Today, the majority of swine purchased by packers is procured through production contracts. According to the United States Department of Agriculture (USDA) Agricultural Marketing Service (AMS), a small percentage of daily slaughter (less than 10 percent) consists of Negotiated Purchased Swine, which is defined as “cash or spot market purchase by a packer of livestock from a producer under which the base price for the livestock is determined by seller-buyer interaction and agreement on a delivery day.”
The remaining daily swine purchases are procured under a variety of contracts. In light of recent commodity price volatility and shifting market forces it is vital that producers are aware of relevant clauses in their current contracts and plan carefully when considering whether to enter into new production agreements.
Types of Contracts
The USDA Grain Inspection, Packers and Stockyards Administration (GIPSA) requires reporting of most production contracts and publishes their terms in the Swine Contract Library . Generally, swine production contracts fall into one of the following categories:
Market Formula Contracts - Formula price based on any market other than the market for swine, for example futures or options contracts.
Swine or Pork Market Formula Contracts – Formula price based on a market for swine other than futures or option contracts such as the AMS reported Western Cornbelt Daily Direct price or the Carcass Cutout price.
Cost of Production Indexed Contracts – Formula prices based on the cost of producing hogs. These contracts typically have a feed price adjustment factor based on a rolling-average corn and soybean meal price. As feed prices increase, so does the amount received for hogs and vice versa.
Ledger Type Contracts - An account held by a packer on behalf of a producer that accrues a running positive or negative balance as a result of a pricing determination included in a contract that establishes a minimum and/or maximum level of base price paid. Credits and/or debits for amounts beyond these minimum and/or maximum levels are entered into the account. Further, the contract specifies how the balance in the account affects producer and packer rights and obligations under the contract.
Considerations Before Entering Into a Contract
Before producers enter into a production contract, they should review the contract carefully and ensure that all obligations under the contract are understood. The decision to have an attorney review the contract is a business decision for the producer to make after considering the burden and benefit. However, if the contract is material to your operation, it is advisable to have counsel review the agreement. An ounce of prevention is worth a pound of cure.
If an amendment is made to the contract, it should be executed in writing by both parties. An amendment can take the form of a formal agreement or a more informal letter agreement. The important thing is to clearly document the change and have both parties signed off on it. Good fences make good neighbors and good contracts make good business relationships. If both parties have a clear and documented understanding, disputes are less likely to arise.
Recent Contract Trends
Like all other aspects of pork production, the advent of higher feed prices has affected production contracts. Packers are generally less likely to offer cost of production indexed contracts given the recent price volatility of feedstuffs. Additionally, packers and producers may be less likely to enter into ledger-type contracts. In general, price volatility makes price risk support less likely in packer contracts.
Pricing mechanisms will evolve as pricing levels for feedstuffs normalize at higher levels. For example, production contracts that include a bonus component will likely tie the bonus directly to efficiency of feed use and conversion. Contracts are also becoming longer and more complex as a result of regulation at the state and federal level and other external pressures, such as environmental risks and animal welfare.
Pork production is a biological process, and as such it can be greatly impacted by factors such as diseases and weather. Producers are at a constant risk of disruptions in flow. It is important to spell out how to address such disruptions when drafting production contracts.
Producers should pay particularly close attention to force majeure provisions. These provisions commonly free from liability a party to the contract that is not able to meet its contractual obligations because of an event deemed to be an act of God such as a strike or natural disaster.
When a producer encounters disruptions as a result of diseases or natural disasters, the terms of the contract will determine whether the producer is liable. One person’s unexpected disaster is another person’s planned-for contingency for which risk of loss has been allocated.
When a producer or owner realizes that he or she may be unable to fulfill production obligations, immediate notice should be provided orally and in writing. If the contract is material, an attorney should first be contacted. A delay in providing notice of nonperformance can expose the counterparty to greater harm, harm that will ultimately be recoverable from the breaching party. Early communication, candor and professionalism can avert most disputes and, thereby, the need for litigation.