William M. Snell and Daniel Green University of Kentucky Department of Agricultural Economics March 2001 Tobacco Contracting Issues and Update for 2001 Agricultural Economics

Contracting in Agriculture/Tobacco Approximately 1/3 value of agricultural production is contracted – Examples include broilers, hogs, milk, fruits, vegetables, turkeys, eggs, cotton, peanuts, and identity- preserved grains Agricultural contracts are generally classified as either production or marketing contracts. Tobacco is contracted in many parts of the world (e.g., Brazil, Argentina, Mexico) Agricultural Economics

2000 Market Review Marketings (315.7 mil lbs) –223.7 mil lbs sold auction – 87.5 mil lbs contracted (28%) – 4.5 mil lbs sold direct Gross Price –$195.49/cwt -- auction –$198.43/cwt – contract (+3 cents/lb) Average contract price netted approximately 10 cents/lb higher than the average auction price Agricultural Economics

Observed Advantages for the Contracting Grower for 2000 reduced marketing costs and higher net return relative to the auction market potential of selling tobacco earlier in the year no tobacco placed under government loan (i.e., pool) price premiums for quality payment day of delivery improved direct communication with buyer regarding company/consumer preferences Agricultural Economics

Identified Advantages for the Contract Buyer in 2000 improved quality of marketings improved supply management improved strip yields in response to reduced tobacco leaf loss and lower moisture levels Agricultural Economics

Contracting for 2001 PM expanding contracting All other manufacturers contracting Most export dealers contracting Competition to sign-up growers What percentage will be contracted? 50-75% ? Impacts on program/grading/grading service/auction markets? Agricultural Economics

Contract Characteristics Tobacco must be produced and cured using recommended agronomic and cultural practices. Tobacco must be stripped and separated into at least three (and preferably four) stalk positions. Tobacco must be delivered free of foreign matter, weighing less than 100 pounds per bale and with a moisture content of less than 24%. Tobacco must be marketed under the federal tobacco program and adhere to all other applicable government rules/regulations. Agricultural Economics

Contract Characteristics (cont.) Contract lengths range from from 1 to 3 year agreements. Contracting seller must offer entire crop and may not lease out any part of the contracted crop. Schedule deliveries to a specified receiving station Minimum prices offered by grade and stalk position Grading procedures and dispute options Sampling procedures (e.g., moisture, temperature, pesticide residues) Agricultural Economics

Contract Characteristics (cont.) Provisions presenting the maximum allowable carryover tobacco sales Payment procedures and terms Contracting firms’ rights to the access of the contracting farm/grower production practice record-keeping requirements (if any). Terms regarding the resolution of disputes are outlined, including the applicable state’s law governing the agreement and the location of any actions, suits, or proceedings arising from the agreement. Contract terms are subject to revision upon major changes or elimination of the federal tobacco program. Agricultural Economics

Contract Price Analysis Contract prices do vary across companies. Some companies not offering a price for certain grades such as mixed, green or variegated (K-style) tobaccos. Given the following grade distribution of marketings; flyings (8%), cutters (30%), leaf (50%) and tips (12%): – the average company price for the 2001 crop (based on the current contract prices) ranges from $199.4/cwt to $202.5/cwt, assuming 100% of the tobacco falls in the company’s top quality grade grouping. –the average company price for the 2001 crop (based on the current contract prices) ranges from $194.4/cwt to $197.5/cwt, assuming 100% of the tobacco is categorized in the company’s second highest quality grade grouping. Agricultural Economics

Selected Grade2000 Price Support ($/cwt) 2000 Average Auction Price ($/cwt) 2000 Contract Price ($/cwt) 2001 Contract Price Range ($/cwt) X3F$188$192 $192 - $200 X4F$188$191$192$192 - $197 C3F$187$188$192$190 - $198 C4F$187$188$191$190 - $198 B3F$186$194$187$188 - $198 B4F$186$192$187$188 - $198 B3FR$193$198$197$199 - $201 B4FR$193$196$197$199 - $201 T3FR$206$207$210$207 - $212 T4FR$206$207$210$207 - $212 T3R$206$207$210$207 - $212 T4R$206$208$210$207 - $212 X5M$168$174$178$0 - $190 B4K$149$164$172$60 - $160 C4G$113$135$92$60 - $155 M4FR$127$164$0$0 - $175

Potential Advantages for the Contract Buyer: enhanced quality control in terms of obtaining the desired leaf characteristics, stalk positions, moisture levels improved supply management in terms of the total volume, specific grades, and flow of tobacco to the market increased rate of adoption of technological innovations necessary to address specific quality or regulatory concerns (e.g., reduced nitrosamines/nicotine levels) potential lower long-term marketing costs due to concentration of markets/buying personnel improved strip yields in response to reduced tobacco leaf loss and lower moisture levels Agricultural Economics

Potential Concerns for the Contract Buyer: reduced selectivity higher leaf costs additional short-run costs associated with establishing receiving stations in terms of rent/building acquisition, buying agents, labor, and technological adoption additional strained relations within tobacco industry (e.g., growers, warehouse owners, and farm groups who oppose contracting) Agricultural Economics

Grower Concerns Tobacco Program ??? Federal Grading Service ??? Price Supports ??? Market Access/Auction Markets ??? Agricultural Economics

Auction Market Issues How many will survive and where will they be located? What volume of sales will they attract? What changes will the survivors adopt to attract buyers and growers? How many buyers will participate? How many sales per year? Will auction markets become a market for primarily low quality tobacco? How will auction market prices be affected by contract prices? Agricultural Economics

Other Grower Issues What will be the typical size of the future contract grower? Will all growers who want a contract be able to obtain one? Will contract production eventually be concentrated in certain geographic areas? What will be the degree of producer independence in making future management decisions? Will contracting producers be obligated in the future to make large capital investments? Agricultural Economics

Other Grower Issues (cont.) What will be the degree of buyer competition in awarding contracts? How will the distribution and overall average of prices change? Will the higher prices initially induced by contracting result in long-term losses in exports, encourage more imports and boost lease prices? Will a changing production and marketing system continue to improve the quality and integrity of U.S. burley? If so, how will this affect future quota levels? Will grading be done by a third-party or company reps, or both? Agricultural Economics

Other Grower Issues (cont.) Will grading evaluations vary depending on current supply/demand conditions? How will the contracting firms respond to a very low quality crop? Will contracting firms continue to commit to contract the farmer’s entire crop? Will contracting companies in the future offer grower financing and/or other inputs? Will the industry experience a reduction in public market info on prices, quantities, grades, etc., as a result of contracting? Agricultural Economics