Contracting: An Overview of
Why, When, Where, & the Future
PIE 231
by:
Joe Parcell
Extension Economist
University of Missouri - Columbia
parcellj@missouri.edu
(573) 882-6533
What is a Contract?
A written or oral agreement between two or more
parties involving an enforceable commitment to
do or refrain from doing something.
Soure: Hall, C., and M. Langemeier. “Contracts as a Risk Management Tool.” Texas
Agricultural Experiment Service, Risk Management Education
Types of Contracts
• Marketing contract
• Bailment production contract
– Generally involve the contractor producing some critical genetic
trait or trains through seed input.
• RR soybean
• Personal Service Contracts
– Contractor provides most of the non-land production inputs
• Seed corn
• Pool Contracts with Closed Cooperatives
– Delivery by producer to a closed (new generation) cooperative
jointly owned and operated by a group of producers to add value to
the raw product.
• Equity contribution in proportion to producer’s commitment
Types of Contracting
• Production
– Production management contracts
– Resource-providing contracts
• Marketing
–
–
–
–
–
–
Forward price
Delayed or deferred
Basis
Flat price
Hedge to arrive
Quality attributes
Production vs. Marketing Contracts
• Production
• Marketing
– Contractor
• Arranges to have a
specific quality and
quantity of commodity
produced
– Contractor
• Buys a known quality
and quantity of the
commodity for a
negotiated price
• Usually owns the
commodity being
produced
• Doesn’t own the
commodity until it is
delivered
• Makes most of the
production decisions
• Has little influence over
production decisions
Production vs. Marketing Contracts
• Production
– Contractee (operator)
• Provides service and other
fixed inputs
• Supplies a small part of total
production inputs
• Usually does not own the
commodity
• Marketing
– Contractee (operator)
• Has a buyer and price
for commodity before
harvested
• Supplies and finances
nearly all of inputs
• Owns commodity while
being produced
Production vs. Marketing Contracts
• Production
– Contractee (operator)
• Few production decisions
• Few price or market
uncertainties
• Marketing
– Contractee (operator)
• Makes most of
production decisions
• Assumes nearly all
production related risks
Relative Price Risk (Percent of Mean Price)
source: USDA, ERS, 1999
All Cattle
Hogs
Soybean
Corn
Wheat
Sorghum
Rice
0
5
10
15
20
25
30
Corn Price Variability (Percent of Mean Price)
source: USDA, ERS, 1999
60
50
40
30
20
10
0
1920s
1930s
1940s
1950s
1960s
1970s
1980s
1990-96
To What Extent has
Contracting Occurred?
Production Contracts
source: USDA, ERS, 1997
100%
80%
60%
40%
20%
0%
Broilers
Cattle
Eggs
Hogs
Vegetables
Value of Production - Marketing Contract
source: USDA, ERS, 1997
40%
30%
20%
10%
s
s
Su
nf
lo
we
r
an
yb
e
So
M
ilo
ce
Ri
s
at
O
n
tto
Co
Co
rn
0%
Value of Production - Marketing Contract
source: USDA, ERS, 1997
100%
80%
60%
40%
20%
0%
Fruits
Peanuts
Potatoes
Sugar beets
Value of Production - Marketing Contract
source: USDA, ERS, 1997
Current Level ?????
60%
45%
30%
15%
0%
Cattle
Hogs
Weekly Contracted or Formulated Kansas Fed Cattle
as Percent of Marketings, 1991 - March 2000
100
Contract % of Marketings
90
80
70
60
50
40
30
20
10
0
1/4/91
1/4/93
1/4/95
Source: USDA and K-State Research and Extension
Week
1/4/97
1/4/99
“Typical” AMS Price Report
DC_LS130
Dodge City, KS Fri Mar 10, 2000 USDA-KS Dept of Ag
Market News
Kansas Feedlot Sales - as of 3:00 Friday
Confirmed: 50
week ago: none
year ago: none
Trade quiet. Not enough slaughter steer or heifer sales
confirmed for a market test. Inquiry and demand fair. Sales
confirmed on 50 slaughter heifers Friday. This week's confirmed
sales 81900 head including 35200 head or about 43 percent
previously contracted or formulated cattle.
Sales FOB feedlot net weights after 4 percent shrink.
