By Roger G. Ginder
Most farmers are well aware of the production and price
risks associated with growing standard corn and soybeans. But
there are emerging markets for specialty grains which generally
offer premium prices. The trade-off for those premiums may be
the need to use different risk management practices and strategies.
The current U.S. marketing system for corn and soybeans has been
built around an undifferentiated bulk commodity concept with product
moving through the channel in response to open market transactions.
But the value of specific traits to the end user are less accurately
priced. And as commodities with different physical or chemical
traits are commingled, much of the differentiated value in those
traits to specific end users is lost.
But increased consistency in raw product has become more valuable
to some intermediate processors and end users. As improved genetics
have permitted specific traits to be produced with smaller yield
penalties, there are more and more cases where the benefits from
identity preservation may exceed cost savings gained from bulk
handling logistics.
Producing and marketing identity preserved products with specific
traits requires greater coordination and a more formal means of
information exchange than producing and marketing bulk commodity
products. Genetics, production practices, harvesting, handling,
storage and processing must be more closely coordinated if the
desired traits are to be preserved for the end users.
The use of contracts among the firms in the market channel is
one means to obtain the required coordination. In many ways, contracts
reduce the level of risk by clearly stating the responsibility
of the producer and the contractor. However there are different
types of risks associated with production under a contract and
producers need to be aware of these.
TRADITIONAL RELATIONSHIPS CHANGED
A set of established relationships has developed over a long
period of time among producers, landlords, lenders, warehouse
operators, suppliers, custom operators and other service providers.
Contractual arrangements can significantly alter these traditional
relationships.
To further complicate the matter, there are a wide variety of
alternative contractual arrangements and each one of these arrangements
may establish its own unique set of changes in the traditional
relationships. Depending on which type of contract is used, extensive
changes in the legal and institutional responsibilities of firms
in the channel will result. The types of risk and uncertainty
vary a great deal depending on the contract. While each individual
contract may have its unique features, it is useful to consider
the general categories of contracts and how channel responsibilities
and relationships may be affected.
Four general types of contracts may be used for grain production.
These are:
1. MARKETING (OR SALES) CONTRACTS -- These contracts involve
a firm agreement to accept or deliver a specified quantity of
grain or soybeans with a minimum content of a specified physical
trait, chemical trait or which have been produced using a specified
set of practices. Pricing may be established prior to production
or pegged to commodity markets with a premium.
2. BAILMENT PRODUCTION CONTRACTS -- These contracts generally
involve the contractor providing some critical genetic trait or
traits through the seed input. Title in the growing crop and
the finished product remains in the hands of the contractor/bailor.
The producer in this case is a temporary holder for the genetic
seed input which remains the property of the contractor.
3. PERSONAL SERVICE CONTRACTS -- These contracts generally
involve the contractor providing most of the non-land production
inputs. These fee contracts sometimes involve more management
decision-making input from the contractor as well. In essence
the contractor provides compensation to the producer for the
use of land, labor and machinery.
4. POOL CONTRACTS WITH A CLOSED COOPERATIVE -- This involves
delivery by the producer to a closed "New Generation"
cooperative facility jointly owned and operated by a group of
producers for the purpose of adding value to the raw product they
produce. Such cooperatives typically require the purchase of
equity instruments by each producer in direct proportion to that
producer's rights and commitment to deliver under the contract.
These contracts are generally sales contracts. However they may
be treated differently than under warehouse regulations, grain
dealers laws, farm programs and other types of governmental institutions
because the member producers are contracting with an organization
they own and control.
CONTRACTING AFFECTS OTHER RELATIONSHIPS
There are at least six entities in the market channel which could
be affected by contracting arrangements. In addition to the farmer
and the contractor, landlords, suppliers, lenders and custom operators
may be affected. While these same agents are also present in the
open market bulk commodity channel, the existence of a contractual
agreement will in many cases change the traditional relationships
among them.
New relationships are forged when a contractor (buyer) executes
a contract agreement with a grower - especially where rights and
interests in the crop are concerned. These new relationships can
be a source of different kinds of risk than those of the producer
marketing grain in the commodity channel. In many cases, the new
risks are more manageable by the producer, and can be dealt with
in a more proactive way. But it is critical that producers understand
that old relationships may have changed.
Several critical areas where the traditional relationships may
be altered by production contracts are:
FINANCIAL AND TAX CONCERNS
Two areas where producers using contracts may encounter increased
risks are financing and taxes. For example, if a marketing or
bailment contract is assignable, unexpected tax consequences could
occur. Likewise, if the producer has entered into some type of
personal service contract, there may be unintended credit consequences
for the producer if liens cannot be granted in the crop. These
types of risks can be managed by carefully evaluating the terms
of the contract with legal tax and financial experts prior
to entering it.
YIELD PENALTIES AND BASIS FOR COMPENSATION
Some specialty grains may have yield penalties or involve greater
production risks than the standard hybrids or varieties. The grower
should be aware of these risks and make sure they are adequately
covered in the compensation schedule.
