Selling a product without securing a market outlet is risky business, but that's how agriculture has operated for years. For the pork industry, that scenario began to change in earnest during the 1990s.
In 1993, 87 percent of U.S. market hogs were sold in the cash market, 13 percent were contracted to packers, according to Marvin Hayenga, Iowa State University agricultural economist. Less than 10 years later, that scenario is nearly reversed.
Based on a January 2001 packer study, Glenn Grimes, University of Missouri agricultural economist, found that 83 percent of U.S. domestic hog slaughter is now sold through contract arrangements.
The 2001 Pork Industry Structure Study has the market contract figure at 71 percent, but it's based on 2000 sales. Grimes' figure for 2000 was 73 percent.
"The critical number is top quality hogs. For 2001 we're around 17 percent in the cash market," says Grimes. "Culls and lightweight hogs equal another 4 percent to 6 percent."
Ironically, the cash market sets the tone for most contracts. The most popular type was "formula tied to cash" at 52 percent of all hogs sold (39 percent in 1997).
It's no surprise that producers marketing the fewest hogs, remain the heaviest cash market users. Meanwhile, only 1 percent of the hogs sold by the largest producers wind up there.
With a dwindling cash market, it begs the question: "How low can it go and still remain a viable price discovery option?"
"It depends on your tolerance for volatility," says John Lawrence, Iowa State agricultural economist, who along with Grimes calculated the outcome of the 2001 Pork Industry Structure Study. "The thinner the market, the wider the price swings. At some point, confidence will erode and we will need an alternative way to price hogs or transfer ownership."
Some packers would like to see the cash market stabilize at current levels. "Packers are in excellent shape when they have 80 percent of their supply contracted," says Grimes. "It still allows them flexibility to roll with the margins."
Lawrence and Grimes agree that if 15 percent of the hogs remain in the cash market, that's enough to meet price discovery needs.
Wholesale meat prices are a possible pricing alternative, and some companies are experimenting with this. Grimes points out that producers marketing 50,000 to 499,999 hogs a year sold 1.4 percent of their hogs based on meat prices. In the 500,000-plus group, 4 percent of the hogs were sold that way.
"That is a fairly thin market now, but once USDA gets control over mandatory price reporting, it could be a more effective option in the future," says Grimes.
Another way to transfer ownership is for packers to produce their own hogs. The survey showed that packers owned 23 percent of 2000 U.S. domestic slaughter. That compares to 9.4 percent in 1997. Smithfield Foods, Premium Standard Farms and Seaboard account for most of that growth.
Whether packer ownership of hogs will grow further is yet to be determined. "We're going to be a coordinated industry in some way," says Grimes. "Right now the bulk of the industry is coordinating through market contracts." He says it will boil down to whoever is most profitable – packers that own hogs or packers that don't.
Regardless of what packers might do, some producers said marketing contracts gave them the security to expand. The survey asked only producers raising 1,000 to 49,999 hogs annually because producers in the top two size groups contract market nearly all of their hogs. Seventeen percent said their operation is larger today than it would have been without a market contract. The average increase for those farms was 114 percent. Conversely, 4 percent of producers with a pre-arranged agreement said they have cut production since holding the contract (cuts averaged 50 percent.)
Certainly producers are increasingly reluctant to expand without having a place to sell their hogs, and lenders rarely commit money unless there's a market contract in hand. "Contracts have helped individuals grow, and as a result have added to the hog supply," says Lawrence.
Interestingly though, the most popular contract (formula tied to cash) provides shackle space and eliminates the hassles of collecting bids to sell hogs, but it does not guarantee price. Even after the 1998/1999-price crash, managing price risk took a back seat. Surveyed producers said what they most want from a market contract is to be able to collect on high prices if and when they occur.
"If you look at when profits are made, it's during the six or 12 months of $20- to $40-per-head profits, and producers don't want to be left out of that," says Lawrence.
"The rules are yet to be written on this," adds Grimes. "If we go through another 1998, then securing risk protection will become more important again."
Producers did contradict themselves when asked about advantages and disadvantages of market contracts. They scored "reduced price risk" as the second highest advantage, following "increased price received." The majority (55 percent) believe they have received a higher price for hogs because of their contract; another 40 percent said they at least equaled the cash market.
Ledger contracts have offered risk protection in the past, and they are still part of some packers' programs (17 percent of market hogs in 2000), but they are probably less popular today with both packers and producers. Producers said if they had to choose a contract where they'd limit their upside price potential or one where they'd have to pay back a ledger, they would rather give up the top dollar.
In some cases, ledger contracts were a way to provide financing for operations to grow, but they grew into monsters following 1998/ 1999. "Packers really didn't want to become lenders," says Lawrence. "I doubt that contracts where the packer is providing all of the risk protection are sustainable." Several ledgers have been erased either voluntarily or through payments since 1998/1999.
Everyone has an opinion about market contracts, but surprisingly attitudes of producers with contracts and those without were not significantly different. Operation size had more impact on attitudes. Producers with large operations believe market contracts have helped coordinate the pork supply chain, and they are opposed to making them illegal. Producers with smaller operations believe that contracts have pushed cash hog prices lower and that contracts should be monitored more closely.
"There's no question that having a contract gives the packer a much better sense of where he is in terms of supply," says Grimes. "I am convinced that if we didn't have these contracts the market would be substantially more volatile."
Bottom line: producers with market contracts like them, they feel they've been treated fairly and they will continue to use them.
"The industry is still evolving, we're experimenting as far as market contracts are concerned and how they can best serve the producer and the industry," says Grimes. "It's a learning process like anything else."
What the industry has learned so far is that market contracts are here to stay.
Editor's note: Sponsors of the 2001 Pork Industry Structure Study include Pork magazine, the National Pork Board, PIC, DeKalb Choice Genetics, Land O' Lakes and the Research Institute for Livestock Pricing.