The Cattle Crush Spread
Last month we talked about the spread between feeder cattle and live cattle. Now let’s make things slightly more complex and throw another factor into the relationship: feed costs. After all, the feeder cattle have to eat something to get fattened up for slaughter.
For the most part, corn is used for livestock feed. Therefore, the combination of feeder cattle costs and corn costs account for the lion’s share of the costs in a feedlot operation. The difference between the cost of the feeders and corn and the price that the live cattle are sold for is called the ‘gross feeding margin’. In the trading pits it’s also called the cattle feeding spread or a cattle ‘crush’ spread.
Building a Cattle Crush with Futures Contracts
At the Chicago Merc, futures contracts are available for feeders, live cattle, and corn. To create a position in the cattle crush spread, one must be long both feeders and corn and short the live cattle. Just like a feedlot operation, you ‘buy’ the feeders and the feed (corn) and then you ‘sell’ them as live cattle to the packers at a price that is (hopefully) greater than your purchase price for the feeders and corn. This is a forward crush spread.
Conversely, one can just as easily implement a ‘reverse cattle crush’ by buying the live cattle and shorting both the feeders and corn. One would do this if they thought that the productions costs (feeders and corn) were way too high and/or the end product (live cattle) was under-priced.
A feeder cattle futures contract controls 50,000 lbs, a live cattle futures contract controls 40,000 lbs, and a corn futures contract controls 5,000 bushels. Therefore, the quantities on the futures contracts for each market in the cattle crush spread will vary in order to replicate the workings of a feedlot.
An average feeder calf weighs about 750 lbs and an average steer (live cattle) weighs about 1,250 lbs. Therefore, the 50,000 lb feeder contract is the equivalent of about 66 calves and the 40,000 lb live cattle contract is the equivalent of about 32 steers. This means that a futures contract spread should have approximately double the amount of live cattle contracts as the feeder contracts in order to approach an equal amount of animals.
We also have to figure in how much feed is used. A rough estimate is that it would take about 50 bushels of corn to raise a feeder to a full-grown steer. So it would take approximately 3,300 bushels of corn to feed the equivalent of the 66 calves in a 50,000 lb feeder cattle futures contract.
Using the above calculations, one could construct a cattle crush position by spreading six live cattle contracts against three feeder cattle contracts and two corn contracts. This gives you twice as many live cattle contracts as feeder contracts and enough corn contracts to cover the approximate amount of feed for the feeder contracts.
The Right Delivery Contracts
It takes time for feeders to eat all of their corn and grow up into live cattle. To reach slaughter weight it’s a 4-6 month process. Therefore, the live cattle contracts in the cattle crush spread should be for a delivery date that is at 4-6 months later than the delivery date for the feeder contracts. The corn contracts should be as close as possible to the same delivery date as the feeders.
For example, if you are looking at buying or selling November 2014 feeder contracts you would use the December 2014 corn contracts and the April 2015 live cattle contracts. If you trade the April or May 2015 feeder contracts you would use the May 2015 corn contracts and the August 2015 or even the October 2015 live cattle contracts.
To gain a perspective of where the cattle crush spread has been and where it has the potential to go, we took a look at the monthly nearest-futures data since 1970. This cattle crush spread is set at a ratio of 6:3:2, meaning that it calculates the difference in the value of six live cattle contracts against the sum of the value of three feeder contracts and two corn contracts.
Importantly, you need to know upfront that this is certainly not perfect because it involves only the closest delivery contracts of the feeders, corn, and live cattle. It does not show the live cattle contracts that are 4-6 months out from the nearest-futures feeders. This gives us an imperfect historical reference. Nonetheless, the man with just one eye can still be the king in the land of the blind.
Notice that the cattle crush has been in a choppy range for decades. All trends seem to be short-term affairs that last a few months and then reverse sharply in the other direction. Over the last decade, a slight downward drift is evident as slightly lower highs and lower lows are evident.
It appears that once the spread drops under +$10k (premium live cattle) it gets close to a bottom. Conversely, peaks quickly follow trades above +$40k (premium live cattle). Whether it move toward the high or low end of the extremes, the spread always returns to somewhere around the +$30K mark, plus or minus $5k.
