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Packer Contract Fever

Article-Packer Contract Fever

The tide has turned - producers are signing packer contracts in droves.Nearly half of the hogs from Dave Hinman's 800-sow, farrow-to-finish operation are presold for the next seven years. The St. Ansgar, IA, producer, like many fellow producers in the Midwest, signed a long-term packer contract this winter.Hinman changed his mind about packer contracts. He has been reluctant to make this move. However,

The tide has turned - producers are signing packer contracts in droves.

Nearly half of the hogs from Dave Hinman's 800-sow, farrow-to-finish operation are presold for the next seven years. The St. Ansgar, IA, producer, like many fellow producers in the Midwest, signed a long-term packer contract this winter.

Hinman changed his mind about packer contracts. He has been reluctant to make this move. However, a new breeding-gestation facility helped nudge him to the contract. He decided a contract would help lower financial risk, even though his lender did not ask for the contract.

Hinman also feared most hogs would soon be marketed under packer contracts, cutting into the current opportunities available in the open market. "I decided if I was going to raise hogs, it was time to get aligned with someone," he says.

Packer Arrangements Grow If this winter's trend to packer contracts continues, Hinman may be in the majority very soon. By the end of 1998, an estimated 60% of the nation's hogs will be marketed to packers through some type of agreement, reports John Lawrence, Iowa State University agricultural economist. He believes 45-48% of the hogs were marketed that way in 1997.

One prominent pork packer agrees. "I believe, personally, in 3-5 years, the major players in our industry will have a very high percentage of their hogs aligned, partnered or contracted," says Ray Bjornson, Hormel Foods Corp., Austin, MN. "However, I don't believe the industry will be 100% contracted like broilers and turkeys."

The change from an open hog market to a packer-contracted market signals an immense change for most pork producers, particularly those in the Midwest. Here, the choice of several packers to sell hogs to on any given day may become a luxury of the past.

Southeastern producers have faced a much tighter marketplace for several years. Packer arrangements between the very large producers have tied up shackle space. For example, Dave Kenyon, Virginia Polytechnic Institute, says 80-85% of Smithfield's southeastern kill is filled up with production from just five major producers.

This has made marketing more difficult for smaller, independent producers. Signing contracts with any packer is a necessity for marketing now, he notes.

Why Now? But in the Midwest, this trend is just taking hold. It appears that packers and lenders are driving the push for contracts.

Hormel Foods was one of the first pork packers to offer a contract in 1993. "Long term, we wanted to insure a supply of high quality pigs coming to us," Bjornson says. "And second, the financial community was adamant that they wanted to shift some market risk away from the financial institution and producer to the packer."

Bjornson says as new construction and expansion took place, the demand for contracts grew. Last summer, Hormel went out and approached their best producers with contracts. Then the hog market took a dive. They are not offering contracts now but this may change.

IBP started offering a "Cash Flow Assistance" contract last year. In a written comment, IBP states, "Pressure from banks providing financing for producers has prompted our company to expand the variety of arrangements offered, including the introduction of longer term arrangements." Their contracts range up to 10 years with fixed terms.

Lender Joel Larson, Farm Credit of Southern Minnesota, agrees lenders encourage packer contracts. "Lenders play a part in that because we're looking for any way to reduce risk, not only to the farmer, but to ourselves," he says.

"Myself, as a consultant, I like to see producers at 50% or more (of production in contracts)," he adds. "Those with a great deal of risk need a higher percentage."

Controversial While some producers have readily jumped on the packer contract bandwagon, the trend remains controversial.

"I'm an opponent of these contracts," reports Walt Hackney of Hackney and Associates, Omaha, NE. "It all boils down to one thing, there is no risk management for the producer himself (in contracts). There is some good cash flow protection for the lender and a guarantee of shackle space to the packer."

Instead, Hackney believes the producer is left with either a debt to the packer when the hog market falls below a typical contract floor of $40/cwt. or out of big profits when prices rise above a typical contract ceiling of $50/cwt.

Hackney's concerns lie with an unexpected downturn of market prices and its effect on the packer contracts.

While each packer offers different contracts, most generally involve a floor and ceiling price. Typically, the floor price is $40-41/cwt. When hog prices fall below the floor at, for example, $36/cwt., packers split the difference with the producer. That means, the producer would receive $38/cwt.

