Contractual Relationships in the Hog Industry: Evolution, Marketing Contracts, and Concerns

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

2. 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

3. 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.

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

6. 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

7. Types 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

9. 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

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

13. Motivations for Vertical Linkages • 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

14. Motivations for Vertical Linkages • 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

15. 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

16. 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

17. 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)

18. 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.

19. 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.

20. 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

21. 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

22. 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

23. 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.

24. 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.

25. 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.

26. Role for Economists • 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?

27. 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?

28. 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.

29. 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

30. 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 ;

31. 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

32. 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

33. 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