One of the consequences of moving to a new equilibrium trading range for commodities is that most of the contracts which define the relationships among cooperative producers have become woefully inadequate and are in need of major revision.
Among others, these contracts include weaned pig purchasing agreements, production contracts where the grower supplies feed, many packer contracts (at least those with a price risk management feature) and contracts which include a "basis" calculation to establish a price.
The typical forms of the weaned pig purchasing contract are 1) a flat fee with a trading range to establish a minimum and maximum and 2) some factor times the deferred lean hog contract. The permanent escalation of feed ingredient costs now make these contracts inadequate to properly compensate the parties.
The flat fee contract historically established a fee of around $32/head but assumed historical feed and building costs. A very efficient weaned pig producer will have costs above $35/head in what appears to be the new trading range. In addition, with weaned pigs priced currently near zero due to fear of the fourth quarter, even the $32/head contracts are being broken.
Similarly, the contracts using futures related pricing (typically at 54-56%) of the deferred futures are blown out of the water. These contracts often had a trading range of $27 to $37 plus or minus a buck or two on each end as floors and ceilings. Since the relationship of feed cost to total pig costs is now changing and has not yet settled, these fixed percentage contracts are becoming untrustworthy not only in the base but in the ceiling and floor.
I am getting some calls about how to establish a fair contract price and I can give you a few principles. First is, the pricing has to follow economic principles and must have a fair and adequate trading range (vs. fixed price) in order to survive the volatility to come. Profit sharing is a popular topic when it comes to pricing weaned pigs but several problems (notably: 1) disclosure and accounting issues, 2) fairness issues such as who creates or is responsible for the final profit/loss?; and 3) persistent periods at the extremes when "too much" profit or loss is being passed back for too long.) conspire to undermine these in the long run. All of these problems lead to frequent dissolution of these types of contracts except among producers who exhibit a very high degree of trust and know each other very well.
The best solution for now seems to be to give a fixed cost component (people are trying around $25/head) and a feed cost slide or adjustment to that. More on variations of that theme next time.
