Bringing home the bacon
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Senior Writer
Eoin Gleeson Aug 22, 2008
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Pork prices soared 68% in China between April 2007 and 2008
Two months ago, the plains of America's Midwest were sunk beneath torrential rains that destroyed three million acres of corn crops. Local radio warned of a 500-year flood as rivers burst their banks and towns from Ohio to New Mexico were evacuated. It was bad enough for the corn farmers who had to be evacuated. But it was a nightmare for the country's cattle and pig farmers. For many, the sight of submerged houses and pigs stranded on barn roofs on their TV sets meant only one thing – they were about to go out of business.
The record price of corn has been devastating for meat producers. Even before it hit a record of $8 a bushel in the wake of the floods, the price of corn and soybean meal had jumped 75% in the space of 18 months. Hog farmers have been losing $30 a pig this year, says Kim Souza in the Arkansas Morning News. Cattle feeders as a whole have been losing $80m a week. And hog prices are so low that farmers have been killing their piglets to use as compost. In Canada, the situation has grown so desperate that the government has actually been paying hog farmers to slaughter their pigs early in the hope it will drive up the value of the remaining hog population.
Livestock farmers haven't been the only ones to suffer. In January, US beef and pork giant Tyson Foods announced it was to stop slaughter operations at one of its flagship plants in Emporia, Kansas. It wasn't long before Tyson had to reveal a 90% cut in profits for the first quarter. Why? Because with livestock farmers shrinking their herds, there simply weren't enough cattle coming through for Tyson to process. The group has had to cut its American slaughter capacity by 21% over the last two years as a result of the States' declining cattle population.
But with fewer cattle being bred to maturity, we may soon be facing not a glut of livestock, but a shortage, says JP Morgan analyst Ken Goldman. The real issue now is how long it will be before the price of livestock begins to take off properly. While supply is falling, demand for meat has never been so strong. China's growing prosperity has brought about a lifestyle change that is as much about the luxuries of pork and chicken as it is about new cars and television. Since 1980, meat consumption per head in China has nearly tripled. The price of pork there has jumped by more than 50% in just one year, yet the butchers' shops remain packed. As James Ferguson said in last week's roundtable, livestock could be next year's great bull market.
And one thing that might kick it off is the good news coming out of the Corn Belt. After the rains cleared this year, corn and wheat farmers planted a bumper harvest. The average corn yield in the US this year is expected to be 155.7 bushels per acre, instead of the usual 150.7. Soybean farmers will squeeze out two bushels per acre more than the historical average of 41.4 bushels per acre. So corn has already slipped back to $5 a bushel. With cheaper feed in the pipeline, declining fuel costs and still-strong demand, meat producers might be on the cusp of a remarkable recovery. So where should your money go? Below we look at the different kinds of livestock that make up the market and consider where the best profits might be.
Lean times for pork
We're already seeing strong growth in meat prices on this side of the water. The Times carried a picture of an English breakfast last week. Around the plate it registered a 22% jump in the price of sausages, a 93% jump in bacon and a 25% increase in the price of your fried egg. But even after adding in these jumps, the real price of hogs has gone practically nowhere for 30 years. In 1977, a hog sold for about 55 cents per pound in America. Today, the same hog would sell for around 79 cents. Through boom and bust, that works out as an annual rise of just 1.1%.
Still, at least when corn prices were constantly falling in real terms (remember that until 2000 commodities has been in a bear market for 20 years) it was still possible to turn a profit from raising hogs. Farmers treated it as a volume business, inseminating as many pigs as possible every six months and stuffing them with corn until they were fat and eventually sold on to meat packers. The 1990s saw an industry shift as producers moved from being "farrow to finish" operators (ie, performing all stages of production) to specialising in each stage of the process. The total number of hog farms fell 70%, but the high levels of production continued – even this year, despite the high and volatile corn price, the US Department of Agriculture expects pig production to increase by 7.4%.
