Hedging Against Rising Lean Hogs Prices using Lean Hogs Futures

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Contents

Hedging Against Rising Lean Hogs Prices using Lean Hogs Futures

Businesses that need to buy significant quantities of lean hogs can hedge against rising lean hogs price by taking up a position in the lean hogs futures market.

These companies can employ what is known as a long hedge to secure a purchase price for a supply of lean hogs that they will require sometime in the future.

To implement the long hedge, enough lean hogs futures are to be purchased to cover the quantity of lean hogs required by the business operator.

Lean Hogs Futures Long Hedge Example

A meat distributor will need to procure 4.00 million pounds of lean hogs in 3 months’ time. The prevailing spot price for lean hogs is USD 0.6015/lb while the price of lean hogs futures for delivery in 3 months’ time is USD 0.6000/lb. To hedge against a rise in lean hogs price, the meat distributor decided to lock in a future purchase price of USD 0.6000/lb by taking a long position in an appropriate number of CME Lean Hogs futures contracts. With each CME Lean Hogs futures contract covering 40000 pounds of lean hogs, the meat distributor will be required to go long 100 futures contracts to implement the hedge.

The effect of putting in place the hedge should guarantee that the meat distributor will be able to purchase the 4.00 million pounds of lean hogs at USD 0.6000/lb for a total amount of USD 2,400,000. Let’s see how this is achieved by looking at scenarios in which the price of lean hogs makes a significant move either upwards or downwards by delivery date.

Scenario #1: Lean Hogs Spot Price Rose by 10% to USD 0.6617/lb on Delivery Date

With the increase in lean hogs price to USD 0.6617/lb, the meat distributor will now have to pay USD 2,646,600 for the 4.00 million pounds of lean hogs. However, the increased purchase price will be offset by the gains in the futures market.

By delivery date, the lean hogs futures price will have converged with the lean hogs spot price and will be equal to USD 0.6617/lb. As the long futures position was entered at a lower price of USD 0.6000/lb, it will have gained USD 0.6617 – USD 0.6000 = USD 0.0617 per pound. With 100 contracts covering a total of 4.00 million pounds of lean hogs, the total gain from the long futures position is USD 246,600.

In the end, the higher purchase price is offset by the gain in the lean hogs futures market, resulting in a net payment amount of USD 2,646,600 – USD 246,600 = USD 2,400,000. This amount is equivalent to the amount payable when buying the 4.00 million pounds of lean hogs at USD 0.6000/lb.

Scenario #2: Lean Hogs Spot Price Fell by 10% to USD 0.5414/lb on Delivery Date

With the spot price having fallen to USD 0.5414/lb, the meat distributor will only need to pay USD 2,165,400 for the lean hogs. However, the loss in the futures market will offset any savings made.

Again, by delivery date, the lean hogs futures price will have converged with the lean hogs spot price and will be equal to USD 0.5414/lb. As the long futures position was entered at USD 0.6000/lb, it will have lost USD 0.6000 – USD 0.5414 = USD 0.0587 per pound. With 100 contracts covering a total of 4.00 million pounds, the total loss from the long futures position is USD 234,600

Ultimately, the savings realised from the reduced purchase price for the commodity will be offset by the loss in the lean hogs futures market and the net amount payable will be USD 2,165,400 + USD 234,600 = USD 2,400,000. Once again, this amount is equivalent to buying 4.00 million pounds of lean hogs at USD 0.6000/lb.

Risk/Reward Tradeoff

As you can see from the above examples, the downside of the long hedge is that the lean hogs buyer would have been better off without the hedge if the price of the commodity fell.

An alternative way of hedging against rising lean hogs prices while still be able to benefit from a fall in lean hogs price is to buy lean hogs call options.

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Hedging Against Falling Lean Hogs Prices using Lean Hogs Futures

Lean Hogs producers can hedge against falling lean hogs price by taking up a position in the lean hogs futures market.

