Today's pork industry demands risk management. Production and marketing contracts offer ways to manage that risk; and research shows that all types of producers are using both kinds of contracts more widely than ever.
But today's contracts are changing. New arrangements, new information and new
issues make research the essential first step in any move toward contracting. These two stories explore today's market and production contracts and look at where things are headed. Next month, you'll get more information on contract law and how to protect yourself before you sign on the dotted line.
Production Contracts Get a New Look
You need to quit taking on so much risk," says everyone from Wall Street to your brother-in-law. The standard reply comes to mind: "If I couldn't handle risk, I wouldn't be a farmer."
There's truth in both statements, but the reality of today's pork industry is much more complicated. A long stretch of below-normal hog prices brings home the full weight of the financial risk involved and forces everyone to review options. You could spread risk out by contracting – whether you contract produce or have others contract for you.
In 1998, according to Pork magazine's Industry Structure Study, 56 percent of hogs in operations between 1,000 and 49,999 hogs were finished under a production contract. For those in operations with more than 50,000 hogs, the percent finished under a production contract rose to 71 percent.
But what is a production contract? Ask 10 people that question and you'll get 10 different answers. That's because production contracts are evolving to fit today's pork industry and market situation, says Laura Cheney, Michigan State University assistant professor of agricultural economics. "Contracting is just another type of production system," Cheney says.
By far, the most common type of arrangement still is a finishing contract, where a producer feeds and cares for hogs from some post-weaning age until they head for market. A company or producer, who controls the genetics or feed or both, maintains animal ownership. For providing labor and housing, the contract grower can get paid in a variety of ways; usually it's a piece rate with bonuses based on performance measures such as feed conversion and mortality, Cheney says. The newest contracts base payment on square feet or pig space in the barn.
It wasn't always that way. In what Cheney calls the first generation of production contracts, most of the arrangements were modeled after contracts in the broiler chicken industry. Pork growers would get some payment based on pounds of pigs or number of pigs produced, then bonuses for efficient feed conversion or low mortality. "Then we realized there's a lot more variability in pork than in poultry," Cheney says. "In the last five years pork production contracts have taken out some of that risk. Payment is not always tied to animal numbers and performance."
Today we have the second generation of contracts. They tend to provide growers with a more fixed income and contractors with increased flexibility to try new marketing and production strategies. Because the grower assumes less risk with this type of contract, less compensation for the grower was expected with this "payment-per-pig-space" arrangement, but Cheney says, that hasn't necessarily been true. "Growers seem to be averaging $12 to $15 per pig for finishing, regardless of the contract," she says. "That says to me that folks are looking for contractees."
Contracts are still evolving into a third-generation version, where the smaller details are being scripted out. The new contracts try to deal with cash-flow issues, often paying growers monthly rather than at the end of a cycle. There are even more bonus programs connected not only to feed conversion and mortality, but also to fellow contract growers' performance. Environmental factors increasingly come into play: more clauses specifically address what will be done with the manure.
Most contracts today last seven to 10 years, a big jump over earlier versions that had a one- or two-year life span. Finishing isn't your only option, either. Wean-to-finish and nursery contracts are relatively recent choices.
What hasn't changed as much is the reason a person signs up to be a contract grower. The top reasons still are to be in or stay in farming and to limit risk. That's why Dan Boettger, New Richland, Minn., signed a production contract nearly three years ago to finish hogs for a company. Boettger and his wife previously owned and operated a 200-sow, farrow-to-finish operation.
"We got out when the first price crunch came," Boettger says. "Contracting gave us an opportunity to stay in pork production. I didn't want to hire an employee, and finishing is less labor intensive than a nursery or farrowing unit." Boettger also values the manure he gets from finishing the 4,000 hogs, which he uses on his crop acres and sells.
What Boettger was looking for and found in a production contract fits Cheney's third-generation outline closely. Boettger's company pays him a flat fee based on pig space. Then, every time the pigs cycle out, he gets a bonus based on feed efficiency, rate of gain, cull rate and death loss. His pigs' performance is rated against that of other producers in a group of the company's growers; top performers get the largest bonuses.
"It's a good trade off for me," Boettger says. "You do lose some of the management responsibilities, but the reduced risk is the biggest benefit. I'm not saying this is the way everybody should raise hogs. It's a system that works for my situation."
"Pork system" is the key phrase. Pork production contracts have been around a while, but they're being viewed more as another way to be a part of the "system" of raising pork. The lines are blurring between "independent" and "contract" pork producers because the options keep evolving.
