Chapter 12: The Changing Food Markets “Nothing is changing in the food markets except everything”

Trends Specialization  Producing or processing only one or a few products (Farming, Packing) Diversification  Multiple plants  Multiple products  Complementary products

Price determination is the broad forces of supply and demand establishing a market clearing price for a commodity.

Price Discovery is the process by which buyers and sellers arrive a a specific price for a given lot of produce at a given location for a specific time period.

Price Discovery A human process, subject to relative bargaining power of the buyer and seller. Two stage process  Evaluate S&D and Pe  Estimate the price for the specific trade.

Price Determination and Price Discovery S D P Q PePe QeQe

Price discovery systems Individual negotiations  Also called private treaty sales  Fed cattle, hogs, grain Organized central markets  Auctions, terminal, electronic Formula pricing  Eggs, wholesale meat, feeder pigs, hogs and cattle

Packer Procurement Method, 1999 HogsCattle Cash market27%65% Formula3220 Futures-based84 Risk share143 Packer owned185 Other13

Percent of U.S. Hogs Sold Through Various Pricing Arrangements, January * Hog or meat market formula Other market formula Other purchase arrangement Packer-sold2.1 Packer-owned16.4 Negotiated – spot *2002 data based on USDA Mandatory Reports, based on industry survey. University of Missouri and National Pork Board*

Performance issues “Least cost” method of price discovery Effect of the mechanism on price behavior Marketing v. pricing efficiency

Centralized pricing All buyers and sellers in one place at one time.  Full and immediate information  Competitive bidding  Equalizes market power  Transaction cost  Physical movement of product

Decentralized Pricing One-to-one negotiations  Reduced transportation cost  Reduced transaction cost  Depends on skills and information  Higher search cost

Trends Decentralization  Move away from central markets Drivers of trend  Transportation  Processing technology  Communication systems  Economies of scale

Decentralization Factors

Hybrid markets Electronic markets  Centralized pricing  Decentralized product movement Examples  Satellite auctions  Electronic auctions  Tel-o-auction  E-commerce

Electronic markets Marketing agency  Lends credibility  Settle disputes  Aids collection and payment Example 

Market Vertical Coordination Communication and distribution Historically relied upon price signals  Markets and spot negotiation Moving toward non-market transactions  Contracts and long term negotiation

Integration Vertical and horizontal Ownership  Mergers  Growth to include function Contract  Formal agreement

Integration? Improved communication and control of the food supply to increase customer satisfaction? An attempt by processors to drive down farm level prices for short and long term gain?

Reasons for Integration Profit potential Risk reduction Improved bargaining power Operational efficiency Improved communication

Food Industry Alliances Preferred/exclusive suppliers Marketing contracts HyVee and Farmland pork

Production Ag Integration Premium Standard Farms Smithfield Foods  Largest pork packer and producer Cargill  Nutrena, Production, Excel  Corn genetics, grain handling, processing US Premium Beef Iowa Quality Beef Supply Coop Farrow-Finish grain farm

Johnson Amendment, 2001 Prohibits packers from owning, feeding, or controlling livestock for more than 14 days prior to slaughter Amended to allow contracting  Farmer must materially participate Excludes coops and poultry Packers would divest in  Hogs 18 months  Cattle 180 days

Contract Integration Market specification contracts  Forward contracts  Common and general Examples  Forward Contracts Little management control by buyer

Contract Integration Market specification contracts  Forward contracts  Common and general Resource providing contracts  Prescribed inputs and management Management and income sharing  Greater integrator control

Integration into farming Horizontal integration  Fewer and larger farms  Networking and alliances Vertical integration  Cooperatives  Input production  Grain and meat processing

Value of Selected Commodities Produced under Production Contracts, 1997 Source: USDA, Economic Research Service, 1997 Agricultural Resource Management Study, special analysis

Value of Selected Commodities Produced under Marketing Contracts, 1997 Source: USDA, Economic Research Service, 1997 Agricultural Resource Management Study, special analysis

Types of contracts Market-specification terms  Product characteristics  Basis of price and payment Examples  Forward deliverable contracts Little management control by buyer

Types of contracts Resource-providing terms  Inputs are specified by buyer  Little price protection Examples  Specialty grain  Processing vegetables High degree of management by buyer

