U.S. Market Outlook

The U.S. hog market has been characterized by volatility, disappointment and surprising strength, all in the first eight months. The winter and early spring were very disappointing as the industry sought to recover from the poultry avian influenza hangover. That is, the challenges that the chicken industry faced in world export markets resulted in some severe negative pricing for not only chicken but also for pork.

Once the chicken industry began its recovery, the pork industry, either coincidentally or not, also began a sharp recovery. Moving through the summer, the industry has shown exceptional resilience. In fact, August prices are usually about 3 percent lower than July, but in 2006, August prices were higher than in July. Figure 1 shows the 10-year average U.S. hog prices on a carcass basis in comparison to the pricing in the first five months of 2006.

As can be seen on the graph, pricing during June, July and August has been exceptionally strong. In fact, a vigorous, above average increase in seasonal pricing patterns actually began in May. It is of interest to note that the increase in pricing in August came despite some reasonably robust production volumes that month. For the year as a whole, through the end of August, U.S. production has been over 1 percent more than last year. Since the beginning of May, however, U.S. hog prices have been 1 percent more than last year. All in all, so far in 2006, U.S. hog producers can be generally pleased with the overall performance of the market.

Perhaps not surprisingly, I argue that the key reason behind the strength in pricing, despite higher production, is U.S. exports. According to the USDA’s Economic Research Service, in the first six months of 2006, U.S. exporters shipped over 1.5 billion pounds of pork products to foreign markets, an increase of more than 15 percent over the same period last year. Needless to say, if all that volume needed to stay in the U.S., there would have been problems.

The top five foreign markets for U.S. pork for January to June 2006 were Japan, Mexico, Canada, South Korea, and Russia. During the same period last year, the top five export markets were Japan, Mexico, Canada, South Korea, and China. The relatively low foreign exchange value of the U.S. dollar, together with animal disease-related restrictions imposed by some major importing countries, largely explain the strong demand for U.S. pork products in the first half of 2006.

It is of interest to note that Japan's imports of U.S. pork for the first half of 2006 do not match the buying patterns of other major importers. Although Japan remains, by far, the largest importer of U.S. pork products, its year-over-year imports of U.S. pork are down by more than 8 percent in the first six months of 2006. The reduction is attributed to larger than normal levels of pork stocks, brought about by very large pork imports in 2004, when animal diseases — Avian Influenza and Bovine Spongiform Encephalopathy (BSE) — were significant factors in shaping Japanese import demand. Imports have also been slowed this year by stepped-up monitoring by Japanese customs authorities to ensure importer adherence to the procedures of the Japanese pork import regime.

USDA notes that first-half U.S. pork imports were 7.5 million pounds higher than in the same period last year, an increase of just over 1.5 percent. Most of the increase is attributable to slightly higher shipments from Denmark and other smaller countries that export to the United States. U.S. imports from Canada, however, were slightly lower than the first half of 2005.

The combination of increased production and exports brings back a theme that I have addressed frequently in these reports. That theme is the idea of how pricing is exceeding what would “normally” be expected given supplies and production. That phenomena is best explained by looking at Figure 2 above. The graph shows U.S. supplies on the horizontal axis and U.S. hog pricing on the vertical axis. Supplies are defined as production plus pork imports less pork exports. The points/numbers on Figure 2 are the years in which the combination of price and production took place. For example, in 1991, pork supplies were between 16 and 17 billion pounds while pricing was just over $70/cwt. In 2001, supplies were about 18.5 billion pounds while price was just over $60/cwt.

The key point of interest of Figure 2 however, is best explained by looking at the diagonal line on the graph. The diagonal line joins the years of the 1990s and the combination of price and supplies during those years. As can be seen, and as can be expected, as supplies increased, prices declined and vice versa, during the 1990s. During the 2000s, however, as supplies continued to increase, prices also increased. As seen on the graph, in 2005, for example supplies were about 19 billion pounds over the course of the year. During the 1990s supplies of 19 billion pounds would have been left with a pricing performance of about $45/cwt. In 2005, however, pricing was nearly $70/cwt. That is an exceptional change and a very important development for the entire industry.

Higher supplies coupled with higher pricing is not to be expected. That counter-intuitive performance of pricing increases along with supply increases suggests that something unusual has been happening. That “something unusual” is the outstanding performance of U.S. pork exports. The continual growth in the demand for U.S. pork has provided a very strong undertone for the entire industry.

