ECON 337: Agricultural Marketing

1. ECON 337: Agricultural Marketing Chad Hart Assistant Professor chart@iastate.edu 515-294-9911

2. What Causes Cycles Response to economic signals Time lag Psychology Biology Investment Livestock Tree crops Land development

3. Seasonal Price Patterns Patterns that repeat themselves with some degree of predictability within a year’s time frame. Driven by supply and demand factors that are impacted by time of year Weather Holidays Input prices

4. Seasonal Pricing Patterns Source: USDA, NASS, Monthly Price Data 1980-2011

5. How to Calculate Seasonal Index Pick time period (number of years) Pick season period (month, quarter) Calculate average price for season Calculate average price over time Divide season average by over time average price x 100

7. Using Seasonal Index to Forecast Observe price in time t1 P1 Forecast price in time t2 P2 Start with P1/ I1 = P2 / I2 Then P1 x I2 / I1 = P2 Assume that cattle are selling at $125/cwt in February. What is the forecast of July?

8. Cost of Production Raised livestock Farrow to finish, Cowherd to finish Accumulate cost from birth through finish Relatively stable cost over time Impacted by input prices and production Feed is typically 60-70% of cost Low productivity increases the cost of those that make it to finish because the fixed costs are divided by a smaller number.

9. Cost of Production Purchased feeder livestock Derived demand for feeder animal Highly variable price Depends upon Expected selling price for finished animal Feed costs

10. Cost of Production Budgets Starts with production function Incorporates input prices Project cost per unit sold Variable $/unit Total $/unit http://www.extension.iastate.edu/agdm/livestock/html/b1-21.html

13. Using Budgets in Planning Project a breakeven “point estimate” Sensitivity analysis for key variables Back calculate from revenue to what you can afford to pay for feeder animal Economic versus financial costs

14. Objective Based Pricing Strategy Cost/hd $/cwt 550# steer calf fed to 1200 slaughter weight

15. How Much to Pay for Feeder Animal Work back from total revenue Cost/hd $/cwt 550# steer calf fed to 1200 slaughter weight

16. http://www.iowabeefcenter.org/Software/Cattle_feeding_budgets.xlshttp://www.iowabeefcenter.org/Software/Cattle_feeding_budgets.xls

17. 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

18. 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.

20. Contract Specs Product specifications PQA, Right to approve inputs Method of pricing Which markets and formula Delivery scheduling Short and long term Exemptions

21. Types 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

22. Types of Contracts Fixed window Formula tied to cash price Predetermined upper and lower bounds Share pain and gain outside window Example: $50 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

24. Types 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

26. Contract Examples Iowa Attorney General http://www.state.ia.us/government/ag/working_for_farmers/contracts/index.html

27. Consumer satisfaction Moisture enhanced pork Preference for attributes Growing interest in safety and production Spot market not sufficient Premiums and discounts Market access and risk Motivations for Vertical Linkages

28. Traditional IO theory Avoid 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

29. 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

30. 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

31. 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)

32. Marketing and Pricing Methods When selling to packers 85% of small producers and 24% of 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.

33. 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.

34. Packer Purchases Using only the cash or spot market 10% of large beef packers surveyed 78% of small beef packers surveyed While nearly all packers bought some cattle on a live weight 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

35. 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

36. 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

37. 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.

38. 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.

39. 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.

40. 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

41. 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

42. 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

43. 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

44. Class web site: http://www.econ.iastate.edu/~chart/Classes/econ337/Spring2012/ Have a great weekend!