Livestock contracts risky by definition

The decision by Silver Fern Farms (SFF) to exercise its right not to sign about 100 Backbone beef contracts is understandable, if unwelcome, confirmation of the inherently risky nature of market linked livestock contracts. The principle is fine – advance commitment of stock from suppliers willing to work with one company and take the chance the contracted price will be better than the spot market price – but in practice it only works when the movements in price are relatively small and predictable.

 

The downturn in demand in the US and other major markets has had a major impact on prices for beef which is more of a commodity than lamb, making it a big risk to offer suppliers the opportunity to contract beef, let alone bulls which are mainly destined for the hamburger trade. Past history underlines the problem with bull contracts: for example in the early 90s, Riverlands had several thousand bulls being reared on contract for a guaranteed slaughter price, but procurement competition meant the spot market exceeded the contract price; Riverlands rightly insisted on suppliers honouring committed contracts which didn’t earn them any friends. But it made it hard to convince farmers they would always benefit from making forward commitments.

 

AFFCO’s cow pools operated for many years when the company was a co-op, representing more than two thirds of its manufacturing cow kill and paying dairy farmers a price at slaughter and declaring a final pool payment a couple of months later. AFFCO introduced its Bull Pool in 1993 in an innovative and successful attempt to gain committed forward supply; the Bull Pool offered money up front on signing the contract, a spot market related price at slaughter and a final pool payment based on the market return.

 

A year later AFFCO introduced its Lamb Contracts on similar principles to the Bull Pool.

 

In spite of the relative success of these various initiatives there were several problems which suggest those contracts weren’t too different from today’s models – the contracted animals for which suppliers received advance payments may no longer have been on the farm at slaughter time, inevitably, in the 1990s at least, procurement premiums lifted prices above the level justified by the market return, weather conditions affected the timing of stock availability, and in-market competition made production planning difficult. As a result contracted suppliers received a somewhat artificial market price more closely aligned with the spot market, although it was made up of several components which rewarded commitment.

 

The one thing to be avoided at all costs was for stock bought on the spot market to command a consistently higher price than contract stock, because this would have undermined the message to suppliers to contract instead of conducting a spot market auction or, worse, sending them to the saleyards. But it was mainly a procurement tool designed to ensure enough throughput to meet orders on hand rather than filling individual contracts, because it’s very difficult to match livestock to specific customer orders except for relatively small niches or special seasonal requirements like Christmas chilled lamb.

 

With the benefit of hindsight, I can sympathise with the situation SFF finds itself in, but it isn’t good for supplier relations. The company should have foreseen the danger of forward contracting its beef, particularly bull, supplies, because there’s no way you can guarantee a price for what is essentially a commodity product. There are some high paying Asian prime beef markets…..and ANZCO has more than 40% of Japanese trade tied up.

 

The lamb trade is completely different and it may well be appropriate for farmers to contract forward, but they will have to make sure they can meet the terms of the chosen contract option. SFF has an obligation to honour contracted prices, even if the market moves against the company, just as suppliers are obliged to accept unfavourable price movements.

 

However the terms of any livestock contract need to be either very flexible or very robust to ensure neither company nor supplier is seriously disadvantaged. SFF deserves credit for its attempt to change supply methods, but it’s important to anticipate all the potential fish hooks. The experience with beef demonstrates the risks involved.

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