Analysis: Cash bulls, paper bears face off in cattle market

CHICAGO (Reuters) - It's high noon in the cattle market, where meat packers are having to pay huge premiums over benchmark futures for cash cattle, while futures traders bet that a series of misfortunes in the beef sector will soon weigh heavily on beef demand and market prices.

This spring fattened cattle at feedlots have sold to meat packers as much as $6 per hundredweight (cwt) over June live cattle futures as a devastating drought in the southern Plains shrunk supplies.

That an extra 5 percent return, in what the industry refers to as "basis value," has been a windfall for feedlots, which suffered one of their worst months ever in April due to high feed costs and expensive replacement cattle.

Traders and hedgers are not buying this industry prosperity. In fact, they are selling the futures, dropping prices 14 percent since early March, due in part to the furor then over "pink slime" in ground beef, which triggered a consumer backlash.

The differing opinions have opened an unusually wide basis gap between futures and cash prices. That gap averaged $6.22 per cwt in April, the widest since 2007 based on weekly data for trades in western Kansas, according to the Livestock Marketing Information Center.

"It's a tale of two different markets," said Don Roose, analyst with U.S. Commodities in West Des Moines, Iowa.

"In reality, the poor demand that the trade is currently factoring in is not as severe as expected," he said referring to the effects on futures from "pink slime" or what the industry labeled textured beef.

The spread has since shrunk, standing at $3.40 on Wednesday.

"Even with a $3 basis today there is incentive to move hedged cattle early because normally the basis narrows through contract expiration," said LMIC director Jim Robb. The June live cattle contract expires on June 29.

WINDFALL

Cattle futures have been knocked off their peak by fears of sliding demand following an uproar over filler beef critics call "pink slime", falling from its record high of 131.250 cents per lb in March.

Futures also took a hard knock three weeks ago when U.S. authorities confirmed the first case in six years of Bovine Spongiform Encephalopathy, or mad cow disease, at a California dairy cow, although it did not enter the food chain.

But sellers of cattle in the cash markets, where prices have fallen by 8 percent from a record high $130 per cwt in early March are putting up a stout fight to keep prices from dropping further, banking on tight supplies.

Currently, feedlots can sell their hedged cattle in the cash market for about $120 per cwt and then buy back their short hedges in the futures for about $116, profiting on the $4 difference.

Short hedges in futures are used by feedlots to lock in a sale price. When the cattle are sold in the cash markets, feedlots buy back those short positions.

The cash-to-futures premium has been good for feedlots.

"It's like money falling from the sky," said Buck Wehrbein, manager of Mead Cattle Company in Mead, Nebraska, which sell fattened cattle to meat packers.

Wehrbein recalled that during his 30-plus years in the business, times when a $5 and $6 negative basis level "sent money flying out the window."

"You've got the opposite thing now, so it's nice to see that it goes our way occasionally too. At a time like this, if you've miscalculated your feed costs then a basis like this will cover up some of those mistakes," he said.

BACK IN BLACK

Meat packer margins returned to the black last month after suffering losses since September due to relatively high prices for cattle versus what they sold the beef for to grocers. That profitability, due in part to higher beef prices, has encouraged paying high prices for cattle.

Feedyards suffered some of their worst losses ever last month, up to $159 per steer, compared with a positive return of $19 a year ago, estimated LMIC's Robb, who pointed out that returns vary among feedlots and regions.

Robb said "there is more than $2 on the table with a basis over $6. If people (feedlots) have cattle ready that had planned for a $1 to $3 basis, they can make some money now compared to what they thought was going to happen."

If packers are willing to buy enough animals, cattle that are hedged, by using futures contracts to lock in a sales price in advance, will flow more freely into the marketplace than normal given these basis relationships, said Robb.

WHAT NEXT?

Because of the wide basis, Roose has been urging his feedlot clients to sell hedged cattle as aggressively as possible to lock in profits, but only if their animals meet weight and quality specifications required by meat packers.

"The real significance of having such a positive basis is it gives the hedger an advantage in moving cattle. Plus, you're probably moving them at lower weight because you're afraid that's going to change," said Roose.

Those profiting from the expensive basis have a small window of opportunity as the spread is expected to shrink as June futures approaches its expiration later next month.

Dennis Smith, analyst and broker with Archer Financial Services in Chicago, said prices in the cash cattle markets are unlikely to decline significantly due to tight supplies.

"I contend that June futures belong only $1 or $2 under the cash market and eventually that's bound to happen. If the trade finally becomes convinced and realizes the packer cannot break this cash market, futures will rally," said Smith.

(Reporting by Theopolis Waters; Editing by Alden Bentley and Bob Burgdorfer)