Producers Rely on Contracts To Manage Increased
Price Risks
James
M. MacDonald and Penni
Korb
U.S. agricultural production continues to
shift away from cash markets and toward greater
use of contracts. According to a new ERS study,
agricultural contracts covered 41 percent of the
value of agricultural production in 2005, up from
36 percent in 2001 and 28 percent in 1991.
The contracts, which are preharvest
agreements for a particular commodity, specify an
outlet, delivery terms, and a method of compensation
for the producer. Some go much further, covering
all elements of production in addition to marketing.
They can help manage price risks, smooth production
at processing plants, encourage production of specific
product varieties or qualities, and elicit the investments
necessary to realize economies of scale. But contracts
can also create new risks for producers, and they
have the potential to extend a buyer’s market
power to drive commodity prices below competitive
levels.
The steady expansion of contracting,
when measured across all of agriculture, masks some
sharp changes in specific commodities that often
occur in response to shifts in government policy,
information flows, or buyer organization. Greatly
expanded use of marketing contracts, for example,
recently followed significant changes in government
peanut and
tobacco programs.
Each program featured the use
of marketing quotas to control domestic supplies,
which, in turn, created stable and relatively high
spot-market prices. Contracts were an important
element of peanut and tobacco production before
the policy change. They covered a quarter to nearly
a half of peanut production until 2002 and half
of tobacco production until 2004, when quotas were
eliminated. Under the quota system, contracts provided
assured outlets, expanded quality controls for peanuts,
and stronger incentives to produce tobacco in specific
quality categories.
Elimination of marketing quotas
loosened supply controls, and cash markets, as a
result, exhibited greater price risks. Use of contracts
jumped sharply because they provided a way to manage
the increased price risks. Contracts covered 80
percent of peanut production by 2004, and two-thirds
of producers said that eliminating marketing quotas
had led to a greater reliance on contracts. Use
of contracts likewise jumped after tobacco marketing
quotas were eliminated; contracts covered 78 percent
of tobacco production in 2005.
Indepth, more accurate market
price reporting may allow producers to manage price
risks better, and may therefore help to preserve
cash markets. But contracts can provide another
avenue for risk management, one on which market
participants have increasingly relied.
|
Download PDF version