Market Vertical Coordination Communication and distributionCommunication and distribution Historically relied upon price signalsHistorically relied upon price signals

» Markets and spot negotiation

Moving toward non-market Moving toward non-market transactionstransactions» Contracts and long term negotiation

Trends

SpecializationSpecialization» Producing or processing only one or

a few products (Farming, Packing)

DiversificationDiversification» Multiple plants

» Multiple products

» Complementary products

Trends Decentralization Decentralization

» Move away from central markets

Drivers of trendDrivers of trend» Transportation

» Processing technology

» Communication systems

» Economies of scale

Integration

Vertical and horizontalVertical and horizontal OwnershipOwnership

» Mergers

» Growth to include function

ContractContract» Formal agreement

Integration?

Improved communication and Improved communication and control of the food supply to control of the food supply to increase customer satisfaction?increase customer satisfaction?

An attempt by processors to An attempt by processors to drive down farm level prices for drive down farm level prices for short and long term gain?short and long term gain?

Reasons for Integration

Profit potentialProfit potential Risk reductionRisk reduction Improved bargaining powerImproved bargaining power Operational efficiencyOperational efficiency Improved communicationImproved communication

Food Industry Alliances

Preferred/exclusive suppliersPreferred/exclusive suppliers Marketing contractsMarketing contracts HyVee and Farmland porkHyVee and Farmland pork

Production Ag Integration Premium Standard FarmsPremium Standard Farms Smithfield FoodsSmithfield Foods

» Largest pork packer and producer CargillCargill

» Nutrena, Production, Excel» Corn genetics, grain handling, processing

US Premium BeefUS Premium Beef Iowa Quality Beef Supply CoopIowa Quality Beef Supply Coop Farrow-Finish grain farmFarrow-Finish grain farm

Johnson Amendment, 2001 Prohibits packers from owning, Prohibits packers from owning,

feeding, or controlling livestock feeding, or controlling livestock for more than 14 prior to slaughterfor more than 14 prior to slaughter

Amended to allow contractingAmended to allow contracting»Farmer must materially participate

Excludes coops and poultryExcludes coops and poultry Packers would divest in Packers would divest in

» Hogs 18 months» Cattle 180 days

Contract Integration

Market specification contractsMarket specification contracts» Forward contracts» Common and general

Resource providing contractsResource providing contracts» Prescribed inputs and management

Management and income sharingManagement and income sharing» Greater integrator control

Integration into farming

Horizontal integrationHorizontal integration» Fewer and larger farms» Networking and alliances

Vertical integrationVertical integration» Cooperatives» Input production» Grain and meat processing

Value of Selected Commodities Produced

under Production Contracts, 1997 Commodity Value of

Production

PercentBroilers 99Cattle 14Eggs 37Hogs 33

Vegetables 8Total value of production under production contracts, all commodities

12

Source: USDA, Economic Research Service, 1997 Agricultural Resource Management Study, special analysis

Value of Selected Commodities Produced

under Marketing Contracts, 1997 Commodity Percent

Sugar beets 82

Fruits 59Canola 46Potatoes 43Peanuts 41Cotton 33Vegetables 24

Barley 19Cattle 9Peas 9Soybeans 9Corn 8

Source: USDA, Economic Research Service, 1997 Agricultural Resource Management Study, special analysis

Types of contracts

Market-specification termsMarket-specification terms» Product characteristics» Basis of price and payment

ExamplesExamples» Forward deliverable contracts

Little management control by buyerLittle management control by buyer

Types of contracts Resource-providing termsResource-providing terms

» Inputs are specified by buyer» Little price protection

ExamplesExamples» Specialty grain» Processing vegetables

High degree of management by High degree of management by buyerbuyer

Types of contracts Management and income Management and income

guaranteeingguaranteeing» Specifies characteristics and input use» Provides price and maybe production risk

ExamplesExamples» Hogs, poultry

High degree of management by buyerHigh degree of management by buyer

Contract grain production Forward contracts for deliveryForward contracts for delivery Specialty grainSpecialty grain

» Seed corn, popcorn, white corn» Formula contract tied to another market

Silage productionSilage production Production for grainProduction for grain

Cattle Production Contracts

Commercial feedlotsCommercial feedlots» Feedlot provides the management

not the buyer or cattle owner

Custom grazingCustom grazing» Cowherds

» Stockers

Cattle Marketing ContractsCaptive supplies of cattle Captive supplies of cattle

» Under the buyer’s control 14 or more days before delivery

Marketing contracts Marketing contracts » Forward contract for delivery» Formula contract

