This article was written by Kim Dillivan, former SDSU Extension Crops Business Management Field Specialist.
As a crop producer you probably dislike the uncertainty that results from market prices that are determined by forces outside of your control. With domestic economies becoming more interdependent, commodity price movements result from changes in global supply and demand. Because these changes are frequently unexpected and the effect on prices difficult to predict, producers face uncertain prices and incomes. One way to help mediate this uncertainty is with a contractual arrangement.
There are two main types of contractual arrangements that agriculture producers frequently utilize: production contracts and marketing contracts. With production contracts producers are paid to raise a crop or grow livestock (essentially the producer provides a service). Under a production contract, the producer never owns the commodity. These types of arrangements are common with crops grown for seed and with some types of livestock. Relative to marketing contracts, production contracts limit the amount of input producers have in the decision-making process. In general, contractual arrangements transfer some production and price risk from producers to buyers.
Contractual arrangements are popular because they provide benefits to buyers. By offering price premiums for commodities that exceed minimum standards, buyers have some level of assurance that they will receive commodities that are fairly uniform. Additionally, by entering into contract arrangements, buyers dictate how much product they receive, when and where they will receive it, and at what price.
Contracts also have obvious benefits for producers. Compared to cash (spot) markets, contracts can be financially attractive, especially if the producer can earn price premiums by exceeding quality standards. Contracts also offer producers greater price and income stability by providing a guaranteed market price. Particularly with production contracts, producers can also benefit from technical advice and expertise provided by the buyer.
With marketing contracts the producer usually owns the commodity being produced. These types of contracts typically specify a quantity to be delivered, product price, delivery time and location, and product specification. Price premiums are often paid for commodities that exceed quality standards. Most contract crop production takes the form of a marketing contract. Two common examples include forward marketing contracts and futures contracts.
Forward marketing contracts may be initiated before the crop is planted. An early awareness of quality goals, quantity, and contract price aids the producer in making production decisions that are profit maximizing. Additionally, forward contracting may help the producer improve cash flow.
Crop producers use the futures market to hedge commodity price risk. Producers who hedge will take a position in the futures market that is equal to, but opposite, their position in the cash market. Because futures prices and cash price tend to move together, if cash prices falter, approximate equal gains will be made in the futures market. In the same way, gains in the cash market will likely be offset by losses in the futures market.
Although agricultural contracts have become much more common, cash markets still represent an important marketing outlet. For some producers, the reduction in risk associated with contracting does not outweigh the loss of autonomy.
References:
- MacDonald, James M., and Penni Korb. Agricultural Contracting Update: Contracts in 2008. EIB-72. USDA, ERS, February 2011, available at http://www.ers.usda.gov/media/104365/eib72.pdf
- Key, Nigel, and James MacDonald. Agricultural Contracting: Trading Autonomy for Risk Reduction. Amber Waves Vol. 4 Issue 1, February 2006, available at https://www.ers.usda.gov/amber-waves/2006/february/agricultural-contracting-trading-autonomy-for-risk-reduction/
