How long will cattle price boom continue?

US cattle has been one of the few bullish commodity prices during 2014, with futures prices up over a quarter since the start of the year to around $171 per hundredweight. The surge didn’t start there though. Since early 2009 cattle prices have more than doubled as beef cow numbers declined from 32.7 million in 2006 to 29 million at the start of 2014. The decline in herd size exacerbated by high feed (corn etc.) prices due to drought, incentivising farmers to send cattle to slaughter. With cattle inventory and production generally following predictable cycles, lasting around 10 to 12 years the upward pressure on prices could continue for another 2-4 years.

Increasing cattle prices spur producers to retain female animals to increase the breeding herd, initially reducing slaughter numbers and as a result, prices increase even further. This is what is happening now. Heifer (female cows who have not given birth) slaughter is down 9% so far this year resulting in nearly 1.7 million fewer females going to market this year and thus lowering slaughter numbers by over 5%.

However, once these female animals begin producing offspring and eventually reach slaughter weight, there may be an oversupply of livestock. Prices begin to decline and it eventually becomes unprofitable to raise and feed young cattle. Producers then begin culling the breeding herd and sending them to slaughter, adding additional numbers to supply and causing prices to decrease even further. This still appears to be some way off however with no indication yet that the decline in cattle supplies has slowed.

Related article: How will the US drought affect food prices?

Economics would normally suggest that consumers would react to the rise in prices by switching to cheaper substitutes. However, alternative meat products have also had their supply problems too. Pork production has been hit, in part due to the loss of livestock to the PED virus. Although prices have since retreated from the peak set in July, lean hog prices are still up almost 13% this year. Meanwhile wholesale turkey prices are up 16% compared with November 2013 due to lower farm output, again a legacy of previous drought conditions.

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Commodity prices face significant headwind even if El Niño does appear

The chances of an El Niño appearing over the next couple months appear to be on the increase. Australia’s Bureau of Meteorology today (Tuesday) raised its estimate of an El Niño occurring to “at least 70 per cent” after temperatures in the tropical Pacific warmed over the past fortnight. Five of the eight international climate models surveyed by the bureau predict El Niño thresholds for sea-surface temperatures will be reached during December.

El Niño typically results in drier conditions across Australia and other parts of south east Asia, Brazil and West Africa but wetter conditions around the southern US states and coastal areas of South America. Despite the potentially adverse weather the impact on commodities is likely to be more muted than previous episodes.

A strong supply outlook for most commodities means any price impact from El Niño is likely to be limited. An improving supply outlook for grains (e.g. soybeans) in the US and Brazil, high cotton inventories and lower crude prices (a competitor to palm oil in the fuel sector) mean commodity prices face a significant headwind even if an El Niño does appear.

The one exception might be nickel. While the typical El Niño sensitive commodity gains an average of 3.2% during outbreaks of the weather pattern, nickel gains an average of 13.9%. A drought in Indonesia normally impacts nickel production by affecting hydroelectric power generation facilities and lowering the water levels of inland waterways that are vital for ore transportation. The exception this year is that all exports of nickel ore have been halted following the introduction of an export ban at the start of the year.

Related article: The commodity most affected by El Niño is…Nickel

Related article: Are agricultural commodities underestimating the risk from El Nino?

Know your commodity indices!

Over the past six months various newspapers and broadcasters have sought to explain the apparent weakness in commodity prices by trotting out what has happened to one commodity index or another, explaining that commodity prices hit a their lowest for x number of years. But what exactly is a commodity index, why should you care anyway and are newspaper reports just picking the one that best fits the story?

In general a commodity price index is a fixed-weight index or (weighted) average of selected commodity prices, which may be based on spot or futures prices. It is designed to be representative of the broad commodity asset class or a specific subset of commodities, such as energy or metals.The value of these indexes fluctuates based on their underlying commodities and can be traded by investors on an exchange.

Just take the four indices shown in the chart. Each of them have been used to describe how commodity prices have developed. While the RICI and CRB indices have finished broadly flat over the past twelve months, the S&P GS Commodity index is down almost 15% while the Bloomberg index is somewhere in between.

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All of them measure different things (commodities), in very different  ways and for different purposes.

The CRB index includes 19 commodities and has been adjusted 10 times since 1957 to reflect changes in market structure and activity. The Goldman Sachs index currently contains 24 commodities is weighted based on the average quantity produced of each commodity over the past five years and is much more weighted towards energy than the other indices. The Bloomberg commodity index meanwhile adjusts regularly based on price movements, requiring that no single commodity can comprise more than 15% or less than 2%. Finally, the RICI index is probably the broadest based of the indices including 38 commodity futures contracts from 13 international exchanges. Unlike many of the other indices the index has altered little since it was established and perhaps gives a more consistent measure over time.

If that wasn’t enough, don’t forget currency movements. All of the four commodity indices highlighted are prices in US dollars. Since most currencies tend to be priced in dollars, movements in your home currency versus the dollar can significantly affect the relative movement in commodity prices that you face.

These commodity indices are designed to enable investors easier access to a range of commodity markets at low cost. But do they actually reflect the commodities that your industry or your country actually use? There’s also The Economist, the IMF, the World Bank and plenty of others.

All of which makes it very difficult to say exactly what commodities are doing…but it won’t stop headline writers and investors trying.