Ag Today August 18, 2016

Welcome to the ‘Meat Casino’! The Cattle Futures Market Descends Into Chaos

Aug. 17, 2016 7:10 p.m. ET

CHICAGO—Wild swings in the cattle futures market have prompted some traders to call it “the meat casino.”

In response, the world’s largest futures exchange has refused to list new contracts, leaving ranchers with fewer tools to hedge the $10.9 billion market. CME Group Inc. said that is because trading of physical cattle has become so scant that the futures market can’t get the signals it needs to set prices.

“It’s madness. The market makes major moves for no reason,” said Blake Albers, a cattle feeder in Wisner, Neb.

The decision to delay new contract listings is the culmination of alarms raised by the exchange and industry groups this year that problems in the physical marketplace have affected futures—a highly unusual meltdown in a market that has attracted more speculators.

Few producers complained as cattle prices surged to record highs in 2014 and early 2015. But as prices this summer sank to five-year lows, financial strain on the industry has highlighted the extent of the problem. Revenue from cattle sales is forecast to drop 3.9% this year to $73.6 billion, after falling 5.7% in 2015, according to U.S. Department of Agriculture data.

Live-cattle futures climbed as high as $1.4155 a pound before free-falling to $1.1580 over seven weeks this spring. That represents a more than $10,000 drop in income for a single contract. Many producers have lost money as prices tumbled to a five-year low of $1.07525 a pound this summer.

“Guys like me who have been around a long time aren’t putting as many positions on,” said Dan Norcini, an independent livestock-futures trader in Coeur d’Alene, Idaho. “It’s just not worth the risk anymore, when there’s no rhyme or reason to these price swings.”

Through July, futures volume fell 1.9% compared with the same period in 2015, and was down 9.7% from 2014, according to CME data.

Each futures contract represents the obligation to buy or sell 40,000 pounds, or around 35 head, of cattle. While few traders actually deliver or receive livestock, they look to the price of cattle sold at auctions and at feedlots to keep futures prices anchored to the real world. But structural changes to the way cattle are bought and sold have made it harder to see physical market prices.

For nearly a century, meatpackers and producers would haul animals to stockyards and auction barns, to physically buy and sell thousands of cattle almost daily for cash. But over time they found it inefficient and expensive to travel miles with cattle in tow to barter over pennies and nickels per pound, so many buyers and sellers gave up negotiating each day.
The number of participants negotiating prices started to decrease in the 1980s and today, only small number of cash trades—which take place just once or twice a week—serve as a proxy for the base price used by the rest of the industry. Most of the cattle delivered to slaughter plants today are priced using a formula that incorporates the cash market value as a base, plus or minus premiums and discounts.

“Someone sells 40 head in Iowa and it has the potential to revalue all the cattle in the nation,” Mr. Albers said.

The deals that do take place between cash market buyers and sellers frequently end up being completed on Friday after the 2:05 p.m. ET close of the futures market. That means financial traders spend most of the week with limited up-to-date data.

“There is very little underlying information to use,” said David Lehman, CME’s managing director of commodity research. The CME has listed only one live-cattle contract since March and it is set to expire in October 2017.

The CME has formed a working group with cattlemen to discuss fixes, including ways to increase the number of cash traders. The exchange shortened trading hours for the livestock futures contracts in February to confine market activity to the daytime, when liquidity is higher, after ranchers complained that speculators had too great an impact on prices in the evening trading.

“Every aspect of the cattle futures contract is under review to see if there’s a way to redesign so it’s a more effective tool for risk management,” Mr. Lehman said.

The failure to list contracts after October 2017 is a problem for ranchers buying calves this summer. They typically need around 18 months to grow to slaughter weight, meaning ranchers are exposed to possible price swings in the 2017 winter.

Steve Sunderman, a partner at a feedlot in Norfolk, Neb., recalls watching cattle futures prices earlier this year rise and fall by more than one cent in just 15 minutes, unprecedented leaps in a market more accustomed to daily moves of fractions of a penny. The swings made him uneasy about locking in a hedge for his cattle on a Friday, when prices had climbed over $1.15 a pound only to settle at $1.12975, thinking the market would likely climb further.

“You lose confidence in your decision,” he said.

Some in the cattle industry blame high-frequency traders who can place or receive orders more quickly, and with more money, than bona fide commercial hedgers—often located in rural ranching communities.

But CME said that opening up markets to a diverse group of investors, including hedge funds and algorithmic traders, adds liquidity to products like cattle futures, which tend to be more thinly traded than gold or oil. Just 10% of the total volume in live-cattle futures came from high-frequency trading in 2015 for which the latest data is available, the exchange said.

“We need to figure out why the cattle market can go from $1.30 in one week to $1.15, when we haven’t added more cattle to the marketplace,” said Ed Greiman, an Iowa farmer who sells about 100 cattle a week and is leading a cattle-marketing committee at the National Cattlemen’s Beef Association.

The solution will have to involve addressing the level of activity in the barns and feedlots, according to cattle industry groups and the exchange.

Some producers are trying to find their own solutions. Superior Livestock Auction LLC, an Oklahoma City-based livestock-marketing firm, piloted a video auction program to broker sales of slaughter-ready animals that would mirror sales in the cash markets, showing bids and offers in the middle of the week. Interest in streaming the auction online has been so strong that it has crashed Superior’s website in the most recent sales.

“The hope is to add a transparent venue for price discovery,” said Jordan Levi, a cattle feeder based in Oklahoma City who spearheaded the initiative. “It’s not a playground. This is U.S. agriculture, and futures should be a risk management tool.”