A few years ago, some beef producers and industry analysts expressed concern that major changes were needed to the Feed Cattle Futures contract and even proposed the even more drastic measure of delisting the contract. Much of the discussion centered on claims of unwarranted fluctuations in Feed Cattle futures prices and associated volatility in basis (local cash price minus the near futures price). Unwarranted basis fluctuations make hedging with Feed Cattle futures difficult. In 2022, we published an article analyzing feed cattle basis risk and its associated determinants. In that article, we concluded that in fact in 2015, feed cattle basis volatility increased significantly as feed cattle prices plummeted in conjunction with the ongoing dramatic beef cattle herd expansion. Once the feed cattle market stabilized by 2018, basis volatility had fallen to levels similar to those of 2010-2013. This is a reassuring conclusion. However, today the feedlot cattle market is once again experiencing strong fluctuations with similar benchmark fluctuations and opposite price trends as experienced a decade ago. This article summarises what is currently happening and highlights what it means for market participants.
Near-term Feed Cattle futures prices have recently doubled, from $130/cwt in May 2021 to more than $260/cwt in June 2024 (Figure 1). The average weekly price change was $2.70/cwt in absolute value (including price changes due to rolling contract months as contracts expire). In contrast, in 2015, near-term Feed Cattle futures prices fell from $225/cwt at the beginning of the year to $160/cwt at the end of the year, with weekly price changes averaging nearly $4/cwt in absolute value. Starting in 2023, typical weekly price changes for near-term Feed Cattle futures have been close to $3.44/cwt up and down.
The main role of futures markets, in addition to risk transfer, is price discovery. Generally, futures markets are central to price discovery. However, research I have done in cattle markets has shown that when local cattle supply conditions are changing rapidly, information is often discovered first in the cash market and then transferred to futures. That is, in these situations, the cash market tends to lead the price discovery. However, a very important aspect of local cash feedlot cattle markets is that price dispersion between individual trades and auction market locations can be quite high, as individual trades consisting of live animals of diverse qualities are represented and bidder activity varies between market locations. That is, when cattle supply is changing rapidly and is reflected in the already volatile cash transaction prices, the price fluctuations between transactions will be even greater. Therefore, when the cash market is leading the price discovery, both buyers and sellers should be careful.
In addition, when the spot market is changing rapidly, the futures market may not be able to keep up with spot market price fluctuations due to price limits set by CME. Therefore, CME increases the daily price limits for futures contracts when price fluctuations are large. For example, the daily limit for Feed Cattle futures prices was $6.25/cwt in 2021, but was increased to $7/cwt in mid-2022, $8.25/cwt in 2023, and $9.25/cwt in July 2024 to reflect lagged spot market price fluctuations.
What does all this mean for market participants? It means basis risk increases when intense volatility is occurring in the feeder cattle market. Figure 2 shows weekly near-field feeder cattle basis for 700-800 pound steers from 2015 through June 2024 for five state market reports compiled by USDA AMS. I selected four major cow/calf and/or feedlot states (NE, KS, MO, TX) that are part of the Feeder Cattle Index where Feeder Cattle futures settle at expiration, and one significant cow/calf state (KY) that is not included in the index. There is a lot of noise on this chart, but some clear patterns can be drawn.
First, the variation in basis by location can be significant, especially when the variations described above are present in local cash market transactions. For example, in the third week of June 2024, the NE basis was $29.80/cwt. This means that the NE cash feeder was $29.80/cwt higher than the nearby feeder futures contract. At the other extreme for the selected markets, the TX basis was -$11.66/cwt. This indicates a range of over $40/cwt between the NE and TX basis for that week. This is not cherry-picking, as the range of weekly basis across these five markets over the past year through June 2024 averaged $32.64/cwt. NE basis was often the strongest, while KY was usually the weakest. Another thing to note is that these are for the composite markets for these states as reported by AMS, and there is even more variation when looking at individual auction barn sale reports.
Second, basis volatility is on the rise again, exceeding levels seen a decade ago when feeder prices plummeted. To explore this a bit more, Figure 3 shows the standard deviation of basis by year for the five markets. I don’t normally like charts with multi-colored bars like Figure 3 because they can be confusing, but this chart is easy to summarize. What is easy to see is that basis risk, as measured by the standard deviation of weekly basis, is significantly higher in 2023-24 than any time experienced in all five markets over the past decade. Also, in some years, basis volatility is similar across locations; for example, in 2017, the standard deviation of weekly neighborhood basis was around $3-4/cwt across the five market regions. However, some years have significantly different amounts of basis volatility across locations. For example, in 2023, basis standard deviations ranged from $6/cwt in Missouri to more than $9/cwt in the Northeast, and we expect a similar trend in 2024.
The bottom line is that this wild feeder cattle market volatility that we have experienced over the past year and a half is probably going to continue for a while. That means that feeder cattle local cash prices are going to fluctuate in economically significant ways, not just from week to week, but also between trades. Price discovery always happens with limited information, and while the cash feeder cattle market plays a bigger role in price discovery in this environment, there will be more winners and losers on both sides of these markets as the futures market tries to catch up. Larger daily limits on futures prices mean that futures can respond better when the cash market is moving more quickly than before, but it also means that the buffer that slows futures price changes is now wider. One feeder cattle operator told me that he keeps a sticky note on his computer screen to remind himself of the latest changes to feeder cattle and feeder cattle futures contract price limits. Knowing these limits is important for anyone who sets up or releases hedges on the day the market is moving. You don’t want to be unable to set up or release hedges in this market environment. Hedging is riskier simply because of the increased basis risk, making the timing of entering and exiting hedges more important. However, when markets are moving rapidly is also when hedges are most valuable and most needed to mitigate price risk. Thus, the value of the feeder cattle futures market in price risk management is high even when basis risk is elevated. If the basis moves against you, there is not much you can do as a short hedger in the feeder cattle market since you do not have the option to take delivery against a cash settled futures position. Shipping cattle from a location with a favorable basis or shipping cattle to a location with a favorable basis is probably an option, but it is not necessarily advisable as it is risky given that basis for a particular location can fluctuate over a period of weeks. However, feeder cattle buyers have more options for sourcing cattle across sex, weight and location and therefore may be selective in purchasing cattle from locations with weaker basis. For them, looking for the best deal may be a good use of their time.
