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Issue # 599

August 13, 2008

The Cow Business - Its Really About People - Nevil Speer, PhD, MBA, Western Kentucky University (reprinted with permission from CattleNetwork.com on 8/11/08)

If you're one of those unique individuals who thrive on ambiguity, then you're feeling right at home within the fed market and its prospective position for the coming fall. Uncertainty has been a resounding theme throughout 2008. And that certainly hasn't changed any; there remain a number of factors which continue to tug the market outlook in various directions. The outcome is lots of activity both on the cash side and in the futures pits. However, before we dig into the underlying causes first a quick review of trading action during the past month or so.

The market established a near-term top around the 4th-of-July with sales at $100-102. Scoring that contra-seasonal surge was directly attributable to strongly higher wholesale values. "Near-term top" is the key phrase, though, as fed cattle prices slipped back to $94-5 in subsequent weeks. But July ended on a positive note: cattle feeders managed to recapture an additional $2-3 and ended the month with $97-8 sales. Feedyard managers extended that streak in August's first week of business by brokering $99-100 and appear poised to retest July's $100+ in coming weeks. The shift in momentum may prove significant going forward, potentially marking a leverage reversal in weekly negotiations: packers have been the sole benefactors in recent months racking up a string of extremely favorable margins.

Back to the uncertainty previously mentioned. That's best demonstrated by recent action at the CME. For example, the December Live Cattle contract transitioned from $114 to $107, back up to $110, and receded down to $106 all in the course of about a month's time. Ambiguity increases the relative importance of each fundamental signal making traders more reactive.

Push-and-pull stems from varying perspectives about both the supply and the demand side. Those bullish about supply argue that feedyards continue to remain defensive about placing cattle indicated by four consecutive months of relatively sluggish activity. That's caused July's on-feed inventory to be at its lowest level in this decade with the exception of '03 and '04. However, there's a flipside to that argument: available supply of feeders outside feedlots is ahead of last year; moreover, grazing conditions have been excellent and there'll be a large influx of heavy, fleshy yearlings in coming months. Meanwhile, beef demand also proves difficult to pin down. On one hand, cutout values are well ahead of last year (the 8-week moving average stands $20 above 2007). On the other hand, much of the recent run-up in prices is directly attributable to stimulus checks. When that influence begins to run out of steam, what then? Recent news by Wal-Mart doesn't bode well as the company noted that July sales were tracking more closely with the "paycheck cycle" - a phenomenon that was somewhat diluted during May and June in accordance with stimulus checks. Regardless, the next few weeks will likely prove very significant in terms of sorting out overall direction as the beef complex transitions into fall.

The Monthly Market Profile has continually emphasized the ongoing struggles within the packing sector over the past several years. In accordance with that theme the Wall Street Journal (August 1) recently featured JBS and their overarching business strategy. Most notably the article highlighted the company's recognition of the packing industry's tenuous profitability prospects (see MMP: November, 2007; MMP: April, 2008) and ensuing opportunities: "Members of the Batista family, which founded JBS and continues to control it, say their strategy of striking when the industry is down is well thought out." Moreover, that strategy is backed by solid access to capital over the long run: ". . . JBS will try to use its deep pockets to take market share away from its competitors."

Per the issue of relative capacity within the packing sector, November's Monthly Market Profile featured some discussion about the cattle cycle with the following observation about the beef industry:

Rationalization must occur because the long-run outlook certainly doesn't provide any indication of increasing domestic supply. Commonly accepted paradigms about cattle cycles likely need to be reevaluated . . . Decision-making at the farm/ranch level is becoming increasingly complex and despite an extended run of high prices there's little interest in growing the cowherd. Packers are in a no-win quandary given limited supply - pay too much for cattle to gain efficiencies or relinquish efficiency in hopes of obtaining more favorable margins: neither is favorable right now. In light of enduring overcapacity, absence of cowherd expansion possesses some important implications for the packing sector, not to mention cattle feeders and agribusiness in general.

USDA's mid-year cattle inventory report provides some further perspective relative to that issue.

The report failed to contain any momentous news - it arrived largely in line with expectations. Beef cow inventory continues to decline: July 1 inventory stands at 33.15 million cows - 200,000 fewer cows (1%) than last year's number. The absence of any major surprises, though, doesn't mean we should write the report off. On the contrary, it's an important component reinforcing a much larger and relentless trend: slowly but surely, the cow/calf sector continues to undergo transformation - primarily in the form of consolidation. Therein we find important implications to the U.S. beef complex.

A large number of producers are quitting the business. In the 15-year period between 1992 and 2007 nearly 145,000 operations with beef cows disappeared (from approximately 902,000 to 758,000). The decline has come almost entirely at the expense of one segment: operations with less than 50 cows. In fact, during that time the industry saw 150,000 fewer such operations (the difference being an increase in 100+ cow operations not represented in the graph below). Granted, operations with less than 50 cows still comprise the majority of beef cow operations. But meanwhile, the decline has not represented vast liquidation but rather a reallocation from small to larger operations; beef cow inventory is only 2% smaller than it was 15 years ago (33.9- versus 33.2- million cows in 1993 and 2008, respectively). As such, an increasing number of cows are held in larger operations.

