IATP: New Beef Cattle (Derivatives) Math
Charging Bull, or The Wall Street Bull, in New York City
By Dr. Steve Suppan | February 6th, 2018
In “Fifth Avenue cowboys,” the indispensable agriculture journalist Alan Guebert asks, why did Pinnacle Asset Management (PAM) announce plans to spend $200 million to buy JBS USA’s cattle feedlot operations, when “according to Iowa State University data, cattle feeders lost an average $51.57 per head from 2008 through 2017”? What is the new math that enables these financial wizards, with $2.3 billion reportedly under management, to entice investors to a money-bleeding part of the meat supply chain?
The new math starts with the background to the forced sale of JBS’s Five Rivers Cattle Feeding, which with 980,000 head feeding capacity spread over 11 states, is the largest feeding operation in the world. JBS has to liquidate assets in several countries to pay the Brazilian government a $3.2 billion “leniency deal” fine because its former co-CEOs, Wesley and Joesley Batista have been convicted of bribing Brazilian politicians, including President Michel Temer, to enable JBS’s global expansion with very, very favorable financing from the Brazilian National Development Bank. (For more background on the factors, including use of slave labor, driving the global growth of the Brazilian meat industry, see IATP’s “The Rise of Big Meat: Brazil’s Extractive Industry.”)
Not content to bribe their way to growth, the Batista brothers allegedly bet against the value of the Brazilian Real in the São Paulo derivatives market during the “leniency deal” negotiations with the help of insider information. This foreign currency exchange bet was not a one-time anomaly for JBS. In 2015, JBS made more money betting $12 billion that the value of the Real would continue to fall, than it did from its global sales of beef, chicken and pork. Since 80 percent of its revenue from meat exports is denominated in dollars, the huge hedge against the value of the Real cannot be explained as part of a traditional commodity sales-related foreign exchange hedging strategy. Brazilian hedge funds admired the strategy in 2015, but as the Batista brothers await trial, that love has disappeared.
In the January 17 press release announcing the PAM acquisition of Five Rivers, quoted by Guebert, the benefits of the sale for JBS USA are clear. All Five Rivers cattle will go to JBS USA slaughterhouses, so PAM has a guaranteed customer buying all of its cattle at prices and at a time not disclosed to the commodity exchanges. Now that JBS no longer owns the cattle it slaughters, the Trump administration can claim that petitions by R-CALF USA for a Department of Justice (DoJ) investigation into the impact of JBS’s captive supply procurement practice on cattle prices in public markets are moot.
PAM has outsourced its management of Five Rivers to two other partners, and hence, has no cattle feeding operation concerns, such as migrant labor abuses, animal disease, nutrition, animal welfare and manure management. PAM can focus on getting investors to buy its commodity derivatives products, with cattle price and supply information that it has legally as the owner of the cattle, but which is unavailable to the public. For PAM, the killing is not to be made in feeding cattle, but in feeding investors financial products, based on proprietary information, that claim to successfully manage price volatility in both beef and cattle derivatives contracts. These investors include retirees, according to a PAM web page.
A key sentence in the press release is, “Completion of the acquisition is subject to U.S. regulatory review and approval, approval from the JBS S.A. Board of Directors and Pinnacle Asset Management, L.P., securing the relevant funding.” Getting other peoples’ money to buy Five Rivers Cattle Feeding depends crucially on the DoJ review and approval, as advised by the U.S. Department of Agriculture. In retrospect, DoJ’s past approvals of JBS acquisitions of U.S. meat and poultry companies certainly relied on faulty due diligence. Given PAM’s dependence on JBS USA to buy its cattle under the old competition-killing captive supply prices, will DoJ scrutinize JBS’ operations with greater rigor than during JBS’ 2004-2016 U.S. buying spree? Don’t bet on it. Such scrutiny could not only draw attention to DoJ’s past due diligence failures, but to the 2008 Senate hearing that featured Wesley Batista as a witness.
