As we begin the new year, a lot of uncertainty remains following a tumultuous 2022, but there are reasons to be hopeful and optimistic. While spot margins are not favorable given the recent sharp selloff in hog prices combined with continued high feed costs, projected forward margins look very promising in deferred marketing periods. The current margin in Q1 2023 has deteriorated to a negative ($9.95/cwt.) which would represent the 3rd percentile of the past 10 years for any first quarter. As recently as last month, projected Q1 2023 margins were above the 80th percentile at $5.20/cwt. or higher, and there likewise was a previous opportunity to protect that level of profitability last August for this year’s first quarter. Coincidently, the projection for Q1 2024 is currently $5.27/cwt. which would be just above the 80th percentile of the past decade (Figure 1).

The contrast between this year’s Q1 and 2024 is very stark, a 10-year historical chart shows how infrequently margin values are either above or below either level (Figure 2).

Fundamentally, the picture is mixed as the pork cutout is down almost 10% from the end of last year and at its lowest value in the past 52 weeks.  Weakness in bellies has been a big weight on the pork cutout as belly prices are down 35% from last year with freezer supplies swelling.  The most recent USDA Cold Storage report pegged belly stocks at 63.06 million pounds at the end of December, up 15.9% from November and 65.7% above last year as well as 31.5% above the 10-year average (Figure 3).

By contrast, ham stocks are at a 10-year low of 53.4 million pounds, down 3.4% from November and 12.9% below last year as well as 22.4% below the 10-year average (Figure 4).

Export demand has been a bright spot with the year off to a solid start.  For the week ending January 19 cumulative export sales reported by USDA’s FAS totaled 44,700 MT with both Mexico and China leading in volume sold.  While down from the same pace a year-ago, exports are still very strong historically for the month of January, not far from a 10-year high.  (Figure 5).

USDA updated pork supply and demand estimates in the January WASDE report, revising pork production higher for the first three quarters of 2023 while revising it down in Q4 relative to previous estimates.  Q4 production is expected to be up almost 300 million pounds or +4.3% from last year, implying the USDA is expecting a big jump in the breeding herd as of March 1 and much higher September-November farrowings as well as a larger pig crop than the last report suggested.  USDA is forecasting total pork production for 2023 at 27.495 billion pounds, up 485 million or 1.8% from last year.

There is growing optimism that the global economy may be in better shape than previously expected, particularly with China re-opening after sustained Covid-19 lockdowns.  Stronger global demand and a weaker dollar which has also been a recent trend would be very helpful and welcome to sustain exports this year amidst increased production.  All the same, growing production towards the end of 2023 into 2024 may threaten what are currently projected to be historically strong margins.

On the feed side, corn and soybean meal prices remain elevated as drought concerns in Argentina and strong demand from China are fundamentally supportive.  While down from the past two seasons, projected Chinese corn imports of 18 MMT based on current USDA estimates would still be historically large, with an increasing share of that corn expected to come from Brazil (Figure 6).

Meanwhile, USDA trimmed their corn harvested acreage estimate in the January WASDE report to 79.2 million, the lowest since 2008-09 at 78.6 million which lowered production 200 million bushels from the previous estimate (Figure 7).

Soybean meal prices are very elevated also as strong demand and weather concerns likewise support the soybean complex.  Longer-term, increased biodiesel production in the U.S. with new plants opening will divert more of the domestic crush to oil which will raise soybean meal supplies; however, this may also lead to more competition for acres which potentially could reduce the corn planting base.  While the U.S. domestic crush projection for 2022-23 was left unchanged in the January WASDE report at 2.245 billion bushels, the figure would still be up almost 2% from last season to a new record high (Figure 8).

Fortunately, hog producers have a variety of ways to protect deferred margins using flexible strategies that allow for further margin improvement if hog prices move up, and/or feed costs come down.  LRP might be an effective tool to protect deferred hog prices that may also have basis applications should cash prices prove particularly weak in Q4 and Q1 of 2024.  Option strategies might also be employed that would likewise protect current hog values while preserving some degree of opportunity to participate in higher prices.  Similar strategies can be used to protect higher potential feed costs while also maintaining the ability to realize a cost savings from lower prices over time.

Given the recent sharp deterioration in spot hog margins, producers should have added sensitivity about taking advantage of opportunities to protect favorable forward margins before they potentially deteriorate.  Being proactive with risk management to secure forward profitability may prove prudent as the year unfolds in 2023.  While it is impossible to know with any degree of certainty where prices are headed, it is important to realize that things often change unexpectedly, and these changes are not always favorable for margins.  The past few years have presented numerous examples of how quickly things can change and disrupt profitability.  The best offense is typically a good defense, and being defensive with margin opportunities is probably wise in the current environment.

