Answers may be tougher to come by, but the same old fundamentals still rule the cattle business.
Doom and gloom. If misery loves company, then these are bountiful times in the cattle business.
• The worst nationwide economic recession in at least 35 years; gross domestic product (GDP) growth in 2008 was a paltry 1.3%. No one is confident on where the bottom is.
• A commodity price bubble propelled corn futures to near $8/bu., crude oil to more than $140/barrel and deferred live-cattle futures contracts upwards of $120/cwt. Prices continued to soar with no ceiling in sight, defying fundamental reality, then plummeted last fall to around $4/bu., $40/barrel and $82/cwt., respectively.
• The unexpected market cataclysm in the international credit markets. The combination bled equity from virtually every industry – whipsawing volatility through the markets like confetti in a whirlwind.
Cattle prices turned so ugly last fall that entire calf crops lost 10% of their auction-market value inside of a week. According to the Livestock Market Information Center (LMIC), 2008 was the first time in 10 years that cow-calf returns fell short of covering cash costs (basis Southern Plains). Losses are estimated at an average of $25-$30/cow as costs grew to $150/head more last year than in 2003.
Cattle feeding suffered its worst economic year ever. Jim Robb, LMIC director, says fed-cattle prices lost $5/cwt. in ECONOMIC OUTLOOK the weeks following the credit-market implosion.
These three separate, yet intertwining threads of price destruction alone have made it tough to sort out what’s happening, much less what it portends.
A perfect storm
“I think the run-up in commodity prices was a perfect storm of variables and events,” says Tim Petry, North Dakota State University livestock marketing economist. “Most commodities went too high relative to their fundamental value.Now, they’ll likely fall further than their fundamental value.”
Growing international demand, as well as investment and hedge funds fleeing anemic financial markets, helped fuel commodity prices and distort basis relationships, transfiguring long-held rules of thumb. For instance, Mike Murphy of Cattle-Fax recently explained that deferred live-cattle futures are driving feeder-cattle prices rather than corn. Too much cattle-feeding capacity chasing too few cattle magnified losses in that sector and underpinned calf and feeder prices at higher prices that fundamentals supported.
Robb says the good news is historical bubbles tend not to repeat themselves very quickly. “We tend to adjust and stabilize; prices then move higher over time,” he explains, adding the recessionary period will likely delay that turnaround.
Looking ahead, Darrell Mark, University of Nebraska livestock economist, says that with demand dampened by global recession, there’s little to suggest commodity prices will ratchet up significantly in the next two years. And the meltdown for financial funds to chase commodities like they did last summer.
At the same time, Robb cautions, “You can’t assume fertilizer prices won’t again rise, for example, or crude oil won’t eventually reach $70-$80/barrel again.”
In fact, you must expect it, given emerging global wealth and demand, which also helped pump up the commodity bubble. For the first time in generational memory, America had lots of competition for commodities. Though demand growth has slowed with the worldwide recession, there’s no reason to expect a return to the good old days when U.S. demand set global commodity prices.
The unraveling of international credit markets was the third financial shock in the last eight years to roil cattle markets directly, Robb says. The first was the 9/11 terrorist attacks, then the 2003 discovery of BSE in the U.S.
He says the pattern of price response following each has been similar. Prices decline for 9-11 weeks, stabilize, and then slowly increase. The current recession will likely retard that price recovery.
Though price behavior following such shocks is predictable, few understand such market shocks for what they are when they’re occurring. If we could, we’d be able to preserve more equity. Robb says prices are significantly higher within the first two weeks of the shock than the 7-9 weeks that follow before finding bottom.
Recession length is a guess
“How long this recession lasts domestically and internationally is anyone’s guess, but a recovery is key to higher cattle prices,” Petry explains. “U.S. unemployment is forecast to increase at least into this summer, and maybe longer. The new administration and Congress are expected to aggressively address the situation, so we hope a recovery can begin by midyear.”
History offers little guidance to the impact of recession on the cattle cycle. Mark reviewed economic recessions during the past century, defined by reduced year-to-year GDP, then looked at cattle-inventory numbers at those times. There was little correlation one way or the other.
Far as that goes, cattle cycles seem to offer less and less in the way of guidance as the historical peaks and valleys become little more than speed bumps. As Mark says, “The cycle isn’t cycling much anymore.”
For the record, the industry is either entering the fourth year of a cycle that began in 2005 with one of the shortest expansion phases in history. Or we’re mired in the 13th year of herd liquidation in the last cycle, the longest cyclical liquidation phase in history. “The things that create cattle cycles haven’t gone away, but they’re being masked by other forces and dynamics,” says Derrell Peel, Oklahoma State University livestock marketing specialist. Primarily, the cattle cycle – the rhythmic increase and decrease of the nation’s herd – stems from cow biology and the lag time associated with producer response to the economic signals encouraging or discouraging production.
In part, Mark explains the cycle’s peaks and valleys have moderated over time, and will continue to do so, because of specialization. In this case, fewer operations control a larger percentage of the nation’s beef cattle (10% of operations currently control about half of all cows). So, fewer cows enter and exit the business willy-nilly. Most of the cows are controlled by folks who by necessity are in the business for the long run.
