Hog contracts: leveling the playing field

By Mark A. Edelman
Posted 1/28/99

According to recent research by marketing experts at Iowa State University and the University of Missouri, nearly 57 percent of 1997 hog marketings were under some form of prearranged agreement with …

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Hog contracts: leveling the playing field


According to recent research by marketing experts at Iowa State University and the University of Missouri, nearly 57 percent of 1997 hog marketings were under some form of prearranged agreement with a packer. This compares to 37 percent in 1994 and 11 percent in 1993. Large producers with more than 50,000 hogs in annual marketings had more than 80 percent of their hogs under a packer contract. This shows that 25-year-old predictions by some industry and policy experts are finally coming true.

Contracting has become the superior method for scheduling marketings in the hog industry. Particularly for younger farmers, contracts help to lock in an income, finance facilities, and shift unwanted risks to others. The real question in the current environment is whether those who are absorbing the price risk want to continue to do so. Will packers, feed suppliers, other investors or independent producers blink first?

Not all contracts are the same in terms of price risks. The research shows that the predominant form was a formula contract which accounts for 39 percent of all hog marketings. Selling prices were typically based on an observable market, such as the Iowa-Southern Minnesota price. However, next were risk share “window” and “cost plus” contracts. They accounted for 8.4 percent of all hogs and 15 to 20 percent of hogs on operations with 10,000 to 500,000 head.

Under one risk share contract, the hog producer is typically assured a floor price, say $30/cwt. When the market is above the floor, the packer pays the floor price and a share of the price above the floor. However, the extra is credited to the producer’s “ledger account.” When prices fall below the floor, the producer still receives the floor price and the difference is deducted from the ledger balance. Since hog prices dropped below the floor and stayed for a long time, packers have increasingly become a major lender to some of the larger producers. Typically, any positive or negative balances are to be paid at the end of the contract.

The ledger contracts mean two things in light of the recent period of extremely low hog prices. First, packers take on an increasing financial interest in selected large hog operations. Second, the selected hog operations with ledger contracts do not face the same financial risks and cash flow problems faced by producers of the other 92 percent of the hog supply.

Perhaps this is one of many reasons why retail prices for pork haven’t declined much even though farm prices plummeted 70 percent. Packers are using part of the extra cash to float additional ledger loans to the hog producers that have the risk share contracts. When push comes to shove in market access, producers in which the packer has a financial interest may potentially be placed first in line for market access. Similar to a franchise network, the packer has a financial incentive to serve company-owned retail outlets first.

One of the interesting issues raised by the research relates to price discovery as hog marketings move from open market to contracting. Currently, existing open market prices — such as the Iowa-Southern Minnesota prices — are used as the basis for 39 percent of the hogs marketed under the formula contracts. If open markets continue to decline, we’ll have to figure out a new basis for setting price in the formula contracts — one that would allow market signals to be translated from consumer through packer to the producer.

It can be argued that the market signals have not worked particularly well during the past three years. Many policy makers, interest group leaders and marketing experts were calling for policies to expand hog numbers at the same time the industry was shutting down four processing plants and importing more Canadian hogs. As a result, supply overran slaughter capacity.

Only a few analysts dared to buck the politically correct propaganda of the time and their message was ignored or attacked when it could not be ignored. Enough about spilled milk. Experts see nothing on the horizon to slow the trend toward more contracting. More contracting may in fact improve coordination and reduce the odds for another slaughter capacity crisis.

In the future, policy makers and the livestock industry will still need to decide whether risk share contracts constitute a “fair” or “unfair” marketing practice. Preliminary results from a national survey of state animal confinement policies shows that no reporting state requires packers to publicly report contract price terms, and no reporting state restricts packers from providing price premiums or long term minimum price contracts for large suppliers of livestock. The only question is whether all producers will have access to similar contract terms.

Edelman is a professor of economics and an extension public policy specialist at Iowa State University.