Production and Marketing Contracts in Agriculture

Production contractsProduction contractsMarketing contractsMarketing contractsTrends in use by commodityTrends in use by commodityAdvantages and disadvantagesAdvantages and disadvantages

Contacts in Agriculture Production and marketing contracts

governed about 36% of the value of U.S. agricultural production in 2001, compared with 28% in 1991.

Prominent in broilers, hogs, sugar beets, processing tomatoes, and tobacco

Small share in corn, soybeans, and wheat.

Contracts in Agriculture Common in some parts of agCommon in some parts of ag

» Land and equipment purchase or leaseLand and equipment purchase or lease» Processing vegetablesProcessing vegetables» Broiler productionBroiler production

Increasing use in other areasIncreasing use in other areas» Hogs, specialty grain, tobaccoHogs, specialty grain, tobacco

More common with large farmersMore common with large farmers

Marketing Contracts Usually set a price (or pricing mechanism) and an

outlet for the commodity, before harvest/delivery. Often limit a farmer’s exposure to wide price

fluctuations and often specify product quantities and delivery schedules.

The farmer retains substantial control over major management decisions since the farmer maintains ownership of the commodity and provides all inputs used during production, with limited direction from the contractor.

Production Contracts Resource-providing contracts Define specific farmer and contractor

responsibilities regarding production inputs and practices.

» specify particular inputs and set production guidelines» allow for contractor technical advice and field visits,

leaving the farm operator with less control over input choices.

Contractor owns the commodity» Grower is paid a fee for inputs provided

CONTRACTS

Why Contracts are UsedContracts offer potential benefits to

both buyers and sellers of agricultural commodities. » Farmers can obtain a guaranteed market for

their production with a known price or pricing system.

» Buyers can obtain an assured and timely supply of product with desired attributes.

Why Contracts are Used» New technologies: Relationship-specific New technologies: Relationship-specific

investments provide incentives for investments provide incentives for “opportunistic” behavior.“opportunistic” behavior.

» Perishability: Timely delivery to Perishability: Timely delivery to processing plant very important (e.g., eggs, processing plant very important (e.g., eggs, poultry).poultry).

» Control of Inputs/Output: Facilitates Control of Inputs/Output: Facilitates “branding” to attract consumers.“branding” to attract consumers.

Contracts may Share Risks

May reduce or remove input and May reduce or remove input and output price risk and production output price risk and production risk for farmerrisk for farmer

May increase strategic risk if May increase strategic risk if contractor fails or production is contractor fails or production is out of compliance.out of compliance.

Contract Reduce Buyer Risk

Known supply and scheduleKnown supply and schedule» Identity preserved productsIdentity preserved products

Greater quality control and Greater quality control and uniformityuniformity

Cattle Production Contracts

Different from other commodities Different from other commodities because the “grower” provides the because the “grower” provides the management inputs and most management inputs and most decisions not the owner of the cattledecisions not the owner of the cattle» Commercial feedlotsCommercial feedlots» Custom grazingCustom grazing

Hog Production Contracts Farmer is paid to provide building and Farmer is paid to provide building and

laborlabor Hog owner provides inputs and Hog owner provides inputs and

managementmanagement Limited production risk, no price riskLimited production risk, no price risk Accounted for 40% of hogs produced in Accounted for 40% of hogs produced in

mid 2005mid 2005

Forward Contracts

Contract for deliveryContract for delivery» Defines time, place, formDefines time, place, form

Tied to the futures marketTied to the futures market» Buyer offering the contract must lay off Buyer offering the contract must lay off

the market risk elsewherethe market risk elsewhere» The buyer does the hedging for youThe buyer does the hedging for you

Forward contract advantages

No margin account or margin callNo margin account or margin call Working with local peopleWorking with local people Flexible sizesFlexible sizes Known basisKnown basis TangibleTangible SimpleSimple

Forward contract disadvantage

InflexibleInflexible» Replace price risk with production riskReplace price risk with production risk» Difficult to offsetDifficult to offset» Must deliver commodityMust deliver commodity

Buyer “Buyer “takes protectiontakes protection””» The known basis may be widerThe known basis may be wider

Cattle Marketing Contracts Forward contract for deliveryForward contract for delivery

» Futures and basis fixedFutures and basis fixed» Single groupSingle group

Basis contract Basis contract » Only basis is fixedOnly basis is fixed» Single groupSingle group