"Some contracts are actually tying the grower's payment price to the hog price – for example, the grower gets a percent of the market price," Cheney says. "People are learning how much risk they want to take, especially local contractors who have been through this last year."
Tom Vincent, president of Brenton Bank, Agri -Access Division, Perry, Iowa, says production contracts are a widely accepted concept in pork production, because "producers are looking for a way to align with some kind of system that will make them a bit more bulletproof to the new, more volatile market swings."
Vincent's perspective is unique – he's an agricultural lender and a pork producer with a finishing contract. Being a contractor helps him understand as a banker which customers might be suited to this system.
Has he pushed contracting more because of the recent market situation? "One of my first questions after someone asks for a loan is 'how variable is your income going to be,'" Vincent says. "If you have the ability and desire to withstand more risk, there are modified contracts available. Then there are those who choose to be much more independent. But a production contract is a good option."
Michigan State's Cheney says lenders have been "very open" to producers who have a contract in hand. That stance will likely increase as low prices and market volatility continue.
Opportunities to get into contracting may be a different story. "There's more of a regional growth right now in Midwestern states where producers have traditionally not been as open to production contracts," she says. "There's more interest in Indiana, Illinois, Ohio, and continued interest in the South and farther west."
Ken Foster, livestock economist at Purdue University, says the market is the driving force behind more producers considering production contracts.
Also, as producers sell out because of low prices – whether forced or by choice – empty facilities could become future contract sites. As soon as there is some price recovery on the horizon, there will be people with an interest in contracting those facilities, he says.
This does not mean that all pork production is headed for contracting. "It's not clear that you need a production contract to survive," Foster says.
What is clear is that the new generation of contracts is presenting producers with another way to secure their future in pork production. Market Contracting: Price or Shackle Space?
Gary Ledger wanted more control over his hog prices and he got it. This Williamsburg, Iowa, producer is using a 6-month formula-pricing contract for his operation. His agreement is pretty straightforward. His packer uses a formula-pricing schedule off a three-day rolling average from the Western Cornbelt hog market.
It may not be extremely lucrative, but it takes away the daily price variation he would face on the spot market. Ledger's current contract ends in mid-December; he then has the choice of renewing it or going another route. "It has allowed me to have a closer relationship with my packer," he says.
Last year, Ledger covered his marketings through October 1998 with lean-futures contracts. "I should have done it again," he adds. "It really paid off last year."
Although his packer contract is serving its purpose, Ledger is interested in looking at a longer-term contract. However, he hasn't found any real attractive options. "I'd like to look at something with a price floor to help cover my cash costs."
That's where long-term contracts come into the picture. Linden Olson, a Worthington, Minn., producer is involved in a 72-producer cooperative that has had a marketing contract since 1995. The biggest reason was to guarantee shackle space for their pigs. But there are drawbacks.
Olson says the contract worked great until last October when their packer changed the pricing system. "Our costs remained the same," he notes. "But instead of making the profit we thought we would from the contract, we wound up marketing our pigs at a small profit or breakeven price."
This same type of scenario happened to Ledger in July. His packer adjusted the premium price, ultimately giving him a smaller profit margin. He didn't like it, but both producers agree there was nothing they could do because both contracts allowed for price changes.
Besides guaranteeing a market for the co-ops hogs, Olson says the group needed the market contract to get a loan. That's one thing that concerns Ledger. "I don't think lenders realize there's a shortage of good market contracts," he explains.
Lenders at Norwest Ag Credit in West Des Moines, Iowa, don't require their producers to have a market contract, but they do require a marketing plan.
"Everyone is so unique and individualized that a market contract either fits an operation or it doesn't," says Tom Ricke, vice president. "Producers with a lot of equity will stay open. Whereas the ones that are highly leveraged will have to prove to their lender that they can compete."
It comes down to you deciding what's best for your operation. "Contracts are fine if all parties understand them," contends Olson. "A lot of difficulties have arisen because of some unforeseen circumstances on both sides but resolved only by one side."
Olson is chairman of the National Pork Producers Council's contracting task force. This group is making necessary revisions to the Production Contracting Manual, and is looking at marketing contracts for finishing hogs, segregated early weaned pigs, and manure contracts.
"We're not writing up a sample contract that we think is ideal," stresses Olson. "We're looking at what items should be included or addressed so that both sides are aware of the issues and resolve them before a contract is signed."
"With long-term contracts, you don't have a lot of room to maneuver, except for number of pigs and where to deliver," says Brian Buhr, retail markets manager with E-Markets, Ames, Iowa.
