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The cousin of consolidation: contracting

January 1, 2000


Ron Wirtz Editor, fedgazette
The cousin of consolidation: contracting

For farm advocates, agribusiness consolidation has brought with it a host of evils, none more precious than the loss of family farm independence, knocked back on its heels by a one-two punch of an eroding cash market and an increase in forward contracting.

As firms and plants have consolidated, left behind are fewer commodity buyers in the cash market, on which small producers still depend heavily. Fewer buyers mean less competition in the cash market and, by extension, lower prices.

Compounding this, consolidation has meant that remaining plants have become bigger (in some cases, much bigger) to capture economies of scale. To guarantee a steady supply of high-quality inputs, processing firms have turned to forward contracts-buy/sell agreements for future crops or livestock-to keep processing plants operating at high capacity and efficiency. Farmers who continue to sell in cash markets argue that these captive markets relegate them to stopgap suppliers who bear the brunt of swings in supply and demand.

More U.S. farmers are signing forward contracts to shield themselves from price risk in a herky-jerky market. But many remain skeptical. While contracts can help with short-term cash flow, they do little to help farmers get ahead in the long run, according to Paul Strandberg of the Minnesota Department of Agriculture.

"In terms of capturing opportunities for major profits, [contracts] definitely cut the tops off the margins" for farmers, Strandberg said. As a result, contracted farmers are not afforded the opportunity to catch up financially when commodity prices turn around. "You're sort of in the soup when it comes to the ledger balance."

Nonetheless, the practice is gaining momentum in the United States and elsewhere. It's estimated that 70 percent of all hogs are now raised on contract, a dramatic increase from 10 percent in 1990. Other ag sectors-poultry, fruits and vegetables-have been using contracts for decades.

Little comprehensive data is collected on forward contracting in other countries, but it appears to be picking up steam across the northern border. "Anything you get [regarding contracting] is by guess or by golly," said Anne Dunford, senior analyst with CanFax, a division of the Canadian Cattlemen's Association. But it appears a growing number of Canadian farmers are using forward contracts and other noncash pricing vehicles.

CanFax surveyed Alberta cattlemen in 1998, and found that one-third of all cattle were sold outside the cash market-8 percent to forward contracts, 10 percent to formula or grid prices (based on carcass quality) and 14 percent were owned by packers. The survey showed 68 percent of cattle still went to the cash market, but Dunford estimated that all cattle sales were in the cash market just 10 years ago.

Maybe more interesting is the fact that forward contracting apparently does not meet with quite the opposition and fear as in the United States. "I don't think there's as much negativity" regarding forward contracts, Dunford said.

Instead, ranchers have been more opinionated over packer-owned and formula grid cattle, which are believed to have more of an effect on the cash market, she said. On top of the traditional ranching risks, Canadians also face the uncertainties of a volatile Canadian dollar, and farmers there see forward contracts as "one more avenue to reduce risk," Dunford said.

"Those (pork producers) under contracts, they are pretty happy," said Martin Rice, president of the Canadian Pork Council. Those without contracts tend not to like them and believe cash market prices are unfair because packers have locked in most of their needed inputs. "As more hogs are taken out of the daily bid and offer system, what's left over is paid residual (money)," Rice said. The Province of Ontario requires public disclosure of contracts—minus any party identity—in hopes of maintaining fair market prices for all pigs, Rice said.

In grain farming, between 15 percent and 25 percent of all grain production is through contracts, involving probably 5 percent to 10 percent of all farmers, according to Errol Anderson president of ProMarket Communication, an agricultural risk management firm in Calgary. In general, the "more progressive" growers are involved in contracting, Anderson said, and look to ensure a profit on every acre harvested rather than holding out for the highest possible return for a harvest.

Despite being "cash-whacked" on the open market, Anderson said, very few small farmers in Canada have forward contracts. "They tend to be gamblers," he said. "It's greed. Why sell now when [they believe] it will be higher later?"

Ron Wirtz
Editor, fedgazette

Ron Wirtz is a Minneapolis Fed regional outreach director. Ron tracks current business conditions, with a focus on employment and wages, construction, real estate, consumer spending, and tourism. In this role, he networks with businesses in the Bank’s six-state region and gives frequent speeches on economic conditions. Follow him on Twitter @RonWirtz.