With current hog prices below $40/cwt., these contracts help producers cover production costs, reports Brian Buhr, University of Minnesota agricultural economist. This, of course, helps them make loan payments on new facilities.

In most contracts, the difference between the price paid to the producer ($38/cwt.) and the lower market price ($36/cwt.) becomes a debt to the producer. As prices hang below the floor price for some time, the debt continues to accrue.

Buhr says, however, that over the life of the long-term contract, hog prices should rebound. Then the debt will be paid off as hog prices climb over the ceiling price, often set at $48-49/cwt. For example, if hog prices were $52/cwt. and the contract ceiling set at $48/cwt., the producer would receive $50/cwt. The $2/cwt. difference between the market price ($52/cwt.) and price paid the producer will accumulate with the packer. This will be used to offset the loans made by the packer during the low hog market.

"The assumption is that over 5-7 years, everything evens out," Buhr explains. The contract helps even out the highs and lows of the hog market. At the end of the contract, the producer and packer must settle up any money owed to each other, or roll the debt into a new contract.

All the pork packers offer several different contracts. And as they gain experience with them, changes occur. Now, some packers charge interest on the debt producers accrue below the floor price. In turn, they also pay interest.

IBP charges interest (prime minus 1%) on the accrued debt. They also pay interest on money they owe the producer.

"I think that packers have learned from these contracts. They are basically lending money," Buhr says. "They're not in the business of doing that and have decided they better get some return from that."

Hackney, on the other hand, says he knows some lenders and producers do not realize they are accruing debt with these contracts. He reports he has received phone calls to back up his claims.

"Producers also probably don't realize that in a systematic manner, the packer reviews their credit," Hackney says. "When they max out, the packer is no different than a lender and will shut them down."

Farm Credit's Larson says they tend to look at the accrued debt as a marketing payback. "The alternative is selling a pig at $7-8 under what they are presently getting," he adds. "Yes, producers have to pay it back, but they are (also) guaranteed a price."

Ironically, Buhr says he initially worried the opposite would happen. He feared packers would be holding substantial amounts of producer money during high prices.

"If you started out with hog prices at $50 and the packer is paying $48, the producer is giving up this money," he says. "The packer could essentially be holding the producer's money and not pay interest on it. That's what I was originally worried about on these residual accounts."

Hackney also notes that a packer has first lien position on this debt, according to Packers & Stockyards rules. He says this may surprise lenders who assume they have first lien rights.

Hackney's business markets hogs for 750 producers across the U.S. He says he does not sign any marketing agreement with a packer for longer than one year. And his method of assuring price protection is through options and other strategies offered through the Chicago Mercantile Exchange.

"There are so many opportunities for producers to direct their own destiny without letting the buyer dictate their destiny for them," he states. "Any contract designed by the buyer probably is not for the benefit of the seller."

Sharing Profits Contracts continue to change. Size no longer is the key to being offered a contract, according to Iowa State University's Lawrence. "With several contracts, size is not the issue," he says. "I had concerns when you had to have 50,000 head to get a contract. I'm less concerned now."

Instead, Hormel reports they do not have a minimum size requirement. Other packers reportedly offer contracts for a minimum of 2,000 hogs marketed/year.

"Quality is the main issue now, not size," Lawrence adds. "I don't think it is a coincidence that this is coming about at the same time there is the push on HACCP and food safety. All of these contracts have provisions for things like PQA III or higher." (See related story on page 24.)

Hormel has led the pack in food safety and quality issues. Bjornson says producers under their contracts must complete PQA level III. All hogs are sold on a grade and yield program. Plus, Hormel reviews facilities and approves genetics, feed and recordkeeping. The producer must be veterinarian-supervised.

"Consumers deserve a safe and wholesome product," Bjornson explains. "We need to provide it. Everybody is responsible from birth to market."

When A Contract Is Right Most hog experts agree a packer contract works best when a producer has the right reason to sign it. "One reason is market access," reports University of Minnesota's Buhr. "Do I need this contract to sell?

"The other part is price risk management," he adds. "I think we need to separate those two. If market access isn't your primary problem but price risk management is, then you can be served equally or better by the futures market, using hedging strategies. Those options are still out there and they are good options."

