November 9, 2016

China changes Canada's pork trade, but not its production fundamentals


An eFeedLink Hot Topic
  • Powered by a 400% increase in exports to China, a cheaper currency and rebounding per capita consumption, hog production and exports set new records, with H1 2015 shipments up 8.5%
  • China overtook Japan to become Canadian pork's second largest export market  –its low cost and ractopamine-free status gives it market advantages over its EU, Brazilian and US competitors
  • Because supply growth is based on higher finishing weights, exporters took advantage of Chinese pork demand by slashing shipments to other Asian countries 40% to 60%
  • With profit margins going into net loss territory, output and exports are poised to stagnate
Canada's swine sector has enjoyed above average growth, but not of the type the industry anticipated. America's late 2015's repealing of country of origin labelling (COOL) legislation was expected to provide support, particularly to live hog exports and to a lesser extent, pork shipments to the United States. Instead, China's new role as top global pork importer boosted the industry's fortune's, but more by redirecting trade flows through boosting output. This is somewhat unfortunate, as the industry has not been this globally competitive since the early 2000s, when a cheap Canadian dollar made it the world's top pork exporter.

Although hog numbers are 12.6% below their record highs of the mid-2000s, higher pig productivity boosted pork production to a USDA estimated record 1.945 million tonnes. This was 2.4% more than 2016's 1.899 million.  Despite the poor sub 1% annual output growth of the last decade, these figures also contain a productivity success story: Canada produced 9.3% more pork than it did in 2004 with 9.8% fewer hogs.  Consequently, on average, Canadian hogs yielded 21.6% more pork than they did 12 years earlier, making for an impressive 1.6% average annual increase in carcass meat yield over this time.

Carcass yield growth is being complimented by a steady rise in sow productivity, which carried over into the past year: The USDA estimates that for 2017, a 0.7% increase in sows (from 1.217 to 1.25 million head) will lead to a 1% increase in the pig crop (from 29.1 to 29.4 million head). Even so, with combined pork production and hog exports coming in ahead of expectations, ending inventories are only rising by 0.5%, from 2016's 13.36 million head to an expected 13.425 million at the close of 2017.

This remains significantly below the 33 million head pig crop and 15 million head closing inventories of the mid-2000s, before a 60% rise in the Canadian dollar's value and 28% dive in per capita consumption (from 28.7kg in 2000 to 20.6kg in 2014) led to a decade of flat exports and output. Fortunately, the cycle seems to have finally turned the corner: Thanks to high beef prices, per capita pork consumption is rebounding to 22.5kg in 2017 and East Asian export opportunities also beckon –if only the industry can take advantage of them.

The past year's output growth does however, have a somewhat narrow, limited foundation: It is primarily the result of a whopping 400% increase in H1 2016 exports to China. Alongside a smaller 2% rise in exports to Mexico, China's demand is boosting shipments by a projected 4%, from 1.24 million tonnes in 2015 to a record 1.30 million tonnes this year.

Even so, having been burned by overinvestment and high debt levels during the late 2000s, Canadian's hog farmers are reluctant to expand capacity compared to their American rivals. This conservative attitude coincided with the closing of several large pork processing plants in recent years and late 2015's repealing of US country of origin labelling (COOL) legislation.

On one hand, the USDA states that construction of new, western Canadian finishing hog barns is not expected to commence until late 2017 and thereafter have no impact on supplies for another year after that. On the other hand, many neighboring Midwestern states have newly constructed finishing barn capacity. Given higher US hog prices, the repealing of COOL legislation and a low Canadian dollar boosting foreign currency earnings, the USDA notes that, "Increased demand for feeder hogs from the United States, where the construction of new finishing barns and market hog production is growing rapidly, will support exports of weanlings." Over the short-term however, unexpectedly strong overseas-based demand from domestic processors are encouraging production of domestic finishing hogs.

On one hand, this is constraining the export of western Canadian weanlings to US mid-western integrators. On the other hand, the closure of large processing facilities in Ontario has made it more logical for that province's swine producers to boost weanlings for export, both to neighboring Quebec and south of the border, both of which continue to have excess slaughtering capacity.

Unexpectedly high demand for pork exports also means that projected 2016 hog exports (all of which went to the US) amounted to 5.9 million head, 2.1% more than the 5.76 million shipped in 2016 –but 200,000 less than the 6.1 million initially projected. With 66% of production exported, disappointing live hog export growth reflected strong overseas demand for Canadian pork, which offered higher returns. This in turn boosted hog slaughter numbers to 21.65 million head or 1% more than what the USDA had initially estimated for 2016. –And by no coincidence, the resulting 200,000 additional swine slaughtered in Canada itself is exactly equal to the downward revision in live hog exports.

