Market Vertical Coordination  Communication and distribution  Historically relied upon price signals »Markets and spot negotiation  Moving toward non-market transactions »Contracts and long term negotiation

Trends  Specialization »Producing or processing only one or a few products (Farming, Packing)  Diversification »Multiple plants »Multiple products »Complementary products

Trends  Decentralization »Move away from central markets  Drivers of trend »Transportation »Processing technology »Communication systems »Economies of scale

Integration  Vertical and horizontal  Ownership »Mergers »Growth to include function  Contract »Formal agreement

Integration?  Improved communication and control of the food supply to increase customer satisfaction?  An attempt by processors to drive down farm level prices for short and long term gain?

Reasons for Integration  Profit potential  Risk reduction  Improved bargaining power  Operational efficiency  Improved communication

Food Industry Alliances  Preferred/exclusive suppliers  Marketing contracts  HyVee and Farmland pork

Production Ag Integration  Premium Standard Farms  Smithfield Foods »Largest pork packer and producer  Cargill »Nutrena, Production, Excel »Corn genetics, grain handling, processing  US Premium Beef  Iowa Quality Beef Supply Coop  Farrow-Finish grain farm

Johnson Amendment, 2001  Prohibits packers from owning, feeding, or controlling livestock for more than 14 prior to slaughter  Amended to allow contracting »Farmer must materially participate  Excludes coops and poultry  Packers would divest in »Hogs 18 months »Cattle 180 days

Contract Integration  Market specification contracts »Forward contracts »Common and general  Resource providing contracts »Prescribed inputs and management  Management and income sharing »Greater integrator control

Integration into farming  Horizontal integration »Fewer and larger farms »Networking and alliances  Vertical integration »Cooperatives »Input production »Grain and meat processing

Value of Selected Commodities Produced under Production Contracts, 1997 Source: USDA, Economic Research Service, 1997 Agricultural Resource Management Study, special analysis

Value of Selected Commodities Produced under Marketing Contracts, 1997 Source: USDA, Economic Research Service, 1997 Agricultural Resource Management Study, special analysis

Types of contracts  Market-specification terms »Product characteristics »Basis of price and payment  Examples »Forward deliverable contracts  Little management control by buyer

Types of contracts  Resource-providing terms »Inputs are specified by buyer »Little price protection  Examples »Specialty grain »Processing vegetables  High degree of management by buyer

Types of contracts  Management and income guaranteeing »Specifies characteristics and input use »Provides price and maybe production risk  Examples »Hogs, poultry  High degree of management by buyer

Contract grain production  Forward contracts for delivery  Specialty grain »Seed corn, popcorn, white corn »Formula contract tied to another market  Silage production  Production for grain

Cattle Production Contracts  Commercial feedlots »Feedlot provides the management not the buyer or cattle owner  Custom grazing »Cowherds »Stockers

Cattle Marketing Contracts Captive supplies of cattle »Under the buyer’s control 14 or more days before delivery  Marketing contracts »Forward contract for delivery »Formula contract  Types of captive supplies, 1999 »Packer owned4% (now 6-8%) »Under contract28%

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 and labor  Hog owner provides inputs and management  Limited production risk, no price risk  Currently 33-35% of hogs produced under a production contract

Hog marketing contracts  Relatively new - growth since 1993 »Open market was 87-89% in 1993 »Open market was about 15% in 2003  Product specification important »Genetics, inputs, food safety  Delivery scheduling  Types of contracts »Formula price »Share price risk

Risk Sharing Contracts  Window contract »Set upper and lower bound »Share the “pain and gain” outside  Cost based price floor »Minimum price tied to feed price »Pay back “loan” »Give up part of higher prices

Contract Examples  Iowa Attorney General »  Current research on web » Hogs: »Production and Marketing Characteristics of U.S. Pork Producers, 2000, »Understanding Hog Marketing Contracts - September 18, 1999 »Cattle: »Packer Concentration, Captive Supplies and Fed Cattle Prices

Packer Motivation for Increased Pork and Beef Marketing Contracts, a

Producer’s Motivation for Entering Marketing Contract with Packer  Access to capital and better financing  Reduced price risk  Assure a buyer  Reduced marketing costs  Improved prices or premiums

Reasons for production integration  Greater control »Product quality / specifications »Scheduling »Industrialization  Risk management  Access to resources

Motivations and Implications  Profit potential??? »Multiply management »Production efficiency and product quality  Thin market concerns  Encourages expansion by reducing risk

So What????  How do you establish value in a system in which there is little or no open market activity?  Do you need to?  How do you determine returns to the various segments?

Open market impacts  Packer may have ability to call supplies  Formula tied to cash market  Potentially depress prices  Potentially increase volatility  Value-based pricing