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An Exciting Week For Cattle Market

The week's cattle kill totaled 612,000 head via the 1 p.m. Estimated Slaughter report from USDA. That is next to the 614,000 estimate we discussed Friday morning. Their number would represent a 4.4% increase over last year, under the 5.8% increase seen over the previous four weeks. This week's kill was a little low due to the weekend weather impact on Monday's kill. If we had just 10,000 head more in the week's run, the kill would have run 6.1% over last year.

With this week's tighter than expected slaughter and lower weights, the amount of beef output was only 2.9% over last year. This is why we had such an exciting week. Exports are only about 10% of our beef production. However, current exports are a little over 20% higher than last year. That means the amount of beef offered to U.S. consumers, after net exports, was likely only minimally higher than last year. Weeks ago all of these U.S. meat buyers were planning on a 4% to 7% increase in beef offered to them during the peak demand time of the year. It is the scramble for the last amount of supply available that gives us these outlier-type price moves. A 1% change in supply in a market at supply/demand equilibrium is much different than a 1% change in supply when 1) supplies are a bit tighter than expected and 2) buyers are scrambling to fill orders in the peak demand period of the year (elasticity of demand).

One of our discussion points yesterday was the need to see how the market traded after it filled the obvious gap on the June contract that was left open on yesterday's gap higher trade. Friday the market filled that, as expected, and continued to break. Limit down settlements were seen for the first two live cattle and the first four feeder cattle contracts. That is a message we can't ignore. Producers are encouraged to look at some price protection options.

Is it time for producers to take action and start hedges/reapply hedges? On that question we have no problem at all looking at the options. We would still avoid hedges using short futures. That leaves either buying a put, buying a put spread, or a three way. If you're relatively new to options let's go through the details.

Buying a put is just like an insurance policy. You pay your premium and that's the most you'll ever pay no matter where the market goes. If prices fall you have unlimited protection (the value of your option rises and offsets the lost value of the physical cattle). The downside for this great level of protection is price. Options prices are determined by where the futures are, volatility of the market itself, and the time left for the option. Buying a $124 August live cattle put is great. The only sticking point is the cost, $5.75 per cwt. in this case. A way of cheapening up the high cost of a put is to do a put spread. If you are willing to limit the amount of downside protection you can cheapen the cost. For example, you still buy a $124 August live cattle put but also sell a lower put, perhaps a $114 August put for $2.10. In that case, your net cost falls to $3.35 excluding commission. The downside is you only make money on this position from $124 to $114 at expiration. If prices fall below $114 you don't make any extra money past that point. This one also has no margin calls. You simply put up the upfront cost, set it and forget it. The third way of doing hedging with options is with an Allendale Three-Way Option position. In this case, you do the put spread idea but you still feel the upfront cost is too much and are willing to take on a little risk. Buying a $124 put and selling a $114 gives you the same downside protection as before. However, to cheapen the cost you also sell a higher call, perhaps a $130 call for $3.30. This gives you the same downside protection on your cattle from $124 to $114. If the market rallies, though, your short-call position may cost you money on a significant rally. In this example, though, because this market is so volatile and those options are so pumped up, the market could rally a full $6 before it starts costing you money. You get a full $10 downside protection but also can have the market rally $6, not a bad sounding deal. The downside here is the margin deposit required at the start. Though minimal, it can increase if the market rallies. This is a strategy more for normal markets where you are relatively confident of potential upside. 

The cash end of the trade has yet to quit. Gains were noted again for wholesale beef and there are still cash cattle sources that are suggesting stability next week. Given the futures action, we wonder if that might be a little hopeful. The government released the raw meat trade numbers for March yesterday. USDA will release their converted numbers over the next two days. The Fresh/Chilled/Frozen category showed a 26.4% increase over the previous year in March. That is over the 21.5% and 19.8% from January and February. We will release updated ideas on March beef demand, Q1 beef demand, and updated price projections next week. Hedgers, it time to get active with limited-risk positions. 
 
Rich Nelson 
| Allendale Inc. | 
815-578-6161
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