Formula contract Formula contract » Price base on another related marketPrice base on another related market» Ongoing agreementOngoing agreement

Hog marketing contracts Relatively new - growth since 1993Relatively new - growth since 1993

» Open market was 87-89% in 1993Open market was 87-89% in 1993» Open market was about 11% in 2005Open market was about 11% in 2005

Product specification importantProduct specification important» Genetics, inputs, food safetyGenetics, inputs, food safety

Delivery schedulingDelivery scheduling Types of contractsTypes of contracts

» Formula priceFormula price» Share price riskShare price risk» Forward contract for deliveryForward contract for delivery

Percent of U.S. Hogs Sold Through Various Pricing Arrangements, January 1999-2007*1999 2000 2001 2002 2003 2004 2005 2006 2007

Hog or meat market formula 44.2 47.2 54 44.5 41.4 41.4 39.9 41.8 38.3

Other market formula 3.4 8.5 5.7 11.8 5.7 7.2 10.3 8.8 8.5

Other purchase arrangement 14.4 16.9 22.8 8.6 19.2 20.6 15.4 16.6 15.2

Packer-sold 2.1 2.2 2.1 2.4 2.6 6.7

Packer-owned 16.4 18.1 17.1 21.4 20 22.7

Negotiated - spot 35.8 25.7 17.3 16.7 13.5 11.6 10.6 10.2 8.6

Risk Sharing ContractsWindow contractWindow contract

» Set upper and lower boundSet upper and lower bound» Share the “pain and gain” outsideShare the “pain and gain” outside

Cost based price floor “Ledger”Cost based price floor “Ledger”» Minimum price tied to feed priceMinimum price tied to feed price» Pay back “loan”Pay back “loan”» Give up part of higher pricesGive up part of higher prices

Weekly Hogs Prices, Cost of Production and Contract

$-

$10

$20

$30

$40

$50

$60

$701/

6/90

1/6/

91

1/6/

92

1/6/

93

1/6/

94

1/6/

95

1/6/

96

1/6/

97

1/6/

98

1/6/

99

Cash Cost + COP

Weekly Hogs Prices, Cost of Production and Contract

$-

$10

$20

$30

$40

$50

$60

$701/

6/90

1/6/

91

1/6/

92

1/6/

93

1/6/

94

1/6/

95

1/6/

96

1/6/

97

1/6/

98

1/6/

99

Cash COP Margin Band Window

Contract Examples Iowa Attorney GeneralIowa Attorney General

» http://www.state.ia.us/government/ag/ag_contracts/http://www.state.ia.us/government/ag/ag_contracts/

Current research on webCurrent research on web» Hogs:Hogs: http://www.econ.iastate.edu/faculty/lawrence/HOGS.htm http://www.econ.iastate.edu/faculty/lawrence/HOGS.htm» Production and Marketing Characteristics of U.S. Pork Producers, Production and Marketing Characteristics of U.S. Pork Producers,

2000,2000,» Understanding Hog Marketing Contracts - September 18, 1999Understanding Hog Marketing Contracts - September 18, 1999

Producer’s Motivation for Entering Marketing Contract with

Packer

Access to capital and better Access to capital and better financingfinancing

Reduced price riskReduced price riskAssure a buyerAssure a buyerReduced marketing costsReduced marketing costs Improved prices or premiumsImproved prices or premiums

Reasons for production integration

Greater controlGreater control» Product quality / specificationsProduct quality / specifications» SchedulingScheduling» IndustrializationIndustrialization

Risk managementRisk managementAccess to resourcesAccess to resources

Overview of the 2007 USDA GIPSA / RTI Livestock and Meat Marketing

Study

Extensive Project Interviews, Surveys of producers and

packers, Analysis of procurement and sales transactions data, Analysis of P&L data, and Modeling and simulation of system economic welfare.

Beef, Pork, Lamb, and Downstream..

General Study Conclusions AMA use for 10/02-3/05AMA use for 10/02-3/05

» 38% for cattle, 89% for hogs, and 44% 38% for cattle, 89% for hogs, and 44% for lambs.for lambs.

» Packer-owned <5% for cattle & lamb Packer-owned <5% for cattle & lamb but 20-30% for hogs.but 20-30% for hogs.

