Overview

Define contractual relationship Evolution and status of hog industry Describe marketing contracts Motivation and concerns Role for economists

Contractual Relationship

Focus today is not on internal transfer Only relationship is the marketing

contract Typically 3-10 years in length or evergreen Defines delivery schedules, carcass

specifications, pricing, and in some cases production practices

Small portion of contracts have risk sharing provisions

USDA MPR Definitions

Negotiated: Purchased in the cash market for delivery within 7 days.

Swine or pork market formula: A formula tied to the cash market for hogs or pork cutout., i.e., weekly average price, 3-day rolling average, percentage of the cutout.

Other market formula: A formula tied to something other than the hog market or pork cutout, i.e., feed prices.

Other purchase agreement: Currently this includes window contracts.

Percent of U.S. Hogs Sold Through Various Pricing Arrangements, January 1999-2009*

Year 99 00 01 02 03 04 05 06 07 08 09

Hog or meat market formula 44.2 47.2 54 44.5 41.4 41.4 39.9 41.8 38.3 37.1 41.2

Other market formula 3.4 8.5 5.7 11.8 5.7 7.2 10.3 8.8 8.5 11.0 7.9

Other purchase arrangement 14.4 16.9 22.8 8.6 19.2 20.6 15.4 16.6 15.2 13.4 11.6

Packer-sold 2.1 2.2 2.1 2.4 2.6 6.7 6.1 5.6

Packer-owned 16.4 18.1 17.1 21.4 20 22.7 23.1 25.7

Negotiated - spot 35.8 25.7 17.3 16.7 13.5 11.6 10.6 10.2 8.6 9.2 8.1

Source; Grimes and Plain, University of Missouri http://agebb.missouri.edu/mkt/vertstud09.htm

Contract SpecsContract Specs

Product specifications• PQA, Right to approve inputs

Method of pricing• Which markets and formula

Delivery scheduling• Short and long term

Exemptions

Types of ContractsTypes of Contracts

Formula• Most common contract• Price tied to another market, typically spot• No risk share• Examples:

» 3-Day rolling average of ISM weighted average +$1.50

» Last week’s average excluding the high and low» 92% of the previous day pork cutout value

Packer does not share risk

Types of ContractsTypes of Contracts Fixed window

• Formula tied to cash price • Predetermined upper and lower bounds• Share pain and gain outside window• Example: $50-60 and split 50/50 above and

below

Floating window• Formula tied to cash price• Boundaries move with feed prices• Do not share outside of window

Packer shares risk

Weekly Hogs Prices, Cost of Production and Window

$-

$10

$20

$30

$40

$50

$60

$70

J-90

J-91

J-92

J-93

J-94

J-95

J-96

J-97

J-98

J-99

J-00

J-01

Cash COP Floating Window Fixed Window

Types of ContractsTypes of Contracts

Cost-Plus • Price direct function of feed prices• Fixed amount for non-feed costs + known margin• Packer assumes all price risk

Ledger • Floor price is fixed or based on feed prices• Producer is “loaned” the difference between floor

and lower cash prices• Loan is repaid at higher cash prices• Packer provides line of credit but not risk share

Weekly Hogs Prices, Cost of Production and Contract

$-

$10

$20

$30

$40

$50

$60

$70J

-90

J-9

1

J-92

J-93

J-94

J-95

J-96

J-97

J-9

8

J-9

9

J-0

0

J-0

1

Cash Cost + COP Ledger

Accumulated Net Estimated ReturnsOne Hog Sold per Month

-200

-100

0

100

200

300

400

J-93

J-94

J-95

J-96

J-97

J-98

J-99

J-00

J-01

J-02

J-03

$564 drop in 28 months

Contract Examples

Iowa Attorney General• http://www.state.ia.us/government/ag/ag_contracts/

Consumer satisfactionMoisture enhanced pork Preference for attributesGrowing interest in safety and

production Spot market not sufficient

Premiums and discountsMarket access and risk

Motivations for Vertical Linkages

Traditional IO theoryAvoid market power, reduce price

volatility, technology complements, minimize transaction costs

Agency theory Integrate rather than contract to

avoid opportunism and shirking by contract partners

Motivations for Vertical Linkages

Asset specificity Firms with more significant relationship-

specific investments (RSI) benefit from predictable throughput and prices

As assets become more specialized, the costs of using the spot market increases

Costs are particularly high when food safety and product quality problems occur encouraging greater process control

