Tobacco Contracting Issues and Update for 20011

William M. Snell and Daniel Green

University of Kentucky

Dept. of Agricultural Economics

March 2001

After decades of relatively minor changes in the marketing of U.S. tobacco, the industry is in the midst of significant changes. Last year, Philip Morris, the nation's largest buyer of U.S. tobacco initiated a pilot contracting project to purchase tobacco directly from Kentucky and Tennessee burley tobacco farmers within the guidelines of the current federal tobacco program. According to company officials, this action was taken primarily in response to better controlling the very specific grades and styles of tobacco that may not be available in a declining quota (supply) market. While the contracts offered under this pilot program did offer a few general production guidelines, the agreement was basically a marketing contract. Under the arrangement, contracting farmers delivered tobacco to a designated receiving station. Company officials graded the tobacco, checked moisture levels, and established prices based on a pre-announced price schedule. No-net cost and burley promotion fees were deducted, but contracting farmers did not have to pay grading or warehouse fees. Contracting farmers had the option of rejecting the offered price and selling their tobacco through the traditional auction market system, which consisted of federal grades and price supports.

Review of 2000 Season

Final data for the 2000 U.S. burley crop indicated that approximately 87.5 million pounds (28% of net marketings) were sold within the contracting system.2 Philip Morris officials indicated that contract agreements ranged from growers contracting more than 100,000 pounds of quota to some contracting less than 100 pounds, with approximately 50% of the agreements being less than 5,000 pounds.3 Gross prices under this alternative marketing system averaged $198.43/cwt, or almost 3 cents per pound above the average auction price. Accounting for the grading fee and warehouse fees (less haul bill rebates), prices under the contracting system netted approximately 10 cents per pound higher than the auction market. Data are not available to assess the quality-induced price differential between the two marketing systems. However, it is likely that some, but certainly not all, of the price differential between the two marketing systems was partially due to an overall higher quality of tobacco sold under the contracting system.

Given the apparent success of the pilot project, Philip Morris announced that the company planned to expand U.S. burley contracting in 2001, while also initiating contracting in U.S. flue-cured regions. Concerned about the potential supply available for their own needs, the other major U.S. tobacco buyers moved quickly following the Philip Morris announcement to initiate their own burley marketing contracts for 2001. Philip Morris, Brown and Williamson (through its leaf purchasing division, Export Leaf), and R.J Reynolds will offer their own contracts, while Lorillard will secure its contracted leaf through Dimon. Leaf dealers, Universal and Dimon will also be contracting to partially fulfill their anticipated export orders. Presently, these buyers have established more than two dozen contract receiving stations for burley tobacco across Kentucky, Tennessee, and Virginia.

In addition to contracting, Philip Morris, Brown and Williamson, Lorillard, Universal, and Dimon indicated that they still plan to buy a portion of their 2001 burley needs through the traditional auction market. However, R.J. Reynolds stated that they intend to acquire all their 2001 U.S. burley (and flue-cured) purchases via contracts. Another leaf merchant, Standard Commercial entertained the option of contracting, but due to cost considerations eventually decided to purchase all their burley needs from the 2001 crop at auction. While it remains unclear the percentage of U.S. burley that will be sold auction vs non-auction this year, currently most estimates indicate that 50 to 75% of the burley crop will likely be marketed directly via contracts in 2001. 4

Contracting Trends in U.S. Agriculture: Implications For Tobacco

Contracting is becoming an increasingly popular marketing option in U.S. agriculture. A recent USDA study indicated that approximately one-third of the value of U.S. agriculture is produced under contracts. Today almost all broilers are grown under production contracts, with an increasing volume of hog production also being contracted. Other commodities produced under contract include milk, fruits, vegetables, turkeys, eggs, cotton, peanuts, and identity-
preserved grains.

Agricultural contracts are generally classified as either production or marketing contracts. Production contracts are more common in vertically integrated industries (e.g., poultry, hogs in the U.S. and tobacco in some parts of the world) where a farmer receives a predetermined fee for raising a specified quantity and quality of a commodity, with the contracting firm providing some inputs, management, and technical advice. The contracting firm in a production contracting system usually retains ownership of the commodity throughout the

production process. Since the contracting firm bears a greater portion of the risk, the firm generally retains a larger portion of the profits.

