Chris Hurt Extension Economist Purdue University

Record 2006 Hog Slaughter and Pork Production Means Moderating Profits

Production is expected to rise by about two percent as a result of a moderate expansion of the sow head in the U.S., higher weaning rates, higher marketing weights, and an increase in the number of live hogs imported from Canada.

The rapid growth in pork exports over the past two years is also expected to falter in 2006 as U.S. beef exports are introduced to much of the world once again. Processor and retail marketing margins are expected to widen in 2006 and be another factor that reduces prices to producers.

Prices are expected to average near $46 per live hundredweight for 51% to 52% lean carcasses. This compares with a $50 price level in 2005. The highest prices are expected to reach near $50 in the spring and move into the very low $40s in late October and November.

Costs of production are anticipated to be slightly under $40 for the year with moderate corn and soybean meal prices. If so, this means profits will average about $6 per hundredweight for farrow-to-finish production. This compares with nearly $9 in 2004 and an average near $10 in 2005.

The extended period of profits beginning in the spring of 2004 and expected to extend through the end of 2006 means that retained earnings will be large and this will provide additional incentive for expansion. In addition, the financial scourge of 1998/1999 is finally seems to be behind the industry.

The Numbers

The U.S. inventory of hogs continues to be very stable. Total inventory numbers in the December report were up only .4 percent with the number in the breeding herd up .7 percent and the market inventory up only .3 percent (see Table 1).

Overall, the U.S. breeding herd has been trending lower as a result of the sow herd shifting to Canada and higher productivity. The U.S. breeding herd dropped from near 7 million head from 1998 to about 6 million head by 2002. Since 2002, the breeding herd has been in a narrow range from 5.9 to 6.1 million head. The .7 percent increase in the breeding herd in 2005 represents 42,000 head and is extremely small by historical standards, but is the largest annual increase since 2000 when the herd was up only .4 percent.

Where are those 42,000 added sows? The evidence points surprisingly to the Eastern Corn Belt (ECB). The region had an increase of 35,000 head, and four of the five states in the ECB also increased in 2005. These were: Indiana (+20,000); Illinois (+10,000); Ohio (+10,000); and Wisconsin (+5,000). Only Michigan had a reduction of -10,000.

Perhaps this is signaling a reversal of the longer-run trend of breeding herd reductions in the ECB. In 1990, 27 percent of the U.S. breeding herd was in the ECB. That portion declined steadily until 2004 when the region accounted for only 17.2 percent. The recovery in 2005 has put the portion back up to 17.7 percent. Two possible explanations are that packing capacity has increased somewhat in the Eastern Corn Belt and may have stimulated some additional sows. Secondly, the Western Corn Belt (WCB) has seen a rapid increase in the use of corn for ethanol production in recent years while the ECB has not had a similar surge (although the ECB appears to be in “catch up mode” since mid- 2005). There is some evidence that this has increased corn prices in the WCB, especially around those new plants and may have served to reduce the incentives to expand hog numbers in the WCB.

So, is the ECB coming back? It is too early to tell from the data, but it will be interesting to watch in coming years.

So What Happened to Demand

The strength of hog and pork prices from the spring of 2004 through this past summer came largely as a result of growing pork demand both in the export market and in the domestic market. For 2005, the available pork per person was down about three percent in the domestic market yet prices were down about five percent (from $52.51 in 2004 to $50.00 in 2005). If per capita supplies were down, yet prices were also down this would seem to indicate a reduction in domestic demand.

Growth in export demand was robust again in 2005 (data is available only through October at this writing). U.S. pork exports expanded by 23 percent in 2005, following a 27 percent increase in 2004. At the same time pork imports dropped as well, falling by nine percent in 2005, and by seven percent in 2004. Thus the pork trade surplus in 2004 was 5.3 percent of U.S. production and rose to 8.2 percent of U.S. production in 2005. Over the past two years, pork trade has increased pork utilization by 5.5 percent of production. So, pork trade is clearly not the reason for lower hog prices in 2005. Domestic pork production per person was down in 2005. While total pork production rose by .7 percent, population growth was near one percent, thus the reduction in production per person. This tells us that supplies were not the reason for lower hog prices.

The two components of price that were likely to have led to lower hog prices in 2005 were higher marketing margins and some weakness in domestic demand. Preliminary data for 2005 show that marking margins increased by seven cents per retail pound compared to 2004. This means that producers received a smaller share of the retail dollar. In 2004, producers received an unusually large portion of the retail pork dollar at 33 percent. In 2005 that portion was reduced to about 31 percent and accounted for about $4.00 per live hundredweight in lower U.S. farm prices. Domestic demand appears to have edged somewhat lower in 2005 as well, perhaps contributing about $.75 per live hundredweight to lower prices.

So the price strengthening components for 2005 were pork trade and moderately lower per capita domestic pork production, while the price diminishing factors were higher marketing margins and somewhat weaker domestic demand.

Unfortunately for 2006 some of these components will weaken again. First net trade is not expected to grow much in 2006, after the huge increases of 2004 and 2005. The reason is the opening of the Asian market to beef. USDA expects a modest four percent increase in pork exports, but that may be too optimistic if Asian nations shift some of their large pork purchases back to beef in 2006.

