The following thought-piece discusses the background to the recent fall in Australian cattle prices, the reasons why we believe the downtrend should continue, and the opportunities generated by the current conditions.
MORE PAIN TO COME FOR AUSSIE CATTLE PRICES
Last August, Merricks Capital noted that Australian cattle prices had hit an all-time high, coinciding with a record level of divergence between Aussie and US prices. We discussed the reasons why the large price divergence was unsustainable and outlined a scenario where Aussie beef prices would converge with global prices, resulting in price falls of around 20%.
Prices have performed in line with these expectations, falling over 20% from peak levels a year ago, but rather than seeing a consolidation or recovery phase ahead, the current indicators suggest even further weakness is possible.
THE AUSTRALIAN STORY – DRIVERS OF AUSTRALIAN PRICES
One of the key factors dominating Australian cattle prices during 2016 was very favourable farming conditions. This followed a period of heavy de-stocking during late 2014 and early 2015 due to drought conditions and a lack of available feed. Over 2016, high levels of rainfall and good pasture conditions developed, resulting in strong cattle demand from farmers who were busy restocking their herd, confident in their ability to raise cattle and take advantage of the attractive farming and pricing conditions. These attractive conditions and the resulting increase demand were the major drivers behind the increasing divergence between Australian and US cattle prices.
However the shift in demand has proven to be unsustainable in an environment of falling processor margins, dry weather and export competition. The motivation to sell has been magnified by poor rainfall in the second quarter of 2017 which has led to increased rates of slaughter.
As a result, the dynamics of the market have reversed and we have moved from a market driven by “demand pull” factors to one characterised by “supply-push” factors.
Another key feature at play in the Australian cattle market is record low beef processing margins, in contrast to the US situation where margins are at near- record levels due to a glut of fatter cattle. Low Australian processing margins act to limit demand for cattle for slaughter which, when combined with higher supply from farmers de-stocking, dampens domestic cattle prices even further.
In a global context, Australian beef is uncompetitive relative to supply from other countries such as Brazil and India, which have gained increased market access into major export markets at the expense of Australian beef. A surge in US exports into Japan has forced Aussie producers to compete at the lower end of the market, while Australian exports to Indonesia could be expected to decline further as the Indonesian government reduces its reliance on Australian live cattle imports that are displaced by Indian Buffalo meat. The recent strength in the Australian dollar has added even more competitive pressure.
US CATTLE CONDITIONS REMAIN UNFAVOURABLE
While conditions in the Australian cattle market have shifted in the last 12 months, there have been few changes in the US and the pricing outlook remains subdued. Supply is forecast to exceed demand.
After a decade of declining herds, the US has been rebuilding the cattle herd since 2014, supported by abundant and cheap feed such as corn. Increased cattle supply and heavier carcass weights have contributed to lower prices and elevated beef processing margins.
While the higher processing margins are helping to drive higher domestic demand and export demand has also been stronger, exports should be tempered by news that Japan will introduce a “snapback” tariff on US beef imports, a 50% tax designed to protect Japan’s domestic cattle producers from rapid rises in imports.
Overall, there has been little positive change in US cattle pricing conditions in the last year. Prices remain low, processing margins are high and the lacklustre conditions should be sustained.
DOWNTREND HAS FURTHER TO PLAY OUT
While the conditions which generated a divergence or “premium” in Australian cattle prices have reverted somewhat, leading to a convergence in prices between Australian beef values relative to global prices, Merricks Capital doesn’t expect any significant improvement in prices in the near term.
CATTLE PRICES: AUSTRALIA VERSUS GLOBAL
Merricks Capital’s Head of Commodities Adam Davis notes that the narrowing of the price spread reflects a fall in Aussie cattle prices rather than a rise is US prices and is merely a “normalisation” of a pricing distortion. “While prices have fallen substantially in the last 12 months, conditions in the Australian market have deteriorated further over this time. We expect to see the spread over US prices narrow even further and, with little to get excited about from a global pricing perspective, there will likely be more pain ahead. ”
Following its success in building markets in the cattle sector, Merricks will shortly launch the Merricks Capital Meat and Livestock Fund, one of the few specialised meat and livestock funds in the sector globally. The fund will actively participate in the Australian, New Zealand and US meat and livestock markets using
a combination of futures and over-the-counter instruments, and will take advantage of the continued pricing dislocation and the negative price outlook.
Mr Davis says “Our strategic positioning has been correct, but we expect it has even further to play out with a cyclical low in Australian cattle price in Q4 2018 – so we will continue to exploit this opportunity”.
The Meat and Livestock Fund has attracted a lot of interest from investors and has been fully subscribed. Merricks Capital intends to build on the success of the fund by offering new opportunities to investors in the future.