The Pork Cutout vs. Lean Hog Spread

Background

Beginning November 9, 2020, CME Group will add another risk management tool to its Livestock product suite: Pork Cutout futures and options. Pork Cutout futures and options will become the second swine-related offering for trade at the Exchange and will complement the existing Lean Hog futures and options contracts.

Like CME Lean Hogs and Feeder Cattle, Pork Cutout contracts will track and cash-settle to an index price upon expiration. The CME Pork Cutout Index is constructed using data published by the United States Department of Agriculture (USDA). While the CME Lean Hog Index reflects the prices paid for hogs in the US, the CME Pork Cutout Index reflects the prices paid for pork. A “cutout” is the approximate value of a hog calculated using the prices paid for wholesale cuts of pork. The values, or cuts, used to calculate the pork cutout include the loin, butt, picnic, rib, ham, and belly.

Correlation

Pork Cutout Index vs. Lean Hog Index

Period

R-squared

All

88%

2020 YTD

49%

2019

58%
2018 81%
2017 89%
2016 74%
2015 65%
2014 97%
2013 85%

Source: CME Group and USDA

The Livestock Mandatory Reporting Act of 1999 (LMR) required all large packers to report all details associated with their purchases of hogs to the USDA. LMR was amended in 2012 to require packers to also report the details of their sales of wholesale pork. This revision was important because it allowed CME to develop and begin publishing the CME Pork Cutout Index alongside the Lean Hog Index.

Looking at the two indexes since 2013, it is apparent that they are highly correlated with an R-squared value of 88%. However, when looking at the correlations by year, this is not the case. Several years have R-squared values below 80%, which suggests the relationship between Lean Hogs and Cutout can vary depending on underlying market conditions.

Breaking correlation down into even smaller increments, another interesting trend jumps out. For example, the chart below shows 20-day moving average correlation.  The overlaid trendline on the chart suggests that the correlation between the indexes may be declining.

Source: CME Group and USDA

Seasonality

Agricultural commodities often have regular and predictable price changes throughout the year. These annual fluctuations reflect not just potential differences experienced due to seasonal changes in the weather, but also reflect different supply and demand scenarios that occur over the course of a normal year.

When looking at the seasonal price index of the Pork Cutout Index, prices in June and July tend to be 8-10 percent higher than average. This seasonal high point coincides with the U.S. summer season when people are more inclined to buy items such as pork chops and bratwursts for grilling.

Source: CME Group and USDA

The Pork Cutout and Lean Hog Indexes have similar seasonal patterns, but they are not the same. For example, the Lean Hog Index declines sharply from its summer high. In a typical year, the Lean Hog Index price in December is 15 percent below the yearly average. The Pork Cutout index also declines from its summer high but does not typically exhibit the same range as the Lean Hog Index. This is partly due to the difference in packer slaughter demand for hogs in December versus strong holiday pork demand for cuts like hams.

Source: CME Group and USDA

The spread

Spread trading (i.e., buying one futures contract and simultaneously selling another) is a widely-used strategy in futures markets and offers some key advantages over outright futures trading (i.e. buying or selling a single futures contract). Advantages include capital efficiencies with lower margin outlay and potentially superior risk-adjusted returns. This is particularly true for the hog and pork markets, where the underlying commodities demonstrate strong correlations with each other due to close economic links but also distinct fundamental drivers that can create profitable spreading opportunities using the associated futures contracts.

Normal market seasonality allows the spread between Pork Cutout and Lean Hogs to follow a predictable pattern over time. The chart below shows that the Pork Cutout Index minus the Lean Hog Index spread is mean-reverting and has been trending wider since 2013. Seasonality is evident in the spread as it typically narrows from January through June before widening through the end of the year.

Source: CME Group and USDA

An example of a situation that would contribute to a widening spread between the two is related to slaughter plant capacity. When slaughter capacity is constrained, there aren’t enough outlets for hog producers to have their hogs harvested. At the same time, the amount of pork being produced is reduced. The expected result is that hog prices trade lower while pork prices trade higher. 

Source: CME Group and USDA

A spread trade using futures is created by buying a futures contract and simultaneously selling another futures contract. For example, Buying 1 Pork Cutout contract and Selling 1 Lean Hogs contract equals a position of being “long” the spread. Conversely, Selling 1 Pork Cutout and Buying 1 Lean Hogs would be “short” the spread.  If the spread between Pork Cutout and Lean Hogs widens, a long  spread position profits while if the spread between Pork Cutout and Lean Hogs narrows, a short spread position profits.

The futures spread trade acts as a hedging transaction altering the trader’s exposure from an outright price fluctuation, to the price differential between the individual legs of the spread trade. The profitability of a futures spread trade will depend of the price direction or differences in price movement for the legs of the strategy.

Product Name

CME Clearing Code

CME Globex Code

Pork Cutout futures

PRK

PRK

Options on Pork Cutout futures

PRK

PRK

Lean Hog futures

LN

HE

Options on Lean Hog futures

LN

HE


More information on CME Pork Cutout futures and options can be found on the CME Group website at www.cmegroup.com/pork-cutout.