As we contemplate the impact of high corn prices on the U.S. hog sector, it behooves us to revisit an old friend - the hog-corn price ratio.
This ratio, computed simply as the price of hogs per hundred pounds live weight divided by the price of corn per bushel, has long been an indicator of pork producers' profitability and, thus, a predictor of output 12 to 24 months hence. It was quite dependable in the days when a key decision was whether to sell grain or "walk it off the farm" in the form of hogs or fed cattle. As the livestock industry has changed, there has been a lot of speculation that the ratio simply isn't as useful as it once was.
Figure 1 shows the hog-corn ratio (computed using Iowa-Minnesota live hog prices and Omaha cash corn) and an eight-week average of year-over-year percentage change in pork production. The eight-week average is used to smooth the data a bit and make the graph much easier to read and use.
We can see the lead-lag relationship of these two measures quite clearly in the early years of this graph. A high hog-corn ratio in late 1990 led to a production surge in mid- to late-1992. The resulting low hog-corn ratio of 1992 led to a production cutback in late 1993.
An obvious exception to this relationship occurred in 1995 through 1998, when very low hog-corn ratio levels of 1995-96 appeared to lead to the surge in production that drove prices to record lows in 1998.
The presence of several confounding factors underscores the fact that no "rule of thumb" should be used blindly.
First, the low hog-corn price ratios of 1995 and 1996 were caused by record high corn prices driven by short supplies and high worldwide utilization. Hog prices were very good in 1996 and it appears that pork producers were not swayed by the low hog-corn ratio because they knew it was temporary. They apparently responded more to price signals than to profit signals in this instance -- perhaps a harbinger of things to come.
Second, the technological shift from small, single-site hog farms to much larger, multiple-site operations was in full swing in the mid-'90s. The rate at which this technology was adopted was hastened by a "hurry-up" mentality regarding both market share and regulations. Many producers believed that they had to act fast to stake out a place in this rapidly changing industry and to build farms before regulations became onerous and limiting.
Since 2000, the hog-corn ratio has reached record high levels and challenged the record low by dropping below 8 in September 2002. And yet, the year-over-year change in production has never been lower than -2.4% in September 2001 and never higher than +6.8% in July 2004. That is much smaller than the -10 to +15 range of years past.
And now we find ourselves with a ratio of 12 -- well below the 18 to 20 range that has traditionally indicated a shift from expansion to reduction or vice versa. What will be producers' responses?
I think we must first consider where the ratio might be over the course of 2007. Current futures prices show ratios of 16.4 to 18.3 for the rest of 2007. Those levels have historically signaled slow and small output reductions. The last time we saw ratios in this range was in 2003. Those led to very small cutbacks in only a few weeks in 2004 and 2005. Corn comprises only about 35% of total costs today and therefore corn costs are simply not the output driver they once were.
On the other hand, these ratios in the 16 to 18 ranges mean more to producers than the last low ones driven by high corn prices in 1995-96, because these corn prices are not supply driven. Lean hog futures are near record highs and yet we only have a hog-corn ratio of 16 to 18? How promising can that be?
Click to view graphs.
Steve R. Meyer, Ph.D.
Paragon Economics, Inc.
e-mail: steve@paragoneconomics.com