PAM, and other commodity trade advisors, have an ally in the Trump administration’s Commodity Futures Trading Commission (CFTC). The CFTC’s Project KISS (Keep It Simple Stupid) project promises to make regulation “less burdensome and less costly” to market participants, such as PAM. Better Markets wrote of the KISS Request for Information (RFI): “Some of the comments already submitted by industry representatives in response to the RFI confirm the fear that what has been cast as merely a regulatory streamlining exercise may actually result in major revisions that weaken the rules.”
The CFTC is taking a new approach to enforcing derivatives law that might benefit PAM in the event it or other relatively small asset managers violate the law. The New York Times reported on February 2 that the total of $47 million in fines levied on Deutsche Bank, HSBC and USB Group for market manipulation of precious metals contracts came with a “silver lining.” The fines, which require no admission of wrong-doing, are chicken feed for these global banks. What would perhaps dissuade them from repeat market manipulation is their legal designation as a “bad actor,” whose activities and products would have to be reported to the CFTC in far greater detail and at much greater cost. However, the CFTC granted the three banks an automatic waiver from “bad actor” status, prompting a protest, according to the NYT article, from Securities and Exchange Commission (SEC) Commissioner Kara Stein. Beginning in 2015, “bad actors” had to apply to the SEC for a waiver following a fine settlement.
On February 5, Public Citizen wrote to CFTC Chairman Chris Giancarlo to protest the waiver incorporated into the settlement: “Any Commission action on whether to apply or grant a waiver from the bad actor disqualification rules should be subject to a public notice and comment, given the severe risks such bad actors pose to consumers, investors and other market participants.”
In September, the CFTC had announced that it would rely on “self-reporting” of law breaking by CFTC regulated entities to expedite their cooperation with the agency. What could possibly go wrong?
The CFTC has yet to agree on an Automated Trading rule (Reg AT), although a third of the volume of live cattle futures contracts on the Chicago Mercantile Exchange (CME) are traded by algorithms and bots, according to a 2015 CFTC White Paper. (The High Frequency Trading subset of automated trading is on the wane, as CME and other exchanges have greatly increased their fees for HFT operation access to their proprietary data, the raw material of HFT strategies.) IATP’s comment in 2016 on the draft Reg AT criticized then-CFTC Commissioner and now-Chairman Giancarlo’s comment that “a finalized Regulation would add no value to industry best practices.” Extreme price volatility is the bane of cattle ranchers, who cannot compete against the automated price hedging algorithms of commodity pool operators, such as PAM. Automated trading is a money-making bonanza for financial entities who can look forward to weak or non-regulation and industry-dependent enforcement.
Nevertheless, the automated trading of cattle derivatives that makes money for PAM, even as its cattle feeding operations lose money, can be disrupted if export demand for U.S. cattle products, the underlying asset of the cattle derivatives products, collapses. “Record beef supplies will require record exports through the end of the decade to keep beef prices near current levels,” said Randy Blach, CEO of CattleFax.
According to David Williams of Informa Economics, IEG, the U.S. meat supply chain economy will collapse, if the current value of exports is not maintained: “Exports are the only hope that everybody has . . . The U.S. consumer cannot handle this excess amount. If we can’t export it, then we’re going to have a total meltdown.”
Notwithstanding the hyperbolic language of the meat industry consultant, and despite the record amount of U.S. meat (much more poultry than beef) consumption the USDA forecasts for 2018, the export dependency of the U.S. cattle industry is a main driver of cattle oversupply. Structural oversupply and the global expansion of fast food demand keeps cattle prices low for ranchers, but ensures cheap raw material for JBS and other slaughterhouses, and abundant data for financial speculation by PAM and other derivatives traders.
If DoJ approves the PAM acquisition of Five Rivers, the 2011 UN Conference on Trade and Development study on the financialization of the commodity markets may need to be updated to analyze financial asset managers who own physical commodity assets, but whose investors have no commercial interest in managing commodity price volatility. New math investing does not follow commodity supply and demand, but algorithmic-driven price movements and rumors of price movements.