| Written December, 1994 |  |
File B3-35 |
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Long-Term Hog Marketing Agreements
John D. Lawrence, extension livestock economist, 515-294-6290, jdlaw@iastate.edu
Although hog prices are at their lowest levels in 20 years (December 1994), some producers are selling their hogs at prices well above these historic lows. They planned for the potential of unprofitable prices and signed a long-term marketing contract with a packer. Their price is based on the conditions of the contract rather than on the current market price as they and the packer share the market hog price risk.
There are five packers serving the Iowa market that have offered or still offers five to 10 year marketing agreements to producers. Other packers are giving serious consideration to offering similar contracts. While there is interest in these contracts, there are also several questions. What are the types of contracts offered, the motivation behind them, and their possible impact on open market prices?
Types of contracts
The exact terms of risk-sharing contracts differ between packers, but the concept is the same. In general, the producer gives up the opportunity for high prices in return for protection from low prices.
There are two basic types of risk-sharing agreements offered by Midwest packers: cost-plus and price-window. Some packers offer long-term agreements that do not share risk, but that pay premiums for characteristics of value to the packer, i.e., scheduled plant delivery and early morning delivery.
Cost-plus contract
The cost plus contract ties the price received by the producer to the cost of producing hogs by way of a production budget and feed prices. For example, the contract may use the ISU Swine Enterprise Records high profit one-third cost of production as the cost and add a profit margin of, $5.00/cwt. as the plus. If the high profit one-third cost is $36/cwt. and $5/cwt. is added, the resulting price is $41/cwt. These contracts typically have a feed price adjustment factor based on a rolling-average corn price (usually Omaha) and soybean meal price (usually Decatur). As feed prices increase so does the amount received for hogs and vice-versa. The contract may share part of prices above the base between producer and packer.
The cost-plus price is independent of the current open-market price of hogs. When hogs are $30/cwt., this contract looks great to the producer, but not so great to the packer. When hogs are $50/cwt., however, the same contract may not seem like such a great idea to the producer. It protects producers from variables beyond their control-hog and feed prices. Cost-plus contracts require producers to be efficient in production factors they control to succeed with the contract price received.
Price-window contract
The price-window contract has an upper and a lower price boundary that establishes a price range or window. When market prices are inside the boundaries, the producer receives the prevailing market price. When prices are outside the window, the producer and packer share the risk. While some contracts guarantee upper and lower boundaries, the more common arrangement is that the difference between the open market price and the boundary price is split equally between producer and packer.
For example, if the window is $40 to $48/cwt., the producer would receive the market price when it is between $40 and $48. If the price is $30 the producer would receive $35, half of the difference between $30 and $40. If the price is $54 the producer would receive $51, half the difference between $48 and $54. Price window contracts may have a feed price adjustment factor to raise or lower the window but typically the producer stands that risk.
Other contract terms
Other important terms are included in these contracts. They require carcass merit pricing and may require that hogs be a minimum quality grade to qualify for the contract. Repeated delivery of sub-standard hogs is grounds for canceling the contract. Scheduled deliveries are also required. While some contracts allow the producer to commit only a portion of his or her production to the packer, others require that producers commit all production and the packer has first rights on any expansion. The contract may also require that genetic stock, nutritional practices, facilities and other production requirements such as the highest level of Pork Quality Assurance be approved. Contract lengths also differ, but are typically in the 5- to 10-year range to assure that prices have time to pass through both a high and a low range.
The contract may have a no net gain clause that keeps track of the price gains or losses under the risk-sharing provisions, and the contract must either continue or be bought out if either party has made a net gain. This assures that the producer and packer have the same long-run average price as in the open market, but without the highs and lows.
Provisions and price levels of long-term packer contracts are usually offered similarly to various producers at one time. However, the terms appear to have changed over time. Just as hog prices have declined in recent months, so have the attractiveness and availability of long-term contracts. The packer’s bargaining position has improved. Contracts signed two to three years ago typically have higher price levels than the contracts offered today.
Why producers use contracts
Producers that sign long-term packer contracts are typically looking to reduce risk either for their own benefit or at the request of their lender. Producers that are highly leveraged often find that the only way to acquire the necessary capital to expand is by reducing price risk.
Some choose these contracts so they can focus on production and worry less about marketing.
Before considering a long-term packer contract, producers must know their cost of production and quality of their hogs. Although lower risk activities often result in lower returns, the price outlook for the next five to seven years may favor some type of risk-sharing agreement for producers concerned about cash flow commitments.
Why packers use contracts
Packers that sign long-term contracts are typically looking to secure a supply of high-quality hogs. They also have greater control over how the hogs are produced (genetics, PQA, etc.) and delivered.
Contracts are one more strategic tool that packers can use against their competition. They are able to secure high quality hogs that then are unavailable to competitors. However, it is doubtful that a packer can pay significantly more for hogs than his competitor for any extended time, and sell the pork at the same wholesale price. While some processors may have a brand name that can extract a premium price, most packers would have to absorb the difference until hog prices turn in their favor.
Impact of contracts on market prices
What is the impact of long-term marketing contracts on open-market prices? Marketing contracts are relatively new in the hog industry, but formula pricing agreements and other captive supply mechanisms are more common in the fed cattle market.
While extensive research funded by the Packers and Stockyards Administration is underway on the cattle market, earlier research on the issue found a relatively small impact on market prices. At first glance, contracts take an equal amount of supply and demand out of the market. The remaining supply and demand would appear to be in approximately the same balance, resulting in similar prices.
To date, packers have contracted for a relatively small portion of their needs and must buy the remainder on the open market. While some people believe that packers will simply bid less for open-market hogs to offset higher prices paid on long-term contract hogs, the packers must stay competitive in the open market. If they do not bid competitively, they will not buy enough hogs to run their plant efficiently, thus driving their cost per unit sold even higher. However, when short-run hog supplies are near packing plant capacities, such as during the large fall hog runs, packers do not have to bid as aggressively to acquire their needed supply. As a result, short-term price volatility may increase.
The long-run price impact of long-term market contracts will depend on the relative changes in supply and demand. If risk-sharing encourages producers to expand because there is less uncertainty about the prices, pork supplies will increase over time. However, contracts may improve communication between producers and packers and increase pork quality and plant efficiency, making pork a better value relative to poultry and beef. If so, pork demand may improve, offsetting some of the price impact from larger supplies. Although the full effect of long-term contracts on open-market prices is not fully known and additional research is needed, it is believed that they do not have a large impact at current levels of contracting.
Summary
Long-term marketing contracts are used by producers and packers as a tool to compete in a rapidly changing industry. Risk-sharing has allowed producers to make the necessary changes to their operation with confidence so that the entire operation is not jeopardized by a short-term cash flow problem. Besides reducing risk for both parties, long-term contracts provide greater communication between producers and packers on product quality and safety.