The economic outlook for U.S. tobacco depends entirely on the outcome of pending legislation, says Kelly J. Tiller, economist with the Agricultural Policy Analysis Center at the University of Tennessee.

This legislation, she says, would do the following: 1) terminate the current federal tobacco program; 2) compensate tobacco quota owners for the elimination of their government-created quota asset; make transition payments to tobacco quota growers to facilitate adjustment to a new environment for tobacco production and marketing; and 4) establish a new national agricultural tobacco policy consistent with other policies affecting tobacco and tobacco products.

The U.S. federal tobacco price support and supply control program, says Tiller, was implemented in the 1930s to increase and stabilize tobacco prices and to offset some of the market power of tobacco manufacturers.

“Instead of a free-market policy that drives down prices and keeps production levels very high, U.S. tobacco policy forces production levels lower to sustain a relatively high price level,” she says. “This is accomplished through minimum price guarantees and production limits via marketing quotas or allotments.”

Unlike other agricultural subsidy or support programs, the federal tobacco program operates at no cost to taxpayers, funded through assessments on producers and purchasers at the point of sale.

The federal program, says Tiller, long has been successful in maintaining profitability in the U.S. tobacco sector. The program's success, she adds, primarily has been attributed to limited quantities of foreign-grown tobacco and the superior quality of U.S.-grown tobacco.

“Increased competition from foreign tobacco that now is a much closer substitute for premium U.S. tobacco has eroded the ability of U.S. tobacco to command a premium price, although the federal tobacco program prevents competitive pricing in world markets. The same quota program that has contributed successfully to the profitability of U.S. tobacco for generations now limits the ability of U.S. tobacco to compete in changing global tobacco markets,” says the economist.

A number of factors, she continues, are collectively pressuring the federal tobacco program. “Domestic manufacturing of cigarettes has declined significantly in recent years, by about 25 percent since the mid-1990s. While some of the manufacturing decline is a response to declining domestic demand for cigarettes, a larger share is the result of declining U.S. cigarette exports as production has shifted overseas.

“While domestic demand for cigarettes has begun to stabilize, market share among manufacturers has shifted considerably as importers and smaller manufacturers with deep-discount brands have gained market share. Most of these brands gaining market share contain little if any domestic tobacco.”

The upward pressure the tobacco program places on U.S. leaf prices has contributed to a wide gap between the price of U.S. tobacco leaf and imported leaf, says Tiller. As a result, U.S. imports of foreign tobacco have soared, and the portion of domestic leaf in U.S. cigarettes has declined dramatically. Further, the price differential — combined with improving quality and quantity of foreign-grown leaf — has led to the erosion of U.S. tobacco exports and a declining U.S. share of world tobacco exports.

Declining domestic demand, increasing exports and declining imports all have contributed to significant reductions in tobacco quotas in recent years, says Tiller. Since 1997, flue-cured tobacco quotas have been cut from 1,020 to 526 million pounds, a 46 percent reduction. Burley tobacco quotas have been cut from 702 to 288 million pounds or a 59 percent reduction.

“As quotas become more scarce, the value of the right to market U.S.-produced tobacco leaf is increasing, resulting in sharp increases in the annual value or lease price of the quotas. As quotas decline, growers must lease in additional quota poundage to maintain production and pay significantly higher quota rental rates.”

So, not only is tobacco production declining, but production costs are increasing, further pressuring the cash-flow situation of many tobacco farmers, says Tiller. Further, the continued survival of the traditional tobacco auction marketing system is questionable now that 85 percent of all tobacco is old through direct contracts with manufacturers and leaf purchasers.

The current U.S. tobacco situation, the limiting confines of the federal tobacco program and the outlook for future world tobacco markets all have led leading tobacco farmers and agricultural leaders in tobacco states to call for an overhaul of the federal tobacco program, says Tiller.

Quotas for flue-cured and burley tobacco were cut by 9.6 percent and 11.2 percent, respectively, in 2003. Flue-cured basic quota was set at 526.3 million pounds, and burley basic quota was set at 287.8 million pounds. Effective quotas also were reduced from the previous year, with flue-cured effective quota falling to 540 million pounds, and burley effective quota falling to 320.2 million pounds.

As quotas have declined, tobacco acreage has declined significantly, notes Tiller. Tobacco acreage in 2003 is forecast at 413,710 acres, the lowest level in the history of the program and down 3 percent from 2002. Flue-cured acreage declined to 239,000 acres and burley acreage fell to 149,200 acres.

Reduced acreage and slightly lower yields are projected to result in the lowest level of U.S. tobacco production recorded, with total tobacco production in 2003 forecast to decline to 830.8 million pounds, the lowest level in 106 years.

In May 2003, major tobacco producers — except R.J. Reynolds Tobacco — settled an anti-trust lawsuit filed by tobacco growers. This settlement, says Tiller, affects the outlook for tobacco production and marketing in several ways.

“First, the participating manufacturers committed to purchase at least 405 million pounds of U.S. tobacco annually over the next 10 to 12 years. While this level is considerably below historical production levels, it provides some measure of a production floor and could stabilize free-falling quotas.

“Participants also agreed to minimum domestic content levels in U.S.-manufactured cigarettes. Further, participants set aside a fund earmarked for pursuing tobacco quota buyout legislation. In addition to the dedicated resources, the settlement of the lawsuit eliminates one distraction among growers, manufacturers and other stakeholders in the tobacco quota buyout.”

The outlook for tobacco production in 2004 and beyond is strikingly different, says Tiller, depending on the outcome of the tobacco quota buyout legislation process.

“If a buyout occurs before the end of the 2003 legislative session, payments of $11 to $15 billion would begin to flow into tobacco states in 2004. Many tobacco growers and quota owners have been anticipating a tobacco quota buyout for years, and a large number of smaller and older growers are expected to exit tobacco production.”

Some growers, she adds, may move to other farming enterprises or shift to off-farm employment while others will retire. It's possible, she says, that fully half of the current tobacco growers may stop producing the crop.

Eliminating quotas, says Tiller, will reduce the costs of production and lead to lower market prices for tobacco. “While it likely will take a couple of years for tobacco markets to rebalance, it's likely that total U.S. tobacco production may increase as U.S. prices decline. The production control program proposed in pending tobacco buyout legislation is much less restrictive than the current program and facilitates adjustment to domestic and world market conditions.”

However, she adds, significant production adjustments may occur within traditional tobacco regions. Production in eastern North Carolina, South Carolina, Georgia, Florida, western Kentucky and central Tennessee would expand significantly.

e-mail: phollis@primediabusiness.com