With regard to 2006, I am forecasting an annual average price of about $64/cwt. While that forecast is down 6 percent from 2005, it still represents a sizeable premium over what would have been the case only six years ago, given the expected supplies and production. So while it may be a disappointing forecast from a producer’s perspective, it is important to recognize that there is a great deal of favourable activity going on to generate a price level that high. With that U.S. forecast in mind the following are the price forecasts for Alberta for the fourth quarter of 2006 as well as the first two quarters of 2007 (See Right)

Prairie Situation

Since the last quarterly outlook report, the biggest single piece of market information was the loss of the second shift at Olymel in Red Deer. A quick glance at Figure 3 below illustrates the situation before the double shift for the first three quarters of 2005; during the double shift from Q4 2005 through spring 2006; and after the double shift starting in June 2006. In other words, one look at the graph and it is easy to see when the double shift started and then stopped. Prior to the double shift, Alberta slaughter was about 58,000 head per week. During the double shift, slaughter was about 68,000 head per week. After the double shift ended at Olymel in the late summer of this year, slaughter in the province declined to about 62,000 head.

The decision by Olymel to end its second shift in Red Deer was due to a lack of labour and a lack of profits. Officials have also laid the blame on a lack of hogs. The labour and profit issues are easy to understand. All industries in Alberta are feeling the labour pinch due to the red-hot economy in Alberta. Even before the energy boom began in earnest, the prairie packing sector suffered from labour shortages. Relatively tough work and moderate wage rates combine to result in heavy turnover, high training costs and constant shortfalls. With regard to profitability, it is reasonably well documented by public results and private estimates that pork packing has brought back poor returns in the last couple of years. This spring and early summer has particularly stunk.

The labour and profitability challenges have combined to make the second shift at Red Deer untenable, at least for the summer. There is hope that a second shift can resume in the fall. It is a catch-22 situation. It is increasingly difficult for a commercial packing plant to pencil out profitability if it cannot run on two shifts. The double shifts help reduce per head kill costs. Conversely, it takes time and labour for a second shift to succeed. As losses mount and labour fails to materialize, the second shift can become unsustainable.

As such, the second shift, which I viewed as a major cause for optimism for the entire prairie hog sector, has become an important casualty. While the Alberta slaughter numbers do not yet fully reflect the loss of the shift, the fact is that it represents the loss of Canadian slaughter space for about 6,000 or so hogs. Those hogs will have to find a home as either weaners or market hogs in the U.S.

Olymel has also blamed a lack of hogs for the end of the second shift. That reason is always a little hard to swallow but there is something to be said for it. First of all, Alberta’s sow numbers have been stagnant for years. Secondly, there have been some significant de-populations going on recently. How many will be re-populating, given the situation, is of course open to doubt. It is of interest to note that while the second shift was operating, the shipment of barrows and gilts off the prairies through North Dakota and Montana was soaring. Figure 4 shows the shipments of barrows and gilts through those two states from January 2005 through the summer of 2006. Of course, Olymel is not the only packer that is going through some “adjustments.”

Maple Leaf Foods says that it is going through difficult conditions driven by currency and protein markets. The company says that it sees substantial cost reduction opportunities and that it is considering new hog production business models to reduce costs. The company goes on to state that this will likely result in redundant assets. Interestingly it also asserts that it sees the potential to expedite movement to second shift operations. In addition it says it is seeking closer alignment between primary and secondary-processing operations. Maple Leaf is the biggest hog producer and the biggest packer. When Maple Leaf says things like: “restructuring; substantial cost reduction opportunities; and new hog production business models,” it makes industry participants very curious if not nervous.

Whatever happens in the future, the company must be asking itself if it really wants to be the biggest hog owner in Canada. A key question has to be, has hog ownership ever met expectations for Maple Leaf? If not, why would it ever meet expectations going forward? The other point relates to whether the company is going to be in the hog slaughter/fresh pork business, the processed business or both. With the purchase of Schneiders, the company has laid claim to the processing business. Now it needs to decide whether it is going to be in the slaughter business. It seems that companies are either really good at the processing end of the business or really good at the slaughter end. Few, such as Smithfield, are really good at both.

Being really good at the slaughter end means operating high volume, highly focused, critical mass operations. Maple Leaf does not do that. It operates a handful of relatively little operations. If it is going to stay in the slaughter business and try to be one of the few operations that does both slaughter and processing well, then it needs to consolidate its kill into one or two plants. One of those plants needs to be a consolidated prairie operation in Brandon. There is a great deal of added costs of operating other plants or building a mid-sized new one in Saskatoon. Saving that money and paying more for workers in Brandon would be money well spent. The other plant, if they feel they need another, could be an arms-length relationship based in Ontario or Quebec. The current slaughter situation needs to be re-thought.

Summer 2006