Little or no increase in AMA use is Little or no increase in AMA use is expected for cattle and hogsexpected for cattle and hogs» Cash market is important outlet for Cash market is important outlet for

small producers and packers and small producers and packers and reported cash prices are used by AMAs.reported cash prices are used by AMAs.

General Study Conclusions AMA use is associated with lower cash AMA use is associated with lower cash

market pricesmarket prices» larger association for hogs than cattle.larger association for hogs than cattle.

Packers and producers benefit from Packers and producers benefit from AMA useAMA use» lower costs, risk control, and quality lower costs, risk control, and quality

management.management. Restrictions on AMA use will have a Restrictions on AMA use will have a

negative economic impact on producers, negative economic impact on producers, packers, and consumers.packers, and consumers.

Beef producers and packers interviewed

believed that some types of AMAs Helped them manage their operations more

efficiently, reduced risk, and improved beef quality.» Feedlots identified cost savings of $1 to $17 per headFeedlots identified cost savings of $1 to $17 per head» Packers identified cost savings of $0.40 per head in Packers identified cost savings of $0.40 per head in

reduced procurement cost.reduced procurement cost.» Both agreed that if packers could not own cattle, higher Both agreed that if packers could not own cattle, higher

returns would be needed to attract other investors and returns would be needed to attract other investors and that beef quality would suffer in an all-commodity that beef quality would suffer in an all-commodity market place.market place.

Reasons for AMAs

Producers surveyedProducers surveyed» The ability to buy/sell higher quality cattle,The ability to buy/sell higher quality cattle,» Improve supply management,Improve supply management,» Obtain better pricesObtain better prices

Packers surveyedPackers surveyed» Improve week-to-week supply management,Improve week-to-week supply management,» Secure higher quality cattle,Secure higher quality cattle,» Allow for product branding in retail storesAllow for product branding in retail stores

Reasons for Cash Only Producers surveyed Producers surveyed

» Independence and flexibility, Independence and flexibility, » Quick response to changing market conditions,Quick response to changing market conditions,» Ability to buy at lower prices and sell at higher prices Ability to buy at lower prices and sell at higher prices

Packers surveyedPackers surveyed» Independence and flexibility, Independence and flexibility, » Quick response to changing market conditions, Quick response to changing market conditions, » Securing higher quality cattleSecuring higher quality cattle

Analysis of procurement

transactions data From the 29 largest plants and included 58 million From the 29 largest plants and included 58 million

animals and 590,000 transactions.animals and 590,000 transactions.» 61.7% cash61.7% cash» 28.8% marketing agreement28.8% marketing agreement» 4.5% forward contracts4.5% forward contracts» 5.0% packer-owned, other, or missing5.0% packer-owned, other, or missing

Regional differences in AMA use.Regional differences in AMA use. Individual negotiation most common method to Individual negotiation most common method to

discover purchase price for fed cattlediscover purchase price for fed cattle

What did the analysis of procurement transactions data

show? Cash, marketing agreement, and packer-owned prices Cash, marketing agreement, and packer-owned prices

similar.similar. Auction higher and forward contract lower than cash pricesAuction higher and forward contract lower than cash prices When AMA use increases cash prices decrease:When AMA use increases cash prices decrease:

» 10% increase in AMA use (as % of plant capacity) is associated 10% increase in AMA use (as % of plant capacity) is associated with a $0.40/cwt of carcass weight.with a $0.40/cwt of carcass weight.

» 10% increase in AMA use is associated with a 0.11% decrease in 10% increase in AMA use is associated with a 0.11% decrease in cash price.cash price.

Impacts are economically small but statistically significant.Impacts are economically small but statistically significant.

What did the packer P&L data show?

Substantial economies of size (declining average total costs of slaughter and processing per head)» Large plants have lower ATCs than small when both are

operating close to capacity.» For all plants ATCs decline over the whole range of volumes.» The representative plant operating at 95% of max observed

capacity is 6% more efficient than when operating in the middle of the observed range of volumes and 14% more efficient than when operating at the low end of observed volumes.

What did the packer P&L data show?

Plant costs are lower for those that procure through AMAs.

Costs are directly lower -- all else constant. Costs are lower because of increased volumes. Costs are lower because of less variable volumes. Cost savings are approx $6.50 per animal.

