TOC INDEX Basis Levels in Cattle Markets Feeder Associations of Alberta Ltd. Alberta Agriculture Market Specialists Introduction Basis levels are an effective tool to use for monitoring feeder and fed cattle markets. They not only provide an indicator of the overall mood of the industry, but will also provide signals for pricing opportunities. This module will outline what a cattle basis is, how to calculate it, and how to use it in a marketing plan. What is Basis? Basis is the difference between the nearby futures market and the cash market. For Canadian producers this means the difference between an American futures market and a Canadian cash market. The only futures markets in North America that have cattle futures contracts are the Chicago Mercantile Exchange (CME) and the Mid-American Commodity Exchange. Both are located in Chicago, Illinois. A futures contract reflects what traders think cattle will be worth at a specific future time, and the cash market reflects the current market. Therefore, as time passes, cash markets and futures markets typically converge. The difference between the two markets, or the basis, will change over time as the nearby futures month gets closer to the present time. It is this changing nature of the basis level that provides opportunities for pricing cattle. How to Calculate Basis Since futures contracts are traded in US dollars and based on US grades of cattle, some effort must be made to convert them to a Canadian equivalent. Once this conversion is done a simple subtraction from the local cash market will yield a basis for that class of animal. This basis will reflect the difference between today s cash price and what the market believes cattle will trade for at a point in the future. Consider the example of a 900 lb steer to be sold as a slaughter weight animal. First, choose the delivery month closest to or just past, when your cattle will be sold. If cattle are targeted to finish in January, use February live cattle futures in the basis Alberta Feedlot Management Guide 4V1:1
calculation. If cattle are targeted to finish in July, use August futures. Normally, you never choose a contract that will expire before your cattle are ready to sell. Live Cattle futures contracts (slaughter weight animals) trade in February, April, June, August, October, and December. Feeder Cattle futures contracts (7-850 lb animals) trade in the months of January, March, April, May, August, September, October, and November Futures contract specifications are listed in table 1. In our example, assume this steer will weigh 1,250 lb by the end of March. The appropriate futures month to select would be the April Live Cattle futures contract. Suppose the April contract is trading at $73US/cwt. This quote is what the trade expects US choice steers will be selling for in April, three months into the future. Convert this price into Canadian dollars so it can be compared to the price of an Alberta, directto-packer, A-grade, fed steer. To estimate the applicable US/Canadian dollar exchange rate expected in April, the futures market is the best tool. Quotations for Canadian dollar futures, as listed in a newspaper, are suitable for this purpose. Thus, the closest Canadian dollar futures contract is March, listed at US $0.75. Converted to Canadian funds, the $73US/cwt slaughter steer price is equivalent to $73 0.75 = $97.33/cwt. The final step in determining basis levels involves converting a local price into live weight equivalents, if it is quoted as a rail grade price. Multiply the rail grade price by 0.59, the average dressing percentage for steers, to estimate the live weight price. If a price range is quoted then take a simple average of the range or consistently use either the low or the high value. Once both the futures and cash markets prices are in Cdn $/ cwt, a simple subtraction will determine the basis. It can be compared to long term average basis levels to determine if it is wide, narrow or about average. The basis level will signal different pricing strategies. Table 2 summarizes historical slaughter cattle bases. How to Use a Basis Basis levels should be used as part of a total marketing strategy and not in isolation. Producers will want to be aware of cash markets, futures markets and basis levels to capture pricing opportunities. Basis levels do fluctuate over time as conditions change and the market interprets these changes. Sometimes the changes in the basis levels are greater than the changes in price levels. Alberta Feedlot Management Guide 4V1:2
