Livestock Marketing Practices and Competition Questions

1. Livestock Marketing Practices and Competition Questions John D. Lawrence Extension Livestock Economist Iowa State University

2. Overview • Recent history and trends • Literature review • Remaining questions

5. Overview of the 2007 USDA GIPSA / RTI Livestock and Meat Marketing Study Data from Oct 02 – Mar 05

6. General Study Conclusions • AMA use was 38% for cattle, 89% for hogs, and 44% for lambs. • Packer-owned <5% for cattle & lamb but 20-30% for hogs. • Little or no increase in AMA use is expected for cattle and hogs -- moderate increase expected for lambs. • Cash market is important -- outlet for small producers and packers and reported cash prices are used by AMAs.

7. General Study Conclusions • AMA use is associated with lower cash market prices -- larger association for hogs than cattle. • Packers and producers benefit from AMA use -- lower costs, risk control, and quality management. • Restrictions on AMA use will have a negative economic impact on producers, packers, and consumers. • Restricting AMAs doesn’t eliminate market power

8. Summary of Cattle Volume of RTI – GIPSA LMMS Study Stephen Koontz, John Lawrence, Gary Brester, Mary Muth, and John Del Roccili (formerly Beef Team Leader - deceased)

9. Beef producers and packers interviewedbelieved that some types of AMAs • Helped them manage their operations more efficiently, reduced risk, and improved beef quality. • Feedlot savings of $1 to $17/hd from improved capacity utilization, more standardized feeding programs, and reduced financial commitments required to keep the feedlot at capacity. • Packers savings of $0.40 per head in reduced procurement cost. • Both agreed that if packers could not own cattle, higher returns would be needed to attract other investors and that beef quality would suffer in an all-commodity market place. • Where do higher returns come from?????

10. Marketing and Pricing Methods • When selling to packers 85% of small producers and 24% for large producers surveyed used only the cash market • Pricing methods by size Large Small • Individually negotiated pricing 74% 32% • Public auction 35% 84% • Formula pricing 57% 6%

11. Packer Purchases • Using only the cash or spot market • 10% large beef packers surveyed • 78% of small beef packers surveyed • Neither the producers nor packers surveyed expected the use of AMAs to change dramatically in the next 3 years

12. Reasons for AMAs • Producers surveyed • The ability to buy/sell higher quality cattle, • Improve supply management, • Obtain better prices • Packers surveyed • Improve week-to-week supply management, • Secure higher quality cattle, • Allow for product branding in retail stores

13. Reasons for Cash Only • Producers surveyed • Independence and flexibility, • Quick response to changing market conditions, • Ability to buy at lower prices and sell at higher prices • Packers surveyed • Independence and flexibility, • Quick response to changing market conditions, • Securing higher quality cattle

14. Analysis of procurement transactions data • From the 29 largest plants and included 58 million animals and 590,000 transactions. • 61.7% cash • 28.8% marketing agreement • 4.5% forward contracts • 5.0% packer-owned, other, or missing • Regional differences in AMA use.

15. What did the analysis of procurement transactions data show? • Cash, marketing agreement, and packer-owned prices similar. • Auction higher and forward contract lower than cash prices • When AMA use increases cash prices decrease: • 10% increase in AMA use is associated with a 0.11% decrease in cash price. • Impacts are economically small but statistically significant.

16. What did the packer P&L data show? • Substantial economies of size • Large plants have lower ATCs than small when both are operating close to capacity. • For all plants ATCs decline over the whole range of volumes. • The representative plant operating at 95% of max observed capacity is: • 6% more efficient than the middle range • 14% more efficient than operating at the low end range

17. What did the packer P&L data show? • Plant costs are lower for those that use AMAs. • Costs are directly lower -- all else constant. • Costs are lower because of increased volumes. • Costs are lower because of less variable volumes. • Cost savings are approx $6.50 per animal. • Weighted-average profits for the four largest companies were -$2.40 per head for packers over the 10/02-3/05 time period.

18. Summary of Hog Volume of RTI – GIPSA LMMS Study Tomislav Vukina (Pork Team Coordinator), Michael Wohlgenant, NC State Mary Muth, RTI

19. AMAs are an integral part of hog producers’ selling practices and pork packers’ procurement practices. • Significant regional differences • stronger reliance on cash/spot markets and marketing contracts is apparent in the Midwest • stronger reliance on production contracts and packer ownership of hogs is apparent in the East.

20. Based on transactions data, there are substantial differences in hog prices paid • On average, the price dispersion is about 40% of the average value of the transaction prices each day. • Controlling for region, quality, or plant size explained little • The regression model can only explain 26-27% of the daily variation in the cash price.

21. Effect of both contract and packer-owned hog supplies on spot market prices • A clarification: they report • a 1% increase in contract hog quantities causes the spot market price to decrease by 0.88% • a 1% increase in packer-owned hog quantities causes the spot market price to decrease by 0.28%. • What is missed is that • a 1% increase in the supply of spot market hogs is associated with a 0.27% decrease in cash market price • Watch the math! Consider 100 million hogs • 61 contract, 31 packer-owned and 8 spot-market • 1% contract or PO is 7.6% and 3.9% of spot market

22. Measured a statistically significant presence of market power in live hog procurement, but the results are inconclusive. • Two approaches were used with somewhat different results. Both found market power. • One found that the benefits of AMA out weighed the market power harm. • The second couldn’t conclude that AMAs were the source of the market power.

23. Estimated TC and ATC functions indicate that economies of scale diminish as the pork packing firm size increases • Estimated that scale economies are exhausted well within the sample output range such that the biggest plants already exhibit negative returns to scale. • Certain combinations of AMAs may reduce costs and/or increase economies of scale. • Relative to using spot market procurements alone, all other combinations of marketing arrangements improve the efficient scale of production.

24. Wang and Jaenicke • Simulating the Impacts of Contract Supplies in a Spot Market–Contract Market Equilibrium Setting • Acknowledge limitations of their model • Results are inconclusive • For formula-price contracts increased contract supplies are negatively related to the expected spot market price when participating producers contract high proportions (greater than 0.8) of their hogs, but are positively related when producers contract lower proportions (between 0.6 and 0.8). • Moreover, increased contract supplies reduce the variance of spot market price under formula-price contracts.

25. Wang and Jaenicke • Formula-price contract offers the highest expected profit to processors and highest expected utility to producers • Because of uncertainty on processing demand, the cash market remains valuable to processors • Important linkage between the contract market and the cash market could, of course, disappear if real-world cash markets become too thin and disappear altogether.

26. Remaining Questions • What are the necessary conditions for a viable spot market? • Do lessons learned in cattle apply to hogs? • What trade-offs are necessary or acceptable? • Quality? Efficiency? • What is the source of market power and what is the cost of controlling it? • What is the risk? • Niche markets and branded products • Asset values and loans contingent on contracts