Types of contracts Management and income guaranteeing  Specifies characteristics and input use  Provides price and maybe production risk Examples  Hogs, poultry High degree of management by buyer

Contract grain production Forward contracts for delivery Specialty grain  Seed corn, popcorn, white corn  Formula contract tied to another market Silage production Production for grain

Forward Contracts Contract of delivery  Defines time, place, form Tied to the futures market  Buyer offering the contract must lay off the market risk elsewhere  The buyer does the hedging for you

Handout Example grain forward contracts

Forward Contract Advantages No margin accounts or calls Working with local people Flexible sizes Known basis Tangible and Simple

Forward Contract Disadvantages Inflexible  Replace price risk with production risk  Difficult to offset  Must deliver contract to specific location Buyer “takes protection”  Usually prices in a wide basis

New Type of Contracts Hedge to Arrive (Futures Only)  First: When favorable lock in price on futures exchange  Second: When basis is favorable lock in basis and delivery period (may roll forward if basis does not turn favorable)  Third: Deliver grain at contracted time

New Type of Contracts (cont.) Basis Contract  First: When basis is favorable lock in basis and delivery period  Second: When favorable lock in price on futures exchange  Third: Deliver grain at contracted time

New Type of Contracts (cont.) Minimum Price Contract  Lock in a minimum (or maximum) price on current futures prices  Pay a fee per bushel  Price moves higher  collect on improve price  Price moves lower  let contract expire

New Type of Contracts (cont.) Floored Average Contract  Lock in a minimum price on March futures price  Pay a fee per bushel  May establish basis at anytime  Average price between harvest and February 1st moves higher  collect on improve price  Price moves lower  guaranteed your minimum price.

Cattle Production Contracts Commercial feedlots  Feedlot provides the management not the buyer or cattle owner Custom grazing  Cowherds  Stockers

Cattle Marketing Contracts Captive supplies of cattle  Under the buyer’s control 14 or more days before delivery Marketing contracts  Forward contract for delivery  Formula contract Types of captive supplies, 1999  Packer owned4% (now 6-8%)  Under contract28%

Captive Supply Research Results 1993 KSU Study: Captive supply shipments associated with a $0.15/cwt to $0.31/cwt decline in cash fed cattle prices 1996 KSU - OSU Study: 1% contract delivery associated with $0.02/cwt to $0.03/cwt. cattle price 1% packer fed delivery associated with $0.13/cwt. to $0.19/cwt. cattle price 1% mktg agrmnt delivery associated with $0.04/cwt to $0.26/cwt. cattle price

Hog Production Contracts Farmer is paid to provide building and labor Hog owner provides inputs and management Limited production risk, no price risk Currently 33-35% of hogs produced under a production contract

Hog marketing contracts Relatively new - growth since 1993  Open market was 87-89% in 1993  Open market was about 15% in 2003 Product specification important  Genetics, inputs, food safety Delivery scheduling Types of contracts  Formula price  Share price risk

Risk Sharing Contracts Window contract  Set upper and lower bound  Share the “pain and gain” outside Cost based price floor  Minimum price tied to feed price  Pay back “loan”  Give up part of higher prices

Contract Examples Iowa Attorney General  Current research on web  Hogs:  Cattle:

Packer Motivation for Increased Pork and Beef Marketing Contracts, a

Producer’s Motivation for Entering Marketing Contract with Packer Access to capital and better financing Reduced price risk Assure a buyer Reduced marketing costs Improved prices or premiums

Reasons for production integration Greater control  Product quality / specifications  Scheduling  Industrialization Risk management Access to resources

Motivations and Implications Profit potential???  Multiply management  Production efficiency and product quality Thin market concerns Encourages expansion by reducing risk

So What???? How do you establish value in a system in which there is little or no open market activity? Do you need to? How do you determine returns to the various segments?

Open market impacts Packer may have ability to call supplies Formula tied to cash market Potentially depress prices Potentially increase volatility Value-based pricing

Discussion Questions Compare the farmers marketing task for poultry vs. corn

Discussion Questions What kind of regulation?  Foreign nationals buying U.S. farmland  Steel firm buying U.S. farmland  Vegetable canner owning farms  Farmers owning vegetable canner  Farmers purchasing more farmland