Begin by examining historical basis levels in terms of their fluctuations, seasonality patterns, and size of the basis relative to the price of the cattle. This will give a good indication of whether the basis levels are narrow or wide and signal pricing opportunities. Producers should calculate their own basis every time they sell some cattle. This will capture differences from grade discounts or the type of cattle sold. Over time this will provide a more effective basis than the industry average. If a basis is narrow, it signals an opportunity for a forward contract. This could be either a basis contract or a price contract. In a basis contract a basis could be locked in and the futures would be priced later. For example, an $8 under August basis contract could be locked in between January and May. The final price is determined at a latter date using the nearby futures price less the basis level specified in the contract. Similarly, with a narrow basis a producer selling finished cattle could use a forward price contract (See Forward Contracting of Cattle). In this case the price on a specific futures contract is locked in for a specific type of cattle. If a basis is wide, it signals an inability of the industry to move product at that price. Often this happens when too many cattle are available for the current demand. This pushes local prices lower and widens the basis. Producers have been known to continue to hold their cattle during this time resulting in over finished animals facing additional weight discounts. A good strategy is to market cattle on time, before they are over finished, and possibly gain a premium for delivering a well-finished steer in a market filled with over finished animals. In this case the effective basis will actually be narrower for the producer selling animals that are not subject to as many discounts. Alternatively, a wide basis level in the fed cattle market is a good signal to buy feeder cattle. Since feeder cattle prices are influenced by the slaughter cattle market, the wide basis will translate into lower feeder prices (see Predicting Feeder Cattle Prices). A wide basis may also be an appropriate time to hedge cattle using the futures market. This would be appropriate if the producer wants to lock in a forward price. However, futures markets often turn lower when there is a wide basis. Therefore, careful analysis of the basis level and price expectations should be undertaken. Alberta Feedlot Management Guide 4V1:3
Feeder Cattle Basis Basis Risk in Livestock Markets Conclusion Basis levels in feeder cattle markets are calculated in the same general way as the live cattle markets. Using the CME Feeder Cattle contract, convert it into a Canadian dollar equivalent before subtracting from the local cash market price. The weight classes can be different between the cash and futures markets and care must be taken to compare two similar classes of feeders. Futures contracts are for 700-850 lb feeders. Feeder cattle markets are sensitive to local supply and demand conditions (see Predicting Feeder Cattle Prices). This will impact the basis levels. Also, the feeder markets in the US will follow their local feeding practices. For example, the use of winter wheat pastures for over wintering feeders makes the US market sensitive to pasture conditions all year long. Poor winter wheat pasture conditions will move feeders into feedlots early and impact both the feeder and live cattle markets. Pricing opportunities are generally the same for feeder cattle markets as live cattle markets. The only exception is that when the basis is wide in a feeder market there is the choice to hold the animals and finish them to slaughter weight. This is not a choice for live cattle where holding the animals longer only increases discounts and reduces returns. In grain markets basis risk is less than the price risk. That is, the odds that the basis will change are smaller than the odds that the price will change. This makes pricing opportunities based on a basis level a sound risk management tool for grain producers. However, in livestock markets the basis risk is not always less than the price risk. This is because livestock markets deal with a non-storable commodity. As slaughter cattle reach market weights, they must be sold or suffer discounts. This will push the cash market lower, and widen the basis. Basis risk is not always less than price risk in livestock markets. While pricing strategies using basis levels are successful marketing tools, they should not be used without understanding the relationships between the different market forces. Producers are encouraged to calculate their own basis levels every time they sell cattle. Alberta Feedlot Management Guide 4V1:4
