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May 26, 2021
In recent years there has been a significant rise in the number of hog contracts relying upon wholesale pork prices, instead of live hog prices, as a pricing mechanism. Fundamentally, the change arose from a desire to price hogs in a way that more closely corresponds to values that consumers pay for pork.
However, the change in pricing arrangements made managing hog price risk more challenging since the primary risk management tools available were lean hog futures and options on lean hog futures. Although lean hog futures prices and pork cutout values are correlated, they can diverge significantly at times. This led to interest in developing a risk management tool that more closely matches the price series used in many cash contracts. Recently, CME Group launched pork cutout futures and options to address this challenge.
Like lean hog futures, pork cutout futures are a cash-settled contract. The new pork cutout futures are settled to the CME Pork Cutout Index. The cutout index is a five-business-day, weighted average of prices available each day in USDA’s report titled National Daily Pork Report FOB Plant-Negotiated Sales-Afternoon.
The index is calculated by multiplying that day’s carcass value by the number of loads traded to determine the daily total value. That process is repeated for five consecutive business days. The sum of five daily total values is then divided by the total number of loads across those same five business days, and the result is the CME Pork Cutout Index. The next business day, the process is repeated, substituting the new day’s information for the oldest day’s value and load count. The index is quoted in cents per pound.
The pork cutout contract, which started trading in November, is the same size — 40,000 pounds — as the lean hog contract, which could ease transition from the old contract to the new. Contract expiration months are February, April, May, June, July, August, October and December, the same as for lean hog futures.
CME Group began publishing the CME Pork Cutout Index in early 2013, which makes possible a comparison over time between the cutout index and the CME Lean Hog Index. Although the hog and pork product indexes are correlated, they do not move together in lockstep. This suggests that for risk managers interested in managing wholesale product price risk, using the new cutout contract could be advantageous since it will more closely correspond to cash price risk.
Typical for a new futures contract, volume and open interest to date have been small relative to existing contracts, although the nearby contracts have been actively trading. For example, in mid-May, the June 2021 pork cutout contract had open interest of nearly 750 contracts and a daily volume of over 30 contracts traded.
This is still a small fraction of the open interest and volume for the June 2021 lean hog contract which, on the same day, had open interest of more than 50,000 contracts and a daily volume of more than 15,000 contracts. Ultimately, if the new pork cutout 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.
Mintert is the director of the Purdue University Center for Commercial Agriculture. He writes from West Lafayette, Ind.
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