1. Overview uDefine contractual relationship uEvolution and status of hog industry uDescribe marketing contracts uMotivation and concerns uRole for economists

2. Contractual Relationship uFocus today is not on internal transfer uOnly relationship is the marketing contract u Typically 3-10 years in length or evergreen u Defines delivery schedules, carcass specifications, pricing, and in some cases production practices uSmall portion of contracts have risk sharing provisions

3. USDA MPR Definitions  Negotiated: Purchased in the cash market for delivery within 7 days.  Swine or pork market formula: A formula tied to the cash market for hogs or pork cutout., i.e., weekly average price, 3-day rolling average, percentage of the cutout.  Other market formula: A formula tied to something other than the hog market or pork cutout, i.e., feed prices.  Other purchase agreement: Currently this includes window contracts.

4. Percent of U.S. Hogs Sold Through Various Pricing Arrangements, January 1999-2009* Year9900010203040506070809 Hog or meat market formula 44.247.25444.541.4 39.941.838.337.141.2 Other market formula 3.48.55.711.85.77.210.38.88.511.07.9 Other purchase arrangement 14.416.922.88.619.220.615.416.615.213.411.6 Packer-sold 2.12.22.12.42.66.76.15.6 Packer- owned 16.418.117.121.42022.723.125.7 Negotiated - spot 35.825.717.316.713.511.610.610.28.69.28.1 Source; Grimes and Plain, University of Missouri http://agebb.missouri.edu/mkt/vertstud09.htm

5. Contract Specs uProduct specifications PQA, Right to approve inputs uMethod of pricing Which markets and formula uDelivery scheduling Short and long term uExemptions

6. Types of Contracts uFormula Most common contract Price tied to another market, typically spot No risk share Examples: »3-Day rolling average of ISM weighted average +$1.50 »Last week’s average excluding the high and low »92% of the previous day pork cutout value uPacker does not share risk

7. Types of Contracts uFixed window Formula tied to cash price Predetermined upper and lower bounds Share pain and gain outside window Example: $50-60 and split 50/50 above and below uFloating window Formula tied to cash price Boundaries move with feed prices Do not share outside of window uPacker shares risk

9. Types of Contracts uCost-Plus Price direct function of feed prices Fixed amount for non-feed costs + known margin Packer assumes all price risk uLedger Floor price is fixed or based on feed prices Producer is “loaned” the difference between floor and lower cash prices Loan is repaid at higher cash prices Packer provides line of credit but not risk share

12. Contract Examples uIowa Attorney General http://www.state.ia.us/government/ag/ag_contracts/

13. uConsumer satisfaction  Moisture enhanced pork  Preference for attributes  Growing interest in safety and production uSpot market not sufficient  Premiums and discounts  Market access and risk Motivations for Vertical Linkages

14. u Traditional IO theory  Avoid market power, reduce price volatility, technology complements, minimize transaction costs u Agency theory  Integrate rather than contract to avoid opportunism and shirking by contract partners Motivations for Vertical Linkages

15. u Asset specificity  Firms with more significant relationship- specific investments (RSI) benefit from predictable throughput and prices  As assets become more specialized, the costs of using the spot market increases  Costs are particularly high when food safety and product quality problems occur encouraging greater process control Motivations for Vertical Linkages

16. Attitude Toward Marketing Contracts by Pork Producers with and without Marketing Contracts 1 = strongly disagree, 6 = strongly agree WithWithout Coordinate slaughter to better meet Industry needs3.72.9 Have caused lower cash market prices4.24.2 Producers with contracts have received higher prices3.93.5 Packers show preference in who was offered a contract3.53.5 Contracts should be made illegal by Congress2.73.1 Contracts should be more closely monitored by USDA4.04.0 Prefer to market all my hogs on the cash market3.04.1

17. Summary of Cattle Volume of RTI – GIPSA Study Stephen Koontz, John Lawrence, Gary Brester, Mary Muth, and John Del Roccili (formerly Beef Team Leader; deceased)

18. Marketing and Pricing Methods uWhen selling to packers 85% of small producers and 24% for large producers surveyed used only the cash market uPricing methods by size of operation LargeSmall Individually negotiated pricing 74%32% Public auction 35%84% Formula pricing 57%6% uFour times as many large producers sold cattle on a carcass weight basis with a grid compared with small producers.