Lean Hogs producers can employ what is known as a short hedge to lock in a future selling price for an ongoing production of lean hogs that is only ready for sale sometime in the future.

To implement the short hedge, lean hogs producers sell (short) enough lean hogs futures contracts in the futures market to cover the quantity of lean hogs to be produced.

Lean Hogs Futures Short Hedge Example

A lean hogs producer has just entered into a contract to sell 4.00 million pounds of lean hogs, to be delivered in 3 months’ time. The sale price is agreed by both parties to be based on the market price of lean hogs on the day of delivery. At the time of signing the agreement, spot price for lean hogs is USD 0.6015/lb while the price of lean hogs futures for delivery in 3 months’ time is USD 0.6000/lb.

To lock in the selling price at USD 0.6000/lb, the lean hogs producer can enter a short position in an appropriate number of CME Lean Hogs futures contracts. With each CME Lean Hogs futures contract covering 40,000 pounds of lean hogs, the lean hogs producer will be required to short 100 futures contracts.

The effect of putting in place the hedge should guarantee that the lean hogs producer will be able to sell the 4.00 million pounds of lean hogs at USD 0.6000/lb for a total amount of USD 2,400,000. Let’s see how this is achieved by looking at scenarios in which the price of lean hogs makes a significant move either upwards or downwards by delivery date.

Scenario #1: Lean Hogs Spot Price Fell by 10% to USD 0.5414/lb on Delivery Date

As per the sales contract, the lean hogs producer will have to sell the lean hogs at only USD 0.5414/lb, resulting in a net sales proceeds of USD 2,165,400.

By delivery date, the lean hogs futures price will have converged with the lean hogs spot price and will be equal to USD 0.5414/lb. As the short futures position was entered at USD 0.6000/lb, it will have gained USD 0.6000 – USD 0.5414 = USD 0.0587 per pound. With 100 contracts covering a total of 4000000 pounds, the total gain from the short futures position is USD 234,600

Together, the gain in the lean hogs futures market and the amount realised from the sales contract will total USD 234,600 + USD 2,165,400 = USD 2,400,000. This amount is equivalent to selling 4.00 million pounds of lean hogs at USD 0.6000/lb.

Scenario #2: Lean Hogs Spot Price Rose by 10% to USD 0.6617/lb on Delivery Date

With the increase in lean hogs price to USD 0.6617/lb, the lean hogs producer will be able to sell the 4.00 million pounds of lean hogs for a higher net sales proceeds of USD 2,646,600.

However, as the short futures position was entered at a lower price of USD 0.6000/lb, it will have lost USD 0.6617 – USD 0.6000 = USD 0.0617 per pound. With 100 contracts covering a total of 4.00 million pounds of lean hogs, the total loss from the short futures position is USD 246,600.

In the end, the higher sales proceeds is offset by the loss in the lean hogs futures market, resulting in a net proceeds of USD 2,646,600 – USD 246,600 = USD 2,400,000. Again, this is the same amount that would be received by selling 4.00 million pounds of lean hogs at USD 0.6000/lb.

Risk/Reward Tradeoff

As can be seen from the above examples, the downside of the short hedge is that the lean hogs seller would have been better off without the hedge if the price of the commodity went up.

An alternative way of hedging against falling lean hogs prices while still be able to benefit from a rise in lean hogs price is to buy lean hogs put options.

Learn More About Lean Hogs Futures & Options Trading

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Continue Reading.

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Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

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Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

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What is the Put Call Ratio and How to Use It

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Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

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The Ultimate Guide to Lean Hogs Investing

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Last Updated on August 16, 2020

Lean hogs are the most commonly traded commodity product for gaining investment exposure to whole hog prices.

The importance of lean hogs is directly linked to the massive global pork industry. More people in the world consume pork than any other animal protein. Worldwide consumption of pork products exceeds 100 million metric tons annually and spans across diverse geographies, economies and cultures.

