Six Lessons of Marketing Contracts

A question many producers and packers are currently addressing is what to do with multi-year marketing contracts that will soon expire.

Multi-year marketing contracts generally require a specified quantity of hogs to be delivered at particular intervals, usually for a period of 3-7 years. Contracts specify a price formula based on input, or market hog or pork prices.

While the pay offs of these contracts require specific evaluations, there are several market lessons to be learned:

Lesson #1:

Marketing contracts' objectives are NOT risk management or profitability.

Table 1 shows the payout of an existing “floor” price contract over different time periods and compares the contract price to the market price. Like many contracts, an adjustment account or ledger keeps track of differences between the contract and market prices paid during the life of the contract. When the adjustment account balance is accounted for by the value “net average contract price” (long-term), the contract returns the average market price for the period, offering no long-term risk protection.

Similar results hold for nearly all variations of long-term marketing contracts with adjustment accounts. No contract will pay an above-market price for a long period. Likewise, no contract will reduce price risk without a fee or price discount (premiums on futures options, for example).

Lesson #2:

Marketing contracts' objectives are supply assurance.

The pricing formula feature of all contracts is necessary to achieve the primary objective: the assurance of supplies.

All contracts have specific provisions on hogs to be delivered. Hence, market prices and market quantities are de-coupled in multi-year contracts. The price formulas still adjust according to pre-defined market prices, but individual quantities are fixed (with some random variation but not specific to overall market price response) to assure supply.

In an individual case, this doesn't create a market problem because other producers are not under contract. They cut back on production so that prices increase and the contract producer begins to pay off the ledger with higher prices. However, at some point the market “tips” from few enough to too many hogs contracted to maintain supply and price response.

Removal of quantity response distorts the hog market and compromises price discovery as the share of hogs under contract increases.

Lesson #3:

Capital markets and price contracts are a volatile mix.

Even without long-term risk impacts (lesson #1), lenders have used marketing contracts for lending decisions based on a “cash-flow assistance” strategy for start-up phases of operations. While contracts shift price risk to a later date, they do not fundamentally alter the long-term profitability of a project or warrant additional capital.

As more lenders demand contracts to improve credit scoring, producers seek more contracts and lenders make more loans based on contracts. Hog production increases, but with no downside supply response (lesson #2); prices decrease and lenders require more contracts; and so on. The bottom line becomes that producers are virtually guaranteed to owe a ledger or receive lower prices due to the credit combination with the supply assurance requirements of contracts.

Lesson #4:

It is impossible to create a price formula that predicts future market conditions — especially when there may be a feedback loop.

Some multi-year price formulas are based on feed prices; some are based on reported hog market prices including live prices, carcass prices and regional markets; and others are based on pork carcass cutout values.

All of these prices are closely related to pork production, so it's generally possible to use them to create a formula that will track the market hog price. However, this creates another vicious cycle. As more hogs are formula priced, fewer hogs are available to determine the market price. Thus, the market price becomes less reliable, so the formula price appears more stable, even though the formula is compromised by the change in the underlying market price.

This cycle can be exaggerated by quality differences between contract and market hogs and by things as simple as changes in market price reporting.

The use of formulas directly reliant on hog market prices erodes the effectiveness of price discovery.

Lesson #5:

Marketing contracts change behavior.

This is the most fundamental of all lessons: individual behaviors create markets, and markets aggregate behavior into prices, which in turn affects individual behavior. Multi-year marketing contracts distort this behavior/price/quantity virtuous cycle.

A packer described the best example of self-defeating behavioral changes, noting when market prices were low (contract prices higher and ledger accruing owed to packer), producers tended to deliver the most possible hogs under the contract and at heavier weights. When market prices became higher, producers delivered fewer hogs at lower weights. The producer gained short-run benefits at the one-for-one expense of a long-term ledger “hole” they were digging. Their behavior was exactly 180° from what it should have been with market prices!

Growers tended to overly discount the ledger account representing a future cost, or were overly optimistic that markets would erase the ledgers through higher prices — especially in light of the market feedback loops described earlier. The contracts altered perceptions and behaviors, which then affected economic outcomes.

Lesson #6:

“Synthetic vertical integration” is inferior to vertical integration.

Competitive models of pork production, that rely on supply chain management from farm through processing, have resulted in the integration of the intermediate hog market.

Multi-year contracts are essentially a mechanism for creating “synthetic vertical integration.” Multi-year contracts may capture some reduction in open market transaction costs (supply assurance), but because of the price/quantity behavior cited, they are a poor substitute for vertical integration.

Packer ownership laws in the Midwest states have played a role in the creation of multi-year contracts, but the ultimate method to reduce incentives for vertical integration is more efficient open markets by reducing transactions costs and improving information.

Where Do We Go From Here?

Swine industry participants are already aware of the lessons outlined above. Producers, packers and lenders have suggested remedies including the use of different formulas, different formula prices and the elimination of ledgers as possibilities.

The certain remedy is to voluntarily eliminate the use of multi-year marketing contracts. However, eliminating them does not solve the demand for risk management and quantity and quality assurance. So, what can be done without them?

• Use the futures market for risk management. Participants argue futures don't work because of design flaws in the lean hog futures contract, including a lack of convergence of cash and futures prices, basis unpredictability, lack of consecutive maturity months, the inability to create multi-year risk management strategies and the existence of multi-year forward contracts.

  If there are fundamental problems in futures markets, there should be efforts to fix futures contracts — the one true market mechanism for risk management.

• Forward price contracts should have a life no longer than the related futures contract. Short-term forward contracts have been used extensively in grain marketing (see Cargill AgHorizons at www.cargillaghorizons.com/aghorizons/performancemarketing/us.htm) for risk management and procurement. The one-year futures contract life gives a reasonable planning horizon for supply assurance purposes without the illusion of safety or control over market conditions.

• Lenders should focus on capital and credit markets and packers should focus on hog markets. The fundamental question remains: is there some reason capital markets are not efficiently allocating investment decisions in the swine industry?

  If so, efforts should be directed at gaining access to cost-effective capital in the swine industry, not distorting capital markets by coupling marketing contracts to credit. It's time to revisit corporate farm laws and their impacts on credit costs to the farm sector.

• Avoid government intervention directly affecting market quantities and prices or capital allocation. Mandatory government policies (e.g., 30% of hogs procured in the open market) will distort market signals just as multi-year contracts do. Similarly, capital access and ownership restrictions in agriculture have affected regional competitiveness. Government policy efforts should focus on assuring the proper functioning of markets — better information on market conditions, realistic capital market regulations and assurances of fair and competitive practices.