Market Preview: Farm Bill Could Impact Hog Market

US - Weekly U.S. Market Preview w/e 2nd November, written by Steve R. Meyer, Ph.D., Paragon Economics, Inc.
calendar icon 3 November 2007
clock icon 7 minute read
The U.S. Senate will begin debate on its version of the 2007 Farm Bill next week and the proposed legislation contains several provisions that, if adopted, will fundamentally change the way hogs are bought and sold. The three provisions are:
  1. A ban on packer ownership of livestock more than 14 days prior to slaughter. Supporters claim that this will bring more equity to the price discovery process and, presumably, result in higher livestock prices. There are exemptions for cooperatives and single-plant firms, but the one key part of the legislation is its prohibition against packer "control" in addition to ownership. Many observers believe this will make marketing contracts illegal. Although they have stated that is not their intent, the bill's sponsors have been unwilling to either drop the "control" language or include language specifying that marketing contracts will remain legal.
  2. A requirement that packers purchase at least 25% of their daily supplies at each plant through negotiated purchases. Negotiated purchases accounted for about 10% of total barrows and gilts in 2006, so this would force at least 15% of total supply off contracts and back to the spot market. Supporters claim that more hogs on the spot market will force packers to pay more, but there is no guarantee of that. Opponents point out that economic theory provides no "right" number and believe that the ability of the price discovery process to arrive at a "correct" value is really a matter of the information available to both sides of the market and the relative size of non-contracted supply vs. demand for non-contracted animals at any point in time.
  3. A proposal to limit to 30 head the number of hogs that can be priced under any one marketing contract and require contracts to contain an established base price. This measure also prohibits the use of any formula price that is not determined by a futures market price, requires all contracts to be offered and bid upon in a public market, and prohibits any premiums or discounts that are not tied to characteristics whose measurement is out of the control of the packer.
USDA investigated some of these issues in its Livestock and Meat Marketing Study, published last January. One of the features of that report included estimates of price elasticities of hog demand. The April 12, 2007 edition of North American Preview included a discussion of these elasticities -- their use and misuse. We think it is appropriate to include that discussion again to make sure producers understand how those elasticities should be used in making these important decisions. The authors of the USDA study have confirmed that the discussion included below is correct and in alignment with how the numbers were derived.

From Market Preview, published in the April 12, 2007 North American Preview:

One of the findings highlighted in the Livestock and Meat Marketing Study's Executive Summary was: ". . . the estimated elasticities of industry derived demand indicate a 1% increase in contract hog quantities causes the spot market price to decrease by 0.88%, and a 1% increase in packer-owned hog quantities causes the spot market price to decrease by 0.28%."

As background, an elasticity is a measure of the responsiveness of one economic variable to a change in another variable. Elasticities are expressed as percentages in order to remove the effect of the units of measurement (i.e. data using pounds has bigger numbers than data using tons).

These measures say that if the number of contracted hogs or packer-owned hogs changes by 1%, the spot market price will move 0.88% or 0.28%, respectively, in the opposite direction.

Some have interpreted that to mean: If we reduce the proportion of hogs sold under contracts by 1%, we will increase spot market prices by 0.88%. Similarly, if we reduce the proportion of hogs owned by packers by 1%, spot market prices will increase by 0.28%.

By that logic, if we just eliminate the 25% or so of hogs owned by packers, we will increase spot market prices by 0.25 x 0.28 = 0.07 or 7%. Better yet, if we just outlaw the contracts used to sell 60-65% of all hogs, we would increase prices by 0.60 x 0.88 = 0.528 or nearly 53%. Wouldn't that be great?

But those numbers are wrong!

The research does not address changing the proportions of hogs sold under these arrangements. It used the number of hogs sold through the various methods. So, a change in the number of hogs sold under contracts would affect the total supply of hogs. No wonder the effect is negative -- it is a demand elasticity that measures the change in total quantity on price.

In addition, each elasticity applies only to the amount of hogs sold under those methods. So, a 1% change in the number of hogs sold under marketing contracts is 1% of roughly 60% or 0.6% of total supply. Similarly, a 1% change in the number of hogs owned by packers amounts to 1% of about 25% = 0.25% of total supply.

Grain Inspection, Packers and Stockyards Administration (GIPSA) data indicated that, for the study period of October 2002 through March 2005, 59% of hogs were sold through contracts, 11% were sold through negotiated trades and 30% of hogs were packer-owned. Given these shares, the correct way to use the estimated elasticities is: Contract supplies: A 1% change in the number of hogs sold under contract would amount to a 0.59% change in total supply and that change in supply would be associated with a 0.88% price change in the opposite direction. The price flexibility for total supply would be -0.88/0.59 = -1.49. Meaning that prices move 1.49% for each 1% change in total supply if the change is sold through contracts.

Spot-market hogs: GIPSA found that the price elasticity with respect to spot market supplies was -0.27. A 1% change in the number of spot-market hogs would amount to 0.01 x 0.11 = 0.0011 or 0.11% change in total supply. The price flexibility for that change in total supply would be -0.27/0.11 = -2.45. Each 1% change in total supply drives prices 2.45% in the opposite direction if the change is sold in spot markets.

Packer-owned hogs: The price elasticity with respect to packer-owned pigs was 0.28. A 1% change in the number of packer-owned pigs would amount to 0.01 x 0.30 = 0.3% change in total hog supply. The price flexibility for that change would be -0.28/0.3 = -0.923. That is, each 1% change in the total supply drives prices 0.92% in the opposite direction if the change is comprised of packer-owned hogs. Those impacts are dramatically different than the raw numbers. In fact, packer-owned pigs have the smallest impact on spot market prices, while spot-market sold pigs have the largest. If you think about it, that makes sense. Wouldn't the pigs sold at the price being measured have the biggest impact on that price?

Whether you like these numbers or not, we need to use them according to how they were derived and what they actually mean -- not according to what we want them to mean. In addition, we need to remember that these numbers are only accurate near the level at which they were estimated. Doubling the number of hogs sold under spot markets would not have a -0.27% impact for each 1%. The -0.27 only applies near the number of hogs that represent the 11% market share in the data set.

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