Companies and individuals involved in the production, distribution and sale of pork products use lean hog futures and options as tools for hedging risk. As a result, these financial products occupy a critical role in global food commodity markets.

How Do Farmers Produce Hogs?

Hog production involves three stages:

  1. Producing and raising young animals
  2. Feeding the pigs to slaughter weight
  3. Slaughtering and fabricating products from the animal

Successful production relies on proper animal husbandry techniques and good economic decision-making.

The hog industry has evolved dramatically in recent years as large private and corporate operations have replaced small family farms.

Farms with larger head counts (number of pigs) have at least two economic advantages:

  1. Lower production costs: Economies of scale allow farmers to feed pigs more efficiently and better utilize their labor.
  2. Negotiating leverage: Larger farms can enter into better contracts with packing operations – the companies that slaughter, process, pack and distribute hogs – since they can offer packers a more consistent supply of hogs.

Hog production takes place in five stages:

  1. Reproduction
  2. Gestation and birth
  3. Feeding
  4. Finishing
  5. Packing

Reproduction

Gilts (young females that have not yet given birth) and sows (mature female breeders) breed twice annually to ensure a steady flow of pigs for the operation.

Operators seek out gilts that show excellent growth, leanness and breeding potential. Farmers purchase boars (sexually mature males) from breeding farms.

Hog breeding takes place in one of three ways:

  1. Pen mating: One or more boars are placed with a group of sows.
  2. Hand mating: One boar is placed with one sow or gilt.
  3. Artificial insemination: A more labor intensive method that allows farmers to control genetics.

Gestation and birth

Female pigs have gestation periods of 4 months and give birth to average litters of 9 -10 pigs. This number has steadily increased in recent years due to improvements in health, genetics and production methods. Traders pay close attention to these yield figures as they determine the future supply of hogs coming to market.

Traders Pay Close Attention to Yields – Image via Pixabay

Weaning

Females wean baby pigs for three to four weeks. After this time, sows are either re-bred or sent to market. During the weaning stage, about 5% of pigs die from suffocation, disease, weather and other factors. Changes to this attrition number can affect supply and hog prices.

Feeding

Grains including corn, barley, milo, oats, distiller’s grains and wheat comprise the main diet of young pigs. Farmers often supplement the diet with oilseed meals and vitamins.

Grains Are a Popular Source of Food for Hogs – Image via Pixabay

Finishing

It takes about six months to raise a pig from birth to slaughter. A barrow (castrated male) or gilt typically gains on average about 1 pound a day during the finishing stages and will weigh about 270 pounds when they are ready for market. Producers usually sell pigs directly to packers.

Packing

Packers slaughter the pigs and butcher the carcasses into cuts that they sell to retailers. A typical 270 pound pig will yield a 200 pound carcass with an average of 25% ham, 25% loin, 16% belly, 11% picnic, 5% spareribs and 10% butt. Jowl, lean trim, lard and miscellaneous cuts and trimmings comprise the rest of the production.

Hog operations fall into four categories:

Type of Hog Operation Description
Farrow-to-Finish Handle all phases of production from birth to sale of a market-ready hog
Farrow-to-Wean Handle raising pig from birth to weight of about 10 -15 pounds and then sell to a feeder operation
Farrow-to-Feeder Raise hogs from birth to feeder stage (weight of 40 – 60 pounds) and then sell to a finishing operation
Finish Only Handle preparation of pigs prior to slaughter

Top 10 Pork Producers

Rank Flag Country Pork Produced per Year (1,000 Metric Tons)
#1 China 54,750
#2 European Union 23,350
#3 United States of America 12,188
#4 Brazil 3,755
#5 Russia 3,000
#6 Vietnam 2,775
#7 Canada 2,000
#8 Philippines 1,635
#9 Mexico 1,480
#10 South Korea 1,332

Top 3 Uses of Lean Hogs

Use of Lean Hog Description
Pork

Ham, pork loins and pork chops and are among the many food products produced from lean hogs. Pharmaceutical Co-Products

