A common remark when talking to cattle producers about hedging their cattle production is that the price of their cattle has no relationship to the MLA/SFE Cattle futures.  If prices are tracked over a week the Futures prices and a specific cattle might not move in the same direction, however if prices are tracked over a month or more it becomes more apparent that almost all of the cattle types in Australia move with the Futures price.

MLA/SFE Cattle Futures are based on the Eastern Young Cattle Indicator, which is a 7 day rolling average prices of young cattle in 24 saleyards across eastern Australia.  One of the common arguments against using the EYCI as the base for Cattle Futures is that it is not representative of the Cattle Market.  In 2005 the number of cattle contributing to calculation of the EYCI was 320,000 head.  The total number of cattle slaughtered in Australia in 2005 was 8.467 million.  This means that 3.8% of the cattle slaughtered in Australia last year were in the EYCI.  When you think that many cattle change hands at least twice before slaughter the EYCI is even less representative of total cattle sales.

The flip side to this argument is that the EYCI covers a big enough geographical area, and covers enough cattle to ensure that it is representative of the cattle market in general.  Basic economic theory ensures the EYCI is representative of all Cattle prices.  Take the following 2 examples. 

Example 1:  A producer has feeder cattle to sell.  He has two options; the first is to sell them direct to the feedlot, the second is to sell them in the local saleyards which contribute to the EYCI.  Which option will he choose?  Usually the producer will sell where he can get the best price.  If the price in the saleyards the week before was $2.00 per kilo liveweight, the producer is likely to use this as his benchmark, and therefore to sell them direct to the feedlot he will need $2.00 per kilo or better.  The same goes if the market was $2.50, the feedlot would have to match that price.  Therefore the local direct price and saleyard price will be very close.       

Example 2:  A processor needs to buy cattle for slaughter.  Ideally the processor wants to slaughter the type of cattle which provide the greatest return.  For a trade steer the processors break-even price is $2.20/kg lwt, for a US Cow the break-even is price is $1.80/kg lwt.  If the price of the trade steer is $2.00 and the price of a US Cow is $1.70 the processor will buy the trade steer as that will make him the greatest profit margin (20¢ vs 10¢).  If the US Cow price moves to $1.55/kg lwt, the processor will buy the US Cow, weakening demand for the trade steer, thereby moving its price down to $1.95¢/kg lwt.   

Cattle buyers will often change the type of cattle they buy according to what they can make the most money off, thereby keeping the difference between prices at a relatively fixed level.  The above examples may be simplistic, but it is these market forces that ensure that all cattle prices follow the same pattern.

Basis:
The difference in the price of physical cattle and the Futures price is usually called the basis.  Basis can be split up into two categories, namely quality basis and geographical basis.

Quality Basis is largely determined by the type of cattle being sold.  For example trade cattle are usually worth more than Japan Ox in dollar per kg terms due to the meat from younger cattle being more highly valued than that of older cattle.  As such the basis of Japan Ox to the EYCI will usually be lower than that of trade cattle.

Geographical basis refers to price differences at different locations.  The local supply and demand situation has a lot to do with the price, and therefore basis, of cattle.  The best example of geographical basis is cattle prices in Queensland and Victoria over the course of a year.  In autumn and winter when cattle are plentiful following the summer growing season cattle prices in Queensland are generally low relative to the EYCI, while in summer when good growth rates encourage producers to hold cattle, Queensland prices are higher relative to the EYCI.  In Victoria the pattern is the exact opposite due to the growing season being in winter and early spring.  Tightening cattle supply in that period strengthens prices relative to the EYCI, while cattle are turned off in late spring and summer, the high supply weakening prices and therefore basis.

The question now is; how can this information be used?  To make use of this basis information we need to relate the basis back to the MLA/SFE Futures contract.  Armed with knowledge of the basis of their product to the EYCI, a producer in Queensland who intends to turn off Cows in the future can forecast a price, and lock in a price range using Cattle Futures.  While the producer will not have eliminated basis risk, they will have eliminated the risk the Cattle Market as a whole, as represented by the EYCI, will fall.

For example, if the producer intends to sell Cows in September, the expected price will be the September Futures contract price plus the September basis.  Let's say September futures are trading at 370¢/kg dwt, and the average September basis is minus 54¢/kg dwt, that is, in September the QLD US Cow price is, on average, 54¢ dwt less than the EYCI.  This gives an expected price of:
370 - 54 = 316¢/kg dwt.

The expected basis range can be estimated from the standard deviation of the historical prices, in this case 35¢ in September. Therefore the minimum price expected is:
370 - 54 - 35 = 281¢/kg dwt.

On the other hand, the maximum expected price is:
370 - 54 + 35 = 351¢/kg dwt.

Summary:     
Hopefully readers of this article will have gained an understanding of why prices for different cattle are related, as well as an understanding of how this relationship can benefit both cattle producers and consumers when planning their cattle sales or purchases.  Ag Concepts tracks the basis of a broad range of cattle types to the EYCI and these are available from the secure section of our website with a username and password.  Before using Cattle Futures to hedge cattle sales or purchases, it is very important to have a good understanding of the basis of your particular cattle type to the EYCI or Cattle Futures.