Contract pricing complicates hog markets

Edward Lotterman | Agricultural Economist

Published January 1, 1999  | January 1999 issue

You Feed 16,000 Hogs...
If the late Tennessee Ernie Ford were a Ninth District hog farmer he might be singing

"You feed 16,000 hogs and what do you get?
Another year older and deeper in debt.
St. Peter don't you call me 'cause I can't go
I owe my soul to the hog kill flo-"

At least that is the opinion of some producers about the contracts they have with hog packers. While such "packer contracts" have been promoted as an instrument to reduce risk for both packers and producers, most include a "ledger" provision that is increasingly controversial. Some producers fear it will lead to the sort of perpetual indebtedness to the "company store" that once prevailed in some Appalachian coal mining towns. Such a comparison may be overblown, but many agricultural economists agree that ledger contracts need closer scrutiny.

The contracts usually are structured something like the following. The contract identifies a price band with a width of $5 that covers anticipated average prices over the length of the contract. Many in the last two years have specified a band of $40 to $45 per hundredweight. As long as the market price at some specified public market, such as South St. Paul, Minn., or Sioux Falls, S.D., is within that range on the day hogs are delivered by the farmer to the packer's plant, the farmer is paid that price. If the public market price is above that price, say $47.50, the farmer receives the upper band limit, $45, and the difference of $2.50 is entered in the contract's "ledger." If the price on the delivery day is below that level, say $37, the ledger balance is reduced by the $3 difference. Similar debits or credits are entered for every out-of-range sale over the life of the contract, typically three to five years. At the end of the contract, if the ledger balance is positive, the packer pays the balance to the farmer. If it is negative, the farmer pays the packer.

The question of what packers will do if a producer has a negative balance and does not have funds available to pay is where the controversy starts. Will packers foreclose on producers' hog facilities or other collateral? At a recent meeting of ag lenders organized by the Minnesota Agri-Growth Council, one participant minimized the threat. "Most of these contracts say the packer has the option to extend the contract until the ledger balance is zero," he commented. But another participant, a bank owner with several customers who have ledger contracts, sharply disagreed. "If that is all the packers plan to do, why do they have contractors sign a personal guarantee for any remaining balance and if they are young farmers, ask that their parents also provide a personal guarantee for any eventual debt?" he retorted.

Such ledger contracts are so new that few have yet reached their end. Thus there is little experience to go on. Most analysts agree that when the majority of contracts were signed, neither side expected the kind of price collapse that occurred in the last seven months. But with hog prices in the low teens, a producer who delivers 100 hogs per week can see her negative balance increase by nearly $6,000 per week. Some have reached levels that are substantially greater than the net worth of the producer.

Defenders of such ledger contracts point out that the producers do receive immediate payment of the lower limit of their contract's price range, and that they are thus getting much higher current period returns than their neighbors who do not have contracts. Current high negative balances will be reduced as soon as hog prices rise above contract ranges' upper limits. In the meantime, the negative balance really represents a low-interest or no-interest loan from the packer to the producer.

From the point of view of economists, the referencing of contract payments to prices in public markets—at the very time such contracts are reducing the number of animals sold in such markets—raises a number of red flags. As public markets lose market share, they become less liquid. Increasingly, public markets are a residual market in which a declining proportion of production has to take up all the price adjustment to shifts in either supply or demand. Prices thus can become more volatile, and some analysts question whether these prices are the same that would have been reached if all hogs were sold in public markets. In other, words is "price discovery" as accurate and as transparent as it would have been without the contracts?

Some smaller independent hog producers call for the prohibition of packer contracts, saying that they are too one-sided and that an individual producer has little bargaining power compared to a packer. But other producers and some hog producer associations maintain that the contracts are freely entered into by both sides and that the majority of all hogs are still sold in daily spot markets. A number of farm organizations and some livestock economists have proposed that packers be allowed to continue to offer contracts under whatever terms they see fit, but that these firms also be required to publicly disclose the terms of such contracts and how many animals they buy each day or week on contract. Reports could be made to U.S. Department of Agriculture's Packers and Stockyards Administration, the agency mandated to regulate the industry.

Many observers note that the poultry industry went to a system of nearly 100 percent contracting and that it is a vibrant one with growing market share and relative financial stability for both producers and processors. While they differ in opinion as to whether or how soon contracting will come to dominate pork production to the degree it does poultry, they generally agree that such vertical integration need not pose a threat to the family farm. Most turkeys and chickens are raised in facilities owned and managed by families. But some hog producers argue vehemently that they will become mere "hog janitors," in the words of some, contractual servants of packers, with little real independence in management or other decision-making.

Coming on the heels of ongoing spirited debates about the environmental effects of the expansion of large, capital-intensive hog facilities, the current collapse of prices should ensure that hogs are the center of many discussions during legislative sessions in many Midwestern states in 1999.

Related articles, fedgazette, April 1996:
Pork 101: The economics of hogs
Small hog farms losing ground
Corn and hogs: Unique complements over time