Marketing contracts typically specify the quantity, quality, price and delivery date for a given commodity, with the producer retaining ownership until delivery. Grain, cotton, and peanuts are often grown under marketing contracts, which include price differentials for different grades and qualities.

Contracting is the marketing method utilized for tobacco in many parts of the world (e.g., Brazil, Argentina, and Mexico). In fact, contracting is the only means to sell tobacco in most of these markets. The company's intensive management control is a necessary function in many countries given no available extension service, producers' overall management skills and producers' lack of access to inputs (particularly financing). In these countries, the tobacco companies (usually leaf dealers) typically provide growers with seeds, fertilizers, pesticides, and facilitate financing, while also offering technical assistance. Producer and industry representatives usually negotiate a series of prices for various grades based on estimated costs of production. Production contracts are offered to a relatively large number of small farms given the structure of land holdings in many of these competing countries.

Access to the production information (via the extension service), inputs, financing, and management skills, are not limiting factors to U.S. tobacco production. In addition, the federal tobacco program guarantees growers access to markets and minimizes price risk. However, marketing inefficiencies, coupled with concerns over supplies and quality of U.S. tobacco, have enticed domestic companies to pursue an alternative marketing system. In addition, tobacco buyers may be shifting to contracting as a means to more closely monitor input use and production practices in anticipation of potential future regulation of the tobacco industry by the Food and Drug Administration.

Characteristics of Current U.S. Burley Tobacco Contracts

The contracts currently being offered to U.S. burley growers would be classified as marketing contracts. However, in general, the contracts do make specific reference to selected production practices and other issues including the following:

( Note that this is not an exhaustive list and these individual contract characteristics vary among contracting companies, and in some cases are not discussed in all contracts. Furthermore, contract terms and prices are subject to revision. Check individual company contracts for complete and updated contract terms.)

•	Contracted tobacco must be produced and cured using recommended agronomic and cultural practices, using only seed varieties that meet minimum standards.

•	Only government approved chemicals may be used in the production of the crop and they must be applied in accordance with applicable recommended rates and regulations.

•	Contracted tobacco must be stripped and separated into at least three (and preferably four) stalk positions, adhering to normal grade distributions by stalk position.	.

•	Contracted tobacco must be delivered free of foreign matter, weighing less than 100 pounds per bale, separated by crop year, and with a moisture content of less than specified level (24% in most contracts).

•	Contracted tobacco must be marketed under the federal tobacco quota program and adhere to all other applicable rules and regulations of the USDA and other government agencies.

•	Contract lengths vary among companies, ranging from one to three year agreements.

•	Procedures for submitting the growers' marketing card and notification of changes in farm quota, including leased-in pounds are outlined.

•	Contracting seller must offer entire crop under contract terms, with some companies disclosing penalties for unauthorized sales.

•	Contracting seller may not lease out any part of the contracted crop.

•	Termination clauses, along with rejection and revocation terms for "non-
conforming" contracted tobacco are discussed.

•	Deliveries of contracted tobacco to a specified receiving station are scheduled to accommodate by buyer and seller.

•	Minimum prices offered by grade and stalk position are disclosed, along with anticipated weight distributions by stalk position.

•	Grading procedures and options available if a grading dispute arises are outlined.

•	Sampling and testing procedures, which vary by company, (e.g., moisture, temperature, pesticide residue levels) are stated.

•	Agreements contain provisions presenting the maximum allowable carryover tobacco sales (i.e., pre-2001 crop) and options to market disaster lease pounds.

•	Payment procedures and terms are disclosed.

•	Contracting firms' rights to the access of the contracting farm are stated in some agreements, along with grower production practice record-keeping requirements (if any).

•	Disclosure of information and confidentiality of information terms are presented.

•	Terms regarding the resolution of disputes are outlined, including the applicable state's law governing the agreement and the location of any actions, suits, or proceedings arising from the agreement.

•	Contract terms are subject to revision upon major changes or elimination of the federal tobacco program.

