Flue-cured contracting on increase

With the recent announcement by Philip Morris U.S.A. that it is expanding its Tobacco Farmer Partnering Program this season to include flue-cured farmers from Virginia to Florida, it's more important than ever before that producers understand the concept of contracting or direct marketing.

Contracting the sale of tobacco to buyers would be the fourth major change to affect the industry in the past three years, with the other being quota reduction, baling and installing heat exchangers in curing barns, says William Givan, University of Georgia Extension economist.

First three changes "A drop in revenue or increased operating costs are the results of the first three changes. But what can we speculate about contracting? Can it offer a positive outlook by helping to slow the economic decline of tobacco production, or is it one more step in the overall move towards concentration in the agricultural sector?" asks Givan.

Experiences with both tobacco growers and product manufacturers reveal a sense of general frustration, says the economist. "Manufacturers see consumers - and the general public - mandating changes in the composition and uses of tobacco. This affects the way they do business - and their bottom line - and these affects transfer to tobacco growers.

"Buyers want tobacco in bales to facilitate moving the commodity, and the public wants tobacco cured in barns without exhaust gases flowing through the leaf," he says.

The current market structure in tobacco consists of a few manufacturers (buyers) facing a multitude of growers (sellers), explains Givan.

"The buyers usually have market control in this type of situation. But keep in mind that neither of these entities can operate for a long time without the other. And, both have a profit objective. So there has to be some give and take. The current tobacco program has, over time, protected growers from price fluctuations and provided a degree of market stability," he says.

More than one-third of all U.S. agricultural production is sold via contracts, says Givan. But most of the contracting is done with commodities for which the producer has little means of price risk protection - either federal programs or futures markets, he adds.

"Witness broilers, turkeys, milk, eggs, some vegetables, some fruits and, in recent years, hogs. Interestingly, peanuts, which are produced under a federal program similar to tobacco, often are marketed through forward marketing contracts."

Like it or not, says Givan, contracting is gaining popularity on the demand side as food manufacturing/processing firms attempt to meet the increasing demands of today's consumer in terms of product quality and uniformity.

"Production contracts are more common in vertically integrated sectors where the contracting firm specifies certain production practices and holds ownership to some of the inputs, such as in broiler production. Marketing contracts generally specify quantity, quality, price and delivery date for products."

Contracting, he continues, is the marketing method used for tobacco in many parts of the world, including Brazil, Argentina and Mexico. A company's management control is necessary in areas where there is no Extension Service and where producers don't have access to inputs, primarily financing. No tobacco was produced in Brazil before leaf merchants introduced it in the 1970s, notes Givan.

The current tobacco program allows for tobacco companies to directly purchase tobacco from existing growers, thereby by-passing the traditional auction market. Direct marketing can occur with or without production contracts, says Givan.

"The pounds of tobacco produced under such an arrangement are deducted from the marketing card and are subject to various marketing assessments. Even with contracting, the tobacco program likely will continue, at least in the short-run. But many growers are concerned that contracting within the program would jeopardize the program."

A grower should ask several questions of a potential contractor before entering an agreement, says Givan., including the following:

- Is it a marketing or production contract? Most likely, at this point in time, it will be a marketing contract. But the contact likely will specify that the grower must have installed heat exchangers in the curing barns. What will be the degree of producer independence in management decisions?

- If it is a marketing contract, specify the price to be paid for each grade of leaf. Are both quantity and quality guaranteed? Are there potential premiums/discounts for quality?

Price stability - Is it a one-year or multi-year contract? If it is a multi-season contract, this would provide some price stability and make the grower more inclined to invest in capital items that can improve efficiency.

- Where will the tobacco be delivered? When will payment be made? How many contract producers are involved? How much tobacco will be contracted?

- Who will be responsible for weighing and grading the tobacco? What will be the fee for these services?

- Is there a "cooling off" period (after signing the contract) in which a grower can cancel the contract? This is similar to some door-to-door sales laws in some states.

Other items for concern include: How will contracting affect auction prices? Will the auction system become an outlet for mainly lower quality tobacco? What will be the effect of current auction prices on contract prices?

If the tobacco program is eliminated, some widespread form of contracting likely will evolve, says Givan. Unlike other crops, there are no futures markets for tobacco to help offset the price risk that would occur without a tobacco program.

"While there is concern that the market power of buyers - without a tobacco program - would reduce the per-unit profitability of tobacco production, the tobacco companies would have to provide enough economic incentive within the terms of the contract to entice a desired level of production."

The current tobacco program imposes significant transaction costs in the consolidation of tobacco production/marketing units, he says. "Elimination of the program would reduce the cost of consolidation, thus increasing economies of scale associated with tobacco production. But who will receive the effects of these lower production costs?"

Tough proposition Increased quota costs coupled with a small decline in yield and/or price can make it nearly impossible for a grower to cover the economic costs of production, says Givan. But profits still can be made, in cases where a grower owns the quota or where the grower rents quota but has no debt on capital items.

There are risks without a tobacco program, he says.

"Any return above costs generally accrue to the restricted resource of production - in this case, the quota. Both tobacco manufacturers and farmers know their production costs. The absence of a program would cause a loss of income to quota holders who rent out quota. What is unknown is how this cost reduction would be allocated between tobacco growers and buyers."

A major unknown about contracting is how many flue-cured growers can survive in a contracting system without back-up protection provided by the existing tobacco program, says Givan. "It stands to reason that contracting companies would find it easier to contract with a few large growers rather than a large number of small producers. And, large producers have the resources to adopt technology that can improve efficiency."

Producers who are not awarded contracts could set up cooperatives to act as bargaining agents in developing multiple-producer contracts for relatively small growers, he says. Or, the existing auction market might be an outlet for this tobacco. But the lack of a government price support program along with a limited volume and buyer competition would adversely affect this marketing option.

Many questions Where will contracted tobacco be produced if there is no tobacco program? Given the existing infrastructure, says Givan, it's likely that tobacco production will remain in current producing areas - at least for a few years.

"Although Georgia growers are among the most efficient flue-cured producers, it's possible that tobacco companies may opt to spread production over several geographic areas to protect against weather and disease risks."

Cigarette manufacturers frequently contend they are unable to buy tobacco separated by stalk position, says Givan. "Farmers reply that they would be glad to oblige if companies would pay sufficient premiums for tobacco harvested in more stalk positions. Growers can lower harvest costs by harvesting fewer times by combining stalk positions."

In addition, he says, farmers contend there is little competition among leaf merchants during the auction. In return, manufacturers contend they must buy whatever is placed on the auction floor to obtain the volume of U.S. tobacco needed for their blends.

"While U.S. cigarette manufacturers cite the quota reductions and consequent short supply of U.S. tobacco as one reason to institute contract purchases, a more substantial reason may be quality considerations.

Price compression "The restricted supply may lead to price compression among grades and tobacco, and contract purchases may help to alleviate this. Further, concerns over nitrosamines and pesticide residues, and the difficulty of monitoring these compounds, increases the benefits of contracts to tobacco producers."