Will packer contracts be a good deal in the future? Iowa State University's John Lawrence recently tackled that question, evaluating several packer contracts currently used in the Midwest.
"There is no clear-cut, superior contract," he reports. Instead, the value depends on the type of contract being offered and a producer's needs.
Lawrence also fielded a number of questions about growing ledger accounts on some of the contracts. The questions deal with how the accounts are handled on balance sheets, the packer's position vs. the lender's position, and what happens if a packer goes out of business.
Contract Performance To evaluate the contracts for their performance, Lawrence simulated what the payments from several different contracts would average from 1988 to 1997. He assumed a hypothetical producer selling 100 hogs/week in the simulations. All the contracts are window or cost-plus contracts. Roughly 10% of the nation's hogs are marketed under this type of contract.
The results are shown in Table 1. Contracts 1 through 4 are cost-based with a ledger account. The producer is protected from prices below the floor, but must pay back the money when prices are on the upside. Contracts 5 and 6 are cost-based contracts with the producer not incurring a debt. Contract 7 is a flat floor price of $40/cwt. and not tied to grain prices. Contract 8 is a $38-48/cwt. window contract.
Some of the contracts reduced price variability experienced by the cash market during the 10-year period. The cash market fluctuated from $27/cwt. to $66/cwt. during that time. But the contract prices generally moderated from $32/cwt. to $66/cwt.
At the end of the 10 years, the average cash price was $47.29/cwt. About half of the contracts averaged $0.16-0.74/cwt. above the cash price. The rest were lower than the cash price, from $0.56-3.13/cwt.
Five of the contracts (1-4 and 7) included ledger or reserve accounts. "The packer essentially loans the difference between the floor and the open market," Lawrence explains. If a floor price is $40/cwt. and the market is $29/cwt., the packer loans the producer $11/cwt. The amount will be entered in an account. As hog prices move above the floor, the producer pays back on that account.
Lawrence's simulations of the contracts show ledger accounts in the positive, meaning the packer would owe the producer money. The accounts varied from $14,662 to $170,966 when using actual cash prices for 1988-97.
Ledger Accounts Build The story changes, however, should cash prices run lower. Lawrence simulated the contracts at 95% of the price levels of 1988-97. Those are also shown in Table 1.
In this simulation, the average 10-year cash price was $44.93/cwt. All but two of the contracts (the cost-based only contracts) showed average prices higher than the cash price. They ranged from $44.19/cwt. to 47.45/cwt.
At the end of the 10-year simulation, the ledger accounts ended up in the negative on two of the contracts. Producers would have owed $73,771 to the packer on one contract and $97,307 to the packer on another. Two contract ledger accounts were positive, though, with the packer owing $11,478 on one and $14,662 on another.
If the 10-year price dropped to 90% of what occurred in 1988-97, the ledger accounts grow massively. Lawrence based the simulations on an average cash price of $42.56/cwt. for the period. The contracts did their job by keeping average prices above cash.
The contracts with ledger accounts reduced the variability of prices the most. But the ledger accounts grew. One contract simulated a debt of $347,229 owed to the packer. Two other contracts showed a $330,030 and a $59,915 debt to the packer. Still another contract was left with a $14,662 positive balance, which the packer owed the producer.
Lawrence says many contracts do not limit the negative balance or address early termination if the balance grows larger than a producer's net worth.
Debt Position Questions Lawrence says he has heard questions about the ledger accounts and the packer's position vs. the lender's position on the debt.
After studying the contracts, he believes the lender still has first position on the debt. "I have yet to see a packer make a move to have a secured interest," he adds. Packers would need to file UCC (Uniform Commercial Code) papers to secure the debt against collateral. Until that is done, the packer is an unsecured creditor.
Another question is how the debt is handled on the balance sheet, Lawrence says. If it is considered a current liability, a large debt could create poor current ratios.
"Problems could occur if a new loan officer or bank examiners go over the books and see your working capital ratio of 0.7 and the bank has a covenant saying nothing below 1.5," he explains. "Some lenders put the debt off to the side on the balance sheet."
In the face of these simulations and questions, Lawrence suggests producers look carefully at packer contracts in the future. While packers generally are not offering contracts right now, they should be when prices improve.
Originally designed to lower risk, the contracts could pose financial problems if prices continue below the floor prices.