Transcript Production and Marketing Contracts in Agriculture Production contracts Marketing contracts

Production and Marketing
Contracts in Agriculture
 Production
contracts
 Marketing contracts
 Trends in use by commodity
 Advantages 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 ag
» Land and equipment purchase or lease
» Processing vegetables
» Broiler production
 Increasing
use in other areas
» Hogs, specialty grain, tobacco
 More
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 Used
 Contracts
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
investments provide incentives for
“opportunistic” behavior.
» Perishability: Timely delivery to
processing plant very important (e.g., eggs,
poultry).
» Control of Inputs/Output: Facilitates
“branding” to attract consumers.
Contracts may Share Risks
 May
reduce or remove input and
output price risk and production
risk for farmer
 May increase strategic risk if
contractor fails or production is
out of compliance.
Contract Reduce Buyer Risk
 Known
supply and schedule
» Identity preserved products
 Greater
quality control and
uniformity
Cattle Production Contracts
 Different
from other commodities
because the “grower” provides the
management inputs and most
decisions not the owner of the cattle
» Commercial feedlots
» Custom grazing
Hog Production Contracts
 Farmer
is paid to provide building and
labor
 Hog owner provides inputs and
management
 Limited production risk, no price risk
 Accounted for 40% of hogs produced in
mid 2005
Forward Contracts
 Contract
for delivery
» Defines time, place, form
 Tied
to the futures market
» Buyer offering the contract must lay off
the market risk elsewhere
» The buyer does the hedging for you
Forward contract advantages
 No
margin account or margin call
 Working with local people
 Flexible sizes
 Known basis
 Tangible
 Simple
Forward contract
disadvantage
 Inflexible
» Replace price risk with production risk
» Difficult to offset
» Must deliver commodity
 Buyer
“takes protection”
» The known basis may be wider
Cattle Marketing Contracts
 Forward contract for
» Futures and basis fixed
» Single group
delivery
 Basis contract
» Only basis is fixed
» Single group
 Formula contract
» Price base on another related market
» Ongoing agreement
Hog marketing contracts
 Relatively new - growth since 1993
» Open market was 87-89% in 1993
» Open market was about 11% in 2005
 Product specification important
» Genetics, inputs, food safety
 Delivery
scheduling
 Types of contracts
» Formula price
» Share price risk
» Forward 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
Other market
formula
Other purchase
arrangement
44.2
47.2
54
44.5
41.4
41.4
39.9
41.8
38.3
3.4
8.5
5.7
11.8
5.7
7.2
10.3
8.8
8.5
14.4
16.9
22.8
8.6
19.2
20.6
15.4
16.6
15.2
2.1
2.2
2.1
2.4
2.6
6.7
16.4
18.1
17.1
21.4
20
22.7
16.7
13.5
11.6
10.6
10.2
8.6
Packer-sold
Packer-owned
Negotiated - spot
35.8
25.7
17.3
Risk Sharing Contracts
 Window
contract
» Set upper and lower bound
» Share the “pain and gain” outside
 Cost
based price floor “Ledger”
» Minimum price tied to feed price
» Pay back “loan”
» Give up part of higher prices
Weekly Hogs Prices, Cost of Production and Contract
$70
$60
$50
$40
$30
$20
$10
$-
Cash
Cost +
COP
Weekly Hogs Prices, Cost of Production and Contract
$70
$60
$50
$40
$30
$20
$10
Cash
$-
COP
Margin Band
Window
Contract Examples
 Iowa Attorney
General
» http://www.state.ia.us/government/ag/ag_contracts/
 Current
research on web
» Hogs: http://www.econ.iastate.edu/faculty/lawrence/HOGS.htm
» Production and Marketing Characteristics of U.S. Pork Producers, 2000,
» Understanding Hog Marketing Contracts - September 18, 1999
Producer’s Motivation for Entering
Marketing Contract with Packer
 Access
to capital and better
financing
 Reduced price risk
 Assure a buyer
 Reduced marketing costs
 Improved prices or premiums
Reasons for production integration
 Greater
control
» Product quality / specifications
» Scheduling
» Industrialization
 Risk
management
 Access 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 10/02-3/05
» 38% for cattle, 89% for hogs, and 44%
for lambs.
» Packer-owned <5% for cattle & lamb
but 20-30% for hogs.
 Little or no increase in AMA use is
expected for cattle and hogs
» Cash market is important outlet for
small producers and packers and
reported cash prices are used by AMAs.
General Study Conclusions
 AMA use
is associated with lower cash
market prices
» larger association for hogs than cattle.
 Packers
and producers benefit from
AMA use
» lower costs, risk control, and quality
management.
 Restrictions on AMA use will have a
negative economic impact on producers,
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 head
» Packers identified cost savings of $0.40 per head in
reduced procurement cost.
» Both agreed that if packers could not own cattle, higher
returns would be needed to attract other investors and
that beef quality would suffer in an all-commodity
market place.
Reasons for AMAs

