The "Why" of Record-High Cattle Prices and Background for Longer Term Strategic Planning
Farm Business Management Update, December 2003/January 2004
By Wayne D. Purcell
The last half of 2003 has seen astonishing developments in the cattle and beef markets. Producers who bought cattle before the surge in prices occurred are reaping a profit bonanza. Behind the scenes, however, a supply-demand picture is developing that suggests producers need to be thinking about expanding their breeding herd or in other ways making adjustments in a longer term strategic planning context. The volatile and record-high prices get in the way of the basics behind the scene and we need to sort out the "why" of the record prices to get back to looking at the things that are legitimate and will last over time.
The Record Prices
In general, the current situation started in late May 2003 when the BSE was discovered in Canada, and the Canadian border was closed to shipments of live cattle, and in particular, to shipments of slaughter cattle. The slaughter cattle that were coming across the border into the United States for slaughter and processing amounted to about 9% of our available supply of fed steers and heifers that make up the bulk of the supply of high-quality beef. A lot of pundits who write about this say that this entire surge in price has been due to a dramatic increase in demand, but that is not correct and is not based on facts or good research. We know something about the demand for cattle at the live animal level and about a property of that demand called elasticity. Basically, our research shows elasticity of demand at the farm level for live slaughter cattle to be about -0.5. Price will move in the opposite direction of any changes in supply or quantity being supplied, and the magnitude of the price move will be essentially double the magnitude of the quantity change. In other words, if we have an increase in supply of 1% in fed cattle numbers, we would expect fed cattle prices to go down about 2%, assuming the demand for fed cattle derived from what's going on in demand at the consumer level is constant and not shifting. The elasticity measure is technically percentage change in price divided by percentage change in quantity.
We can build a graphic framework to demonstrate this. In Figure 1, we have a negatively sloping demand curve that looks like most empirically derived demand curves we work with. It has some curvature to it then starts to flatten at the bottom price levels: the expected normal shape. We can put in a supply curve and, for purposes of this illustration, let's put it in as a vertical line and call it supply (SS). What has happened is the supply curve has shifted to the left virtually overnight when the Canadian border was closed. This new position we labeled S'S'. There are some differing estimates as to what percentage of our slaughter numbers the Canadian cattle made up. If we go to recent numbers on fed steers and heifers and think about the Canadian cattle, which are predominantly fed steers and heifers when they come into the U.S. for slaughter, shipments from Canada made up about 9% of our available supply. It's fairly easy to suggest that we would have seen about an 18% increase in price, given the -0.5 elasticity, if nothing had happened except the short-term and dramatic reduction in supply of market-ready, fed cattle. The BSE announcement came in late May, and western Kansas fed steer prices for the week ending May 31, 2003, were $80.02 per hundred weight. If we take an $80 market price and add 18% because of the dramatic reduction in supply, we get $94.40. That price estimate is the first we could generate that would be an estimate of what we could expect to occur with the 9% reduction in supply.
Figure 1. Basic Supply-Demand Economics
The fed cattle market has actually moved above the $94 to $95. The packers have been trying to keep the doors open and keep their business operating at a level somewhat near the planned and designed level for their plants. The packers were also caught with contract commitments to retailers. As the cattle numbers started to tighten through the summer months and into the early fall, the packers scrambled and bid up the cattle on occasion to try to meet those commitments. Interestingly, they were able to do it, at least partially, because the box beef cut out values went up as fast, or faster, than did live cattle prices. To put this in context, Figure 2 shows weekly western Kansas fed steer prices and weekly box beef cut out values for the 600-750 lb. boxes as a percentage of their respective prices for the week ending May 31, 2003. The peak price for the fed steers (as of the date of this paper) was $106.68 which occurred the week ending October 18, 2003; up 33% from the $80.02 in late May. The highest weekly price for the Choice box beef cut out values was $194.32 for the week ending October 18, 2003; up 31.5% from the $147.78 recorded the last week in May.