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The outlook for forward hog margins is less optimistic than it was even a month ago following the release of the USDA’s September Hogs & Pigs report. The surprising data indicating there were fewer pigs than what the market anticipated produced a bullish response in the futures market, although that soon faded as the calendar turned over to October. Spot December Lean Hog futures subsequently dropped about $13/cwt., and despite a recent bounce remain below the level we were trading prior to that quarterly report. Factors including a concern over labor shortages that could impact processor capacity in the winter months when it is needed the most as well as a significant slowdown in pork export sales to China recently have in part been attributed to the recent slump.

Meanwhile, feed costs have crept higher despite what generally have been better than expected yield results for both corn and soybeans as harvest winds down. Strong corn demand from the ethanol sector as margins swell to multi-year highs have supported the spot market, while concerns over South American weather and high fertilizer prices potentially reducing corn acreage in the U.S. next spring are adding premium further out on the curve. As a result of pressure from both lower hog prices and higher projected feed costs recently, forward margins have deteriorated over the past month and are only about average from a historical perspective looking back over the past 10 years. (Figure 1)

Figure 1 – Hog Margins (Q4 2021 – Q3 2022)

Focusing on either the spot Q4 or upcoming Q1 marketing periods, where margins are currently negative, there have been ample opportunities over the past several months to protect historically strong profitability and well above average margins. In fact, Q4 margins briefly breeched the 90th percentile of the past decade following the September Hogs and Pigs report, with projected profitability at $7.89/cwt. on September 30th (Figure 2). This followed a series of opportunities to protect at least 80th percentile margins going back to the middle of May. While it is obviously too late to do anything about protecting Q4 margins now that the marketing period is almost half over, there may be upcoming opportunities to address risk further out in 2022 if the margin landscape improves.

Figure 2 – Q4 2021 Hog Margin

In order to take advantage of these opportunities however, it is important to know where your margins are at. By taking account of your various input costs and expenses, and projecting hog sales revenue against those, you can begin tracking forward profitability and put that into a historical context. This will allow you to objectively determine favorable opportunities to initiate margin protection and shield your operation from either rising feed costs or declining hog prices.

While no one can know for certain what the markets will do as we move forward in time, it is probably safe to say that we can expect more volatility given increased uncertainties. Will China begin to see sow liquidation due to depressed prices and negative margins? Are there going to be less corn acres next spring because of high input costs? Is South America going to have a drought during their growing season? If strong demand continues from the ethanol sector, is it possible that the balance sheet may end up being much tighter than what the market expects?

Looking again at the graph of Q4 hog margins in Figure 2, you will notice that there has been quite a bit of volatility over the past six months. Margins have ranged from over $7.50/cwt. positive to about $5/cwt. negative since the middle of April. Swings in both hog prices and feed input costs have led to these changes in projected profitability, and this volatility creates opportunities. In addition to signaling beneficial times to initiate margin coverage, these price swings also allow for opportunities to improve existing margin protection. Examples of this include reducing cost in hedging strategies, creating more price flexibility in hedge positions, cutting exposure to performance bonds, and taking equity out of positions.

Moreover, with recent improvements to the LRP program and new alternatives like the CME’s pork cutout contract, there are now a variety of ways that margin protection can be established and more opportunities to create complimentary or supplemental positions once this protection is put in place. Regardless of the tools used, the main point is to have a plan and be disciplined with following through on that plan. Does your operation have triggers in place to establish coverage in forward time periods? Do you anticipate what types of supplemental strategies might allow you to improve on that coverage over time?

Figure 3 – Q4 Hog Margin 10-Year Seasonal

Figure 3 displays the seasonal tendency for Q4 margins over the past 10 years. The recent spike in margins to above the 90th percentile corresponds to a typical period of strength where margins seasonally peak at the 85th percentile by the first week of October. A secondary period of strength typically occurs from mid-January to mid-April (highlighted by the green bars), suggesting that producers be ready to execute on possible opportunities that may show up into that period. Similar approaches could be taken for other periods such as Q2 and Q3 2022.

Inventorying your costs and revenues to project forward margins and putting a plan together that will allow your operation to take advantage of opportunities once they arise can put your operation in a better position to be competitive. Now more than ever, it is important to be proactive in managing forward profitability. Please feel free to contact us with questions on how to create a margin management plan and take change of your bottom line.

Trading futures and options carries a risk of loss.  Past performance is not indicative of future results.  Insurance coverage cannot be bound or changed via phone or email.  CIH is an equal opportunity employer.  © CIH.  All rights reserved.