Like so many value-based marketing programs, the participants in the Nebraska Corn-Fed Beef program faced the challenge of price discovery for cattle sold on their value-based grid. Growing concern over using previous-week indexes or averages as the base price led to a new system of base-price discovery. In January 1999, the NCFB Program began offering a pricing system that utilized the Chicago Mercantile Exchange (CME) Live Cattle Futures contract to establish the base price.

Carrying the burden

Arguably, one of the greatest challenges faced by value-based marketing programs is how to determine a base price. Selling all of your cattle on the previous week's average cash price means you are putting pressure on everyone else-who are still trying to sell cattle in the spot market-to price your cattle for you.

"That is a hard thing to swallow as a feedyard operator," says Alan Janzen, Henderson, Neb., owner and general manager of Circle 5 Feedyard. "We are giving up the negotiating portion of marketing and putting that monkey on someone else's back. When cattle are sold on a pricing formula half of the cattle are already moving, so the cash seller is starting out in the hole in regards to marketing position. Then I'm asking him to price my cattle as well as his." Cattle marketed on a value basis are typically priced off of the previous weeks' U.S. Department of Agriculture's weighted average for a state or region. But as the number of cattle marketed on a value basis increases, the number of cattle sold on the cash market decreases. The result is that fewer cattle set the price for the whole bunch.

"It's a self defeating pricing mechanism for the industry," says Mr. Janzen. "It's one that I don't think is viable over time as more and more cattle are sold in value-based arrangements."

Futures pricing

The participants in the NCFB program set out to identify alternative pricing options. In 1999 a new pricing system was adopted by the NCFB program using the CME live-cattle futures price to establish the grid base.

"With the increase in volume of the live cattle contract and the efficiency of the futures market, we felt that basis would be a good way to explore pricing," says Mr. Janzen, who headed the task force charged with developing the NCFB program. "Most of us in the feedyard industry trade our grain inputs on basis and are already very comfortable with doing that."

"The futures are a good price discovery mechanism. It's open out-cry and you have people on both sides of the market," says Logan McClelland, marketing advisor for NCFB from Wayne, Neb. "The futures are an opinion of what people think of the market. It has speculators in it, of course. It has traders, buyers and sellers, producers and end users. It's a mix of everybody."

Certainly not all cattle are hedged. In fact a small percentage of them are, adds Mr. McClelland, but at least the mechanism is there that gives price discovery.

In addition to price discovery the NCFB pricing system provides stability and efficiency. The current cash pricing system trades in a relatively small window during short periods of time each week. The CME is an efficient market that trades a high volume of cattle during specific trading hours. In the cash market if you are not trading during a specific few hours on random days you will likely miss the opportunity to trade at that week's top price.

How it works

There are two pricing options for qualifying producers wishing to sell cattle on the NCFB value-based grid. The directors of the NCFB program negotiate each month's basis with the packer a year in advance. The base price is then calculated by adding or subtracting the appropriate NCFB basis from the appropriate CME live cattle futures price for the time period the cattle were priced. It is then divided by 63 percent to convert to a dressed price.

The "cash settle" pricing option is based upon live cattle futures prices. The base price is the five-day average of the CME's live cattle futures close of the spot month prior to the slaughter date.

"Currently NCFB cattle are slaughtered on Tuesdays. So the price for next Tuesday's kill will be based on the previous five-day future closes of the spot month," says Mr. McClellen. For example, June is the spot month. So you would use the live-cattle closing price for a June contract on Tuesday, Wednesday, Thursday and Friday of this week and Monday of next week. The average of those closing prices becomes the base price plus or minus the predetermined NCFB basis. Feeders must schedule cattle eight days before slaughter. "If you want to schedule cattle for the Tuesday kill you need to call me by Monday of the previous week," says Mr. McClellen.

A five-day average is used to help take some of the market swings out. By taking all five days and averaging them, a feeder doesn't take such a huge hit from the volatile futures market.

While the majority of cattle are priced using the cash settle pricing option, cattle also can be forward contracted to the packer any time before one month prior to the first day of the delivery month. The price is picked by the producer and then if it is hit on the futures, the NCFB basis is applied and a contract is made. But because price is determined before delivery, such a pricing system is often criticized for adding to captive supplies. Still, the program's need for a consistent supply of qualifying beef and some producers' need for risk management makes forward contracting a viable option for NCFB producers.

Maintaining stability

There are those that might argue that the futures market is manipulated. Mr. McClelland would argue back that it's such a big market it would difficult to do for any length of time.

"As volume goes up stability increases," adds Mr. Janzen. "I've liked what I've seen in CME. There were times when the number of open-interest contracts were down in that 50,000 to 60,000 range and you had some worries that volume was thin enough that you would move the market when you placed orders. But now that volume has increased, you see less and less volatility. I think that's positive for that contract, and we can have a lot more confidence as trade volume increases."

For more information about the NCFB program contact Sandra Milton, executive director, at (402) 475-2333 or e-mail smilton@necattlemen.org