AMAs impact price, but producers and consumers lose if AMAs are

restricted Cost savings and quality improvements outweigh the Cost savings and quality improvements outweigh the

effect of potential oligopsony market power that AMAs effect of potential oligopsony market power that AMAs may provide packers. may provide packers. » Even if the complete elimination of AMAs would eliminate Even if the complete elimination of AMAs would eliminate

market power that might currently exist, the net effect would market power that might currently exist, the net effect would be reductions in prices, quantities, and producer and be reductions in prices, quantities, and producer and consumer surplus in almost all sectors of the industry because consumer surplus in almost all sectors of the industry because of additional processing costs and reductions in beef quality.of additional processing costs and reductions in beef quality.

» Collectively, this suggests that reducing the use of AMAs Collectively, this suggests that reducing the use of AMAs would result in economic losses for beef consumers and the would result in economic losses for beef consumers and the beef industry.beef industry.

Effect of both contract and packer-owned hog supplies on spot market

prices These effects are negative and indicate that an increase in These effects are negative and indicate that an increase in

either contract or packer-owned hog sales decreases the either contract or packer-owned hog sales decreases the spot price for hogs. spot price for hogs.

Specially, the estimated elasticities of industry derived Specially, the estimated elasticities of industry derived demand indicate demand indicate » a 1% increase in contract hog quantities causes the spot market a 1% increase in contract hog quantities causes the spot market

price to decrease by 0.88%, and price to decrease by 0.88%, and » a 1% increase in packer-owned hog quantities causes the spot a 1% increase in packer-owned hog quantities causes the spot

market price to decrease by 0.28% market price to decrease by 0.28% » a 1% increase in cash hogs causes a 0.27% decrease in cash price a 1% increase in cash hogs causes a 0.27% decrease in cash price

Measured a statistically significant presence of market power in live hog

procurement, but the results are inconclusive.

Two approaches were used with somewhat Two approaches were used with somewhat different results. Both found market power. different results. Both found market power. » One found that the benefits of AMA out One found that the benefits of AMA out

weighed the market power harm. weighed the market power harm. » The second couldn’t conclude that AMAs The second couldn’t conclude that AMAs

were the source of the market power.were the source of the market power.

Estimated total and average cost functions indicate that economies of scale diminish as the pork packing

firm size increases Estimated that scale economies are exhausted well Estimated that scale economies are exhausted well

within the sample output range such that the within the sample output range such that the biggest plants already exhibit negative returns to biggest plants already exhibit negative returns to scale. scale.

Certain combinations of AMAs may reduce costs Certain combinations of AMAs may reduce costs and/or increase economies of scale. and/or increase economies of scale.

Relative to using spot market procurements alone, Relative to using spot market procurements alone, all other combinations of marketing arrangements all other combinations of marketing arrangements improve the efficient scale of production.improve the efficient scale of production.

AMAs impact price, but producers and consumers lose if AMAs are

restricted.

Three different simulations:Three different simulations:» 25% reduction in contract & packer-owned hogs25% reduction in contract & packer-owned hogs» increase the spot/cash market share to 25%increase the spot/cash market share to 25%» complete ban of packer-owned hogs. complete ban of packer-owned hogs.

Producers lose because of the offsetting effects of hogs Producers lose because of the offsetting effects of hogs diverted from AMAs to the spot marketdiverted from AMAs to the spot market

Consumers lose as wholesale and retail pork prices riseConsumers lose as wholesale and retail pork prices rise Packers would gain in the short run but neither gain Packers would gain in the short run but neither gain

nor lose in the long run.nor lose in the long run.

Cost Efficiencies are Significant

Although a reduction in AMAs leads to an Although a reduction in AMAs leads to an improvement for hog producers through a reduction in improvement for hog producers through a reduction in the degree of market power, the loss in cost efficiencies the degree of market power, the loss in cost efficiencies offsets the gains from reduced market power. offsets the gains from reduced market power.

In all instances, the price spread between farm and In all instances, the price spread between farm and wholesale prices would be expected to increase because wholesale prices would be expected to increase because of the net increase in the costs of processing. Moreover, of the net increase in the costs of processing. Moreover, wholesale, and hence retail, prices would increase, wholesale, and hence retail, prices would increase, causing pork to become more expensive for consumers.causing pork to become more expensive for consumers.