Hog and Pork Marketing Trends

Jon Caspers, Member
NPPC Board of Directors
Swaledale, Iowa

 

In my mind, there is but one trend to consider regarding the marketing of hogs: The market that has been the interface between hog producers and packers is rapidly disappearing. Not changing. Disappearing. It's disappearance is not the result of any concerted effort by producers, whether large or small, or packers. It is simply the result of these parties’ response to competitive forces that originate with consumers’ desires for high quality (as defined by each different consumer’s tastes and preferences) at the lowest available cost and entrepreneurs’ desires for high returns at the least possible risk. Such desires, for both consumers and entrepreneurs, are nothing new but they have manifested themselves in the pork industry in historically different ways in recent years. And, their manifestation in the future will likely be different yet.

I believe there are two absolute trends in the pork industry that will change the face of transferring ownership of pigs from producers to packers. These trends are the continued (and even increased) use of marketing contracts and a shift in valuation point from the live animal or carcass level of the value chain to the wholesale or boned cut level.

Continued and Increased Use of Marketing Contracts

First, a bit of history. Marketing contracts were, for the most part, developed by packers in response to producer requests. It was producers, not packers, who first proposed marketing contracts in an effort to guarantee access to slaughter capacity and, in many instances, to reduce price or cash flow risk. As a few packers responded, others quickly developed their own programs in order to prevent their competitors from tying up the supply of good, lean logs. In the early days of market contracts quality was a key driver -- packers wanted to secure the best hogs.

In the rush, many mismatches between producer goals and contract features were created. Many producers who, after the slaughter capacity problems of the fall of 1994, were concerned about having a place to sell pigs signed contracts that included price risk management when they neither wanted nor needed that feature. Others signed formula contracts that they erroneously believed would affect the average price received enough to offset the risk posed by price variation. Still others signed contracts that put floors under prices and included a "ledger" feature that they believed would never get too large and would self-liquidate over time. So they believed!

Virtually all of these contracts were written by packers. Some had terms that were somewhat negotiable. Others were strictly contracts of adhesion or "take it or leave it" deals. As with any contract, the party that wrote these (i.e., the packers) made sure to take care of their interests. Many terms gave them unilateral power to change everything from quality standards to delivery to the pricing matrix itself. All were predicated on "historic" hog cycles and price levels and this doomed them to problems in a market like that of late 1994 through 1999.

Marketing contracts are now a permanent part of the landscape in the pork industry. As can be seen in Table 1, their use has grown dramatically in just the past three years.

NPPC is supportive of producers' rights to decide whether they need a contract to guarantee market access and manage price risk. We see contracts as a viable alternative for coordinating systems which neither the producer nor the packer want to vertically integrate. Contracts can make non-integrated systems competitive. We are also convinced that the first generation of marketing contracts, many of which are about to expire, are not fair enough to both sides of these transactions to accomplish these goals.

Our experience to date has taught us a few things, many of which have not been pleasant. Here are the highlights:

• History doesn't always hold OR make sure you look at ALL of history. Did anything really suggest $10 hogs in the fall of 1998? No. But nothing really suggested that hog prices would stay in the $35 to $60 range of the '80s and early '90s either. If all of history is considered, the possibility of lower priced hogs was clear. Was it "probable" in today's world? Again, no. But probability distributions theoretically contain every possible outcome, including positive and negative INFINITY. Never think it will never happen. The result of this narrow view of history is huge ledger balances that may never be repaid. The lesson for producers and packers is to consider the full range of possible outcomes and develop adequate contingency plans. These contracts are, at least in theory, long-term and supposedly win-win relationships.

• Producers should match contract provisions to their critical needs. If market access is the key issue, then agree to supply hogs to packer A in turn for packer A agreeing to take your hogs on a timely basis and leave price risk management up to the separate parties. The lesson is for producers to carefully analyze what is actually needed and negotiate for only those features. The arrangements must be win-win or no deal.

• Be wary of any contract clause that gives one party (usually the contract writer) the unilateral power to change a contract provision. The ability to change business relationships is needed but changes should be the result of negotiation, mediation or, as a last resort, arbitration. Our experience with packers' changing weight discount ranges, leanness premiums and a host of other items at their own whim has been entirely negative and will probably be played out in more than a few courtrooms over the next few years. The lesson here is to carefully review contracts and develop alternatives to the unilateral change provisions. Change is often a necessity; but leaving the decision in one party's hands is a recipe for disaster. The need for change should be a signal for renewed negotiation and, if a mutually acceptable decision cannot be reached, possible mediation or arbitration.

• Provide for changes in government services and information. A main source of unhappiness with contract performance has been packers' decisions regarding base prices after the USDA-AMS changed their price reporting system in 1999. At least one packer chose to use a reported price that was clearly in the packer's favor in spite of ample data demonstrating a method of mimicking the discontinued "Iowa-Southern Minnesota Practical Top" price report. The only recourse for producers to what they considered a breach of contract was to breach the contract themselves and sell hogs on a $20 cash market. Some recourse! The lesson here is to include the possibility of information changes in the contract and spell out how such changes will be handled. Again, negotiation, mediation and/or arbitration are all possible courses of action.