On the plus side this might be the last year that is the case, says JP Morgan analyst Ken Goldman. With corn at $8 a bushel, it has been costing $150 to fatten a hog. But meatpackers, thanks to the huge supply, only play $100 a hog. So the finishing farms have been losing $50 a pig. The result? Fewer pigs are now being farrowed, says Goldman. Finishers are now slaughtering sows, not shifting them to breeders, so there should be many fewer hogs coming to market over the next year. The US swine herd population is expected to shrink as much as 10% before the end of the year, according to the National Pork Producers Council. That should mean rising prices, says Tom Dyson in the Daily Wealth newsletter. It's likely to take another seven months to work through the excess, but when the shortage comes, it will last two years – the length of time it takes a commercial hog operation from scratch to production and that should send hog prices to record highs.
But this isn't the only reason to get exposure to pig livestock at the moment. There is also China. There may have been a glut of pork in the US and Canada, but pig populations are being devastated on the other side of the Pacific. Outbreaks of blue ear disease – a reproductive and respiratory illness – killed 70,000 animals and infected 280,000 more in China last year. Pork is so much a part of the national fabric in China that the government keeps a central reserve and has dispensed 30,000 tons of live pigs to 22 cities nationwide since the outbreak. But when the earthquake struck earlier this year, more than three million pigs disappeared. These twin disasters helped drive the price of pork up 68% from April 2007 to April 2008.
The disease problem will only get worse in China, says Tom Dyson. Peasant farmers have long accounted for 70% of hog production, but they are now moving to the cities in search for more lucrative manufacturing jobs. In response the government has been setting up factory farms similar to those in America. That might stop supply falling further, but with China's polluted water and the overcrowding in hog sheds it will also mean disease will spread even more readily than it already does.
So there is a really big opportunity for America and Canada to export to China, and they've been quick to pick up on it. There has been a 311% increase in pork exports to China and Hong Kong in the last year, with America accounting for about half of China's total pork imports. Shipping costs are the biggest obstacle, says Larry Rohter in the New York Times. The cost of shipping a 40-foot container from Shanghai to the United States has risen to $8,000, compared to $3,000 early in the decade. But with the price of oil dropping off, there are bright prospects for North American pork exporters. In the meantime, keep an eye on prices, says Tom Dyson. "The last time the hog business washed out like this in 1998, live hog futures jumped from ten cents to 70 cents in two years – we'll see something similar this time."
Beef: from bust to boom
If the pork business has been a washout, then cattle farming has been deluged. Of the 28,000 dairy farmers in Britain in 1995, more than half have quit the business, which has been on a knife edge ever since the BSE outbreak led to a ban on British exports. So the doubling of feed costs over the past year is the last thing farmers needed. As one beef farmer at the Royal Show told The Sunday Times last month: "We must be mental cases to carry on, but we just keep smiling and holding the gun to our heads".
It's the same story in America. More than 80% of US beef is corn fed, explains Steve Kay in Meat & Poultry magazine. If you own a cattle feedlot, and feed costs are rocketing, you only have two ways to go. You can feed up fewer cattle and slaughter the others, or feed less to each cow and get a lower price for it (because it will weigh less). The results of this can be less than good. In the Spanish town Prado Negro, cattle have been so neglected by farmers, who can't afford the feed costs, that a herd of 150 have stormed the village, "destroying trees, property and imprisoning residents in their own homes", according to the Calgary Herald.
Returns on livestock were still just positive last year in America, according to Jim Robb of the Livestock Marketing Center. But there has been a $100 per cow decline since 2004 – as bad a fall as when BSE wiped out Asian and Mexican trade in 2003. Farmers were quick to liquidate their herds back then, and they've been doing so again. The July cattle on feed inventory, which measures the number of cattle in US feedlots, saw a 9% drop in new placements on last year, according to the US Department of Agriculture. Some American farmers have been taking downsizing to the extreme, replacing their herds with midget cows – three-foot cattle that eat only a third as much feed as their full-sized cousins. "Some 17,000 of the little critters live in the US, and their population is growing by 20% a year," a rancher told the Wall Street Journal.
But as the Irish Independent pointed out this week, with fewer finished cattle being brought to market, there is a severe shortage of beef on global markets. In Ireland, lively cattle mart trade has seen livestock prices jump 20% in a year. "A Europe-wide deficit in beef is expected to set cattle prices soaring over the coming weeks," Majella O'Sullivan reports in The Independent.
