BROOKINGS, S.D. - "Cattle feeders and packers have been trading more cattle on a formula based pricing system and fewer on a negotiated basis in recent years according to data reported by USDA's Agricultural Marketing Service," explained Darrell R. Mark, Adjunct Professor of Economics at South Dakota State University, in his regular Cattle & Corn Comments column on iGrow.

In 2004, negotiated pricing accounted for 50 to 60 percent of fed cattle sales. Such sales would include direct feedlot sales where the packer takes delivery of the cattle within fourteen days, terminal stockyard sales, public auctions, etc.

Negotiated grid pricing accounted for another 10 percent or so of total fed cattle sales in 2004. Forward contracting fed cattle, wherein the cattle feeder and packer would agree on a specific price prior to the cattle being ready for slaughter (i.e., more than two weeks), generally accounted for less than 10 percent of fed cattle sales.

Formula pricing was used for 25 to 30 percent of fed cattle sales in 2004. Formula pricing cattle involves using a reference price from an external source as the base price for the sales transaction.

"Often, this reference price is based on the preceding week or weeks' plant average price or the price in a specific market report (e.g., the 5-area fed cattle price)," Mark said.

Over the last decade, Mark said the data shows that the percentage of fed cattle sales made on a negotiated basis has declined while formula based sales have increased.

In the first half of 2013, formula sales accounted for 60 percent of fed cattle sales. Negotiated sales were only about 22 percent of sales, while negotiated grid pricing was less than 7 percent.

"The doubling of formula-based fed cattle sales at the expense of negotiated transactions brings about the "thin market" issue that is typically the focus of most concern associated with this trend," he said. "This occurs when a few negotiated sales are being used as a base price in the formula to price a large percentage of cattle."

In other words, Mark said the price for a few cattle is used to set the price for a majority of cattle and concerns about representativeness of the quality of the negotiated sale cattle arise, as does the potential for manipulation of negotiated sales pricing in an effort to adversely affect the formula's base price.

"Generally, this concern is greater for formula pricing that relies on plant average prices for the formula's base. Often, base prices that use a specific market reported price offer more transparency. However, they too can be a problem when the volume of cattle represented in the market report is low - or when the market report is unavailable," he said.

Mark said the latter issue arose during the government shutdown in October when USDA-AMS was not able to publish its daily and weekly slaughter cattle price reports, some of which are used in determining formula base prices.

"While the low volume of a thinly traded negotiated market can be problematic for formula pricing, this pricing mechanism does offer advantages for buyers and sellers too," he said. "Typically, formula based pricing, once arranged between the buyer and seller, has few transaction costs - neither buyer nor seller has to re-negotiate prices every day or week. As a result, it can also help to manage some price risk. Formula pricing can also help both buyers and sellers schedule future sales/delivery of cattle from feedyards to packing plants."

Other recent trends

Mark points to some other recent trends in cattle feeding which have made some of these advantages to formula pricing more attractive to cattle feeders. One is the large switch from custom-fed cattle (for investors) to company-owned cattle.

"As cattle feeding became largely unprofitable in the last few years and capital requirements for owning cattle increased, fewer investors were feeding cattle. As a result, feedlot owners increased their proportion of ownership of their feedyard's cattle in an effort to maintain inventory," he said.

Another trend that Mark said has likely contributed to more formula-pricing cattle is that there are fewer farmer-feeders and small feedyards feeding cattle in the last few years.

"The dwindling inventory of feeder cattle and poor economics of feeding have resulted in larger feedyards having a larger percentage of the nation's cattle on feed. These larger feedyards may be more likely to use formula pricing," he said.

Finally, Mark said the widespread adoption of feeding beta-agonists has made marketing dates (i.e., feedlot closeout dates) more scheduled and definite for feedyards.

Mark explained that because these additives are fed for a specific number of days at the end of the feeding period, once they have been introduced to the cattle, the marketing date is narrowly defined and cattle feeders are less likely to hold cattle over for another week. Formula pricing cattle under an arrangement for specific delivery date(s) can assist with marketing cattle under such a feeding program.

"It would appear from a cursory overview that the increase in formula pricing cattle and declining negotiated sales is a result of market needs by both cattle buyers and sellers," Mark said. "While the negotiated market volume generally hasn't been thin enough to cause significant pricing problems, a continued decline of negotiated cattle sales will likely prompt more concerns by cattle feeders and generate additional research."