Pharmaceuticals rank second to meat in products obtained from lean hogs. The following are a small handful of the pharmaceutical products we obtain from hogs:

  • Cortisone
  • Blood Albumens
  • Heart valve replacements
  • Heparin
  • Estrogens
  • Insulin
  • Melatonin
  • Antidiuretic Hormone (ADH)
  • Oxytocin
  • Pespin
  • Thyroxin Industrial Co-Products

    Lean hogs make contributions to the production of many industrial products including the following:

  • Leather treatment agents
  • Plywood adhesives
  • Glue
  • Gloves and shoes
  • Buttons
  • Bone china
  • Bone meal
  • Brushes
  • Insulation
  • Upholstery
  • Insecticides
  • Cosmetics
  • Crayons
  • Floor waxes
  • Antifreeze
  • Plastics

    What Drives the Price of Lean Hogs?

    Some of the specific factors that move lean hog prices include:

    Feed Prices

    The cost of grains and feeds represents more than two-thirds of the production costs of producing pigs.

    Historically the price of livestock feed, especially corn, is inversely related to the price of lean hogs. As the price of corn rises, farmers take their hogs to market at lower weights to save on the higher costs. This creates an excess supply of hogs in the marketplace.

    Corn is such an integral part of the process of raising pigs that many farmers dependent on lean hog prices will hedge their exposure to corn prices. Traders looking to invest in lean hogs should keep a careful eye on grain markets and the factors that influence grain prices.

    Weather

    Extremely warm weather in the late summer and early fall can make hogs inactive and lessen their desire to mate. This could result in a smaller number of births in the winter months. The reduced supply can translate into higher prices at market in the following summer months when the pigs are taken to market.

    Hot Weather Can Make Pigs Inactive, Reducing Yield – Image via Pixabay

    On the other hand, cold winter weather can increase the number of births that take place in the spring months. Lean hog traders should pay close attention to weather patterns in key hog production regions.

    China

    China is a behemoth when it comes to pork production and consumption. The country produces and consumes about half of the world’s supply of pork products. In addition, China accounts for about 20% of the global supply of pork imports.

    As China continues its transformation into a world superpower, it will require more food to feed it growing population. The country will likely increase its volume of pork consumption as its population gets wealthier. Other emerging economies such as Mexico and South Korea may also have greater demand for pork as their economies get stronger.

    Substitution

    Pork competes with other animal protein products such as chicken, beef, lamb and fish.

    Many factors can impact which of these products consumers choose, but price often plays the biggest role. If pork prices rise, consumers may substitute other animal proteins in their diets.

    Other factors that could lead to substitution are the health benefits of the various choices. Hog farmers in the United States have made efforts to reduce the antibiotics used to produce pigs. In addition, the industry has changed the diet fed to pigs in an effort to produce leaner and healthier meat. How the public perceives these benefits can determine demand and price for lean hogs.

    3 Reasons You Might Invest in Lean Hogs

    Buying lean hogs can be a great addition to an investment portfolio for the following reasons:

    1. Bet on Demand from China
    2. Inflation Hedge
    3. Portfolio Diversification

    Bet on Demand from China

    Growth in Chinese demand for pork might be the best reason to invest in lean hogs.

    The global supply of pork has tightened in recent years as Chinese imports have risen sharply. If these patterns continue, there could be supply shortages and higher lean hog prices.

    Pork is a Key Ingredient in Chinese Cooking, Pushing Up Demand – Image via Pixabay

    Of course, the biggest determinant of demand in China will be the economy. However, pork has long been the favored animal protein in the country, and demand elasticity might be less than for other types of meat.

    Inflation Hedge

    Investing in lean hogs is a way to hedge against the loss of purchasing power from inflation. Livestock is almost certain to become more expensive if the world economy starts to overheat.