And with bans on US exports being lifted, beef exports have surged 34% in the first four months of this year. As Steve Kay reports, the futures market (see below) forecasts that cattle prices will be 30% higher in February than they were last year. With demand from Asia growing ever stronger – Meat and Livestock Australia has just reported that the country exported 540,000 cattle to South East Asia in the last 12 months, a 17% jump on last year – beef feedlots and packers are going to have to fight for the livestock.
Chicken: Asia's growing appetite
One group in the meat business that hasn't been wiped out by the cost of animal feed is chicken farmers. Poultry farming is far less energy intensive than beef and cattle farming, so farmers don't face the same intense pressures to lift prices as pork or beef farmers. Heading into a recession, that gives chicken producers a serious advantage. The last time there was such a dramatic surge in grain prices, back in the early 1970s, sales of chicken soared at the supermarket as pork and beef became too expensive for the average household.
That's not to say that chicken producers are immune. Poultry companies in the America have had an awful time this year, notes Matt Andrejczak for MarketWatch. Industry giant Pilgrim's Pride reported recently that grain prices had pushed up the cost of producing a live chicken by 65% over the past two years. The group has shut down a chicken processing complex and six of its 13 American distribution centres in recent months to cover costs.
But it's not US consumption investors should be focusing on. The real shift will be seen in developing countries. What was once a luxury food source – before incomes rose and roads existed to transport such a delicate cargo – has now become a staple in the diet of Asia's emerging middle class, for example. China goes through 24 billion chickens a year, compared with 600 million pigs. However, the pressure on animal feedstocks means that for meat consumption to remain sustainable over the next ten years, chicken will have to become even more popular – rising from 35% of current meat consumption to 57%, says Morgan Stanley. That's a huge shift and suggests that poultry prices will rise, along with beef and pork prices.
Meat producers – pork, cattle and chicken – will continue to feel the pain for some time yet, according to JP Morgan analyst Ken Goldman. The cost of bringing a food product to the supermarket shelf makes up about 19% of each dollar an American consumer spends on food. But over the next five years, that's expected to jump to 29.9% on the back of fuel and grain costs. However, by the time farmers have rebuilt their herds after the recent slaughter, they will find plenty of demand out there, whatever the price. In the meantime, we have a look at how to get your hands on some livestock of your own below.
The best ways to buy into livestock
Pork ETFs
"Pork has been cheap for sometime" in America, but that is about to change, said Matthew Bradbard of MB Wealth last week. The easiest way for you to play the surge in pork prices is through a hog ETF. The London-listed Lean Hogs ETF (HOGS) tracks the price of futures contracts for pigs on the Chicago Mercantile Exchange. Live hogs refer to the pigs sold at the market, lean hogs to pig contracts sold on futures exchange. One US pork producer that's in a great position to feed China's appetite for the meat is Smithfields Foods (NYSE:SFD). The stock has suffered recently on the back of feed costs and the glut in American pigs, but on a forward p/e of 13, it is still an attractive play on exporting pork to China. Chinese hog producer Zhongpin (Nasdaq:HOGS) is already thriving, reporting a 100% jump in quarterly profits last week. It trades on a forward p/e of 8.5.
Cattle ETFs
There are two types of cattle that are tracked by the futures market – Live Cattle and Feeder Cattle. Feeder Cattle are cows in the feedlock. Live Cattle are those ready for slaughter. Strong American beef exports and tight supply due to early slaughters are driving up the price of Live Cattle, while fewer Feeder Cattle are finding their way into the feedlots. The Cattle on Feed report for July confirmed a 10% drop in inventories for the month. But while beef producers fight it out for real cattle, you can pick up exposure to livestock easily through a cattle ETF. London-listed Live Cattle ETF (CATL) does exactly what its name suggests. The iPath Livestock Total Return Index (NYSE:COW) will also do the job for you.
Promising plays on chicken
As Deutsche Bank analyst Eric Katzman puts it, "chicken protein remains a brutal business". But once industry giants such as Pilgrim's Pride (NYSE:PPC) digest fuel and feed costs, they are bound for a recovery by 2010. With a forward p/e of 10.6, Katzman recommends you buy now while Pilgrim's is cheap. But if you can't wait that long for a recovery, then you might consider Mexican chicken outfit Industrias Bachoco (NYSE:IBA), which is doing good business with the ever-expanding Hispanic community in America. The company trades on a forward p/e of 13.
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