What's the most obvious interpretation from the culmination of the data? Namely, it provides a logical explanation for failure of typical cattle cycle characteristics to be manifested in recent years. What's most important, though, is realization of the broader trend which is unlikely to change in the near future - especially in light of higher operating costs and capital investment requirements (as illustrated below). That's where analysis gets really interesting because it speaks to the business environment in which the industry operates.

The trend represents not only changing structure but also a shift in demographics and attitudes. And it's those aspects which portend how we'll likely do business in the coming years. Several years ago I provided some interesting survey data which highlighted selected characteristics of cow/calf operations categorized by number of cows maintained. Several key trends were evident within that data. First, operator age tends to be fairly constant across various categories up the 250-cow threshold: larger operations are increasingly operated by younger producers. Second, as cow/calf operations become larger, an operator's level of education also tends to increase. Third, labor efficiency per cow maintained improves dramatically as operations become larger; those with 250+ cows dedicate half the time per cow compared to those with less than 50 cows. Moreover, within that realm, utilization of paid versus unpaid labor also shifts; as operational size increases a higher proportion of time commitment results from paid labor. Fourth, financial performance tends to improve as an operation runs more cows. Lastly, and most revealing, increased beef cow inventory is linked with larger operations; total acres and farms sales correspondingly increase.

In other words, beef production at the cow/calf level is transitioning from smaller operations towards larger, more diversified businesses; these farms and/or ranches tend to be more profitable than their predecessors and increasingly operated by younger, better-educated producers who utilize hired labor. And amidst that consolidation several key factors are important. First, and most obvious, producers are attempting to take advantage of economies of scale. Second, and more importantly, though, data indicates that cowherd inventory is positively related overall operational size; however, cowherd size does not keep pace with growth in other enterprises. What's the implication? Cattle (at the cow/calf level) are decreasingly neither a primary focus nor core competency for many operations.

That's a two-sided proposition: on one hand, in light of future returns diversified operations are less vested in the cow/calf enterprise and may readily liquidate; on the other hand, diversification means that cows serve an alternative purpose within the overall business strategy thus making liquidation less likely. Regardless of how that plays out several other aspects are important. Primarily, there exists an important derivation of producer attitudes with increasing size and diversification.

In accordance with increasingly larger, more diversified business operations (which mandate more careful time management) comes the perception of greater sophistication: level of education, knowledge of technology, awareness of issues, business skills and openness to new relationships are all perceived to be largely more advanced relative to the previous generation, who likely operated smaller farming operations.

The beef industry is increasingly operating in a capital-intensive, high-stakes business environment. How individual producers adapt to those changes remains to be seen. However, in response to the question, "As you look to the future, what does the industry look like?", Dr. John Lawrence sums it up well with the following observation: "Fewer cattle, fewer producers, more efficient, more diverse. Current prices and losses are leading to a consolidation in all sectors and a reduction in the beef cow herd. The remaining producers will those who are more efficient, more innovative, or have lower opportunity cost" (National Cattlemen, August '08).

What's the inference? Successful managers increasingly recognize that profitability is not driven strictly by increased production or tactical success in daily operational logistics. In other words, net income growth stems not from work-for-work's-sake but rather from improved strategic planning. That mindset accentuates emphasis upon financial oversight, risk management, value-added marketing and further adoption of economies of scale.

Cattle Numbers Keep Dropping: Prices Headed Back Up - Chris Hurt, Extension Economist, Purdue University (7/29/08)

Better days are likely ahead for the cattle industry as numbers keep dropping as producers adjust inventories downward in the face of high feed and forage prices. At mid-year the number of all cattle and calves was modestly lower than the two previous years, with total inventories near the lows of 2004. Beef cow numbers have dropped about 1 percent this year, reflecting continued discouragement from calf prices below the cost of production.

It is somewhat surprising that beef cow numbers did not decrease even more given the 5 percent higher cow slaughter rates in the first-half of the year. Producers indicate they will continue to modestly decrease the size of the beef cow herd in the last-half of 2008 as beef heifer replacements are down 2 percent. In addition, the rate of heifer slaughter outpaced steer slaughter in the first-half of 2008, indicating a greater tendency to send heifers to slaughter this year compared to last year. The 2008 calf crop is estimated to be down slightly, so that the number of calves weighing less than 500 pounds are also down slightly. There is more optimism in the dairy sector. Milk cow numbers were up 1 percent and replacement heifer numbers were unchanged from last year at this time.

The high corn prices in June helped cattle feedlot managers elect to reduce placements, which were down 9 percent. The number of cattle on feed is 4 percent below year-previous levels. Small placements in the months of March to June will cause beef supplies to drop sharply in the September to December period this fall.

Beef production in the first-half of the year was up almost 3 percent with prices below year-previous levels. Finished cattle prices averaged $91 in the first-half, $1 lower than a year earlier. Prices for 500 to 550 pound steer calves at Oklahoma City averaged $121 in the first-half compared to $124 a year earlier as surging feed prices made calves less desirable this year.