    Low interest rates from the Federal Reserve and other central banks have produced speculative bubbles in assets ranging from equities to high-yield debt to cryptocurrencies.

    Yet food remains the most basic and fundamental necessity. Food commodity prices could see the largest increases if the economy experiences higher inflation. Lean hog prices could benefit from these conditions.

    Portfolio diversification

    Investing in lean hogs might be a way to diversify a portion of a portfolio out of stocks and bonds and into commodities.

    Should I Invest in Lean Hogs?

    Lean hog prices are extremely volatile. Unlike crude oil or gold, the primary traders of the commodity are not speculators, but industry players hedging their risk exposures.

    Changes in weather, corn prices and demand from China, among other things, often create huge price swings. For this reason, traders may want to avoid taking large speculative positions in the commodity.

    However, traders might want to consider buying a diversified basket of commodities that includes lean hogs.

    Investing in a basket of commodities that includes lean hogs, other livestock and poultry, other agricultural commodities, metals and energy can provide a portfolio with protection against inflation. It could also insulate against large movements in individual commodities.

    Traders should also consider specifically investing in lean hogs because of the enormous importance of the Chinese market. Investing in lean hogs provides a way to participate in future economic growth in this huge economy.

    However, traders should also consider these three risks of investing in lean hogs:

    1. An economic slowdown in China could seriously limit demand for pork.
    2. Better hog breeding techniques and animal husbandry practices could create oversupplies of lean hogs.
    3. Health and environmental concerns could lead to decreases in pork consumption. In particular, hog producers have come under attack from environmental groups for waste and animal cruelty. Changes in perceptions about the industry could dampen demand.

    What Do the Experts Think About Lean Hogs?

    Pork industry experts are generally very optimistic about the prospects for lean hog prices in the future. Experts cite demand, especially from international sources, as the main catalyst for higher prices.

    We’re currently seeing so far this year in 2020, 15 percent more exports of pork, and it’s all going to foreign consumers. Strong demand is how we would explain the situation of more supply but even higher prices.

    – Chris Hurt, agricultural economist at Purdue University

    Chris Hurt Discusses the Hog Market – Image via YouTube

    Another expert shares this optimism and believes higher beef prices in the United States might fuel more pork demand.

    We’re pushing 4 percent more pork this year and 4 percent more pork next year. We’re going to be pushing those per capita offerings over 52 pounds per person [domestically], which is about as high as we’ve ever seen

    – Steve Meyer, vice president for EMI Analytics-Pork

    How Can I Invest in Lean Hogs?

    Investors have several ways to get investment exposure to lean hogs:

    Lean Hog Trading Methods Compared

    Leverage? Regulated Exchange? Lean Hog Futures 5 N N Y N Y Y Lean Hog Options 5 N N Y N Y Y Lean Hog ETFs (ETNs) 2 N N N Y N Y Lean Hog CFDs 3 N N N N Y Y

    Lean Hogs Futures

    The Chicago Mercantile Exchange (CME) offers a futures contract that settles into 40,000 pounds (18 metric tons) of lean hogs.

    The contract trades globally on the CME Globex electronic trading platform and has a variety of expiration months and cycles.

    Futures are a derivative instrument through which traders make leveraged bets on commodity prices. If prices decline, traders must deposit additional margin in order to maintain their positions. At expiration, lean hog contracts are financially settled.

    Investing in futures requires a high level of sophistication since factors such as storage costs and interest rates affect pricing.

    Lean Hogs Options on Futures

    Options are also a derivative instrument that employs leverage to invest in commodities. As with futures, options have an expiration date. However, options also have a strike price, which is the price above which the option finishes in the money.

    Options buyers pay a price known as a premium for each contract. An options bet succeeds only if the price of lean hogs futures rises above the strike price by an amount greater than the premium paid for the contract. Therefore, options traders must be right about the size and timing of the move in lean hog futures to profit from their trades.

    Lean Hogs ETFs

    These financial instruments trade as shares on exchanges in the same way that stocks do.