Buhr says he hears a lot of anxiety about market access from producers. Some of the anxiety is warranted. But each producer's situation is different, depending on proximity to nearby packers and quality of hogs being produced.

Both Buhr and Lawrence do not believe most packers will risk contracting over 70-80% of their slaughter capacity. It would expose them to too much market risk. This would still allow room for market access to producers who do not wish to make contracts.

IBP reports 50% of their hog purchases are currently made through marketing arrangements. And they hope to build this percentage.

The experts contacted for this story discussed a number of issues producers must consider before and during negotiations with a packer for a contract.

1. Make sure you can generate an adequate return from the contract. "If all the contract does is just take all the price risk out of it, but at the same time takes most of the profit potential out for the producer, it is not a good contract," reports Lee Fuchs, AgriBank, St. Paul, MN.

A contract offering a $38-48/cwt. window doesn't look as good when compared to a $47/cwt. market price average, adds Brian Buhr, agricultural economist, University of Minnesota.

2. Tie hog prices to cost of production.

"I think the good contracts for producers tie the price of the hog partially to the cost of production," Fuchs says. "Then the producer is assured the profit margin will be there."

A newer contract called the cost-plus contract ties the hog price producers receive to the current price of corn and soybean meal. These contracts appear to perform better over time than the traditional window contracts (Figure 1).

The problem with window contracts, Fuchs says, is hog prices may be high, but corn and soybean prices may be equally high. This can greatly affect a producer's profitability.

3. Insist on renegotiation clauses that apply to both packers and producers in the contract. Buhr says producers should be sure they are covered in case circumstances reduce their production or need for a contract.

"Often, we see four or five clauses about what happens if a packer can't do something," he says. "The producer needs to be part of the negotiation and make sure it protects them in case something happens."

4. Make sure the contract allows an "out" for a producer if the packer matrix changes. "I've warned people against agreeing to price your hogs on (a packer's) current system for a long period of time," states Steve Meyer, economist with the National Pork Producers Council (NPPC).

"I think that changing a matrix should be an out clause for the producer," he says. "A packer can change a matrix faster than a producer can change genetics. He ought to have the right to opt out."

5. Consider how debt accrued during low hog markets is repaid. "Make sure you look at the terms on how that debt gets repaid so it is not a burden when you start having to pay it back," AgriBank's Fuchs says.

"Make sure the debt is not callable by the packer prior to the maturity of the contract," he adds. "I would also make sure the packer doesn't charge above market interest rate on the liability. They shouldn't be making excessive amounts of money on it."

6. Plan the "divorce" before signing the contract. Iowa State's Lawrence says producers must consider if they are committed to producing hogs the length of the contract. If they are not, they better have a way to get out of the contract.

7. Know the packer's long-term financial viability. A packer's bankruptcy can create a financial nightmare for a producer with a contract to the packer.

All contracts can be considered an asset of the packer in a bankruptcy proceeding. This means hogs produced under the remainder of the contract can still be considered assets of the packer, according to Neil Harl, ISU attorney specializing in agricultural law.

"A bankruptcy trustee has the right to go through the contracts and accept or reject contracts that would be beneficial," Harl says. He has not seen this happen to a producer. But he admits it is possible.

"You have to have a fair degree of confidence in the party you're doing business with," he suggests. "If the party is shaky financially, be cautious."

8. Be careful about tying up 100% of your production with one packer. "Some contracts require that you commit all of your production to the packer," NPPC's Meyer says. "I'm uncomfortable with this."

Walt Hackney, Hackney Ag. Associates, agrees. He says a producer loses all negotiating ability when locked into one buyer.

9. Seek help if you're uncomfortable negotiating a contract. Buhr says producers who feel packer negotiations are out of their skill range might want to hire a professional. He suggests looking for legal counsel through state bar associations.

ISU's Lawrence says another option is hiring a professional production management firm. Several now exist that include packer negotiations in their menu of services.

10. Make sure the contract is a win-win situation for the producer and packer. "I would not sign a packer contract out of fear or because that's what everyone else is doing," reports Fuchs. "I would do it for good business reasons. It usually means you want to form some alliance with the packer because he is important to you for long-term survival and prosperity."

Packers echo this same mentality. Both Hormel and Swift & Co. report they want contracts with long-time, good customers who are committed to their programs.