Table 1. Contract Specifications for Grains, Oilseeds, and Livestock by Commodity Exchange. Commodity Price Trading Minimum Price Daily Price Cont ract Months Options 1 Quoted Units Change Limit Winnipeg Commodity Exchange Phone: (204) 925-5000 (Prices in Cdn$) Barley 1 $/t 20 or 100 t $0.10/t $5/t Mar, May, Jul, Oct (Western) Dec Canola 1 $/t 20 or 100 t $0.10/t $10/t Jan, Mar, May, Jul, Aug, Sep, Nov Flaxseed 1 $/t 20 or 100 t $0.10/t $10/t Jan, Mar, May, Jul, Sept, Nov Oats US$/t 20 or 100 t US$0.10/t US$5/t Mar, May, Jul, Oct, Dec Feed Wheat 1 $/t 20 or 100 t $0.10/t $5/t Mar, May, Jul, Oct, Dec Feed Peas $/t 20 or 100 t $0.10/t $5/t Feb, Apr, Jun, Aug, Oct, Dec Chicago Board of Trade Phone: (312) 435-3500 (Prices in US$) Corn 1 4 and 34/bu 5,000 bu 34/bu 124/bu Mar, May, Jul, Sep, ($12.50/cont) ($600/cont) Dec Oats 1 4 and 34/bu 5,000 bu 34/bu 104/bu Mar, May, Jul, Sep, ($12.50/cont) ($500/cont) Dec Soybean 1 4 and 34/bu 5,000 bu 34/bu 304/bu Jan, Mar, May, Jul, ($12.50/cont) ($1,500/cont) Aug, Sep, Nov Soybean Meal 1 $ and 4/ton 100 tons 104/ton $10/ton Jan, Mar, May, Jul, ($10.00/cont) ($1,000/cont) Aug, Sep, Oct, Dec Soybean Oil 1 $ and 4/cwt 60,000 lbs ($0.0001)/lb 14/lb Jan, Mar, May, Jul, ($6.00/cont) ($600/cont) Aug, Sep, Oct, Dec Wheat 1 4 and 34/bu 5,000 bu 34/bu 204/bu Mar, May, Jul, Sep, ($12.50/cont) ($1,000/cont) Dec Mid American Commodity Exchange Phone: (312) 435-3558 (Prices in US$) Corn 1 4 and 1/84/bu 1,000 bu 1/84/bu 124/bu Mar, May, Jul, Sep, ($1.25/cont) ($120/cont) Dec Oats 4 and 34/bu 1,000 bu 1/84/bu 104/bu Mar, May, Jul, Sep, ($1.25/cont) ($100/cont) Dec Wheat 1 4 and 34/bu 1,000 bu 1/84/bu 204/bu Mar, May, Jul, Sep, ($1.25/cont) ($200/cont) Dec Soybean 1 4 and 34/bu 1,000 bu 1/84/bu 304/bu Jan, Mar, May, Jul, ($1.25/cont) ($300/cont) Aug, Sep, Nov Soybean Meal $ and 4/ton 20 tons 104/ton $10/ton Jan, Mar, May, Jul, ($2.00/cont) ($200/cont) Aug, Sep, Oct, Dec Live Cattle $/cwt 20,000 lb 224/cwt 124/lb Feb, Apr, Jun, Aug, ($5.00/cont) ($300/cont) Oct, Dec Lean Hog $/cwt 20,000 lb 224/cwt 124/lb Feb, Apr, Jun, Jul, ($5.00/cont) ($300/cont) Aug, Oct. Dec continued Alberta Feedlot Management Guide 4V1:5
Table 1. Contract Specifications for Grains, Oilseeds, and Livestock (continued). Commodity Price Trading Minimum Price Daily Price Cont ract Months Options 1 Quoted Units Change Limit Chicago Mercantile Exchange Phone: (312) 930-1000 (Prices in US$) Live Cattle 1 $/cwt 40,000 lb 224/cwt 124lb Feb, Apr, Jun, Aug, ($10/cont) ($600/cont) Oct, Dec Feeder Cattle 1 $/cwt 50,000 lb 224/cwt 124/lb Jan, Mar, Apr, May, ($12.50/cont) ($750/cont) Aug, Sep, Oct, Nov Stocker Cattle $/cwt 25,000 lb 54/cwt 24/lb Jan, Feb, Mar, Oct, ($12.50/cont) ($500/cont) Nov, Dec Lean Hog 1 $/cwt 40,000 lb 224/cwt 24/lb Feb, Apr, Jun, Jul, Index ($10/cont) ($800/cont) Aug, Oct, Dec Frz.Pork Bellies 1 $/cwt 40,000 lb 224/cwt 34/lb Feb, Mar, May, Jul, ($10/cont) ($1200/cont) Aug Kansas City Board of Trade Phone: (816) 753-7500 (Prices in US$) Wheat 1 4 and 34/bu 5,000 bu 34/bu 254/bu Mar, May, Jul, Sep, (Hard Red Winter) ($12.50/cont) ($1,250/cont) Dec Minneapolis Grain Exchange Phone: (612) 321-7145 (Prices in US$) Wheat 1 4 and 34/bu 5,000 bu or 34/bu 204/bu Mar, May, Jul, Sep, (Hard Red Spring) 1,000 bu ($12.50/5000 ($1,000/5000 Dec (bu cont) bu cont) Wheat 1 4 and 34/bu 5,000 bu 34/bu 204/bu Mar, May, Jul, Sep, (Soft White) ($12.50/cont) ($1,000/cont) Dec 1 Options traded on these conts. Note: The Mid American Commodity Exchange is an affiliate of the Chicago Board of Trade where Mid American futures and options are traded. Alberta Feedlot Management Guide 4V1:6
Table 2. Alberta Direct Sales less CME Live Cattle Close (Thursday) - in $Cdn per cwt. Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual 1989-3.92-4.56-5.69-0.96-3.48-4.95-6.85-9.15-6.64-5.65-4.10-4.30-5.05 1990-6.62-5.42-5.25-0.43-4.23-4.97-5.55-6.96-7.96-1.95-3.10-2.08-4.58 1991-2.95-4.50-6.20-1.13-4.91-3.59-6.24-7.79-9.72-12.92-13.69-12.01-7.21 1992-11.14-10.04-10.25-4.80-6.36-5.09-6.53-7.20-10.05-7.99-9.25-6.90-7.97 1993-6.00-2.60-4.40 0.26-2.36-6.94-7.47-6.98-8.82-7.77-5.16-8.30-5.57 1994-5.63-10.12-8.96-7.59-6.13-6.89-10.48-14.94-14.22-12.53-7.32-8.88-9.54 1995-9.98-9.27-8.25-2.16-2.27-3.55-5.67-7.61-10.06-11.83-9.15-10.59-7.58 1996-9.56-12.93-10.92-8.74-9.62-15.60-13.40-14.38-12.69-1.63-2.80-8.73-10.03 1997-8.05-7.73-6.15-3.15-5.28-5.95-7.97-11.51-14.29-9.00-7.90-10.01-8.11 1998-9.02-11.27-8.07-11.25-9.78-12.97-13.19-12.36-12.99-16.64-9.27-5.98-11.15 1999-3.52-12.52-10.41-5.18-3.19-6.82-9.53-10.69-11.66-12.43-7.07-2.93-7.88 2000-6.29-11.29 Averages 1989-97 -7.10-7.46-7.34-3.19-4.96-6.39-7.79-9.61-10.49-7.92-6.94-7.98-7.29 1994-98 -8.45-10.27-8.47-6.58-6.62-8.99-10.14-12.16-12.85-10.33-7.28-8.84-9.28 1995-99 -8.03-10.75-8.76-6.09-6.03-8.98-9.95-11.31-12.34-10.31-7.24-7.64-8.95 1996-00 -7.29-11.15 10-year SD 2.80 3.39 2.32 3.21 2.29 3.66 2.58 3.20 2.70 4.23 3.54 3.12 1.91 1989-97 CV 39% 45% 32% 101% 46% 57% 33% 33% 26% 53% 51% 39% 26% Alberta Feedlot Management Guide 4P1:7