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

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

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

5. 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.

6. 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.

7. Price Determination and Price Discovery S D P Q PePe QeQe

8. 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

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

10. Percent of U.S. Hogs Sold Through Various Pricing Arrangements, January 1999-2002* 1999200020012002 Hog or meat market formula44.247.254.044.5 Other market formula13.220.821.911.8 Other purchase arrangement4.64.66.68.6 Packer-sold2.1 Packer-owned16.4 Negotiated – spot35.825.717.316.7 *2002 data based on USDA Mandatory Reports, 1999-2001 based on industry survey. University of Missouri and National Pork Board*

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

12. 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

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

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

16. Decentralization Factors

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

18. Electronic markets Marketing agency  Lends credibility  Settle disputes  Aids collection and payment Example  http://www.e-markets.com/ http://www.e-markets.com/

20. 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

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

23. 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?

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

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

26. 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

27. 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

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

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

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

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

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

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

34. 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

35. 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

36. 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

37. 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

38. Handout Example grain forward contracts

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

40. 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

41. 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

42. 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

43. 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

44. 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.

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

46. 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%

47. 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

48. 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

49. 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

50. 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

53. Contract Examples Iowa Attorney General  http://www.state.ia.us/government/ag/ag_contracts/ http://www.state.ia.us/government/ag/ag_contracts/ Current research on web  Hogs: http://www.econ.iastate.edu/faculty/lawrence/HOGS.htm http://www.econ.iastate.edu/faculty/lawrence/HOGS.htm  Cattle: http://www.econ.iastate.edu/faculty/lawrence/Cattle.HTM http://www.econ.iastate.edu/faculty/lawrence/Cattle.HTM

54. Packer Motivation for Increased Pork and Beef Marketing Contracts, 1999. a

55. 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

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

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

58. 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?

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

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

61. 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