Pork is the most widely consumed protein in the world and U.S. hog farmers produce more today than ever. Advances in technology and production efficiency contributed to a new record of 27 billion pounds produced in 2019. That is a 44% increase compared to production at the turn of the century.
Export demand has been a main driver supporting this growth. According to the U.S. Meat Export Federation, over a quarter of all pork production was exported in 2019. This is despite trade disputes with some of the main U.S. trading partners such as China and Mexico. As the Chinese have struggled to deal with pork shortages due to an outbreak of African Swine Fever, the U.S. has responded by exporting more pork than ever to China.
While the production practices and export markets have evolved over time, so too have the pricing mechanisms used by industry participants.
The Futures Markets
CME Group has been home to futures contracts for all-things swine since the 1960s. Frozen Pork Belly futures were listed in 1961 and traded for 50 years before being delisted in 2011. CME Live Hog futures were first listed for trade in 1966 as a physically delivered contract. In 1997, the contract was converted to its current form of cash settlement to the CME Lean Hog Index.
The CME Lean Hog Index is calculated using data published by the USDA in its daily “National Daily Direct Hog Prior Day Report – Slaughtered Swine” report (HG201). CME Group utilizes data from the producer-sold hogs in the Negotiated and Formula categories of the report. Negotiated trade is simply a cash market transaction that is determined between buyer and seller. Formula trade represents transactions where the pricing mechanism is based on a formula price for hogs, pork, or pork products.
When the original hog contract was launched in the 1960s, negotiated trade was the only transaction type. As the cash market has evolved and the industry has changed, negotiated trade has decreased significantly. The below chart shows how negotiated trade for hogs has declined from 20% in 2001 to around 3% now.
The decline in negotiated hog trade is a function of the industry moving away from terminal, or spot markets, to forward contracting to ensure a continuous and reliable supply. As a result, the Lean Hog Index is now almost entirely comprised of Formula trade. Negotiated hog trade is still important, however, because negotiated transactions provide the base price for much of the Formula trades.
Hog and Pork Prices Diverge
The Livestock Mandatory Reporting Act of 1999 (LMR) required large packers to report all details associated with their hog purchases to the USDA. In late 2012, LMR was amended to require packers to report wholesale pork sales to the USDA. When the new data became available in 2013, producers began to use formulas based on pork sales in addition to those based on negotiated hogs. Consequently, the Formula category was renamed “Swine or Pork Market Formula” or “SPMF”.
In 2015, CME began publishing the Pork Cutout Index. While the Lean Hog Index tracks the prices paid for hogs, the Pork Cutout Index reflects the prices paid for pork. The “cutout” is the approximate value of a hog calculated by using the prices paid for wholesale cuts of pork.
The lifetime correlation between the Pork Cutout and Lean Hog Indexes has historically been very high at 88%. However there are times when the supply and demand for hogs compared to the supply and demand for pork can diverge. For example, during seasons where certain cuts of pork are in high demand, like your holiday ham. The volatility was also seen during the height of the pandemic-related closures, when correlation was around 53% from March through May 2020.
Many of the largest U.S. meat packers are vertically integrated in that they not only slaughter hogs, but also fabricate and package the pork end-products. Because of this, prices for hogs and those for pork often move in the same direction. However, slaughter capacity can affect the relationship.
COVID-19 shut down slaughter plants and drastically reduced slaughter capacity causing the price for slaughter ready hogs to drop sharply. Pork prices, however, jumped as meat production was constrained by roughly 60%.
The COVID-19 pandemic provided one example of how an additional tool could help manage risk across the entire hog/pork marketing channel.
As more producers sell hogs in formula contracts based on the cutout, it is important for them to have a more precise hedging instrument. Launching in November, CME Group Pork Cutout Futures and Option contracts are intended to address that need. Additionally, they have the potential to reach new market participants further down the pork processing chain, as well as those that transact in the international meat trade.
A confluence of factors has combined to drive pork demand in 2020. As long as export demand follows its current path, a new method for helping the pork supply chain manage price risk could be a welcome addition to the market.