Figure 2. Weekly Fed Steer Prices and Box Beef Cut Out Values As a Percentage of Their Respective Prices for May 31, 2003
To this point, it's fairly easy to see why, in general, packers were able to pay prices above $100 per hundred weight on a live-weight basis for cattle. The operating margins were largely being protected because the box beef values were going up essentially as fast as the cattle prices. When we look at the levels of those plots for the most recent weeks in November, it's easy to see why this market started to show some topping action and became very volatile. After reaching a peak of $194.32 in box beef cut out values in mid-October, those values leveled off to the point that the average for the week ending November 1, 2003, was $171.09 - a substantial decline in the selling price or revenue stream for the packers. Their reaction was to reduce the slaughter levels and go to a four-day work week to try to get some relief from substantial negative margins that were showing up as we moved into November. During November, weekly beef production is declining significantly.
The discussion in the local and national media about sticker shock in beef prices started to heat up in early November. If we look at the numbers, it's not difficult to see why. No weekly prices for beef at retail are available, and monthly prices come out with a bit of time lag. If we look at the September price for Choice beef at retail, it was $3.71 lb. (up about 3% from the $3.61 lb. average price for May). Through September, little, if any, of the price increases that have been occurring in the live cattle and box beef markets had been passed up to the consumer. That is why I've said in many forums that this is not a demand phenomenon, because, at least through September, demand had never really been tested. The consumer had never seen the higher prices, and now those higher prices are starting to work up through the system in October and into November. The October price for Choice beef at retail was $3.93 lb. (up about 9% compared to May). The sticker shock is, in fact, starting to happen in restaurants and institutions as well as in the fresh beef market in our local food stores.
What we have is a very unusual shock to the supply side of the market. I've worked through the numbers assuming demand is constant and stable, which is not exactly the case. Obviously, demand is not going to shift 9% overnight as the supply curve did, but we have some evidence that suggests demand is continuing to move higher, which accentuated the price phenomenon. Table 1 shows the quarterly demand index for beef that I maintain and post on the internet at www.aaec.vt.edu/rilp. We're showing 1980 and 1998 as base years in these numbers. We built the demand index with 1980 as a base. Notice that by 1998 these numbers generally show that demand had declined in a cumulative fashion almost 50%. I rescaled the indexes and set 1998 as 100. We can look at the latest number in the quarterly demand index, third quarter 2003, for example, and say that demand since the third quarter 1998 is up about 16.5%, given that the index for quarter three is 116.492.
The situation is also clear if we look at the prices being discovered for live cattle futures. The record-high prices we are seeing are a temporary phenomenon. Prices for all the futures months are volatile, but we've seen the nearby contracts like the October and November trade above $100. December had traded above $98. If we look out to June as we move through mid-November, we find it trading in the mid-$70's and August is lower still. This is a very well-informed and very intelligent price discovery process that is going on in the Chicago Mercantile Exchange. We can assume, quite correctly, that the people trading this market know as much as they possibly can about when the Canadian border is likely to open again. It's rather apparent that they expect to see it open by the late spring and early summer months next year, and something unexpected would need to happen in the policy negotiations that are now on-going to keep that from happening.
I'm not sure we need to go back down to the mid-$70's as the June futures are showing when the border reopens and things start to come back to a more normal set of supply-demand conditions. With the continued improvement in demand and the fact that we are likely to start to hold some heifers for herd building purposes as we move through mid 2004, I suspect an $80 market is a more reasonable projection from a mid to late November vantage point. That still leaves the same point intact: these record-high prices we've seen are coming from a supply-side shock, they are not going to be sustained, we will go back to a more normal set of conditions when the Canadian border reopens. We must keep in mind that some disruption of cattle production in Canada has occurred. I'm not suggesting that when the border opens, we will immediately see an equivalent of about 9% of our normal slaughter levels come back across the border. It's probably going to be more of a hit-and-miss proposition, and we'll have to work back toward normality. It may take most of the year for that to occur, but the key point will be that the opening of the border and the move back into our supply channels of a significant number of fed cattle and slaughter cattle coming out of Canadian feedlots will move us back toward more nearly normal prices.
Table 1. Quarterly Beef Index 1980-2003
|Quarter 1||Quarter 2||Quarter 3||Quarter 4|
The Changing Marketplace
The short-run price distortions will come back to more normal circumstances during 2004, but change in the marketplace will continue. Any long-run strategic planning by producers needs to be carried out in a way that reflects how the livestock marketplace will function.