The real story of Canadian pork however, lies in its odd combination of shifting trade flows and unshifting production fundamentals. Powered by a whopping 400% rise in H1 2016 shipments to China (from 33,000 tonnes in H1 2015 to 165,000 tonnes this year), 2016 will see a record 1.3 million tonnes of pork exported. With two-thirds of production exported, this should be great news, but in fact, the impact is at best modest.

Even though Chinese pork exports look set to rise by nearly 200,000 tonnes over the previous year, much of this will be offset by a substantially poorer performance in almost every other major market: While overall H1 2016 exports rose 8.5%, exports to all markets except China fell by 8.7%, from 566,000 tonnes in H1 2015 to 517,000 tonnes in the same period of this year. H1 2016 exports to America, its largest market US fell by 7.8%, while those to South Korea (-22%), Taiwan (-60%), Hong Kong (-43%), Australia (-45%), New Zealand (-40%) and Colombia (-45%) fell by anywhere from 40% to 60%.

Hence, while a short-term industry is in effect, what we are seeing is not so much a boom in exports but a redirecting of trade flows to markets that offer the highest returns. China, where exports grew very rapidly, saw its pork importing prices rise by 50% from Q1 2015 through Q3 2016. Mexico, the only other major market to register an export increase, similarly saw its import price rise 25%. Whereas a 40% rise in pork import price held exports to Japan's large but stagnant market nearly level, a 13% drop in US pork importing prices led to an 8% drop in shipments to that country.

In South Korea, a 1% fall in import prices –when combined with a 50% rise in what China was willing to pay for Canadian pork– resulted in a 22% drop in shipments to South Korea. The logic was simple: The cost of shipping Canadian pork to South Korea and China is nearly the same. With China suddenly offering to pay 50% more for the same quantity of pork, shipments were diverted from Korean to Chinese ports.

China's strong preference for Canadian pork is explained by two factors. First, Canadian pork is free of the banned additive ractopamine. That gives it a huge advantage over US pork, which is the only country whose export prices are as low as those of Canada.

The second reason is one of cost: As the above chart shows, with their currencies depreciating, Brazil and EU could supply China with the cheapest pork possible for most of 2015. However, with the Euro recovering in value after resolving the Greek financial crisis, European pork went from having a 10% cost advantage over other countries to being 20% more costly than its competitors. Similarly, the Brazilian real's 50% depreciation puts its pork cost below US$1/kg early this year before feed cost inflation gave it a slightly higher price than Canadian pork but with a reputation for significantly lower quality. With US pork sidelined by ractopamine use, China opted for as much Canadian pork as it could buy.

Of course, with Canadian pork now enjoying a similar cost advantage in many parts of Asia and Latin America, the question is why don't producers boost output to take advantage of this opportunity? The reason is that Canadian pork prices track US hog futures. Because Canadian feed costs are higher than those of the United States, Q3 2016 saw falling US hog futures drag Canadian pork returns into a net loss position.

Hence, while Canadian pork's global trade fundamentals have not been this good since the early 2000s boom years, negative returns are destroying the incentive to expand production. Aside from poor returns, the other reason for not expanding production is the medium-term trade forecast. After a nasty 5% to 6% fall in 2016, China's pork output is expected to rebound by up to 3% in 2017. This will keep China's pork demand –and overall Canadian pork exports to that country– constant at 1.3 million tonnes. With this year's trade expansion expected to tail off amid sagging returns, domestic demand remains more than 2% below peak consumption levels at the turn of the century.

All this puts Canadian pork in paradoxical and somewhat sad position. With most of the expansion in Chinese pork demand occurring in the early part of this year when returns were positive, some windfall profits were made. But with returns turning negative amid flattening foreign demand and slack domestic consumption, there is very little incentive to expand production in a manner that would let them to retake the East Asian market shares lost when shipments were diverted from markets like Australia and South Korea to China. In sum, Canadian pork's ten years of flat output and exports are over but future growth is poised to be incremental.

This is unfortunate, as Canadian pork's combination of low price, high quality reputation and ractopamine-free status is unmatched in the world market. Even so, with Canada's currency projected to stay at low levels for several years, any, unexpected improvement in Canadian hog rearing returns could lead to a medium-term production surge and better-than-expected trade performance.

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