The Market's Fine Print

What's At Stake With A Broken Basis

John Harrington
By  John Harrington , DTN Livestock Analyst
A look at this chart shows how erratic live cattle basis has been. (DTN chart by John Harrington)

What does the convergence of cash cattle and live futures have in common with springtime in the Yukon?

Both occurred on a Wednesday.

In fairness, the daffodils in Whitehorse this year lasted nearly a short week. I guess global warming is good for something.

What you are about to read may seem tediously familiar. I've been hammering away at the same threadbare topic for months, not unlike Trump forever droning about America's fallen state or Clinton harping non-stop on the importance of presidential temperament.

In all honesty, I'm not entirely sure whether the need to constantly rehearse the broken state of cattle futures (i.e., a near useless tool for risk managers) says more about my frustration in fully articulating the problem or speaks more about its intractable nature.

Maybe my fixation on cattle basis and volatility problems is not unlike Woody Allen's morbid obsession in his classic production of "Annie Hall." When Annie complains to boy friend Alvy that he only gives her books with the word "death" in the title, he replies, "That's right, 'cause it's an important issue."

At the risk of sounding overly dramatic, I guess I do believe the CME's current rat's nest of unpredictable basis behavior and extreme price volatility is exactly a matter of economic life or death for many ranchers and cattle feeders. If the current futures market (i.e., theoretically a platform affording risk management strategies to big and small beef producers alike) cannot reinstate the demonstrable logic and integrity of hedging, it will decay into a chaotic arena of random and senseless speculation.

Not only will such an imbalanced exchange (i.e., excessively heavy on speculators and chronically short on commercials) compound the necessary task of risk transfer, it potentially increases risk for the very traders who seek to minimize it. Within such a "lose-lose" environment, beef producers of all size will be forced to seek out other methods of risk management. Since large operators probably stand to be more successful in this regard than their smaller counterparts, accelerated consolidation and concentration may be inevitable.

For those of you who haven't been paying attention to the dysfunctional basis, let me rewind the tape on the last 60 days of feedlot cash and live futures. More or less, the significant disconnect between country and board through the last half of summer reflects an alarming trend that's been on a roll for several years.

When the August live contract first took the point in early July, it soared nearly $7.50 over the 5-area steer average, roughly 4-5 times larger than the 2015 premium and 11-12 times greater than the 5-year average. Over the next eight weeks, the basis averaged a positive $4.40, right at nine times fatter than the 2011-2015 average.

Admittedly, the spread between cash and board did jaggedly narrow from Independence Day to the August expiration (i.e., the weekly average of the board premium faded from $7.40 to $1.65). But even if hedgers manage to stall until the 59th minute of the 11th hour (good luck on those acrobatics, by the way), they would have still been sent home with a basis approximately $1 stronger than either 2015 or the long-term average.

There may be a few short hedgers out there who have been extremely skillful/lucky this quarter in dancing cash and paper as perfectly as Fred Astaire and Ginger Rogers. Understandably, these tycoons of choreography demand to know: "So what's wrong with a stronger than expected basis?"

To be sure, selling cattle a buck over the board when you initially anticipated revenue a buck under is virtually like finding a suitcase of money on your front stoop.

Yet it's imperative to remember that one hedger's basis ceiling is another hedger's basis floor. If an unusually strong basis is cause for a short-term party among short hedgers, the same could trigger a sad funeral recession for long hedgers. Given a healthy risk management system, long and short commercials take turns claiming small basis victories. But the general basis experience must not be about good or bad surprises.

Basis predictability is far more important than the exact relationship of cash and futures at any given time. That's the only way commercial accounts can anticipate price risk and manage it.

But talk about a rare commodity. How do we sow the seed for greater cattle basis predictability? I have two suggestions, neither of which is likely to get a standing ovation.

First of all, let's radically redesign the delivery system for live cattle, making the channels far more active for commercial longs (i.e., packers, retailers, food managers). The old network of delivery points needs to be scrapped, allowing longs to accept cattle right at major packing plants. The inefficiencies of terminal markets were abandoned nearly 50 years ago, and it's high time the delivery process mirrored certain implied realities.

Next, let's mandate that all feedlot cattle be marketed through open negotiations. Formula pricing should go the way of disco and fax machines. Bring back full-time buyers and sellers. Heck, maybe if you called it a jobs program federal money might be available.

I'll pause for a moment, allowing the tar to cool and the feathers to settle. A good number of you no doubt are especially troubled by the latter. Stubbornly independent cattlemen don't like to be told what to do. Believe me, I understand.

Yet whether you recognize it or not, the broken marketing system at hand is just as dictatorial, limiting necessary options of risk management and survival. It's time to think outside the box, even outside some previously cherished comfort zones that can no longer be defended.

For more from John see www.feelofthemarket.com

(CZ)

John Harrington