Contract Price Analysis

The selection of a contracting company, if one elects to contract, should not be made solely on price. However, undoubtedly contract prices will be one of the key variables one will consider when debating whether to sign an agreement. Interestingly, the introduction of contracting is boosting the price of U.S. burley tobacco in the short-run as individual tobacco companies and dealers attempt to lure tobacco away from other companies and away from the auction market. This enhanced degree of competition would on the surface appear favorable to the grower, but presents some immediate and long-term concerns for tobacco growers. Anticipated higher grower prices are one of several factors that are currently boosting lease prices and thus causing some of the benefits (i.e., rents) to be passed on to quota owners. In addition, these higher prices are continuing to further erode the price competitiveness of U.S. burley in the international market, which may adversely affect future U.S. burley exports and could encourage more imports. A higher quality product induced by this changing marketing system may offset some of these price concerns. But, the higher prices evolving from this current market situation will likely result in a further erosion of the U.S. burley market share in both domestic and international markets.

Some specific observations from the contract price schedules include the following:

(Note: The list below offers only "general" comments about the major tobacco buyers' price schedules known as of mid March, 2001. Several contracting firms have revised initial price schedules and the current prices disclosed in these contracts continue to be subject to revision. Check individual company contracts for specific prices and grades. Also note that price supports for individual USDA burley grades have not been established for the 2001 crop. These loan rates are generally announced by the USDA sometime during the summer months.)

•	Contract prices do vary across companies, with some companies not offering a price for certain grades such as mixed, green or variegated tobaccos.

•	Out of the109 USDA burley tobacco grades, the number of grades currently listed as acceptable in the contracts range from 71 to 101, with an average of 90 across all reviewed contracts.

•	The difference in the quality of tobacco accepted across the contracts warrants special consideration when comparing prices. For example, while one contact may offer higher prices for the better quality grades, significant discounts are placed on lower quality grades (if these grades are accepted at all).

•	Assuming the most recent 5 year (1996-2000) distribution of marketings by grade, the average company price for the 2001 crop (based on current contract prices) ranged from $176.1/cwt to $190.4/cwt. Note these averages take into consideration that some contract prices are zero for certain grades.

•	Given the following grade distribution of marketings, flyings (8%), cutters (30%), leaf (50%) and tips (12%), the average company price for the 2001 crop (based on the current contract prices) ranged from $199.4/cwt to $202.5/cwt, assuming 100% of the tobacco fell in the company's top quality grade grouping.

•	Given the same grade distribution as above, the average company price for the 2001 crop (based on the current contract prices) ranged from $194.4/cwt to $197.5/cwt, assuming 100% of the tobacco was categorized in the company's second highest quality grade grouping.

Contract, Support and Auction Prices for Selected Grades

Selected

Grade	2000 Price Support

($/cwt)	2000 Average Auction Price

($/cwt)	2000 Contract Price

($/cwt)	2001 Contract Price Range 1/

($/cwt)
X3F	$188	$192	$192	$192 - $200
X4F	$188	$191	$192	$192 - $197
C3F	$187	$188	$192	$190 - $198
C4F	$187	$188	$191	$190 - $198
B3F	$186	$194	$187	$188 - $198
B4F	$186	$192	$187	$188 - $198
B3FR	$193	$198	$197	$199 - $201
B4FR	$193	$196	$197	$199 - $201
T3FR	$206	$207	$210	$207 - $212
T4FR	$206	$207	$210	$207 - $212
T3R	$206	$207	$210	$207 - $212
T4R	$206	$208	$210	$207 - $212
X5M	$168	$174	$178	$ 0 - $190
B4K	$149	$164	$172	$60 - $160
C4G	$113	$135	$92	$60 - $155
M4FR	$127	$164	$0	$ 0 - $175

1/ This range is based on the schedule of prices offered by the five largest contracting firms as of mid-March 2001.

Potential Advantages/Concerns Over Tobacco Contracts

The adoption of contracting in tobacco has potential benefits and concerns for both buyers and sellers. These benefits and concerns will vary across companies and growers and are likely to vary over time.

