Cattle Versus Hogs: Inter-Commodity Meat Spread Provides Opportunities

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When you go to the supermarket, the butcher section is where the carnivores often purchase the main course for their meals. There are many choices when it comes to meats or animal proteins. Beef, pork, turkey and chicken are the most popular options. Shoppers tend to make wise economic choices; they look at prices. Beef and pork are American favorites. Steaks and burgers -- ribs and pork chops are staples when it comes to a great American tradition, the barbeque.

Therefore, it makes sense that there is seasonality when it comes to beef and pork prices. Cattle and hog prices tend to move higher leading up to periods of peak demand. In the United States, that peak demand occurs during grilling season. Therefore, the period between Memorial Day at the end of May until Labor Day at the beginning of September is the time of the year where the grills are smoking and Americans consume more beef and pork. Of course, there is year round demand for these meats. Futures prices tend to reflect the seasonal increase in demand that occurs around grilling season. When consumers decide which meat to slap on the grill, beef or pork, price can be a determining factor.

Cattle and hogs both trade on the futures exchange. Both are agricultural commodities or animal proteins. The live cattle futures contract trades on the Chicago Mercantile Exchange (CME). There is another cattle contract -- the feeder cattle contract that also trades on the CME.

Each cattle contract represents cattle at different stages of their lives but only the live cattle contract has a mechanism for physical delivery. The feeder cattle futures trade only on a cash settlement basis. Lean hog futures have a physical delivery mechanism and they trade on the CME. Animal protein producers raise certain types of cattle and hogs only for their meat.

When they reach a certain age and weight they go to processing plants as the first step in their ultimate journey to the dinner table. The term processing plant replaced slaughterhouse -- the former sounds much nicer in these days of political correctness. When it comes to investing in or trading futures on animal proteins, an understanding of price history and value relationships often provides important clues as to future price direction. The spread between live cattle prices and lean hog prices is an inter-commodity spread. This spread reflects both supply and demand issues for both meats. When a shortage or deficit in cattle or hogs develops, it affects the spread. If price divergence on a historical basis occurs, consumers tend to favor the cheaper meat over the more expensive one over time. This tends to cause the long-term inter-commodity spread to move back closer to historically normal levels.

If we look at a long-term continuous chart of the price relationship between the two meats, we can make some interesting observations. The monthly chart of the price of live cattle futures divided by the price of lean hog futures illustrates that the long-term average is around 1.3:1.

This means that over the long haul there has been around 1 pound of beef value in every 1.3 pounds of pork value. You can see that up until 2014 each time the price relationship strayed too much from around 1.3:1 it inevitably returned to that level. As I write, we are in the midst of the largest divergence dating back all the way to before 1979. Based on active month futures prices it now takes 2.34 pounds of pork value to equal 1 pound of beef value. This is because there is a shortage of cattle and a surplus of hogs in March of 2015. The historical price relationship between cattle and hogs tells us two things. First, either the price of cattle is too expensive relative to the price of hogs or the price of hogs is too cheap relative to the price of cattle on a historical basis. Second, it is likely that consumers will eventually correct this divergence by purchasing cheaper pork while avoiding the more expensive beef.

Consumers tend to make wise economic choices.

In the world of commodities, inter-commodity spreads like the one between cattle and hog prices can offer valuable clues for investors and traders alike.