Types of captive supplies, 1999Types of captive supplies, 1999» Packer owned 4% (now 6-8%)» Under contract 28%

Captive Supply Research Results

1993 KSU Study:Captive supply shipments associated with a $0.15/cwt to $0.31/cwt decline in cash fed cattle prices

1996 KSU - OSU Study:1% contract delivery associated with $0.02/cwt to $0.03/cwt. cattle price

1% packer fed delivery associated with $0.13/cwt. to $0.19/cwt. cattle price

1% mktg agrmnt delivery associated with$0.04/cwt to $0.26/cwt. cattle price

Hog Production Contracts Farmer is paid to provide building Farmer is paid to provide building

and laborand labor Hog owner provides inputs and Hog owner provides inputs and

managementmanagement Limited production risk, no price riskLimited production risk, no price risk Currently 33-35% of hogs produced Currently 33-35% of hogs produced

under a under a productionproduction contract contract

Hog marketing contracts Relatively new - growth since 1993Relatively new - growth since 1993

» Open market was 87-89% in 1993» Open market was about 15% in 2003

Product specification importantProduct specification important» Genetics, inputs, food safety

Delivery schedulingDelivery scheduling Types of contractsTypes of contracts

» Formula price» Share price risk

Risk Sharing Contracts

Window contractWindow contract» Set upper and lower bound» Share the “pain and gain” outside

Cost based price floorCost based price floor» Minimum price tied to feed price» Pay back “loan”» Give up part of higher prices

Weekly Hogs Prices, Cost of Production and Contract

$-

$10

$20

$30

$40

$50

$60

$701

/6/9

0

1/6

/91

1/6

/92

1/6

/93

1/6

/94

1/6

/95

1/6

/96

1/6

/97

1/6

/98

1/6

/99

Cash Cost + COP

Weekly Hogs Prices, Cost of Production and Contract

$-

$10

$20

$30

$40

$50

$60

$70

1/6

/90

1/6

/91

1/6

/92

1/6

/93

1/6

/94

1/6

/95

1/6

/96

1/6

/97

1/6

/98

1/6

/99

Cash COP Margin Band Window

Ledger Balance: $/Live Cwt

$(200)

$-

$200

$400

$600

$8001/6

/90

1/6

/91

1/6

/92

1/6

/93

1/6

/94

1/6

/95

1/6

/96

1/6

/97

1/6

/98

1/6

/99

Contract Examples

Iowa Attorney GeneralIowa Attorney General» http://www.state.ia.us/government/ag/ag_contracts/

Current research on webCurrent research on web» Hogs: http://www.econ.iastate.edu/faculty/lawrence/HOGS.htm» Production and Marketing Characteristics of U.S. Pork Producers,

2000,» Understanding Hog Marketing Contracts - September 18, 1999

» Cattle: http://www.econ.iastate.edu/classes/econ135/lawrence/

» Packer Concentration, Captive Supplies and Fed Cattle Prices

Packer Motivation for Increased Pork and Beef Marketing Contracts, 1999.a

Pork BeefReduce plant operating costs by improving plant scheduling 3.5 2.9Secure higher quality animals 4 4Secure more consistent quality of animals 4.3 4Assure food safety 3.8 3Long run price risk management 3 2.8Week-to-week supply/price management 3.5 2.2Reduce costs of searching for animals to procure 3.5 2.3Able to purchase animals for lower price 2.3 1.8aScale of 1 to 5, 1=not important to 5=very importantSource: Reported by Lawrence, Schroeder, and Hayenga (2001)

Producer’s Motivation for Entering Marketing Contract with Packer

Access to capital and better Access to capital and better financingfinancing

Reduced price riskReduced price risk Assure a buyerAssure a buyer Reduced marketing costsReduced marketing costs Improved prices or premiumsImproved prices or premiums

Reasons for production integration

Greater controlGreater control» Product quality / specifications

» Scheduling

» Industrialization

Risk managementRisk management Access to resourcesAccess to resources

Motivations and Implications

Profit potential???Profit potential???» Multiply management

» Production efficiency and product quality

Thin market concernsThin market concerns Encourages expansion by Encourages expansion by

reducing riskreducing risk

So What???? How do you establish value in a How do you establish value in a

system in which there is little or system in which there is little or no open market activity?no open market activity?

Do you need to?Do you need to? How do you determine returns to How do you determine returns to

the various segments?the various segments?

Open market impacts

Packer may have ability to call Packer may have ability to call suppliessupplies

Formula tied to cash marketFormula tied to cash market Potentially depress pricesPotentially depress prices Potentially increase volatilityPotentially increase volatility Value-based pricingValue-based pricing