Source: USDA Kansas Dept of Ag Market News Dodge City, KS
Percentage of Days Mid-Session Fed Cattle Cash Price Not
Reported by AMS, Kansas, Nebraska, and Texas, 1991-99
70
Percentage of Days
60
Texas
50
Kansas
40
30
20
Nebraska
10
0
91
92
93
94
95
Year
96
97
98
99
Figure 7. Ratio of Weekly Choice Western Kansas Fed Steer
Price to Nearby Live Cattle Futures Price, 1991 - July 1999
1.10
Price Ratio
1.05
1.00
0.95
0.90
1/4/91 1/4/92 1/4/93 1/4/94 1/4/95 1/4/96 1/4/97 1/4/98 1/4/99
Source: LMIC and K-State Research and Extension
Week
Table 1. Hog Pricing Methods,
January 1999 and 1997
% of Hogs
Pricing Method
Jan 2000
47.2
Formula (off cash market)
Fixed tied to futures (cash contract) 8.5
Fixed tied to feed price, no ledger
3.3
Fixed tied to feed price, with ledger
9.0
Window risk sharing, no ledger
3.8
Window risk sharing, with ledger
0.8
Other (packer-owned, transfer)
1.7
Total Non-Cash Purchases
Total Cash Market Purchases
74.3
25.7
Source: Grimes and Plain, University of Missouri
Jan 1999
44.2
3.4
2.9
6.9
3.6
1.0
2.3
64.2
35.8
1997
39.1
2.9
5.3
3.1
6.1
56.6
43.4
Figure 8. Ratio of Weekly Iowa-S. Minn. Barrow and Gilt Price
to Nearby Lean Pork Futures Price, 1991 - July 1999
0.85
Price Ratio
0.75
0.65
0.55
0.45
Dec '98
0.35
1/5/91 1/5/92 1/5/93 1/5/94 1/5/95 1/5/96 1/5/97 1/5/98 1/5/99
Source: LMIC and K-State Research and Extension
Week
Percent of Acres Planted to VACC by
Farm Size (source: University of Illinois)
50%
40%
30%
20%
10%
0%
ALL
1 to 499
500 to 999
1000 to
1499
> 1500
1998 Allocation of Value Added Contracts
source:University of Illinois
Yellow, food
grade
14%
Other corn
5%
Hi-Oil
37%
White Corn
12%
Other soybeans
4%
Waxy
8%
STS soybeans
11%
Organic
2%
Food grade
soybeans
7%
Reason for Producing VACC
source:University of Illinois
Reason
All
1-499
10001499
1.21
>1500
1.36
500999
1.24
To increase profit
1.27
To earn a premium
1.89
1.88
1.68
1.89
2.07
To diversify risk
3.30
3.21
3.16
3.45
3.24
Future contracting
opportunities
To learn about new crops
3.44
4.08
3.22
3.45
.43
4.49
4.77
4.53
4.58
4.26
To expand total acreage
farmed
4.86
5.15
4.64
4.93
4.88
1.35
1=most important, 2= second most important, . . . 6=least important
Producer Involvement
source:University of Illinois
Produced VACC in the past 3
years
if no, would consider
% of farms producing VACC
in:
1996
1997
1998
VACC acreage as a % of total
acres operated in 1998:
All
1-499
10001499
38.6
>1500
7.2
500999
22.9
24.5
57.0
40.2
66.9
68.4
71.2
31.7
16.5
22.6
4.2
5.5
5.5
12.4
15.9
15.9
21.7
24.1
24.1
23.7
28.8
28.8
7.4
3.0
5.1
10.2
7.2
41.5
Importance of Information on VACC
source:University of Illinois
Information
All
1-499
10001499
2.25
>1500
2.29
500999
1.89
Average premiums paid
2.23
Typical contract terms
2.86
3.00
2.75
2.91
2.85
Availability of contract types
2.82
3.15
2.67
2.91
2.73
Addition risks of contracting
3.18
3.21
3.03
3.20
3.29
What firms are offering
contracts
Contract terms that farmers
should avoid
3.56
3.31
3.19
3.82
3.63
3.54
3.92
2.97
3.84
3.52
2.48
1=most important, 2= second most important, . . . 6=least important
Investment in Facilities
source:University of Illinois
Type of Investment
All
1-499
500-999 1000-1499 >1500
Storage bins or facilities
16.6
5.9
0.3
21.9
18.4
Harvesting equipment
11.8
11.8
7.7
14.1
12.2
Planting equipment
7.1
5.9
7.7
7.8
6.1
What are Elevator Managers
Thinking?
Elevator Survey Results of IP Importance
source: E-Markets, Inc. and Context Consulting
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
0.41
0.41
Today
In 5 Years
0.2
0.24
0.22
0.18
0.17
4
5
0.13
0.03
1
0.03
2
3
Importance (1 = not important, . . ., 6 = very important)
Elevator Survey Results
source: E-Markets, Inc. and Context Consulting
70%
0.64
60%
50%
40%
0.25
30%
20%
0.11
10%
0
0%
YES
NO
Don't Know
Refused
Do you anticipate increasing your involvement with
specility grains over the next two years?
Outlook for Missouri Producers
Value vs. Cost of IP
• Marginal Value = Marginal Cost
– The premium paid for the commodity must at least
equal the cost of obtaining the premium.
– The cost of altering production to not receive a
discount must be at most as great as the discount.
What are the Demand Drivers and
Where will Contracting (IP) occur?