19. Beef producers and packers interviewed believed that some types of AMAs uHelped them manage their operations more efficiently, reduced risk, and improved beef quality. Feedlots identified cost savings of $1 to $17/head »improved capacity utilization, »standardized feeding programs »reduced financial commitments to stay full. Packers identified cost savings of $0.40 per head in reduced procurement cost. Both agreed that if packers could not own cattle, higher returns would be needed to attract other investors and that beef quality would suffer in an all-commodity market place.

20. Packer Purchases uUsing only the cash or spot market 10% large beef packers surveyed 78% of small beef packers surveyed uWhile nearly all packers bought some cattle on a liveweight basis, 88% of large packers purchased cattle on carcass grids, while almost no small packers used this method. uNeither the producers nor packers surveyed expected the use of AMAs to change dramatically in the next 3 years

21. Reasons for AMAs uProducers surveyed The ability to buy/sell higher quality cattle, Improve supply management, Obtain better prices uPackers surveyed Improve week-to-week supply management, Secure higher quality cattle, Allow for product branding in retail stores

22. Reasons for Cash Only uProducers surveyed Independence and flexibility, Quick response to changing market conditions, Ability to buy at lower prices and sell at higher prices uPackers surveyed Independence and flexibility, Quick response to changing market conditions, Securing higher quality cattle

23. What did the analysis of procurement transactions data show? uCash, marketing agreement, and packer-owned prices similar. uAuction higher and forward contract lower than cash prices uWhen AMA use increases cash prices decrease: 10% increase in AMA use (as % of plant capacity) is associated with a $0.40/cwt of carcass weight. 10% increase in AMA use is associated with a 0.11% decrease in cash price. uImpacts are economically small but statistically significant.

24. What did the packer P&L data show? uSubstantial economies of size (declining average total costs of slaughter and processing per head) Large plants have lower ATCs than small when both are operating close to capacity. For all plants ATCs decline over the whole range of volumes. The representative plant operating at 95% of max observed capacity is 6% more efficient than when operating in the middle of the observed range of volumes and 14% more efficient than when operating at the low end of observed volumes.

25. What did the packer P&L data show? uPlant costs are lower for those that procure through AMAs. uCosts are directly lower -- all else constant. uCosts are lower because of increased volumes. uCosts are lower because of less variable volumes. uCost savings are approx $6.50 per animal. uWeighted-average profits for the four largest companies were -$2.40 per head for packers over the 10/02-3/05 time period.

26. u The information and characteristics that consumers are demanding may require tighter vertical linkages.  Can the spot market provide the non- measurable process control for consumers?  If so, at what cost?  Who will pay the added costs?  Will greater control speed consolidation? Role for Economists

27. u The great success of formula pricing contracts is likely to lead to its demise.  Producers want an agreement, but fear thin markets.  How much volume is needed for satisfactory price discovery?  Where should it take place?  Who should be involved? Role for Economists

28. u Concerns about contract linkages negatively affecting prices  Research is inconclusive on price impacts.  Thin market implications.  Arguments have been greater in the industry where there is less contracting.  Politically charged debate. Role for Economists

29. GIPSA Rule 2010 uJune 22, 2010 published a proposed rule, as required by the 2008 farm bill and through existing authority under the Packers and Stockyards Act of 1921 uReleased during a series of listening sessions across US involving Secretary of Agriculture and US Attorney General

30. GIPSA Rule 2010 uProvide further definition to practices that are unfair, unjustly discriminatory or deceptive, including outlining actions that are retaliatory in nature, efforts that would limit a producer's legal rights, or representations that would be fraudulent or misleading. uAdditionally, the proposed rule reiterates USDA's position that a producer need not overcome unnecessary obstacles and have to always prove a harm to competition when they have suffered a violation under the Act ;

31. GIPSA Rule 2010 uDefine undue or unreasonable preferences or advantages; uImprove market transparency by making sample contracts (except for trade secrets or other confidential information) be made available on GIPSA's website for producers; uProhibit packers selling to packers uOther provisions for contracts and arbitration uhttp://archive.gipsa.usda.gov/psp/fb_news_release. pdf Release 0326.10http://archive.gipsa.usda.gov/psp/fb_news_release. pdf

32. GIPSA Rule, 2010 uIndustry sharply divided over rule uSome view it as necessary and long over due uSome view it as necessary and will turn back decades of economic evolution and restrict innovation in marketing

33. Summary uMarketing contracts are common in hog market Most common is tied to dwindling cash market for price discovery uLess common but widely used in fed cattle marketing uUSDA GIPSA has proposed rules that will restrict and possibly prohibit use of contracts