• Be very careful about narrowing the market that serves as the base for a large percentage of the contracts in force. Many of today's contracts use the Iowa-Southern Minnesota 10:30 a.m. report to price a given day's purchases or deliveries. So, the price of all of these contracted hogs is determined by purchases occurring before 10:00 am. on a given day. In addition, a good portion of the contracts is priced at the midpoint of the range of prices reported at 10:30 am. These contracts are priced on an even narrower set of hogs -- the highest- and lowest-priced lots sold before 1p:00 am. on a given day. As the base market is narrowed more and more, the more open to manipulation it becomes. And when producers have tried to take an active role and report the prices they receive to AMS, many have found it impossible to get a bid on their hogs before 10:00 am. but easy to get bids at higher prices after the 10:30 am. report. We believe it is blatant manipulation but we also admit it was our own "collective" doing that made it possible. The lesson here is to be careful about the scope of the price determining market. One of the best features of the impending Mandatory Price Reporting system is its inclusion of a prior day report that will include ALL of the hogs purchased by plants which slaughter over 100,000 head per year. These data, since they are on such a broad set of hogs, will be practically impossible to manipulate. Furthermore, the records and enforcement provisions of the Mandatory Price Reporting Act promise to make the data accurate and hold packers accountable for such accuracy.

So what should the response be? Regulation is a possibility but not one that we are extremely fond of. Standardized disclosure requirements would reduce confusion and facilitate comparisons and competition. The catalog of contracts required by the Livestock Mandatory Price Reporting Act of 1.999 will help producers be aware of what is available to them

But the most important action to be taken is for producers to learn more and be more vigilant about their business dealings. It is unbelievable the number of producers who admit that they never had their attorney review the marketing contract that they signed. It is shocking how many producers never read the contract themselves. This is just lousy business practice that must end in today's more sophisticated world. The courts will not likely remain sympathetic forever to producers who do not follow sound business practices.

Last year, NPPC have assembled a committee of experts to review marketing contracts and write a much-needed and valuable addition to the pork producers' decision-making arsenal. NPPC's Guide to Marketing Contracts was released in March at the National Pork Industry Forum in Kansas City. It covers many of the issues I have discussed today and demonstrates the performance of the various marketing contracts over recent years. It is not meant to be legal advice but is meant to stimulate what we believe to be the correct and necessary questions that producers should ask themselves and any packer who offers a contract.

Changed Valuation Point

The trend to more and more contracts, though, poses one obvious question. If there are no more hogs sold as live animals or as carcasses in a spot market, how do we determine the value of the critter that is produced by one entity and processed by another? How do we know how much to write the check for?

The equally obvious answer is "By using another market which is correlated to the value of the product." I believe that the industry must find a way to value the product transferred from producers to packers based upon it's direct contribution to the value of the product sold by packers. This means a shift to wholesale cut or, even better, boned cut pricing.

There are two main advantages to such a system. First, it puts producers and packers on the same side of the market. Both parties can divert the time, energy, and expense of dickering over the price of pigs or carcasses to accomplishing those tasks that add value in the eyes of the packers' customers.

Second, it sends clearer signals about the characteristics valued by consumers. Producers can clearly focus on increasing those characteristics which add value and be rewarded for doing so. Packers can do likewise knowing that they will capture some margin above the cost of goods sold. Since both parties are responding to the same signals, consumer needs should be met better than in the current situation of fuzzy, frequently contradictory signals.

There are also problems to shifting toward a wholesale cut or boned cut pricing system. The most obvious is the current thinness of these markets (even thinner, in many instances, than the hog/carcass market) and the low proportion of total trades reported. The widespread use of price formulas based on the reported wholesale and boned cut markets leave much incentive for packers to voluntarily report the high end of the actual prices they receive. Factoring this into a downstream pricing mechanism is beneficial for producers.

A second problem is making this a true component pricing system. The realities of packing plants preclude, at least for now, tracing cuts all the way though a plant and valuing a pig based on actual cut yields. NPPC has :recently developed prediction equations that use common carcass measurements to predict wholesale cut and trimmed, boneless muscle yields. We believe that these, or equations much like them, could serve as the basis of a downstream product pricing system. We have not yet analyzed data from an AutoFOM machine which is designed to measure and predict individual cut yields. Such analysis should be done by early 2001.

The third challenge for such a system is the lingering, and sometimes well founded, mistrust of packers by producers. A downstream product pricing system would likely depend even more upon packers' measurement and weighing systems than does the current carcass performance system. I doubt that many producers are completely comfortable with that and I'm not sure packers are either. The best solution to this is likely a third-party evaluation method, carried out by either a governmental agency or an independent company.

Summary

So, as with most things in life, the future holds challenges to our current knowledge and information levels. The pork industry of the future must be highly coordinated to efficiently utilize large capital investments at every step of the value chain. Perhaps more important, though, this coordination must facilitate product delivery that satisfies consumer desires every time. No (or at least not many) slip-ups will be allowed in the competitive world of the future which is filled with target markets that consist of one individual consumer.

 

Table 1
Percent of U.S. Hogs Sold through Various Pricing Method, 1997-2000

Pricing Method

1997

January
1999

January
2000

Formula (a reported price plus some amount)

39.1%

44.2 %

47.2

Fixed price tied to futures market price (i.e., a cash contract)

2.9%

3.4%

8.5%

Fixed price tied to feed price, no ledger maintained

5.3%

2.9%

3.3%

Fixed price tied to feed price, ledger maintained

6. 9%

9.0%

Window, risk sharing, no ledger maintained

3.1%

3.6%

3.8%

Window, risk sharing, ledger maintained

1.0 %

0.8%

Other (packer owned, internal transfer)

6.1 %

2.3 %

1.7%

Total non-spot market purchases

56.6 %

64.2 %

74.3%

Total spot market purchases

43.4 %

35.8 %

25.7%

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