Wednesday, June 23, 2010
Quick! What Is The Common Link Among Users Of Production Contracts?
Have you produced a commodity under terms of a production contract? It might have been poultry, hogs, specialty corn, non-GMO beans, or a myriad of other commodities. Maybe you have not, but some of your neighbors and friends have. Think about the commonality for a moment. What characteristics are present in those who use production contracts? Is it age, financial stability, amount of hair loss, risk aversion, or what? Is it possible to connect dots and point to a farmer who obviously would or would not engage in a production contract?Production contracts help buyers and sellers manage their risk in the production and transfer of a commodity. A trio of economists at Illinois, Kentucky, and Iowa State set off to paint a picture of a typical production contract farmer, and had some difficulty deciding what he might look like. Their research notes that contract production has been growing, all the way from 11% of farm production in 1965 to 41% in 2005. That is the result of more organized supply chains, more discriminating consumers, more efficiency in buyer-seller relationships, quality control, and several other dynamics in agriculture. The economists report, “The risk preferences of producers have also been shown to impact the intensity of agricultural contracting decisions, with more risk-averse farmers preferring production contracts over the use of marketing contracts or spot markets in the U.S. hog industry.” While marketing contracts help control price risk, production contracts provide more decision opportunity to the producer.
University of Illinois economist Nick Paulson said he and his colleagues used USDA’s Agricultural Resource Management Survey for the data on production contracts, and tried to match characteristics of producers to those who either use them or do not use them, but limited their research to corn and soybean production contracts. Additionally, they limited the geography to 1,647 farmers in IL, IN, IA, MN, MO, and OH. One of the theories was that production contracts would be used more by farmers who are risk averse, and want to reduce their risk with the use of the contract. Paulson and partners say income, wealth, age, off-farm income, and debt to asset ratio are often indicators of risk aversion, as are education and experience.
In their analysis of those 1,647 farms, the economists looked at total value of farm production, household net worth, total off farm income, the debt to asset ratio, the operator’s age, experience, and education. They also looked at whether the farm was defined as a hobby farm, if crop insurance was purchased, and what other alternatives there were in the area compared to the production contract.
So which of those would you estimate as being an indicator of whether someone would engage in contract production? Initially, it appeared that intensity of corn production would be a significant indicator, but it wasn’t. Only crop insurance practices were an indicator of risk aversion, and for someone engaged in contract production, there was a significant chance they would have a crop insurance policy. Paulson and partners say that makes sense, because, “Yield insurance covers the yield risk that could exacerbate losses under a marketing contract, ultimately reducing the risk of the farmer not being able to deliver on a contract. Revenue insurance covers both yield and price risk, thus reducing the incentive to enter into a marketing contract to manage price risk.”
On the opposite end of the scale were those operating hobby farms, who were among the least likely to engage in contract production, because of the loss of managerial freedom and potential liability burden. Other factors, such as net worth, age, off farm income or others had little significant impact on the decision to contract.
For soybeans, the more intense the soybean production the more likely one would be to contract. And farms with a higher value of farm production would be more likely to contract by a factor of nearly 1.5% for each $100,000 of farm production. Additionally, operations with higher debt to asset ratios were more likely to contract soybean production. Among other factors, crop insurance usually indicates soybean production contracts, but hobby farming does not.
The economists work hard to correlate contract production with the risk aversion by farmers. Paulson’s group says, “Similar to contracts with formula pricing, tying price to quality attributes of the commodity may expose the farmer to more price risk driven by quality uncertainty. This implies that, all else equal, more risk-averse producers would tend to enter into contracts where price is independent of quality attributes.” But they say specifying a quantity to be delivered exposes a greater production risk, and that would probably mean a risk-averse farmer would not engage in contract production specifying a quantity. They did find that more highly educate farmers were more likely to use production contracts.
The researchers also wondered if alternatives offered more comfort to farmers, and those who would be expected to engage in contract production opted for the alternative. They said, “There exists highly developed commodity, credit, and, for corn and soybean, subsidized insurance markets that can be used to manage and mitigate price and production risks. The importance and ability of risk-sharing to be achieved through contract design may be dominated by the opportunities afforded by these other risk management alternatives.” And they add, “We find almost no evidence of observed producer or contractor characteristics impacting the attributes of the marketing arrangements at the contract level, more specifically pricing, quality, and quantity provisions within the contract.”
Summary:
Production contracts are being increasingly used to manage risk, however, when one tries to identify the commonality among farmers who use production contracts, it is difficult, if not impossible, to point to any given demographic, economic, or personality factor. Although the use of crop insurance would seem to have commonality with someone who wants to manage risk, that is not always the case, and many crop insurance users, do not go near production contracts.
Posted by Stu Ellis on 06/23 at 01:04 AM | Permalink