The problem with high commodity prices is that they act as the cure for ... high commodity prices.
Beef producers are enjoying the fruits of their labor now, but parabolic price changes and the market dysfunction that comes with them never end well. I'm having flashbacks to similar rallies in crude oil, natural gas, and wheat in 2022; as we were reminded, high commodity prices bring supply and thwart demand; when the music stops, it is hard to find a chair to sit on.
How Did We Get Here?
Years of drought in cattle-producing areas of the country, which work against the practice of grazing, have devastated the cattle supply. As of the beginning of the year, U.S. cattle and calf inventory were just shy of 90 million head; this is the smallest since 2015. On that occasion, the cattle market peaked just as the fundamental story was the most bullish; tight supplies pushed prices into the $1.70s before reversing to trade into the $0.90s about a year later.
This time around, the tight supply has forced prices into the $1.80s without any adjustment to demand for beef. Perhaps consumers are still experiencing a Covid lockdown hangover in which they prioritize experience over price, but the outcome is always the same in commodities. Eventually, consumers change their behavior, and prices soften; "This time is different" isn't an effective speculative strategy.
Where Are We Going?
There is a seemingly insatiable demand for beef, with little sign of consumers altering habits to avoid high prices. But we have seen this play out in the commodity realm before; bull trends can sometimes go further and longer than expected, but I've yet to see such rallies be sustainable in the long run.
Tops and bottoms don't happen in a flash; they take some time. We suspect the cattle market has started the process of topping out. As previously mentioned, the 2014/2015 supply crunch reversed itself just as supplies reached extreme lows similar to the current environment. Further, speculators in the futures markets are holding sizable net long positions. The latest report was released last Friday and was based on the previous Tuesday's data. Given the price action since we suspect speculators are getting closer to an overcrowded position, that works against long-term price gains from lofty levels.
Chart Source: QST, Barchart
Live cattle futures had been trading in a relatively tame uptrend channel that started in mid-2022, but a break above resistance in late May resulted in a parabolic rally. We suspect the move started with buy-stop running, was propelled by momentum and breakout trader buying, then eventually exacerbated by futures contract expiration (June 5 was the first notice day for the June cattle futures contract traded on the CME). In other words, there was a perfect storm of overwhelmingly bullish fundamentals, traders caught on the wrong foot, and other traders were overly aggressive, allowing prices to trade out of bounds.
Although such rallies are authentic and meaningful, they are rarely viable with time. Aside from a retest of recent highs and possibly a probe to a slightly new high, we foresee prices coming back down to earth. A test of what was previously resistance, but is now support, is highly probable. That would put the August contract near 167.00. However, as we have seen with other commodities in recent years, cattle prices will likely fall back into the trading range. This could mean a decline to the high-150.00s; if you are a beef consumer or an inflation tracker, this is good news.
How to Position
If you are a producer, hedges are critical. With prices at all-time highs, there is an attractive opportunity for risk reversals involving the purchase of put options for insurance along with the sale of a call option to finance the long option protection. If the underlying cattle are owned in the yard, the only cost of the hedging strategy is the opportunity cost of giving up gains above and beyond the strike price of the short call. If you are a speculator, risk reversals might also make sense because it provides a substantial amount of leverage and unlimited profit potential. Better yet, risk isn't immediate (there is room for error). You will find an example of such a strategy by clicking on this link to a strategy idea we offered to our brokerage clients on June 6.
