Pork cut-out contract offers new hedging tool

The Chicago Mercantile Exchange designed its contract as a way to better reflect the wholesale value of the pork that comes out of slaughter plants. | Maple Leaf Foods photo

Farmers are big beneficiaries of the new Chicago pork cut-out contract, say industry leaders.

“That’s another tool for pork producers, a tool that we really needed,” said Scott Hayes, National Pork Producers Council vice-president, about the Chicago Mercantile Exchange futures contract for processed pork, not pig, prices.

“That was a hedging tool that we really needed.”

However, the contract is attracting only tiny trade today and hasn’t yet proven that it can become a long-term viable part of the pig price discovery process.

“Ultimately, if the new pork cut-out futures contract is going to be successful, it must attract more volume and open interest to provide the liquidity hedgers need to manage price risk effectively.”

The contract was designed by the exchange with the help of the pork industry, including well-known economists such as Steve Meyer, as a way to better reflect the wholesale value of the pork that comes out of slaughter plants.

Farmers and others had long complained that the CME lean hogs futures contract well reflected cash market sales of hogs, but that many production contracts included an element of cut-out values in their formulae, which didn’t always correspond with cash hog prices.

“Although the hog and pork product indexes are correlated, they do not move together in lockstep,” said Jim Mintert, director of the Purdue University’s Centre for Commercial Agriculture.

“This suggests that for risk managers interested in managing wholesale product price risk, using the new cut-out contract could be advantageous because it will more closely correspond to cash price risk.”

The cut-out value contained in the CME contract is composed of a rolling average of real pork cut-out prices reported to the U. S. Department of Agriculture by processors. Those prices must be reported by all major processors, so the index of cut-out values is seen as accurately reflecting the commercial market.

The contract is cash settled against the index, so producers, processors, marketers and speculators who use the contract do not have to worry about delivery.

The creation of the cut-out contract has been long sought by the U.S. hog industry because of concerns about the accuracy of relying upon dwindling cash market sales of pigs, and because an increasing number of hog sale contracts are based more on cut-out values than contemporary cash sales of pigs.

Farmers didn’t want to replace the lean hogs contract, which is close to a pure play upon pig values, but they did want to be able to include cut-out values in their overall risk management programs.

With production and sales contracts coming in many different styles, with differing reliance upon cut-out and cash values, being able to have futures contracts reflecting different elements of the value chain provides options toward more accurate risk management.

“Now we have both, which allows producers to hedge pigs based on what their agreement says,” said Hayes during the World Pork Expo in Des Moines, Iowa.

The low liquidity of the new contract is nothing new and no surprise to futures markets observers and participants. Good ideas for new contracts can be hard to stitch together in a way that works well for commercial users.

It’s also notoriously difficult to get futures market users to be early adopters of new contracts. Usually a new contract needs to build volume and open interest before mainstream commercial users will embrace it.

That sometimes creates a chicken-or-the-egg situation.

People are using the CME cut-out contract. Dozens of contracts, each representing 40,000 pounds of pork, have been trading daily on the nearby month, with the June contract having open interest of about 750 in mid-May.

That pales in comparison, Mintert notes, to lean hogs volume of about 15,000 contracts per day.

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