Motivations for Vertical Linkages

Attitude Toward Marketing Contracts by Pork Producers with and without Marketing Contracts1 = strongly disagree, 6 = strongly agree

WithWithout

Coordinate slaughter to better meet Industry needs 3.7 2.9

Have caused lower cash market prices 4.2 4.2

Producers with contracts have received higher prices 3.9 3.5

Packers show preference in who was offered a contract 3.5 3.5

Contracts should be made illegal by Congress 2.7 3.1

Contracts should be more closely monitored by USDA 4.0 4.0

Prefer to market all my hogs on the cash market 3.0 4.1

Summary of Cattle Volume of RTI – GIPSA Study

Stephen Koontz, John Lawrence, Gary Brester, Mary Muth, and John Del

Roccili (formerly Beef Team Leader; deceased)

Marketing and Pricing Methods

When selling to packers 85% of small producers and 24% for large producers surveyed used only the cash market

Pricing methods by size of operation Large Small

• Individually negotiated pricing 74% 32%

• Public auction 35% 84%

• Formula pricing 57% 6% Four times as many large producers sold cattle on a carcass

weight basis with a grid compared with small producers.

Beef producers and packers interviewedbelieved 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/head

» improved capacity utilization, » standardized feeding programs» reduced financial commitments to stay full.

• 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.

Packer Purchases Using only the cash or spot market

• 10% large beef packers surveyed• 78% of small beef packers surveyed

While nearly all packers bought some cattle on a liveweight basis, 88% of large packers purchased cattle on carcass grids, while almost no small packers used this method.

Neither the producers nor packers surveyed expected the use of AMAs to change dramatically in the next 3 years

Reasons for AMAs

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

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

What did the analysis of procurement transactions data show? 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? 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. Weighted-average profits for the four largest

companies were -$2.40 per head for packers over the 10/02-3/05 time period.

The information and characteristics that consumers are demanding may require tighter vertical linkages. Can the spot market provide the non-

measurable process control for consumers?

If so, at what cost? Who will pay the added costs? Will greater control speed consolidation?

Role for Economists

The great success of formula pricing contracts is likely to lead to its demise.

Producers want an agreement, but fear thin markets.

How much volume is needed for satisfactory price discovery?

Where should it take place?Who should be involved?

Role for Economists

Concerns about contract linkages negatively affecting prices

Research is inconclusive on price impacts.

Thin market implications.Arguments have been greater in the

industry where there is less contracting.Politically charged debate.

Role for Economists

GIPSA Rule 2010

June 22, 2010 published a proposed rule, as required by the 2008 farm bill and through existing authority under the Packers and Stockyards Act of 1921

Released during a series of listening sessions across US involving Secretary of Agriculture and US Attorney General

GIPSA Rule 2010

Provide further definition to practices that are unfair, unjustly discriminatory or deceptive, including outlining actions that are retaliatory in nature, efforts that would limit a producer's legal rights, or representations that would be fraudulent or misleading.

Additionally, the proposed rule reiterates USDA's position that a producer need not overcome unnecessary obstacles and have to always prove a harm to competition when they have suffered a violation under the Act ;

GIPSA Rule 2010

Define undue or unreasonable preferences or advantages;

Improve market transparency by making sample contracts (except for trade secrets or other confidential information) be made available on GIPSA's website for producers;

Prohibit packers selling to packers Other provisions for contracts and arbitration http://archive.gipsa.usda.gov/psp/fb_news_release.

pdf Release 0326.10

GIPSA Rule, 2010

Industry sharply divided over rule Some view it as necessary and long

over due Some view it as necessary and will turn

back decades of economic evolution and restrict innovation in marketing

Summary

Marketing contracts are common in hog market• Most common is tied to dwindling cash market

for price discovery

Less common but widely used in fed cattle marketing

USDA GIPSA has proposed rules that will restrict and possibly prohibit use of contracts