    There is one ETF that trades in London and invests in lean hogs:

    There are three US ETFs that invest generally in livestock:

    Lean Hogs Futures and Commodities

    paul mansfield photography / Getty Images

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    Lean hog futures are critical hedging instruments for the pork industry and because of the volatility of hog prices. Trading in these futures often attract plenty of speculative positions. The lean hog is another term for pork that is traded on the options and futures exchanges of the Chicago Mercantile Exchange (CME).

    Contract Specs

    Some important characteristics of the lean hog futures contract are as follows:

    • Ticker Symbol: LH
    • Exchange: CME
    • Trading Hours: 10:05 a.m. to 2:00 PM EST
    • Contract Size: 40,000 pounds
    • Contract Months: Feb, Apr, May, Jun, Jul, Aug, Oct, and Dec.
    • Price Quote: price per pound
    • Tick Size: $0.00025 or 2.5 cents per pound = $10.00 (0.00025 x 40,000 lbs).
    • Last Trading Day: The tenth business day of the contract month

    Fundamentals

    Most hog production occurs in the Midwest. The largest hog producing states are Iowa, North Carolina, Minnesota, and Illinois. The U.S. is the world’s largest pork exporter. Typically, it takes six months to raise a pig from birth to slaughter. Hogs are generally ready for market or slaughter when they reach a weight near 250 pounds.

    A market hog with a live weight of 250 pounds will typically yield 88.6 pounds of lean meat (Pork Facts 2001). This lean meat consists of an average of 21% ham, 20.3% loin, 13.9% belly, 3% spareribs, 7.3% Boston butt roast and blade steaks, and 10.3% picnic. The rest goes into jowl, lean trim, fat, and miscellaneous cuts and trimmings (USDA-AMS).

    Pork bellies, which used to trade on the CME, are mainly used for bacon and can be frozen and stored for up to a year before processing. The contract was discontinued due to a lack of liquidity.

    Seasonality tends to lead hog prices higher between May and July the heart of grilling season in the United States.

    Corn and Hogs

    The price of corn has a strong correlation with lean hog futures because hogs eat corn. If the price of corn rises substantially, farmers tend to take their hogs to market at lower weights (younger) to avoid high feed costs. At these times, lean hog futures prices tend to drop due to increased supplies.

    One can estimate the future amount of hog production by monitoring the Hogs and Pigs Report. When the number of newborn pigs is lower than in previous quarters, it is likely that hog production will be lower in six months later when they are ready for market.

    Reports

    The Hogs and Pigs Report comes out quarterly. The hogs report presents data on the U.S. pig crop including inventory numbers and weights. The data highlights the current supplies and projected supplies for the future. The CME Lean Hog Index is a two-day weighted average of cash prices.

    Developments Over Recent Years

    Pork is a staple animal protein around the world. Over recent years, the hog futures market has experienced a great deal of price volatility.

    In 2020, lean hog futures rose to all-time highs at over $1.33 per pound when porcine epidemic diarrhea or PED caused the death of over seven million suckling pigs, creating a pork shortage and caused the price of the animal protein to skyrocket. An effective immunization has prevented further outbreaks of PED. In 2020, the price of lean hog futures moved back to the 60 cents per pound level.

    In 2020, the Chinese bought the largest U.S. hog processing company Smithfield Foods. While there was some opposition, the sale of the company was eventually approved by Congress, and now China controls an integral part of the U.S. and international pork market.

    With over 1.3 billion people to feed, the purchase of Smithfield Foods is another example of China’s appetite for commodity resources around the globe. Pork is a vital animal protein and a staple in the diets of many people.

    The world population has increased exponentially, and competition for food will continue to strain the fundamentals of lean hogs and other foods when supply shortages appear. Demographics are likely to cause new highs in many food markets during periods of tight supplies.

    Hedging Against Rising Lean Hogs Prices using Lean Hogs Futures

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