AgDM newsletter article, May 1998

Evaluating packer contracts

John LawrenceBy John Lawrence, extension livestock economist, 515-294-6290, jdlaw@iastate.edu

The US pork food chain is rapidly becoming tightly coordinated as producers and processors look for alternatives to the daily bid and quibble system of marketing hogs.  These alternative agreements involve contracts to determine the number and type of hogs to be delivered, the delivery schedule, acceptable management practices, and the method of pricing.  The contracts are often 4-7 years in length, but may also be as little as six months in length with an “evergreen” clause. 

A 1995 study estimated that less than 40 percent of the 1995 US hog were marketed under some type of contract.  Estimates for 1998 are over 60 percent.

The appeal to the processor is obvious.  They are able to lock up a predetermined number of high quality hogs to fill a portion of their needs.  In addition to providing better scheduling and plant utilization, and better communications to improve safety and quality, they can block their competitor from the hogs.  The appeal to the producer is that these contracts assure market access and, depending on the type of contract, provide a price incentive, price risk sharing, or cash flow assistance.

Contract types

     Formula price: The hog price is based on a formula tied to a related market plus a bonus.  For example, the three day Iowa Southern-Minnesota average price plus $.75/cwt for early delivery.

     Risk sharing: Hogs are formula-priced, but an upper and lower boundary price are set in the contract.  The “pain or gain” above or below the price range is typically shared between the producer and packer.

     Cash flow assistance: Hogs are formula-priced but a price floor, often tied to feed prices, is set in the contract.  At low prices the producer is “loaned” the difference between the formula price and the floor.  At higher prices the loan is paid back and a positive balance in the ledger may accumulate.

How they compare

There are a multitude of contracts available.  They continue to evolve over time.  Also, not all contracts are available to all producers.  Each contract has its own advantages and disadvantages that must be considered.  In addition to evaluating the contract, you should also consider how your hogs will perform under the packer’s value grid, delivery conditions, and the strength and vision of the packer.  Yet, the most often ask question is, “Which marketing system will give me the best price?”

Assumptions

Eight packer contracts were compared to the cash market over the 10-year period 1987-1996.  Weekly price data for Iowa Southern Minnesota barrows and gilts, North Central Iowa corn prices, and Decature soybean meal prices were used to simulate the contracts and a typical producer’s cost of production.  Table 1 summarizes the production assumptions used.

Table 1. Average Prices and Estimated Cost of Production, 1987-1996

Central Iowa corn ($/bu)

$2.32

Decature soybean meal ($/T)

190.83

Estimated cost of production ($/cwt)

40.92

Non-feed cost ($/cwt)

18.00

Whole-herd feed efficieny

330

Non corn and SBM feed cost ($/cwt)

$30.00

Iowa S. MN barrows and gilts ($/cwt)

47.36

Contract specifications

Contracts 1 through 4 have a price floor tied to the corn and soybean meal price.  Prices below the floor must be paid back either at higher prices or by forgoing part of the higher prices when they occur.  Contract 7 has a fixed price floor irrespective of feed prices and prices below the floor must be paid back.  Contracts 5 and 6 have prices tied to feed prices.  The producer forgoes prices above or below the cost determined price range, but does not maintain a ledger account.  Contract 8 is a standard window contract in which the producer and packer split the pain or gain above or below the window.

Price received

Table 2 summarizes the average price of the alternative marketing systems and the distribution or prices over the 10 year period.  The averages, with a couple of exceptions, are all relatively close to the cash average.  However, the distribution of prices paints  a more complete picture of the impact of the contracts over time.  The cash market was below $40 14 percent of the time.  Two contracts (1 and 4) were never below $40.  Four contracts were below $40 10 percent or less of the time.  At the other extreme, the cash price was above $52 23 percent of the time.  Contracts 2, 3, and 4 were above $52 22 percent of the time or more.

Table 2. Estimated Price for Cash Market and Packer Contracts, Weekly Prices, 1987-1996

 

Cash

Cont #1

Cont #2

Cont #3

Cont #4

Cont #5

Cont #6

Cont #7

Cont #8

Average

$47.36

$46.59

$47.68

$47.81

$48.68

$43.64

$44.88

$47.52

$46.23

 

 

 

 

 

 

 

 

 

 

<40

14%

0%

10%

6%

0%

10%

10%

14%

14%

40-43

15%

17%

17%

16%

10%

41%

21%

16%

15%

43-46

14%

31%

15%

23%

22%

32%

30%

17%

14%

46-49

22%

32%

22%

22%

35%

9%

30%

19%

29%

49-52

13%

12%

13%

11%

10%

3%

1%

11%

16%

52-55

8%

4%

8%

9%

9%

3%

2%

8%

10%

55-58

6%

3%

6%

6%

7%

2%

3%

6%

3%

58-61

4%

1%

4%

4%

6%

0%

2%

4%

0%

>61

5%

0%

5%

3%

1%

0%

0%

5%

0%

The estimated returns per hundredweight are summarized in Table 3.  The cash market produced an average return of $6.45/cwt for our “typical” producer. All of the contracts generated positive returns over the life of the contract, but five showed negative returns at least part of the time.  However, only contract 8 had weeks with loses greater than -$5/cwt.  Most returns were in the $0 - $10 range.

Table 3. Estimated Returns for Cash Market and Packer Contract, Weekly Prices, 1987-1996

 

 

 

 

 

Contract

 

 

 

 

 

Cash

One

Two

Three

Four

Five

Six

Seven

Eight

Average

$6.45

$5.68

$6.76

$6.90

$7.77

$2.73

$3.97

$6.60

$5.32

-$5 or less

4%

0%

0%

0%

0%

0%

0%

0%

2%

-$5 - 0

14%

0%

16%

2%

0%

0%

18%

16%

19%

$0 - 5

26%

51%

28%

48%

36%

100%

26%

32%

34%

$5 - 10

29%

41%

29%

25%

38%

0%

55%

27%

28%

$10 - 15

14%

7%

14%

15%

16%

0%

0%

13%

9%

$15 - 20

7%

1%

7%

5%

6%

0%

0%

7%

4%

$20 - 25

4%

0%

4%

4%

3%

0%

0%

4%

4%

$25 & up

2%

0%

2%

1%

0%

0%

0%

2%

0%

Ledger account

Table 4 details the ledger account that the cash flow assistance contracts require.  It assumes that the producer is selling 100 hogs a week. If the contract price differs from the cash price, the ledger will have either a positive balance (packer owes producer) or a negative balance (producer owes packer).  These balances can be quite substantial.  You and your lender must understand how these balances work and how they are to be treated on the balance sheet.

Table 4. Estimated Contract Ledger Account Balances, Marketing 100 Hogs per Week, 1987-1996

 

One

Two

Three

Four

Five

Six

Seven

Eight

Average

$119,882

-$1,639

$13,527

-$14,361

NA

NA

$7,305

NA

Minimum

1,335

-17,680

-17,818

-107,363

NA

NA

-34,467

NA

Maximum

194,202

1,100

26,248

26,387

NA

NA

15,864

NA

Last

106,491

0

6,789

-84,526

NA

NA

10,462

NA

Summary

Long-term packer contracts are becoming increasingly common as the minimum required size of the contract decreases and producers become more comfortable with them.  The contracts available today have different features, provide the producer different price protection, and have different requirements. 

Remember that past performance is no guarantee of future performance.  Prices over the next decade are likely to average lower than the past ten years.  As you consider these contracts you should first determine the needs of your operation and determine if a contract may benefit you.  It is also necessary that you read and understand the contract and have it reviewed by your attorney and lender.

 

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