"All market contracts include pricing, delivery and Pork Quality Assurance provisions, but it's the subtle points that can make a difference," says John Lawrence, Iowa State University agriculture economist. "There's no slam-dunk contract that's superior to everything else out there. You need to decide if the packer's vision coincides with your vision of the industry."
From a packer's perspective, the bottom line is quantity and quality assurance, says Buhr. Long-term contracts help packers ensure that top-quality producers stay in business. Look at a packer's business strategy statements. These are sensitive to the volatility of farm prices. Contracts help them smooth out the variation with their credit and cash flow.
"As producers, we need to know exactly what packers need from a product standpoint," contends Ledger. "There's not enough information feedback for what the end needs are. If we are going to be in the food business, and produce the kind of product that the processor and retailer need, we need to receive the information to let us produce it. That's what vertical integration has done. Somehow independent producers need to be involved in this."
No matter what kind of marketing agreement you're considering, Lawrence says there are three things you must do: Read and understand it. Have your attorney read and understand it. Have your lender read and understand it.
So what's the future hold for marketing contracts? "Contracting is part of the long-term trend in agriculture," Lawrence says. This goes back to efficiency of plant operations for packers and access to capital for producers. "Packers are adhering to a higher set of standards for the consumer than the open market allows," he explains. It's the same type of scenario in other industries. For instance, General Motors contracts with someone for tires; it doesn't just buy them on the open market whenever it needs a new supply.
Buhr agrees that market contracts will be more common. A potential snag could occur if Congress passes a mandatory price-reporting bill. Right now, the outcome is anyone's guess.
"This isn't a great time for producers to get a marketing agreement because packers are holding most of the cards," notes Ledger. "As the hog supply changes, there should be more opportunities in the future."
Read Between the Lines
What should be included in a marketing contract? There's no easy answer, but there are some guidelines you need to consider.
For starters, Linden Olson, Worthington, Minn., producer and chairman of the National Pork Producers Council's contracting task force, has some suggestions:
- Is this a risk-management strategy or am I looking for a way to even out my cash flow? There are other options besides contracts. You need to determine which business tools are best for your operation.
- Marketing contracts are not meant to guarantee profits.
- Is there any liability to the contract holder's estate if the contract holder should die?
- What happens if a disaster hits, such as a tornado or disease outbreak that causes reduced production or requires a herd depopulation?
- Remember that the person you discussed and signed the original contract with may not be there when disagreements arise.
- A contract that only sets a long-term price leaves you vulnerable to many factors, including feed prices, inflation on inputs, rising costs in property taxes, energy and labor. A long-term contract that looks good today may not look so good if conditions recur – that happened in the early 1980s.
- Make sure that all terms are clear and not subject to more than one interpretation.
- Be cautious of any clause that gives the contractor the right to change it at will. It will nearly always favor the contractor.
In addition, John Lawrence, Iowa State University agricultural economist, and Brian Buhr, retail markets manager for E-Markets, Ames, Iowa, expand the list even more:
- Payment method. This includes the current pricing grid, base price and your pay out on this system. You need to understand how and when the packers change or adjust their price grids. If that occurs, how much warning do you get? Do you have time to change your genetics to fit the packer's demands or will you need to find another packer?
If you don't want to face price risk if changes occur, Buhr says you can try to negotiate grandfather option in the grid price, but this may be hard to do.
- Delivery. Buhr recommends that you know exactly how much delivery right the contract gives you. For instance, does it give you priority if there's a backlog of hogs on the market? He doesn't have a solution on how to approach this except to discuss it before signing the contract.
You also need to know which packing plant you'll be delivering to, who pays for shipping if the packer changes the destination and when the hogs will be delivered.
- Will a ledger/balancing account be a part of the agreement? This increases your market stability but doesn't remove long-term risk.
- What are the packer's pork quality requirements for your hogs? This includes weight, backfat, grade, delivery time and day, volume and penalties if you don't meet your obligations.
- Length of contract.
- The time in the market price cycle that you sign the contract. This is a bigger factor with short-term contracts vs. long-term contracts and those with renewal options.
- Clauses that let you exit the contract if the packer changes weight and grade premiums/deductions or other factors that affect total value.
- Include a renewal clause for yourself or your packer at the end of the contract term.
- Make sure you can cancel your contract obligation if the packer closes and see that it provides for any necessary recourse.
- Include predetermined production growth to make sure your packer will accept additional hogs.
- Add a provision that lets you transfer the contract to another producer, possibly with packer consent.
- Define a process for binding or non-binding arbitration or a court settlement of disputes.
Remember, these are just starting points. Once you make the decision to consider a marketing contract, discuss it thoroughly with your attorney and lender before signing.