Margin and Opportunity Shifts with Supply

 

by Lance Zimmerman, M.S., Analyst – CattleFax
 
Summary
 
The industry has seen prices across all classes of cattle and beef reach all-time highs and correct back to multi-year support levels in the span of three years. Beef demand throughout that time has been strong to exceptional compared to recent history. So, many discussions on recent price movements have rightfully gravitated to supply.
 
Background
 
Beef supply and price have generally followed an inverse relationship throughout recent history.  As supplies reach 10-year lows beef and cattle prices are generally approaching 10-year highs, and vice versa. This relationship has grown so consistent over time industry participants simply call it the cattle price cycle (CHART 1).
 
From the mid-1970s through today, there has only been one major disruption in the trend of higher prices as supplies tighten and lower prices as supplies become more abundant. That disruption came in the early 2010s as a combination of recession-based demand recovery, record-setting drought conditions and extremely tight U.S. protein supplies combined to extend the uptrend in price and catapult cattle and beef values even higher in late 2014 and early 2015 (CHART 2).
 
 
Discussion
 
Understanding the Rally

Production follows profit is a simple way to define how price and supply move together in the cycle.
 
During times of tighter supply, end users – in this example retailers – recognize beef inventories in the meat case are running lower than normal. So, they increase consumer prices to better balance interest with supplies, but the retailer takes the extra margin from the consumer and bids more at the wholesale level to take product away from competition.
 
The packer likewise recognizes that shackle space remains constant as cattle supplies contract. To minimize per unit fixed costs, the packer takes the extra revenue from the retailer and uses it to bid more for fed cattle. Forcing packers to battle among themselves for additional market share.
 
Similarly, feedyards recognize that bunk and pen space needs to be 100-percent utilized to maximize production efficiency. So, in the end, they take the extra dollars – ultimately provided by the consumer – and pass them down to the cow-calf producer.
 
There are higher prices from retail to wholesale to cattle markets, but only the cow-calf producer is exceptionally profitable as the industry signals to its factory to increase production. That signal is profitability.
 
This scenario paints a nearly perfect picture of what happened in the early part of the 2010s. A record-setting drought and higher feed costs set the wheels in motion for production cuts through the late 2000s, and as the U.S. and global economies recovered, tighter beef supplies met exceptional demand.
 
Realizing the Fall

The exciting rally to the 2014 price highs in the cattle cycle transitioned quickly to a frustrating break over the last 18 months. Many cattle producers expected the magnitude of the break as protein supplies grew, but the surprise has been the speed of the price correction.
 
Previous cattle cycle downtrends in the 1980s, 1990s and 2000s lasted from 227 to 371 weeks with an average length of 292. In other words, it takes 5.5 years, plus or minus a year and a half, to go from cycle highs to lows. The price declines ranged from 26 to 47 percent with an average decline of 37 percent (CHART 3).
 
 
The current downtrend is at week 85 – not even one-third of the way to the average length of the three previous cycles. Yet, the price decline reached 41 percent by late April. That is 21 points larger than the average of the biggest breaks through week 85 in other cycles, and it is already worse than the total correction of two previous cycles.
 
Considering how fast prices reached an extreme high, it is not altogether shocking the correction came nearly as swift. The dramatic shift in prices has also done its job in taking margin away from cattle producers and handing it back to processors and end users.
 
That is likely a point of concern for cattle producers, but it is also normal cattle cycle behavior. Annual increases in beef production have become common since spring 2016 – pushing as high as 11 percent larger than year-ago levels in late April. U.S. restaurants and grocery stores are selling more beef, but they also have to market record-large volumes of pork and chicken as well.
 
From 2014 to 2015, per capita consumption of beef, pork and poultry increased 8.9 lbs. per person, and beef consumption actually declined 0.2 lbs. during that time. The end user segment needed incentivized to move those extra pounds of protein, and better meat and poultry margins provided the necessary motivation.
 
Last year, the CattleFax fed cattle price as a percent of the USDA All-Fresh Retail Beef Price, minus the hide and offal value, declined 2.2 points from its record high 24.7 percent in 2014. CattleFax estimates that further declines in the ratio will lead to a 2016 average around 20.5 percent (CHART 4).
 
 
Incentivizing the Consumer

The restaurant and retail segment is realizing historically strong margins on beef sales today. In April, the retail beef prices were down 3.8 percent compared to a year ago, while the USDA composite boxed beef cutout value was 15.4 percent. Advertised prices for beef items also remains relatively high, only down 4 percent year-over-year in April, according to the USDA.
 
End users have been slow to adjust beef prices lower, but the message to them is clear: more supplies are coming. With those additional supplies, retailers will gain confidence in the lower price trend and increased beef availability. 
 
Beef advertisements at retail struggled under the pressure of tighter product availability and smaller margins from 2009 to 2014. However, the retailer’s advertised beef price to wholesale cutout ratio turned higher in spring 2014, and it has been supportive to additional beef featuring since. Those signals generally have to exist for months and even years to build sustained beef advertising growth (CHART 5).
 
The same trend was prevalent at the restaurant level this spring. Some of the largest promotions started at the fast-food restaurant segment.
 
The dollar menu of the early 2000s might be dead and gone, but the $4 menu special is alive and well in 2016. Wendy’s started the trend with the 4 for $4 deal, Burger King is offering a 5 for $4 menu special, Carl’s Jr. and Hardees joined the movement with its $4 Real Deal, and McDonald’s is trying to gain traction with the McPick 2 for $5.
 
New limited time offers and other menu items are also featuring beef. Burger King sold an all-beef hot dog through the spring, Subway has a new slow-roasted beef sandwich, and McDonald’s is exploring options for an all-fresh beef Quarter Pounder.
 
Conclusions
 
Market Implications

These promotions are the start of bigger promotions to come as beef production likely increases annually by around 1 billion pounds each of the next two years. After end users enjoy a brief period of stronger margins, promotions will start becoming more aggressive and retailers and restaurants will battle among each other for increased market share.
 
During the price rally throughout the early 2010s, plenty of industry participants voiced concerns that beef might have priced itself out of the marginal beef consumer’s diet. It is difficult to support those concerns with data, but it is easy to see how promotions will start to win those supposedly marginal consumers back.
 
This will become more evident over the next few years, and growing demand will signal a new long-term support level in beef and cattle prices. Margins at the production level will turn historically higher, and the incentives to expand once again will be more evident as the industry transitions in to the next decade.
 
Additional Resources

 
 
 
 
 
 
 
 
 
 
 
 
 
 

Tags: Beef Issues Quarterly, Summer 2016, Trends Analyses

June 28, 2016