Across the past 10 to 15 years, the market has moved away from price as a coordinating mechanism and an instrument of quality control. During the same time period, we have seen a series of legislative initiatives by Congress to stop or slow the trend. Cow-calf producers in particular need to understand what is happening and why.
A detailed coverage of what is happening and why can be found in Contracts and Captive Supplies in Livestock: Why We Are Here, Implications and Policy Issues at www.aaec.vt.edu/rilp. This is a version of my testimony at the USDA forum in Denver in September 2000. A less detailed treatment of the topic on why we are seeing a move away from price-driven systems to contracts, captive supplies, and vertical alliances is located on the same website and is entitled Questionnaire Regarding Livestock Marketing: House Committee on Agriculture. This effort provides my answers to a series of questions raised by then Chairman, Larry Combest, from the House Ag Committee. His questions revolved around the "why" of the move away from price-driven systems and whether we should enact legislation to slow or stop the trend. Briefly, the move away from price-driven systems in cattle has come for a number of reasons.
During the 1990's, moves away from the price-based systems gathered momentum the moves were often initiated and encouraged by producers who recognized the problems associated with all cattle selling at one price each week. Contracts, pricing grids, vertical alliances, and even vertical integration where packers own the cattle during the feeding phase started to grow in frequency. With the ability to specify or control cattle types to support new and branded fresh beef lines, the large packers changed the commodity-oriented business models and spent billions on new products. A first step in most vertical alliances was to guarantee tenderness. High-cost technologies during fabrication are being employed to ensure tenderness when the genetics of the cattle still offer variable performance.
The dollars were not spent on new products until quality control via non-price means was realized. Quality assured, pre-cooked, and microwavable entrees are major contributors to the growing demand for beef. The beef sector is poised to regain market share if profits can be sustained over the next 5 to 6 years to accomplish herd expansion and to realize the resulting eventual increases in per capita production and, therefore, in per capita supplies.
Producers are sometimes in a dilemma. It appears the moves away from price-driven systems brought increases in packer spending on product development work. Pending Congressional initiatives that would ban packer ownership, ban contracts and marketing agreements, or even require a certain percentage of slaughter cattle be bought in a "competitive market" could stop that product development work. Not allowing any food processor to control the raw material to fit the needs of the new branded product line will surely discourage development of those branded lines, but the move away from the price-driven systems in cattle is very controversial.
Producers should do long-term strategic planning with these policy and market intervention issues in mind. The papers by Ward and by Bailey at www.aaec.vt.edu/rilp under Market Interventions deal with the pros and cons of "packer ban" legislation and focus attention on the inevitable, unanticipated consequences of Congress' efforts to legislate solutions to economic problems. The next few years could be volatile due to all this, but I suspect the eventual result is that non-price means of coordination and quality control will be allowed in some form because they are proving to be so important to demand growth which is, in turn, critically important to every cattle producer.
Longer Term Strategic Planning
The beef sector faces a positive future if the increases in demand since 1998 can be sustained. Increasing demand takes money and new investments. Consequently, it is important that processors' interests not be influenced by excessive market regulation. Even if we get to that balanced posture and don't fall into a trap of regulation, producers must consider a number of fact-based issues.
The herd building phase of the cycle could last 5 to 6 years longer if demand continues to increase at the same time. Producers should spend some time to be well informed and make objective decisions. The www.aaec.vt.edu/rilp website has papers by leading Land Grant University researchers on COOL, on extension of Mandatory Price Reporting, and on Packer Ban legislation under the heading Market Interventions. A publication by Hudson and Purcell under Publications shows the results of research on margin sharing, premiums and how premiums might be divided, and compensation guidelines for vertical beef alliances. Fact-based decisions and awareness of what the research literature is saying about the continuing changes in the marketplace will be a necessary base of information for all producers. If we keep the incentives right and don't get caught trying to block changes that are being prompted by basic rules of economics and by profit-based opportunities along the supply chain, the beef market should be kind to cow-calf producers for years to come.
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