Cattle prices would have been lower in the first-half of 2008 if not for improvements in trade. The low value of the U.S. dollar is discouraging imports and encouraging U.S. beef exports. During the January to May period, beef imports dropped by 22 percent and beef exports surged by 34 percent. These are dramatic changes and account for about 3 percent of U.S. production. Even though beef production in the U.S. has been up this year, improved trade has taken all of that increase with continued population growth, per capita availability moved below year ago levels in the second quarter of 2008 and will move even lower in late 2008 and 2009. This means higher cattle prices are likely on the way.

Given the expected continued weakness of the U.S. dollar, it is likely that USDA will have to revise the current forecasts of beef trade for 2008. USDA currently expects exports to rise by only 18 percent for the year compared with a 34 percent actual increase in the first five months. USDA forecasts 2008 imports to be down by 12 percent for the year compared with a 22 percent reduction in the first-five months.

Where do cattle prices head? The answer is higher, but how much? Futures markets are well aware of the anticipated decreasing per capita supplies that U.S. beef consumers will face for the next two to three years. Futures prices got ahead of the actual supply reductions in June as Midwest flooding drove corn prices to record highs. Improving crop production prospects have helped temper cattle futures prices as well. As an example, August live cattle futures have dropped $8 from June 20th and cash prices of finished cattle have dropped about $5, to the mid-$90's.

Generally, finished cattle prices make their summer lows late in the summer and begin to move higher in late-August or September. This year, beef supplies are expected to be about 2 percent higher in the summer quarter, and then drop by 5 percent in the final quarter. This is when cash cattle prices will have strong fundamentals to establish record high prices. Assuming third quarter prices average about $97 and the fourth quarter is near $100, then 2008 choice steers will average about $95, which is $3 above the 2007 record. We can expect to see new record high cattle prices in 2008, 2009, and 2010.

Calf prices will improve as well. Last fall, 500-550 pound steer calves averaged $120 per hundredweight at Oklahoma City. This fall, with stronger fed cattle prices and with somewhat more moderate feed prices, steer calves will probably be in the $120 to $130 range. In the Eastern Corn Belt, calves tend to be about $3 to $5 lower.

Those cow-calf producers who have held on until now should see the fruits of their patience. In 2009, there may be more acres return to crop production from the CRP. Hopefully more haying and grazing will be allowed from CRP acres as well. The massive surge in corn ethanol demand will begin to level off, especially for the 2009 corn crop. World grain production may move higher and beef trade should continue to improve dramatically. Cattle prices should be trending higher over the next several years with some potential for relief from extreme feed prices.

CBOT Corn Review: Market Rebounds; Bearish Report Already Traded - Ian Berry, Dow Jones Newswires (8/12/08)

CHICAGO (Dow Jones)--Brushing aside the government's bearish crop reports, Chicago Board of Trade corn futures rebounded Tuesday on sentiment that the market was oversold and that the government's projections had already been traded.

September corn ended up 113/4 cents to $5.09 per bushel; December corn ended up 11 1/2 cents to $5.28 1/2; and March corn ended up 11 cents to $5.47 3/4.

Prices dropped in early trading following the release of the U.S. Department of Agriculture's crop production and supply-and-demand reports, but climbed steadily throughout the day.

The December contract fell as low as $5.04 1/2 in early electronic trading. End-users and short-covering helped the market rebound, traders said.

"There just wasn't really interest in pushing it and testing the $5 level," said Arlan Suderman, an analyst for Farm Futures. "I'm not ready to say for sure that the bottom is in, but it's becoming more difficult to press this market lower."

He said there have been past instances in which the market hit its seasonal low on the day of a bearish August crop report and then rallied.

The USDA report projected total corn production at 12.288 billion bushels, up from a July projection of 11.715 billion bushels and higher than analysts' average estimate of 11.938 billion bushels.

The projected yield climbed to 155 bushels per acre, up from the government's July estimate of 148.4 bushels and above trade estimates of 152.3 bushels per acre.

But after dropping almost $3 since late June, traders said the market had already traded the optimistic crop outlook. Weeks of periodic rain and moderate temperatures have boosted the crop, traders said.

"It's sell the rumor, buy the fact," a trader said.

Spread trading was also a feature of Tuesday's market, traders said. UBS bought 500 contracts of CBOT December corn and sold 500 contracts of CBOT December wheat.

The trade is already looking ahead to the last several weeks of the growing season. A late planted crop has raised concern that an early frost or even a typical first frost would damage yields.

"Traders are also starting to look ahead to whether we need to have a little bit of a risk premium in the market going into the growing season, whether we can close this out before we have a frost or not," Suderman said.

CBOT oats futures ended slightly higher. September oats were up 1 cent at $3.57 per bushel, and December oats closed up 1 cent at $3.76 1/2. The government's crop production report decreased projections for both yield and production. The USDA now projects a crop of 89.897 million bushels, down from its July estimate of 92.872 million bushels.

Ethanol futures were higher. September ethanol climbed $0.037 to $2.100 per gallon and December ethanol ended up $0.057 at $2.103.

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