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Ideas for Bolstering the Cash Market: Part 1

Evaluate Options Rationally, Not Leap During a Panic & "Never Before" Situation

This edition is a bit long but given the introduction of legislation Tuesday, it seemed appropriate to speed up the sharing of this information.

There are reasons that the negotiated cash market has “thinned” and alternative marketing arrangements (AMA) have gotten much more use. We’ve discussed the advantages of AMAs in the past but the disadvantages of selling cash don’t get as much attention.

Beyond the data mined in the Mandatory Price Reporting information and the USDA RIT study, there are the interviews with cattlemen and packers that reveal the difficulties with cash marketing that have been a part of research done by Stephen Koontz, economics professor at Colorado State University.

Koontz’s interviews with feeders over cash marketing problems pinpoint things like less control over timing, meaning feeders don’t have the control over shipping day, pen clearing for incoming cattle and extra days of feed costs. Those and other things have costs in operational efficiency. Then there are risk factors, like cost and performance problems associated with cattle not being shipped at the optimal time for grading and yield. Both small and large feeding operations complained about that problem. The larger operations said they could not risk having large portions of their showlist not marketed when they had planned for them to be gone. The risk for small operations was not getting good bids when they needed them.

Interestingly, packers also had complaints about timing. AMA cattle provided more predictable flows of cattle and there was more communication between feeders and packers on AMA cattle than with cash deals. For both ends, inefficiency means higher costs.

But all of the AMAs, whether formula, forward contracts or branded beef, all rely on a cash market price as part of the pricing equation, not just supply and demand of AMA cattle available.

As thin as cash cattle markets are, Koontz noted that several other major ag commodities are worse off. Other means of marketing have advantages and that has hurt the use of cash markets and that makes the entire marketplace less useful.

Markets and market information can be considered a public good and that is a key reason the government collects and disseminates market information. While the public pays for that information through taxes and user fees, the other means of marketing, like AMAs, do not pay anything extra for that information, even though it often forms the basis of their marketing arrangements. Those who use the cash markets invest time and resources into establishing cash market pricing. Everyone else “free rides” on the efforts of the cash traders, Koontz points out. Other segments in the production chain both downstream and upstream all free ride on the pricing discovery of the cash marketers.

Koontz said achieving the economically optimal level of a public good in competitive markets requires group action and some level of market intervention. Rather than government, in most cases, it is associations of individuals who reach the conclusion that they must take the bull by the horns because doing nothing is not a solution.

Koontz put together a series of potential options, ranging from voluntary steps individuals could take to more structured initiatives that mandate behavior and include economic incentives. The intermediate ones suggest new information provisions and changing business practices. Several options could be tried at once to chip away at shortcomings hurting the cash market. But, Koontz said, the steps must take into account the costs and risks inherent in cash trading and provide incentives or offsets to those problems.

It is important to note that the order of the suggestions goes from least effective and most flexible to most effective and least flexible. This just constitutes highlights -- the original is 15 pages of detail.

1) Forum - Koontz’s first suggestion -- not so much a first step in a series as a new approach for research and resolve -- was the creation of a specific forum in which AMA participants would discuss regional and national cash markets. Trends, behaviors and perceptions need airing before they become bigger problems. This would be a natural extension of association work and could help prevent litigation and legislation. Some of this has been happening within associations but needs engagement across usual association lines.

These discussions need to be transparent and open so no one feels there is any secrecy. This approach relies on goodwill, creates no direct economic incentives for cash marketing, allows for the most freedom for individual operations but opens up more possible avenues of action.

2) Basis Trading - Another approach would be to shift cattle pricing to a basis market, much as grain is traded now. Basis -- cash price minus futures price -- has not been a particularly favored route for cattle feeders in the past and likely, only the thinness of the cash market is leading folks to take another look at it now. The futures contract would require considerable study and likely, some changes, to make such an approach work. And the contract is owned by the CME, not the cattle industry. This approach may or may not help bolster the cash market and while some may consider it better than the current too thin market, the industry might not like the concept over a longer period.

There would also likely be issues with how USDA-AMS reports cattle trades compared to how grain trades are reported. Basis trades with short-term, say, 14-day delivery would likely be reported as forward contracts in cattle, whereas the grain markets would consider that a cash trade. Basis trading for cattle would be better reported as cash trades.

3) New Trading and Reporting Technology – Boxed beef price reporting in the early ‘80s and Mandatory Price Reporting (MPR) in 2001 were the last new changes in cattle pricing and information. That means no new items in 19 years. Our monitoring equipment -- computers and cell phones -- is new but they are reporting roughly the same level of pricing as early ‘80s. Feeder cattle have made use of video, satellite and electronic auctions but fed cattle have lagged behind. Much of the fed cattle transaction involves an in-person, visual evaluation of the cattle and follow-up phone calls and haggling. Electronic trading has not entered into the picture much.

MPR data is after the fact, derived from packer databases. The bid/ask procedure is unknown and depth of the market is only available from state association or national services. This somewhat mysterious process is frustrating to more than a few feeders.

While lots of electronic data is available on stock and futures markets, fed cattle markets have not taken advantage of these examples. This would provide lots more information and transparency that could help the depth of the cash market. Koontz raises the possibility that “numerous cattle feeding enterprises may be able to place a relatively small number of cattle in the cash market and elicit high-quality price discovery.”

We see this as not so much the number of head available being the key as the obvious availability of the cattle and perhaps, more competition for them.

Koontz regards this approach as more flexible and under the control of the industry rather than a cumbersome government program.

There is the question of whether more transparent trading will attract more interest to the cash market or if feeders and packers would stick to eyeballing and the phone. There are established relationships in many cases and trust involved. And a click must be followed by actual shipping of cattle.

4) Agreement on Institutional Practices -- Koontz defines institutions as the rules and customs associated with trading fed cattle. That includes such customs as packers bidding first on cattle, feeders following up with offers, packers arriving first bid first, the high bidder is “on the cattle,” a subsequent bid must be advanced a certain amount, there is an order to follow-up bids and in some regions, there is a seven-day pickup. (Is it just us, or does this really seem derived from cowboy poker?)

There are other customs not as pervasive, like “right of first refusal.” This means the packer with that right only has to match a new offer.

A lot of cattle are put on the grid for premiums and discounts and have a formula base price. Keeping those premiums and discounts and bidding the base price on a Choice Grade, Yield Grade 3 could also be formalized.

National agreement on some of these “institutions” could improve the functioning of the cash market and cut down on risks.

Some other institutions could be added. For example, harvesting cash cattle early in the week would eliminate some disadvantages, or at least have them scheduled higher in the lineup than AMA cattle. The rule could be that there would be no delays in scheduling cash cattle unless there was compensation. These and other steps could lessen risks for cash cattle. The perception among many is the AMA cattle get preferential treatment.

This approach is another that can be set and controlled by the industry -- packers and feeders figuring out what works for both.

Next time: Parts 5-9 of Koontz's prescriptions plus parting thoughts.

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