What’s for Dinner: Beef or Pork? By Jim Huang

When I started my career in commodity futures two decades ago, I took lectures from a former trader at the CME livestock pit. Mike used his favorite trade to explain the complex concept of inter-commodity spread. Here it is:

Beef and pork typically had a retail price difference of $1 per pound. For example, a local butcher shop prices pork loin roast at $1.99/lb. and ground beef at $2.99. This price relationship was stable but subject to seasonal variations. Whenever the price spread gets too large, it has the tendency to converge to the long-term mean.

Mike believed that cash market price pattern drove futures price relationship. When he observed the spread growing to $1.80, he would short the cattle-hog spread: Sell CME Live Cattle Futures and Buy CME Lean Hog Futures.

With this trade, Mike expected hog/pork prices to go up relative to cattle/beef prices, reducing the spreads in both the spot and futures markets.

This trade was remarkable in that it mainly relied on common sense and easily observable data. As long as you know beef comes from cattle and pork from hog and could go to grocery stores to check out the prices, you could handle this trade.

Could we still deploy Mike’s strategy today? The answer is yes. Comparing to the pre-Internet age, we now have a lot more data available to validate this trade idea. Therefore, besides planning a trip to Costco or Super Wal-Mart, I suggest you read on.

Cash Cattle Markets
Live cattle trades in Texas, Oklahoma, New Mexico, and Kansas averaged $170/cwt (100 pounds) for the week ending May 12th, according to USDA data. This represents a 21% gain over the year-ago price of $140. Cattle auctions in Nebraska, Iowa and Minnesota averaged $175-176/cwt last week, up 22% y/y.

USDA weekly Southern Plains cash cattle price trend shows the five-year average at around $120. Cattle price has been rising rapidly in the past three years.

Cash Hog Markets
Market hogs averaged $77.31 last week, down $30 (-28%) y/y, according to the USDA. Current price is approximately $5 below the five-year average.

The latest CPI data shows that consumer price grew at an annual rate of 4.9% as of April. While food inflation is much higher at 7.7%, the category “Meats, poultry, fish, and eggs” only logged in an increase of 2.8%.

However, not all meats are created equal. Beef price continues to go up, while pork, chicken and eggs pulled back from last year’s high prices.

WASDE Report
USDA closely monitors agricultural market conditions and publishes the monthly World Agricultural Supply and Demand Estimates (WASDE).

The latest WASDE, published on May 12th, estimated the total U.S. red meat and poultry production for 2024 at 1% below 2023 level, as lower beef and lower pork production offsets higher poultry production.

Beef production is forecast lower with expected declines in both fed and non-fed cattle supplies. Pork production is forecast slightly lower.

For 2024, cattle prices are forecast above 2023 on tighter supplies. Hog prices are forecast higher on improved demand and slightly lower supplies.

The CFTC publishes the Commitments of Traders (COT) reports and provides a breakdown of open interest for futures and options markets. It categorizes the reportable open interest positions into four classifications:
• Producer/Merchant/Processor/User
• Swap Dealers
• Managed Money
• Other Reportable

What’s the key takeaway from the May 9th COT report on cattle and hog?
Live Cattle futures (LE)
o LE open Interest: 317,715, down 8.5% from previous week;
o Managed Money decreased long positions by 11.7%; their long/short ratio is 7.1. Speculative traders are still bullish on cattle prices, but they have started to take profit.

Lean Hog futures (HE)
o HE open Interest: 230,026, basically unchanged (-0.1%) from prior week;
o Managed Money increased short position by 14.9%; their long/short ratio is 0.68. Speculative traders are bearish on hog prices.

Cattle and Hog Spread Trade – Explanation and Illustration
The 20-year chart shows that the price spread between live cattle (LE) and lean hog (HE) broadly stays in the range of $20-$60 per 100 pounds. Whenever the price breaks out of the range, it will get pulled back in.

From January to May 2001, the spread fell nearly $50 from $45 to -$2. However, it rebounded strongly to $38 in just two months. Last May, from the bottom of $22, the spread rose all the way to $92 in March. It recently pulled back to $80, which is still well above the upper range of $20-$60.

If you study the market fundamentals in hog and cattle, you will find significant uncertainty about future price trend. However, based on historical data, it’s not unreasonable to expect the spread to narrow and converge to the mean, regardless of whether the individual prices are trending up or down.

The spread relationship holds true because of the substitution effect. High beef price would nudge consumers to lower priced pork. The change in demand in favor of pork would pump up its price relative to beef price, reducing the spread at the end.

If a trader holds this view, he could short the cattle-hog spread like what Mike did 20 years ago: Sell CME Live Cattle Futures and Buy CME Lean Hog Futures.

October cattle contract (LEV3) is quoted $166.2 per 100 lbs., while October hog contract (HEV3) priced at $77.425. on May 12th. Thus, the price spread is $88.775. Both contracts are based on 40,000 pounds of meat and require $1,600 in margins.

For the spread to narrow $1, our trade would gain $400. If the cattle-hog spread falls back to the upper range at $60, the futures account would profit $11,510. Using the initial margins of $3,200 as a cost basis, the spread trade return would be 360%.

The above example is for illustration only. Our trade would stand to lose money if the price spread did not converge. For example, if the spread widens to $92, futures account balance would be reduced by $1,290, a negative return of -40%.

Happy Trading.

*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.

CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com/cme/