As cash hog prices have fallen to near or below breakeven levels for many pork producers, we thought it would be good to take a look at some historical relationships between the various published prices that the U.S. Department of Agriculture (USDA) releases. The relationship between the different purchase methods changes constantly, especially when markets are making major moves such as we have seen recently.
Figure 1 shows daily data for prior day base purchase prices by purchase type from January 2002 through last week. One of the most notable characteristics of this graph (and the underlying data) is the variability or "noise" that it contains. The source of this noise is the wide differences in packer-buying programs that are manifested in different base price and premium and discount schedules.
Figure 2 shows daily data for prior day net slaughter prices by purchase type for the same period. Note the "quietness" of these data series relative to the prior day base prices. One reason, of course, is that those widely variant packer-buying philosophies must, at the end of the day, arrive at hog values that are reasonably similar. The net money paid by each packer must be competitive.
In addition, there is more certainty in the slaughter data in that the day for which the data are recorded is more certain. Prior day slaughter data include the prices for all of the pigs actually slaughtered on a given day. Prior day purchase data include prices for trades in which the price and a delivery date were agreed to on the prior day -- regardless of when the delivery date may actually be. That variation in delivery date is another source of some of the variability that we see in the daily purchase prices.
Impact of Mandatory Price Reporting
The proposed rules for the renewed mandatory price reporting system will remove one source of this variation. Should the proposed rule become final, a purchase will qualify as "negotiated" if it represents agreement on a price through buyer and seller interaction. The requirement for "agreement on a delivery date" is being dropped since many negotiated sales do not arrive at a specific delivery date on the day that a price agreement is made. This change will put the prices of these sales into the data for the day of the negotiation instead of the day of the delivery. We think that is a proper change that will better reflect the prices negotiated on each day.
Of particular note in both of the graphs below is the relationship of the Other Market Formula prices to the others. Other Market Formula prices are prices based on Chicago Mercantile Exchange (CME) Live Hogs Futures markets. These prices have averaged $1.16 below negotiated prices and over $2 below hog/pork market formula and other purchase arrangement prices since January 2002. Is this proof that selling based on futures markets is a bad idea? Not necessarily.
What it really means is two things. First, when producers sell to packers based on futures market prices, packers will make sure they include enough basis in that price to cover them in virtually all instances. They will hardly ever use the average basis. The reason is that the packer is now taking the basis risk. There is no such thing as a free lunch. If you don't want basis risk, you have to pay someone else to take it and that results in a lower price for your hogs.
The other reason has nothing to do with futures markets and nothing to do with packers and everything to do with human nature. Note that the Other Market Formula line rarely goes above the other prices, but is frequently far below them. That variation is due to producers' experiences and expectations.
After a time of low prices, producers who were burned by low cash prices say, "I'm not doing that again," and aggressively forward price hogs based on futures -- and miss out on the ensuing cyclical rally. That's what happened in 2004.
The shortfall of Other Market Formula prices in 2006 was the result of producers' concerns about a normal cyclical low in the fall of 2006. Those concerns were, no doubt, fed by the predictions of well-meaning agricultural economists based on years and years of data that showed a four-year hog cycle. If 2006 was the cyclical low, then it was a very mild cycle, and producers would have clearly been better off if they had sold hogs on the cash market.
Futures Market Rewards
The good side of this discussion is that producers who have sold hogs on futures-based contracts (again, we point out, based on the advice of well-meaning agricultural economists) are this year being rewarded. Those prices have run $3 to $4/cwt. higher than the negotiated and swine/pork market formula prices since mid-August. That difference will likely grow as we move through the fall, as a good number of hogs were priced on October and December futures at $70 or more.
Hogs and Pigs Report Analysis
Watch your e-mail this weekend for our summary and analysis of Friday's Quarterly Hogs and Pigs Report from USDA.
Click to view graph.
Steve R. Meyer, Ph.D.
Paragon Economics, Inc.