The second negative component for 2006 is further increases in marketing margins. I am expecting marketing margins to increase about 6 to 8 cents in 2006 and this will have some added dampening effect on live hog prices.

Pork Supplies and Prices

Pork production in 2005 was up only .7 percent, but is expected to increase by about two percent in 2006. The number of head available for slaughter is expected to reach a record high of 105.4 million head, an increase of 1.8 percent from last year. This results from a combination of a small increase in U.S. sows farrowed, increased pigs per litter, and some increase in the number of pigs from Canada. Weights are expected to be up by about .3 percent in 2006, to make total pork production in the U.S. up around 2.1 per cent (see Tables 2, 3 and 4).

In the first-half of the year, production is expected to be up by just one percent. However, production in the last-half of 2006 may rise by about three percent. This likely will mean that the highest prices will come in the first-half of the year with weaker prices in the last-half.

Prices on a live basis for 51% to 52% lean carcasses averaged near $50 in 2005. With larger production, slowing pork export growth, rising Canadian live hog imports, and widening U.S. marketing margins, hog prices are expected to drop to an average closer to $46. Winter prices are expected to average in the mid-$40, and move into the higher $40s for the spring quarter. Summer prices may be a bit discouraging this year having averaged above $50 for the past two years. For the third quarter this year, I expect prices to begin July near $50 per live hundredweight, but weaken to below $45 by the end the end of the quarter at the close of September. Fall prices are expected to drop further, and average in the $42 to $45 range.

Profit Prospects

Profit prospects deteriorated a bit in late 2005 with a weaker hog price forecasts and with greater increases in corn and soybean meal prices than had been anticipated. But, the year still appears to one of continued profitability for farrow-to-finish producers.

Figure 1 provides my estimates of quarterly profitability from 2003 through 2006. In 2004, the industry garnered $8.90 per live hundredweight of estimated profits. That number rose to $10.10 per live hundredweight in 2005, and is expected to drop to an average about $6.30 in 2005. If this forecast holds valid, the industry will have operated at a profit for 11 consecutive quarters dating back to the spring of 2004. By historical standards this is an unusually long period of unbroken profitability. Especially given that this level of profitability has still not resulted in a sizable build-up of the breeding herd.

Many still relate the current run of good profits back to the massive financial difficulties of 1998 and 1999. The hypothesis is that the losses were so large and painful at that time that a psychological barrier to expansion has existed since. To shed some light on this question, I have tracked the financial consequences for a producer of 10,000 head of hogs per year (about a 500 sow operation) in continuous operation from the start of 1998 through 2006. You can see that losses by mid 1999 had mounted to nearly $300,000. Also, recognize that by the first quarter of 2004, the operation was just about at zero.

What this means is that the losses of 1998/1999 had been covered and during the long period from 1998 to early 2004 the producer had no accumulated profits above normal costs of production. With the long run of profits starting in the spring of 2004, the producer would have garnered profits of about $500,000 by the end of 2005. In 2006, those profits are expected to accumulate to near $700,000. While this is an oversimplification in that it does not consider the income tax consequences of losses and profits, it does help to illustrate that most pork producers now have overcome the financial difficulties of 1998/1999 and are likely to have accumulated substantial retained earnings. Accumulated retained earnings may be a strong reason for existing producers to consider further expansion in 2006.

Implications for the Industry

The pork production industry has been on a profitable roll since the spring of 2004. It appears that positive returns will continue at least through 2006. Hog prices for the year are expected to average near $46 on a live weight basis with costs of production a bit under $40. Retained earnings have been accumulating for hog producers since the spring of 2004, and their improved financial heath will likely lead to further expansion of the breeding herd in coming months.

The potential for greater expansion in 2006 could set the industry up for a more difficult profitability period in 2007 and 2008. However, expansion will have to be larger than is now indicated for pork supplies to drive away all profits. The other uncertainties in addition to the level of further expansion are what level of pork exports the U.S. will be able to maintain given the opening of U.S. beef exports in late 2005, and secondly how much marketing margins will increase in 2006 and 2007.

Slaughter hog numbers will reach record levels of 105.4 million head in 2006. This compares with about 100 million in 2002. There may be some concern for slaughter capacity especially in the last quarter of 2006 when numbers are expected to reach 28 million head. However, several new plants have been added in recent years and other existing plants have expanded somewhat (see Steve Meyer’s slaughter capacity estimates at http://www.porkboard.org/porkfacts/porkFactPDFS/pg77.pdf ). The industry also has some flexibility especially with Saturday kill levels. Even if capacity is tight in the fall of 2006, USDA Hogs and Pigs inventory data should provide sufficient advance warning if numbers are going to be large. In addition, unlike 1998, the majority of hogs marketed today are under coordinated arrangements with packers. Thus, there is a much smaller likelihood of a mismatch between production numbers and slaughter capacity.

The late year rally in corn and soybean meal prices in 2005 seems over done relative to continued bearish fundamentals for both crops. If so, some reduction of those prices may be expected this winter. Of course, South American weather can impact those prices and the U.S. growing season in 2006 can be influential as well. However, very large anticipated ending stocks as of August 31, 2006 imply that a relatively major set-back in 2006 production will be required to move prices substantially higher.