Futures prices for lean hogs, corn and soy indicate ongoing profitability into 2012 for the average unhedged pork producer. While the future is impossible to predict, one thing is certain: Price volatility in these three key commodities will continue, driven by global demand and supply fundamentals for pork and feed inputs.
With respect to demand, the U.S. pork industry is well-poised to deliver to the world a relatively low-cost product on the strength of “top-of-class” production and infrastructure advantages. This advantageous position is reflected in U.S. pork exports’ positive trend-line over the last decade - to the tune of more than 20 percent of annual pork production. However, there are three potential downside factors to keep in mind.
- First, along with the benefit of expanding global markets, particularly in Asia (and especially China), comes the risk of future demand fluctuations and the consequent impact on U.S. pork prices.
- Then there is the supply side of the equation, which remains an area of caution when considering the current run of industry profitability.
- Finally, even assuming favorable pork demand and supply, there is the ever-present concern about feed input costs in the face of key drivers such as bioenergy demand, the battle for acres and weather-induced yields.
Within this context then, it’s more important than ever for producers to protect their profitability and margins through a disciplined, multi-faceted approach to risk management.
Different Types of Tools
Producers can manage hog and, in certain cases, feed-cost volatility through multi-year risk-sharing arrangements with packers or through outright ownership from a forward integration perspective. A producer’s proven ability to deliver consistent and quality pig flow is key to determining those arrangements.
Also, exchanges such as the Chicago Mercantile Exchange and Chicago Board of Trade allow producers to take risk off the table with respect to both hog prices and feed-grain inputs. Related to such on-exchange risk-management alternatives, the MF Global situation has brought to light the need to assess and address an additional risk — that being third-party management of margin accounts. This can be partially mitigated through the diversification of third-party brokers.
Another possible strategy entails the use of off-exchange derivatives designed to mimic what producers can access with the CME and CBOT but without the margin-call requirements. These futures look-alikes essentially provide producers the ability to protect margins through a structured “hog crush” involving lean hogs, corn and soy. The counterparty is highly important here, and the producer should perform the necessary due diligence to ensure overall comfort with the derivatives provider that he/she chooses. Rabobank and Rabo AgriFinance, its U.S. farm financing arm, have seen a heightened producer interest in just such a structure, given our counterparty position and breadth of capabilities.
The overall success of a risk-management strategy hinges on the strength of a producer’s balance sheet. A substantial equity base as well as a committed multi-year revolving and term debt-capital structure are paramount to ensure sufficient liquidity to manage the appreciations in working capital and margin-call levels over the last five years. Producers also need to be prudent in selecting debt-capital providers that are knowledgeable in the pork sector and can see through the cycle and volatility.
There is no better time than the present to protect margins and manage risk on both sides of the ledger. Producers who do should be better positioned to profitably navigate 2012, no matter the degree of unforeseen volatility.
What can YOU Expect from the European Union?
Last year was a disappointing one for the entire E.U. pork industry, with a peak in feed costs bringing margin pressure all along the value chain. Producers on average saw below-breakeven margins for the fifth consecutive year, as the surge in feed costs outweighed relatively high hog prices.
At both slaughter and further processing levels the situation was slightly better. Long-term price contracts with retail and foodservice players restricted processors’ ability to forward on rising raw material prices in the first half of 2011. Price stabilization over the summer helped processors regain position somewhat, although subsequent price increases once again pressured margins.
E.U. Domestic and Export Markets
In the last few years, E.U. domestic pork demand declined due to economic uncertainty, especially in southern Europe. In 2011, fresh pork sales in Spain dropped 9 percent in the first six months, while sales in Germany dropped 3 percent in the first three months. Rabobank expects that trend will continue, with an overall decline in E.U. pork consumption of about 1 percent in 2012.
E.U. pork exports surged in 2011, increasing 23 percent from January to August. The main drivers were disease-related production declines in Asian markets, as well as the Russian ban on Brazilian pork imports.
Rabobank expects E.U. pork exports to decline further in 2012 due to:
However, Rabobank does not expect the decline to be as sharp as forecast. Increased disease incidence in pork in China and Russia, as well as continued high feed costs, will slow production growth in many countries and support export demand and prices for E.U. pork.
Restoring Market Balance
The signs suggest that market balance will be restored in 2012 and result in a profitable year for the E.U. pork sector.
At the primary level, margin pressure should be relieved due to a combination of lower production — which will support prices — and a positive outlook for feed prices.
The lack of profitability at the primary level over the last few years will drive reduction of the E.U. sow herd in the coming months, and 2012 EU pork production is expected to decline 3.6 percent. We anticipate smaller, less-efficient farmers will stop production, while specialized and more-efficient producers will invest in expanding capacity.
E.U. pork companies are highly dependent on feed costs, which account for 50 percent to 70 percent of total production costs. For 2012, Rabobank forecasts a stable to slightly declining price trend for grain and oilseed markets, which should relieve some feed-cost pressure on E.U. pork producers. Still, economic developments and other swing factors — policy, exchange rates and supply uncertainty — could affect grain prices and pork margins.
For processors, 2012 will be a difficult year as lower pork supply will increase competition and drive prices. Sourcing position and the ability to pass on material prices will largely determine profitability — the key factors being plant utilization and efficiency, client dependency and market position.
In the end, the outlook for the E.U. pork sector is improving but remains fragile. The key to real recovery lies in developing demand in both the E.U. and export markets. The economic crisis also will impact E.U. pork players differently; with southern and central Europe more severely affected, look for northwestern Europe to further strengthen its position within the E.U. pork sector.
Editor’s note: The risk management article is by James Kenwood, Rabobank’s U.S. pork specialist and relationship banker responsible for pork production and pork packing/processing client relationships, through the targeted delivery of senior debt capital, leasing, risk management and M&A services. The article about the E.U. pork sector is sourced from a research report by Rabobank’s global Food & Agribusiness Research and Advisory group.