If the contract is a marketing contract, the producer should make
sure the premiums paid are large enough to compensate for the
likely differences in yield. The contract should be evaluated
under "worst case" scenario outcomes as well as expected
outcomes. The contractor's responsibility and the producerís
responsibility for such losses can be clearly stated in advance.
An alternative approach to the yield risks is to write the contract
on an area or acre basis so the crop produced on a specific area
is contracted rather than a specified number of bushels.
PRICING OF GRAIN
Methods of pricing specialty grains may vary a great deal from
one type of contract to another. Payments under marketing contracts
for specialty grains may closely resemble the cash forward contracts
used for commodity grains. The major difference is the presence
of special traits and a premium.
If prices are tied to cash market prices for commodity grain,
then price risk management steps similar to commodity grain could
be appropriate. If the contract turns possession of the grain
over to the contractor and it is not priced until a later time,
then the risks associated with a standard price later contract
must be assessed. One risk is that these types of contracts are
not covered by Iowaís grain indemnity fund. In general,
these arrangements are credit sales contracts and the producer
is unsecured whether specialty grain or commodity grain is involved.
Other bailment contracts or personal service contracts may involve
fixed payments to the producer. Here the producer incurs less
price risk but must be sure that the payment covers all costs
for the inputs he or she has provided.
GROWER OBLIGATIONS FOR QUANTITY
The producerís obligation to deliver quantity may also
be a source of risk and uncertainty. Some specialty crops may
not be insurable. A clear understanding of how shortfalls and
excess production are to be handled should be incorporated in
the contract. Heavy penalties or reductions in the rate of payment
for a shortfall could represent a potential loss of not only the
specialty premium but also reduce returns below levels available
in the commodity market.
Quantity-based contracts that require the producer to locate
substitute product may represent a significant risk - especially
if the producer assumes production risks due to "Acts of
God" beyond his or her direct control. Risks of weather delays
could also result in failure to meet quantity obligations. Unlike
forward contracts for commodity grain, which are usually not made
for the full yield expected, many production contracts are for
full expected yield. Hence, there should be "triggers"
in these contracts that specify when planting is no longer a viable
option.
TRANSFER OF OWNERSHIP
Where title to the grain is held by the producer, ownership
risks are present at least during the production period and sometimes
during part of the storage period. It is desirable to clearly
designate when actual ownership is transferred and when this risk
is terminated. Ownership risk can be especially troublesome where
there are stringent provisions in the contract and storage risk
is assumed.
RISK OF CONTRACT TERMINATION
Termination of any contract can generate serious losses for one
or both parties, especially when the grower has incurred higher
production expenses. Where bailment contracts or personal service
contracts are used, the conditions for terminating by the contractor
can be viewed as a risk factor. These risks can best be managed
through clear specification in the contract about what constitutes
a breach, the notice required before termination, the producerís
right to correct a problem, who has residual rights to the crop
after termination and events that may "trigger" termination,
such as death, disability and financial emergency. It might also
be useful to specify conditions that must be met before the grower
can terminate the contract.
Management of these risks can best be accomplished through complete
and clearly stated contract terms that take into account production
risks beyond the direct control of the producer and contractor.
GROWER OBLIGATIONS FOR QUALITY
Quality obligations are also a potential source of risk. In most
cases, the commodity quality standards for moisture, foreign matter,
test weight and condition must be met along with the specialized
traits in the grain. Quality is determined by a combination of
the producerís practices, the genetics and "Acts of
God" which are beyond the control of either the producer
or the contractor. In some cases such as moisture or foreign matter,
there may be extra costs associated with correcting quality problems
when they do develop.
Management of these risks is best accomplished through the contract
terms. If responsibilities and contingencies are clearly specified
for both the producer and the contractor, these can be fairly
shared and better managed. As with quantity problems, "trigger"
points or threshold points can be specified for "Act of God"
contingencies. Penalties can be established for quality problems
which are under the producerís direct control. Responsibility
for insurance cost and other quality maintenance expenses should
also be specified and cover both the growing season and post harvest
period.
PAYMENT RISKS
As stated earlier, some marketing and "bailment-likeî
contracts may technically be credit sales contracts that leave
the producer in the position of an unsecured creditor if the contractor
is unable to pay. In these cases, the same precautions that must
be used by producers of commodity grains are appropriate. Like
price later or deferred payment contracts for commodity grain,
the seller is in essence making an unsecured loan to the buyer
for the value of the crop. In this situation, it is important
to deal with reputable buyers and to avoid buyers who may not
be capable of paying for the grain. Payment risks may also exist
for personal service contracts where a flat payment is made to
the producer. These risks can be minimized by dealing with reputable
and financially sound contractors.
CONCLUSIONS
Production of specialty grains brings some different kinds
of risk management needs. Production or marketing contracts which
clearly define the responsibilities of the buyer and the producer
can be of great value in managing these risks.
There are several very different kinds of contractual arrangements.
Executing a contract changes some of the traditional relationships
between buyers, sellers and others in the market channel. Much
of the ìoldî knowledge about marketing and risk management
needs to be re-evaluated when a contract is used. It is absolutely
essential that producers who produce grain under contract seek
advice from an attorney and fully understand the terms before
signing an agreement.
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