Purdue study finds alliances don't hog-tie pork industry

by 5m Editor
29 January 2004, at 12:00am

WEST LAFAYETTE - Some agricultural observers fear packing companies have sold hog farmers a pig in a poke. They contend business alliances between packers and producers will damage the pork industry and, ultimately, hurt consumers.

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Purdue News

A study by Purdue University agricultural economists challenges that assertion. The study concludes that contract market and vertical integration structures that are rapidly replacing traditional spot markets can be good for hog farmers and packers, and provide consumers with consistent, high-quality products.

While profit margins and production volumes can differ depending on market conditions and how closely aligned farmers are with packers, in most cases the relationship can be beneficial to both, said Allan Gray, one of four Purdue agricultural economists who conducted the study. Their findings are detailed in the paper "Evaluation of Alternative Coordination Systems Between Producers and Packers in the Pork Value Chain."

Using market prices and other data from 1998 through 2000 as a basis, the economists simulated spot market, contract market and vertical integration production systems for a fictitious small Midwest packing company. The company, modeled after an actual packer, processes 74,000 hogs per week.

"We found that profits for packers and producers weren't greatly increased by increasing vertical coordination," Gray said. "But there was a dramatic difference in the variability of the quality of the product being produced. That is, in a spot market system, producers are making decisions on when to market their hogs based on the information that they currently have available. The packer, then, simply takes whatever hogs the producer is selling. In that case, you get a wide variation in the sizes, shapes and forms of the hogs being sold.

"In a contract system, the packer has information on what the prices of hams, bellies, loins and other pork products are, and then is able to transfer that information back to the producer and say, 'These are the kinds, sizes, shapes and forms of hogs that we need.'"

Spot market sales are made in an open market. Contract markets, also known as "shackle space" agreements, permit producers to sell their live hogs to particular packers. Producers are paid a fixed amount per hog delivered, including an assumed $5 a head call option. In vertical integration, the packer owns the live hogs from the feeder stage through slaughter and determines when the hogs are sent to the packing plant. Producers are assumed to be paid $20 for each hog transferred.

The vertical integration system is common among the nation's leading pork processors. Critics claim the system encourages consolidation and could lead to a handful of companies controlling the pork industry.

The Purdue study did not attempt to disprove that allegation, nor defend vertical integration, Gray said.

"Many people start from the premise that the packers are the smoking gun - that the packer is a monopoly and is forcing people to move to vertical integration," he said. "So, in our study, we built a model that doesn't allow that to happen. Our numerical model specified that the packer has no market power. With our model we were able to ask, if the market power issue is not there, do all the parties involved still benefit from a coordinated production system?"

In both production efficiency and profitability, the answer was yes for producers and packers. Study results indicated the vertical integration system maintained a more consistent flow of hogs through the production chain than did spot markets. Also, the contract and vertical integration systems were better than spot markets at delaying the marketing of lighter pigs, which yield fewer usable pounds of lean pork.

The study also indicated producers in spot markets could sell their hogs at higher prices than contract and vertical integration systems, but only when markets were strong. Conversely, hog farmers were less vulnerable to price volatility when operating by contract or in a vertical integration structure.

"Producers who are in a vertically coordinated system are not always getting as high a return," Gray said. "Our model showed about $20-$25 a head in the vertically coordinated system, but it's almost a guaranteed return. So there's no risk. A producer who's in an open market may get $28-$30 a head on average over time, but there will be wide swings from negative numbers per head to positive numbers per head in any given time period.

"Some producers are fine with that risk and would rather have the higher return on average. Yet, there are many producers who would prefer to be in a vertically coordinated system at $20-$25 a head with little risk."

Between the two coordinated systems, producers fared better under contracts and packers under vertical integration, the study found. Producer margins averaged $41.20 per hog in a contract system, compared to $20 in vertical integration. Packer margins averaged $21.76 per hog in vertical integration, compared to $4.78 under contract.

Consumers also win when hog farmers align themselves with packing companies, Gray said.

Through industry coordination "we're getting a more uniform set of products," Gray said. "If there's a more uniform set of products coming through the system, producers and packers are better able to sell those products in the marketplace.

"Take Smithfield Foods Inc., a vertical integrator, for example. If they are achieving the kinds of reduction in variability of product that we show in our model, then they can create a product in the consumer marketplace that has a very consistent nature - much like the poultry industry has done with chicken. And if you look at what's being sold in the grocery stores, that's exactly what Smithfield has done. That appears to be, in large part, a result of their vertical integration system."

Other Purdue agricultural economists who contributed to the study included Michael Poray, Michael Boehlje and Paul Preckel.

Source: Purdue News Service - 28th January 2004

5m Editor