According to the Jan. 1 USDA beefcow inventory, beef-cow numbers are 2% lower than a year earlier at 31.7 million head. Beef replacement heifers are also 2% less at 5.53 million head. Cattle and calves on feed were down 7% at 13.9 million head. All cattle and calves stand at 95.5 million head, vs. 96 million a year earlier.
“We’ve said at least since 1991 that the cattle cycles aren’t going to swing up and down as they did through the 1970s and 1980s,” Robb says. “The cycle is still a factor in planning, but less important. Planning these next few years based upon the cycle would be missing the point.”
A new environment
For all the volatility in today’s market, the industry fundamentals haven’t changed, though the relationships between them have altered. It’s the environment in which those fundamentals operate that’s changed and will likely continue to shift. Chief among them is the higher cost of energy.
“We built production agriculture on cheap oil. Since World War II, we (the nation) have focused on technology to exploit cheap energy,” Peel explains. “It’s not that we’re going back to cheap energy over the long term, it’s that we’ll learn to adjust to higher energy costs within industries.”
In the cattle business, for example, Peel says producers won’t quit fertilizing, but they’ll adjust where and how they apply it. He adds, “That disfavors intensively managed pasture and forage systems.”
Further, Peel explains cow-calf producers have been able to focus on price in the past, as fixed-cost operators, and less on the margin between cost and sales price like stocker operators and cattle feeders. Rather than try to outguess market volatility, finding price lows and highs, Peel believes all segments will find more opportunity by focusing on the margins, whatever the prices are.
Notwithstanding the current downturn in commodity prices, few are betting prices will return to previous trading ranges on average over the long haul. The associated volatility due to price levels and other forces means managing price risk grows in importance, too.
Petry cautions: “Don’t just lock in one side of a transaction or production equation; lock in a margin. Otherwise, you’re exposed to more risk, and it could haunt you in a hurry.”
Some lenders are increasing riskmanagement requirements as a condition of granting loans. Whether added lender demand or the need to carry cattle for more days and pounds, Mark explains, “Both credit availability and the cost of it will continue to be bigger drivers of the business.”
Faster change will probably be a hallmark, too. “It could be several years before we understand the implications of the current adjustments and how we should do business relative to them,” Peel says.
“The new economic reality is that we’re in the most severe economic recession in 35 years. Volatility and financial shocks will continue,” Robb says. “You have to manage within that new system. You must look at three- and fourmonth windows of opportunity rather than figure that selling weaned calves in October or backgrounded calves in February, like you always have, is necessarily the most profitable strategy.”
Business as usual, sort of
But the cattle business remains a commodity business, defined by breakeven economics on average over time.
Consider the Return on Investment (ROI) to cow-calf operations. Looking at data from Standardized Performance Analysis in the Southern Plains, Peel says the average ROI runs 1.0-1.5%. In Mark’s neck of the woods, it’s a touch higher. Year in and year out, though, returns are low. These economists see nothing on the horizon to suggest ROI will increase or decrease much in the years ahead.
Amid the current economic chaos, Peel explains one thing producers are left with among the fundamentals is the fact that time is an able elixir.
“If there’s one lesson from previous economic upheavals and times of uncertainty, it’s the knowledge that we’ll survive this as an industry; we’ll come out of it eventually,” Peel says.
Bottom line, there is nothing currently, or in the foreseeable future, that suggests to cow-calf producers, all else being equal, that it makes any more sense to expand than contract.
“We’ve had a bad year, but that doesn’t mean the basics no longer apply,” Petry says. “I don’t think there’s any reason to throw in the towel… Don’t throw all of your plans and strategies out the window because of a glitch this one year.”
Petry continues, “The same management strategies we’ve used in the past still apply; efficiency is still the name of the game. You’ve got to know your costs. For cow-calf producers as marketers of grass, that means knowing your resources and stocking accordingly.”
In fact, as others have discovered in the past, these days may be precisely the time to expand, if done for the right reason.
“For the well-established operator who is doing well, I don’t think cautious expansion is out of line,” Mark says.
Likewise, Petry says, “If you’re planning to expand because it improves your efficiency, I believe you should continue with that plan.”
There are at least two logical reasons for optimism – supply and demand.
At least in the short term, the fact remains that cattle numbers are tight relative to cattle-feeding capacity. Given how strong domestic demand has remained through the financial chaos – though end meats have outshone middle meats – any surge in demand should buoy prices exponentially. Global demand should continue to grow this year, as well.
Plus, for the first time in 35 years, projections forecast a decline in year-toyear broiler production. Pork production should be steady to lower, and beef production is predicted lower.
“Beef demand will drive cattle prices the next few years because we don’t have any over-supply problems,” Mark says.
Longer term, international demand growth has the potential to outstrip supplies sooner than later.
“When things are changing, you need to think about how you do things differently,” Peel says. “It’s hard to imagine that the answer for anyone today is to keep doing things exactly the same way they always have.
“I don’t think survival or extinction is inevitable. If you decide you’re going to succeed and at what level, and are willing to do what it takes, you can,” Peel says. “If you’re unable or unwilling to adjust to the new environment, then your future is probably limited.”