay to buy live cattle. In all agricultural commodities, when the futures price is discounted, and the supply/demand balance is unchanged, the basis needs to increase to keep animals or grain moving though the marketing channel.  In Worthing, all things being equal, the $1.50 discount in the delivery value will be made up by an increase the basis during October. The cattleman selling to the local packer will still get the same cash price for their cattle.

Adjusting the futures price at Worthing will align the cash and futures markets and create a level playing field for cattle producers everywhere.  That ultimately brings futures markets back in line with their stated purpose: to provide an accurate mechanism for everyone in the commodities supply chain to discover a transparent price and manage risk.

 

Tim Andriesen is Managing Director of agricultural and alternative investment products at CME Group.

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