Ready, Set, and…Wait!
Once the 6:3:2 cattle crush reaches an extreme reading of +$40k and above or +$10k and below, a trading opportunity may be setting up. However, it is still not a green light to jump in. Recall that we are not trading the same delivery contracts for all three markets. The live cattle contracts need to have a later delivery than the feeders. Therefore, an extreme reading on the nearest-futures spread is a signal to investigate further.
An extreme reading on the nearest-futures chart prompts us to further examine the crush spread with an input of the correct delivery contracts (i.e. a live cattle contract that is up for delivery 4-6 months later than the feeder contract). Ideally, the crush spread you select should have at least three months until the feeder contracts expire. That way you have plenty of time for a trend to develop and mature before you have to start planning the rollovers. Also, you should still peek at the deferred spreads. Sometimes there are aberrations in the distant month contracts that are not found in the more liquid closer delivery contracts. This can heap an abundance of financial rewards on the diligent trader.
Due to the slight downward trend of the last decade, we would advise waiting for a price of $5k (premium cattle) or lower before getting involved with the long side of a cattle crush spread position. Let the novice traders take the higher priced, lower probability trades. Our objective is to consider only the high-probability, high reward-to-risk trade setups and ignore everything else.
Shooting Fish in a Barrel
A record corn crop in the US has brought feed prices down dramatically this summer. However, feeder prices have rallied even faster than the price of the live cattle as a supply shortage persists. This is due to the smallest cattle inventory in several decades after the 2012 drought slaughtered the livestock industry.
Feedlot profit margins have started to narrow considerably. Some feedlots are projected to be operating in the red starting in the fourth quarter. In the futures markets, some of the 2015 cattle crush spreads are negatively priced. Common sense indicates that this is not sustainable. Either the input costs (feeders and corn) need to drop or else the output costs (live cattle) must rise.
To that end, we are very interested in the crush spread between the August 2015 live cattle and the April 2015 feeders and May 2015 corn:
At yesterday’s closing price of 147.80, the value of an August 2015 live cattle contract is $59,120. The sum of six contracts is $354,720.
The April 2015 feeders closed at 216.80, yielding a value of $108,400 per contract. The sum of three contracts is $325,200.
The May 2015 corn closed at $3.59 1/2. This puts the value of a contract at $17,975. The sum of two contracts is $35,950.
Subtract the value of the live cattle contracts from the value of the feeders and corn contract and you get -$6,430. Notice that the output side (live cattle) of this crush spread is trading below the price of the input side (feeders and corn)! With the spread price currently inverted and ample time before deliveries (at least seven months), this just might be a lucrative buying opportunity shaping up.
Bullish Setups and Signals
The 2015 August-April-May cattle crush spread does not have a lot of chart history at the moment. Therefore, there is not a persistent trend on the charts that one could use to key off of for an upside reversal. Instead, we have to look for some sort of price pattern.
At the moment, a classic chart pattern may be developing: The famous Double Bottom. The 2015 August-April-May cattle crush spread posted a contract low of -$8,540 on June 27th, it bounced as high as -$802.50 on July 21st, and it sank to a low of -$8,387.50 on September 9th. If they hold, the similar lows from June and last week would set the formation. Therefore, one could buy against these lows. It is also possible that the spread may also decide to return to this area several times. A trader should risk a close well below this level in case it turns into a trading range.
The July high of -$802.50 is an overhead barrier that should also be monitored. A strong close above this level would put the spread at a level not seen in several months. This would be a classic breakout trade signal (think Donchian breakout, or “Turtles” style trading) that one could use to identify a bullish turnaround for the 2015 August-April-May cattle crush spread.
For tracking purposes, the blog will make a hypothetical trade by purchasing six 40,000 lb August 2015 live cattle contracts and simultaneously shorting three 50,000 lb April 2015 feeder contracts and shorting two 5,000 bushel May 2015 corn contracts if this 6:3:2 cattle crush spread trades at -$8,000 (premium the sum of the feeders and corn) or if it closes above the July high of -$802.50, whichever comes first. Initially, the spread will be liquidated on a two-consecutive day close below -$4,500 below the entry price.