Livestock Takes its Place in the Commodity Lineup By Michael S. Fischer, Senior Financial Correspondent Tuesday, July 08, 2008
LONDON (HedgeWorld.com)—These days there are lots of reasons to like livestock—besides the nutritional value.
Although livestock prices have risen rapidly in recent years, they have lagged the commodity rally over the past year. However, this appears to be changing. Beef prices have been rising, with choice beef up 18% year-on-year, and U.S Department of Agriculture pork cutout up 6%.
ETF Securities Ltd. reports a strong upturn in demand this year for its livestock exchange-traded commodities. These added $238 million to assets under management during the first half, a 1,080% increase, spread evenly across livestock, lean hogs and live cattle. According to the firm, the rise in inflows preceded the recent pickup in prices by about six weeks.
Because of livestock’s unique characteristics within the commodity sector, it has a low correlation to most other commodities as well as to other asset classes and so provides excellent diversification benefits in an equity portfolio.
Investment Characteristics of Livestock
Commodities have been the top-performing asset class for five of the past 10 years, outperforming equities by approximately four to one, according to ETF Securities. Commodities have a low correlation to most other asset classes, and livestock stands out in this regard. It trades differently than a normal commodity because it has distinct life and price cycles. In addition to having a low correlation with most major asset classes it also has a low correlation with other commodities and with most indicators and markets; though at times some commodity prices, such as corn and soybeans and broad agriculture, do have high correlation with livestock prices because they are key inputs.
Over the past 10 years, livestock, lean hogs and live cattle have had a small negative correlation with the Standard & Poor’s 500 stock index, highlighting their diversification benefits. Only oil and natural gas within the commodity sector share this distinction. During the worst periods for the S&P 500 during the past decade, livestock, lean hogs and live cattle have eked out positive returns.
Fundamentals of Livestock
Livestock refers to a domesticated animal intentionally reared to make products, such as food or fiber, or for its labor, according to ETF Securities. The term generally excludes poultry or farmed fish. The firm’s ETCs are based on the DJ-AIG Livestock Index, which itself is based on Chicago Mercantile Exchange futures contracts, comprising 66% live cattle and 34% lean hogs.
The delivery unit of live cattle on the CME must weigh 40,000 pounds, or contain 30 to 40 steers averaging between 1,050 pounds and 1,200 pounds. The actual number depends on the weight of the steers. The CME Lean Hog Index is a two-day weighted average of USDA reported cash prices for producer-sold swine or pork market formula transactions. The contract is based on 40,000 pounds of slaughtered hogs.
According to Nicholas Brooks, head of research and investment strategy at ETF Securities, livestock is different from any other commodity; it can’t be analyzed in the same way as copper, aluminum or oil or even corn, he said. The reason for this is the biological constraints that limit the ability to store livestock for long periods and that create life cycles and seasonal patterns that affect prices.
The cattle cycle, which is measured by the peak-to-peak in inventories, has historically averaged between eight and 12 years, with a breeding-to-slaughter period of 30 months. Feed is the primary cost, but the price relationship is also affected by lifecycle, storage and transportation constraints.
For lean hogs, the cycle has historically averaged around three to four years, with a breeding-to-slaughter period of 10 months. The relationship with feed prices is similar to that of live cattle.
Livestock is resource intensive, requiring large amounts of water, land and feed. According to Mr. Brooks, seven tons of corn and soybeans and 7,000 gallons of water are needed to produce one ton of meat. These requirements are running up against some stark demographic statistics: Since 1900, global population has doubled while water use has increased sixfold. Accelerating urbanization in emerging economies is reducing land available for crops and grazing. As a result, stress on water and land resources is increasing livestock production costs.
The main cost in raising livestock is feed; about 70% of livestock feed by volume is corn, with soybeans making up most of the rest, and the prices of these commodities have been rising. A key factor driving corn and soybean prices has been the push in the United States and other countries to boost biofuel production. This season, an estimated 33% of U.S. corn production will go to ethanol, which in turn will have knock-on effects on other crops, including soybeans.
Initially when feed prices rise, slaughter rates rise because it is more expensive to feed the livestock and margins are squeezed, according to ETF Securities. This drives meat prices down (as occurred last year). But as supply dwindles, pricing power returns and the increasing cost of inputs begins to be reflected in prices.
Mr. Brooks said he believes high prices for feed have become a permanent feature of the livestock sector. “I do believe structurally prices will remain higher for quite some time,” he said, citing the significant proportion of corn production going to ethanol and disruptions caused by weather.
Disease is a key variable in livestock supply and demand, according to ETF Securities, although it’s unpredictable and difficult to factor into production costs. Outbreaks of disease can significantly affect export demand and prices for animal products, and can dramatically alter countries’ export capabilities. For example, the 2003 discovery of bovine spongiform encephalopathy, or “mad cow disease,” in the United States caused an immediate loss of beef exports to Japan, South Korea and Mexico, and Brazil experienced an outbreak of foot-and-mouth disease in 2005.
Avian influenza, or “bird flu,” remains a concern in China and has increased as a threat in Europe. Bird flu can benefit pork and beef prices because as it causes poultry prices to rise, demand for pork and beef as poultry substitutes also rises.
Demand Outlook
A positive relationship exists between per-capita GDP and meat consumption. The United States has large GDP per capita and high meat consumption. The combination of rising per-capita income in developing countries and natural population growth should keep demand for meat on a structural uptrend, according to ETF Securities.
Although demand for meat in China and Brazil is still low by developed country standards, it is quickly catching up in those countries. If Chinese consumption moves toward developed country levels, when combined with the size of its population, the potential effect on global demand is enormous. This effect has already been seen with many other commodities. In addition, the recent earthquake in China is estimated to have killed more than 3 million pigs, adding to near-term import demand.
Overall, because of the high slaughter rates over the past year, supply is diminishing at the same time demand is holding up and in fact is growing at a robust pace, according to ETF Securities. There are decent supply and demand dynamics affecting livestock at the moment. In addition, a very sharp rise in the key input costs for livestock is giving livestock producers big incentives to try to increase their prices. And once supply has reached a low enough level, it will be within that pricing power, and prices will come through. Already, the firm has seen some increases come through in beef prices.
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