Short the Hog Margin If You Expect Lower Pork Price

HE1! ZC1! ZM1!
On August 1st, USDA Daily Hog and Pork Report shows that benchmark Iowa Carcass Base Price averages $128/cwt. This is a 15% increase year-over-year, and a whopping 70% higher than the five-year average of $75. Is pork still affordable?

Meanwhile in the futures market, while August Lean Hog contract (HEQ2) is quoted at $120.50/cwt, October (HEV2) is sharply lower at $97, and December (HEZ2) is even lower at $87.80. Do we expect pork price to fall a few months down the road?

Let’s find out what moves pork price. We start with hog production. It consists of five phases:
1. Farrow-to-wean
2. Feeder pig
3. Finishing
4. Breeding stock
5. Farrow-to-finish

Pork price fluctuates following a cobweb pattern due to production lags and adaptive expectations, according to Cambridge economist Nicholas Kaldor.

When prices are higher, it draws more investments. However, due to breeding time, there is lapse in the cycle. Eventually, market becomes saturated, leading to a decline in prices. Production is thus decreased. Again, this leads to increased demand and prices. The Hog Cycle repeats, producing a supply-demand graph resembling a cobweb.

Hog farmers make business decisions based on their expectations of production profit, which is called Hog Crush Margin. It is defined by the value of lean hog (LH) less the cost of weaned pig (WP), corn (C) and soybean meal (SBM). Below is a sample formula.
HCM = 2 x LH - WP - 10 x C -.075 x SBM

In futures market, traders could replicate the economic hog crush margin with a Hog Feeding Spread involving CME lean hog (HE), CBOT Corn (ZC) and CBOT Soybean Meal (ZM). There is no futures contract for weaned pig (piglet).

The size of relevant futures contracts: HE, 40,000 lbs.; ZC, 5,000 bushels; and ZM, 100 short tons. A typical hog feeding spread is 7:3:1, which may be expressed as:
Hog Feeding Spread = 7 x HE – 3 x ZC – 1 x ZM

If you expect hog margin to grow, Long the feeding spread: Buy lean hog, sell corn and soybean meal. For a shrinking margin, Short the spread: Sell hog, buy corn and meal.

According to Chicago-based consultancy CIH, hog margin for July 1st-15th was $16.74. Margins surged over the first half of July as hog futures rallied while projected feed costs mostly trended sideways during this period.

I expect a narrower hog crush margin going into 2023. It may likely turn negative.

My theory: On the one hand, corn and soybean meal prices may fall but stay elevated. Russia-Ukraine conflict, bad weather and supply chain bottleneck present real risk for global food supply shortage. On the other hand, pork price could fall faster than feed ingredients. The combined effect is a narrowing hog crush margin.

Several factors are at work: Firstly, the hog cycle. Higher price this year will induce more production next year, eventually lowering price. Secondly, with hyperinflation and a pending recession, we should expect substitution effect. Consumer would choose lower-priced protein over pork, reducing pork demand. Finally, China is the wild card.

China is the world's largest pork producer. In 2018, it produced 54 million tons (MT) of pork, accounting for 45% of global pork production. With the outbreak of African Swine Fever starting in August 2018, it is estimated that half of China’s hog stock was wiped out over the next year. Pork production in 2019 was 42.55 MT, down 21%.

To make up for the shortfall in domestic supply, China began buying pork in the global market in a big way. Frozen pork import grew from 1.19 MT in 2018, to 2.11 MT in 2019 (+75%), and 4.39 MT in 2020 (+108%), which took up half of global pork trades that year.

CME lean hog rallied 60% in 2019. More buying from China means more pork demand in Americas and Europe. Global pork price and pork futures price both went up as a result.

However, the party did not last long. China’s large hog firms aggressively racked up production capacity with government support. Muyang Group 002714 , the largest hog producer in the world, grew sales from 9 million hogs in 2019, to 18 million in 2020 (+100%), and 40 million in 2021 (+120%). It is on track to produce 55-60 million hogs this year (+38%~+50%).

With domestic production largely recovered, China reduced pork import to 3.71 MT in 2021, down 15%. For the first six months in 2022, China imported only 810,000 tons, down 65% from the same period in 2021.

China’s pork price has doubled from its February low. Again, with the Hog Cycle at work, there will be an oversupply of pork next year, further reducing the need for import.

We could examine corn price trend further. Corn generally traded in the range of $3 to $4.50 per bushel but shot up to $7 in May 2021. It broke record again this year at $8 per bushel in April. I expect the corn price to fall but stay elevated from previous-year level.

Soybean Meal is 50% higher than two years ago. Again, I expect it to fall but stay higher than pre-2020 level.

Happy Trading.

Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.