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Can dairy beef prices foretell future price trends?
Producers, in fact all cattle market participants, constantly seek clues as to which direction the market might move. Recent research at Iowa State University suggests that fed dairy cattle prices (e.g., Holstein steer prices) could be a key indicator. The notion - they respond first to changes in the market. Fed dairy cattle prices often rise at a steeper rate than beef-type cattle prices when supply tightens or demand improves. Similarly, fed dairy cattle prices typically slump more sharply when supply rises or demand sags.
Cattle cycle forces can drive such supply and demand shifts, so can structural forces. Sometimes these forces combine. Such shifts can show up as notable changes in fed cattle basis - the difference between the cash price for fed cattle and the nearby CME live cattle futures price.
ISU researchers Christopher Pudenz and Lee Schulz do a deep dive into identifying and analyzing how structural change and market fundamentals impact basis and basis forecasts in their recently published paper, Packer Procurement, Structural Change, and Moving Average Basis Forecasts: Lessons from the Fed Dairy Cattle Industry.
Structural change weakens basis
Fed dairy cattle sell for less than beef breeds, so basis is weaker for fed dairy cattle (Figure 1). In late-2016 fed dairy cattle basis slid sharply. A key reason was a structural change occurred as at least one large packer exited the fed dairy cattle market. In economics, structural change is a dramatic shift or change in the way an industry or market functions.
The structural change triggered a price break in Iowa Holstein steers sold at auction beginning in the week ending December 3, 2016. The break in formula prices came later.
Variation in the timing of a structural break for direct sales to packers, including formula, forward contract, and negotiated grid, reflects the various idiosyncrasies of sale types. For instance, long-term formulas are standing agreements between cattle producers and beef packers that aid in supply chain management for both parties, while short-term formulas are not rooted in the same long-term, supply-chain-based considerations. These marketing arrangement agreements are negotiated periodically and can have long durations. This likely explains why the structural break in the formula basis for fed dairy cattle did not occur until the week ending August 12, 2017.
Change complicates basis forecasting
Moving averages of historical basis values provide a useful method for forecasting basis. Fed cattle basis follows seasonal patterns. That’s why producers often use historical basis levels to help forecast basis. These forecasts often take the form of moving averages of various lengths (3-year, 5-year, etc.), which are appealing due to data availability and straightforwardness of implementation. When a location or time period does not undergo structural change, longer moving averages produce optimal forecasts.
However, structural changes, such as the one that began in 2016, make forecasting from two- to five- year, or longer, historical data less reliable. Using only the previous year’s basis or another alternative may be a better approach.
The researchers found cattle weight, seasonality, ground beef prices, by-product values, and fed cattle slaughter capacity utilization to be important basis determinants. Plus the impact of some of these factors has changed over time. Beef packing plant(s) reducing or discontinuing fed dairy cattle slaughter was found to have had a large negative impact on basis, i.e., weakening of basis. On average, the impact on basis was -$14.52/cwt. for Choice quality grade auction fed dairy steers, -$13.81/cwt. for Select grade steers, -$9.30/cwt. for formula sales, -$24.83/ cwt. for forward contract sales, and -$15.96/cwt. for negotiated grid sales. For each sale type this average impact was from the timing of the structural break until March 16, 2019, the end of the data series used in the study.
One packer announced in mid-2016 it would stop purchasing and processing Holstein cattle. Anecdotal evidence indicates other major packers reduced fed dairy slaughter volume. Some fed dairy cattle buyers may also have changed details of their procurement activities. An individual packer’s proportion of auction, negotiated, formula, forward contract and negotiated grid purchases could have changed, as could have provisions of certain purchase arrangements.
Changing consumer demand also likely influenced the fed dairy cattle market. Many branded-beef programs specifically exclude cattle demonstrating dairy breed characteristics. These, and other shifts in the beef demand profile, may have driven packers’ decisions regarding fed dairy cattle procurement.
Position in cattle cycle matters
Rising beef-type cattle supplies may also have influenced the timing of the structural change.
The current cattle cycle started in 2014 when the cattle and calf inventory was the smallest it had been since 1952. The combination of tighter supplies and improved beef demand initiated a period of unprecedented profitability for the cow-calf industry and encouraged producers to expand their herds starting in 2015. The current cattle inventory cycle entered its eighth year in 2021, peaking in 2019.
Packers choosing to move away from Holstein slaughter as fed cattle inventories grew is no surprise, especially given the manner in which plants often use beef from fed dairy cattle.
Carcass characteristic differences between beef- type and dairy-type fed cattle have resulted in some plants specializing in slaughter, fabrication and marketing of dairy beef. Plants that do not specialize in processing fed dairy cattle may still procure them, but they typically use fed dairy cattle to fill existing market obligations, especially when the supply of beef-type cattle is tight and prices are high. Conversely, these plants reduce fed dairy cattle slaughter when supplies rise and prices moderate.
What should we expect going forward?
Most of the time drivers make tiny adjustments as they drive down the road. They don’t swerve violently to the right and left. But if a deer jumps out in the road, they react accordingly.
Occasionally drivers encounter a road closure. They detour - sometimes a short distance, other times a long way. But they eventually get back on track to their destination. The structural change in the fed dairy cattle market was a sudden, extended detour.
In 2020, the cattle inventory cycle entered a period of contraction. This continued in 2021. The Livestock Marketing Information Center is projecting the cattle cycle will not show an increase in beef cow numbers until 2024. The smaller cow herd will reduce calf and feeder supplies. Lower fed cattle and beef supplies will follow. Packing capacity relative to cattle supplies will improve, i.e., not be so tight, so impacts on basis will be less. In fact, since summer 2020, fed dairy cattle basis has returned to more typical levels, reminiscent of the time before the structural break in late-2016.
A known Holstein fed cattle buyer announced this last summer it will build a new, state-of-the-art beef harvest facility. Several other beef packing capacity expansions and new facilities have been announced. Even more operational capacity could come from technology implementation. Technology investments could help address labor challenges, manage costs, and reduce waste.
Multiple factors fuel growing popularity among dairy producers to breed dairy cows to beef bulls. One key factor could be lower packer demand for fed dairy cattle, manifesting in very weak basis levels, from late-2016 through mid-2020. Dairy steer prices decreased enough to provide ample incentive for producers to change existing production plans and attempt to market higher value calves.
Lee Schulz, extension livestock specialist, 515-294-3356, firstname.lastname@example.org