AgDM newsletter article, September 1998

Long-term marketing contracts with packers: A journey through the downside

Neil Harl John LawrenceBy Neil E. Harl, Charles F. Curtiss Distinguished Professor in Agriculture and Professor of Economics, 515/294-6354, harl@iastate.edu and John Lawrence, Extension Livestock Economist, 515/294-6290, jdlaw@iastate.edu

No one likes risk, especially price risk.  Fluctuations in live hog prices and feed costs in recent years have led to innovative arrangements involving risk sharing.  Ideally, a producer would like to off-load the downside risk while retaining the upside.  Packers would prefer the opposite. 

Packer contacts

A recent study estimates that 57 percent of 1997 U.S. market hog production is sold under a long-term marketing agreement between the producer and packer.  This figure is expected to rise to nearly two-thirds of the 1998 market hog production.  While the majority of these agreements are simple formulas tied to the cash market price, a small portion involve risk sharing or cash flow assistance from the packer to the producer.  The exact provision in the contract differs across packers and even across contracts from the same packer depending on when the contract was signed as the nature and terms of these contracts have evolved over time. 

Cost-plus contracts – There has been particular interest in “cost-plus” contracts that establish a minimum floor price that the producer receives for hogs.  The floor is based on corn and soybean meal prices plus other cost of production and is designed to help the producer’s cash flow but the producer is not necessarily guaranteed a profit.  There are several variations on the theme, but in general these contracts loan producers the difference between the market price and floor price when prices are low and the producer pays back the loan when the open market price is high.   The contract may also require that the producer pay into an account that the packer holds when prices are high to build a reserve for the next downturn in the market.

These contracts lend producers the difference between the market price and floor price when prices are low and the producer pays back the loan when the open market price is high.

Some contracts call for negative balances to be paid to the packer within 30 days after termination of the contract.  That will be difficult for some producers and next to impossible for a few.

Figure 1.  Cash and Contract Prices for Hogs

Figure 1 Cash and Contract Prices for Hogs 

Figure 1 shows the price paid under one hypothetical contract similar to those offered producers last winter simulated over 52 weeks from July 1, 1997 to June 30, 1998.  The cash price is the weekly average price for Iowa-Southern Minnesota barrows and gilts reported by the USDA.  The contract requires that the producer pay in a portion of the revenue at higher prices; the producer is paid the floor price at low prices.  If the reserve account is used up, the producer is loaned the difference between the cash price and the floor price.  This producer is assumed to have sold 100 hogs a week or 5,200 per year.  Figure 2 shows the balance in the reserve account.  The producer receives lower prices than other producer during times of high prices and higher prices than others when cash prices are low.  Over the long run the producer receives the same average prices as everyone else, plus or minus interest, if any, on the reserve account.

Figure 2.  Estimated Reserve Account Selling 100 Hogs per Week

Figure 2. Estimated Reserve Account Sellling 100 Hogs/Week

Most of these contracts are 4 – 10 years in length.  The traditional hog cycle has given us highs and lows that are expected to cause fluctuation in the balance in the reserve account.  However, there is concern that an extended down turn in hog prices could result in large sustained negative balances in the reserve account.  Although the contracts typically stipulate that the contract must continue until the account balance is zero or for some predetermined period of time, there are questions about the negative balance.  Some of these questions include:

Some contracts place limits on the size of the negative balance.  One sets the maximum negative balance at $250,000.  Others don't impose such a limit.

At the end of the contract term, the program expires.  Positive balances are usually paid to the producer without interest.  Negative balances are to be paid by the producer in cash, usually without interest, and usually within 30 days.  Some contracts provide for continuation of the marketing contract beyond its stated term to work off negative balances.

The problem

Questions are being raised about the consequences of large—and growing—negative balances.  What's the position of the packer as a creditor?  What does this mean to the producer's lenders?  Is a negative balance a current liability?  Or should it be viewed as an intermediate term liability?  What if the negative balance exceeds the producer's net worth?

The packer’s position – Some of the contracts—but not all—specify that the producer is to execute and deliver to the packer upon request security agreements and financing statements under the Uniform Commercial Code.  The security agreement contains the details of the amount owed—and identifies the collateral to back it up.  The financing statement is filed publicly—usually at the state level—to put everyone on notice this may be a credit obligation against the collateral.

But few contracts say those documents are to be prepared—and filed.  If the packer files a financing statement and has obtained adequate documentation for the obligation, the packer would have a security interest in the property described as collateral.  But that security interest—which is similar in effect to a lien—would be subject to perfected security interests already in place held by the producer's regular lenders.  That could involve a perfected security interest or purchase money security interest in the pigs involved, for example.  That means when push comes to shove, and someone moves to grab the collateral, the packer would fall in behind the producer's other creditors with a prior perfected security interest.  Of course, if the producer had no creditors—or no creditors with perfected security interests—the packer could be in a first position.

If the packer did not file a financing statement under the UCC, or a security agreement as a financing statement, the packer is an unsecured creditor.  That would be the case whether or not the producer had other creditors.

The producer’s position – What if the ledger account shows a positive balance and the packer files for bankruptcy?  It would appear that the producer would be viewed as an unsecured creditor unless UCC filings had been made by the producer.  If the regular lender has a security interest in the feed (or in the crop used as feed) which is fed to pigs and the packer has a security interest in the pigs, the courts have generally favored the holder of the security interest in the animals.

Packers and Stockyards Act

Since 1921, purchases of livestock have been governed by the Packers and Stockyards Act passed that year.  It has been well established for many years that "unfair" and "deceptive" practices are a violation of P&SA.  Many cases have involved failure to make payment.  Early cases often stemmed from insufficient funds checks or refusal to honor drafts drawn for the purchase price of livestock.  Since 1976, prompt next day payment has been assured unless waived by the producer.

The long-term contracts discussed here seem to involve payment—even though in some cases payment may be a credit against prior negative balances.  The more difficult question is whether this type of arrangement, which guarantees a price, violates the Packers and Stockyards Act by restricting access to packers.  That would be a particular concern only if larger producers have contracts.  Also, the question has not been litigated as to whether these contracts could be construed, in some instances, as credit sales under the prompt next-day payment provision of P&SA or as a loan to the packer.

Is it a current liability?

From a lender's perspective—and the lender's regulator's perspective—is it a current liability or an intermediate term liability?  If it's a current liability, it could cause loan classification problems.

Because the liability arose out of the sale of current assets, it's likely to be treated as a current liability unless it's secured by other than current assets.  As a result a producer may have sufficient working capital due to the contract, but a poor current ratio.  This could be upsetting to bank examiners.

Limit on negative positions

Many of the contracts do not place a limit on negative balances and do not contain a procedure for early termination of the contract if balances balloon to levels exceeding the producer's net worth.  Clearly, the contracts were not drafted with the thought that negative balances would pose a serious financial problem for the parties.

Some contracts call for negative balances to be paid to the packer within 30 days after termination of the contract, as noted.  That will be difficult for some producers and next to impossible for a few.

In conclusion

The contracts were designed as a risk management tool and a way to even out cash flow.  In normal circumstances, the contracts work well as price fluctuates around the price floor with the price floor close to the long-term average price.  However, continued low prices cause negative ledger balances to increase.  In those instances, it's a time bomb with the potential for causing some financial—and legal—turmoil.

 

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