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Producers surveyed
» The ability to buy/sell higher quality cattle,
» Improve supply management,
» Obtain better prices
Packers surveyed
» Improve week-to-week supply management,
» Secure higher quality cattle,
» Allow for product branding in retail stores
Reasons for Cash Only
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
Producers surveyed
» Independence and flexibility,
» Quick response to changing market conditions,
» Ability to buy at lower prices and sell at higher
prices
Packers surveyed
» Independence and flexibility,
» Quick response to changing market conditions,
» Securing higher quality cattle
Analysis of procurement
transactions data
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From the 29 largest plants and included 58
million animals and 590,000 transactions.
» 61.7% cash
» 28.8% marketing agreement
» 4.5% forward contracts
» 5.0% packer-owned, other, or missing
Regional differences in AMA use.
Individual negotiation most common method to
discover purchase price for fed cattle
What did the analysis of procurement
transactions data show?
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Cash, marketing agreement, and packer-owned
prices similar.
Auction higher and forward contract lower than
cash prices
When AMA use increases cash prices decrease:
» 10% increase in AMA use (as % of plant capacity) is
associated with a $0.40/cwt of carcass weight.
» 10% increase in AMA use is associated with a 0.11%
decrease in cash price.

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?
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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 effect of potential oligopsony market power
that AMAs may provide packers.
» Even if the complete elimination of AMAs would
eliminate market power that might currently exist, the
net effect would be reductions in prices, quantities, and
producer and consumer surplus in almost all sectors of
the industry because of additional processing costs and
reductions in beef quality.
» Collectively, this suggests that reducing the use of AMAs
would result in economic losses for beef consumers and
the 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 either contract or packer-owned hog
sales decreases the spot price for hogs.
Specially, the estimated elasticities of industry
derived demand indicate
» a 1% increase in contract hog quantities causes the spot
market price to decrease by 0.88%, and
» a 1% increase in packer-owned hog quantities causes the
spot market price to decrease by 0.28%
» 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
different results. Both found market power.
» One found that the benefits of AMA out
weighed the market power harm.
» The second couldn’t conclude that AMAs
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
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
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Estimated that scale economies are exhausted well
within the sample output range such that the
biggest plants already exhibit negative returns to
scale.
Certain combinations of AMAs may reduce costs
and/or increase economies of scale.
Relative to using spot market procurements alone,
all other combinations of marketing arrangements
improve the efficient scale of production.
AMAs impact price, but producers and
consumers lose if AMAs are restricted.

Three different simulations:
» 25% reduction in contract & packer-owned hogs
» increase the spot/cash market share to 25%
» complete ban of packer-owned hogs.
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Producers lose because of the offsetting effects of
hogs diverted from AMAs to the spot market
Consumers lose as wholesale and retail pork prices
rise
Packers would gain in the short run but neither gain
nor lose in the long run.
Cost Efficiencies are Significant


Although a reduction in AMAs leads to an
improvement for hog producers through a reduction
in the degree of market power, the loss in cost
efficiencies offsets the gains from reduced market
power.
In all instances, the price spread between farm and
wholesale prices would be expected to increase
because of the net increase in the costs of processing.
Moreover, wholesale, and hence retail, prices would
increase, causing pork to become more expensive for
consumers.