Potential advantages for the buyer:

•	enhanced quality control in terms of obtaining the desired leaf characteristics, stalk positions, moisture levels, and overall uniformity by more closely monitoring input use and management

•	improved supply management in terms of the total volume, specific grades, and flow of tobacco to the market

•	increased rate of adoption of technological innovations necessary to address specific quality or regulatory concerns (e.g., reduced nitrosamines/nicotine levels)

•	potential lower long-term marketing costs due to concentration of markets/buying personnel

•	improved strip yields in response to reduced tobacco leaf loss and lower moisture levels

Potential concerns for the buyer:

•	reduced selectivity, assuming buyer commits to purchasing the entire crop of the contracting grower

•	additional short-run costs associated with establishing receiving stations in terms of rent/building acquisition, buying agents, labor, and technological adoption

•	additional strained relations within tobacco industry (e.g., growers, warehouse owners, and farm groups who oppose contracting)

Observed Advantages (from the 2000 season) for the Contract Grower:

•	reduced marketing costs

•	higher net return relative to the auction market

•	potential of selling tobacco earlier in the year

•	no tobacco placed under government loan (i.e., pool)

•	price premiums for quality

•	payment day of delivery

•	improved direct communication with buyer regarding company/consumer preferences

Grower/Warehouse/Industry Concerns of Contracting

It appears that both Philip Morris and their contracting growers agreed that contracting worked well for the 2000 crop. In general, it was a very good quality crop and one that was produced during a period of tightening supply of quality tobacco in the world market. Despite the success of the 2000 season, many growers (both contracting and non-contracting), farm groups, and policy makers have concerns regarding the potential future implications of contract growing. At the top of the list is the issue of how will contract growing affect the federal tobacco program and the USDA grading service?

The only two entities that can eliminate the tobacco program are the U.S. Congress or the quota owners/growers. Support for the program in Washington D.C. appears to have been enhanced in recent years in response to an improved understanding of the effect the program has on tobacco consumption, taxpayer costs, and small family farms. In addition, the current administration has voiced its continued support of the program. Quota owners and growers have resoundingly expressed their support of the program for the next three years in the recent referendum. The tobacco companies do not have a vote in the continuation of the program. Publically, they state that they support the program as long as the quota owners/growers support the program. But while they do not have a vote in the program, in reality, the actions of the tobacco companies affect the political and grower support of the program. Some growers may ask the question if contracting provides me with a guaranteed market, price and production level, then do I really need a program? In reality, the program helps establish the parameters contained in the contracts. Contracted tobacco does not have a price support level, but obviously the contract prices offered are influenced by the current support prices. Presently, any grower disappointed with the contract price has the option of removing their tobacco from the receiving station and selling the tobacco at the traditional auction market where they will receive a price support that is attached to a federal grade. Thus, the tobacco program and the presence of a federal grading service at auction markets continues to provide a safety net for growers under this dual marketing system. But with a high percentage of the 2001 crop anticipated to be contracted, the financial security of the USDA grading service is very much in question. 5 Without a federal grade, technically results in a tobacco program with production controls (i.e., quotas), but without price supports. In response to this concern, farm groups are presently lobbying policy makers to require that all tobacco be federally graded.

Another major issue associated with direct marketing is the likely concentration of traditional auction markets. Currently, most contracting firms are working with a few select warehouse operators to assist them in soliciting growers and/or using their warehouse facilities as receiving stations. However, the other warehouse owners/operators not associated with a contracting firm are very nervous and uncertain regarding their future. Some have already closed their doors, with many waiting to see what unfolds with the 2001 season. Some warehouse officials have proposed that a buyers premium be added to the cost of tobacco at auction (in lieu of sellers paying marketing fees) in order to "level the playing field" between the auction and contract price. However, tobacco buyers have expressed their concerns that such action would further erode the competitiveness of U.S. burley exports and cause an even greater movement to contract buying. Consequently, it appears that a significant concentration of warehouses will likely evolve by 2002.6 In response to this potential environment, the Burley Tobacco Growers Cooperative Association is presently examining the future potential of establishing some regional receiving stations for growers who cannot, or opt not, to sign a contract and who do not have access to a nearby auction market.

In reality, most buyers may, at least in the short-term, like to have some degree of selectivity provided by the auction market. This is especially true when examining the needs of the export market where buyers have very specific orders of certain grades and stalk positions. In addition, some growers will continue to support the auction market given their concerns over contracting, allegiance to certain warehouse owners/operators, an in many cases, the dependence of the warehouse as a source of credit. Thus, it appears that at least in the near future, a dual burley marketing system will continue to emerge consisting of contract receiving stations and a few regional auction markets. If an auction system survives, many other questions arise including:

•	How many will survive and where will they be located?

•	What volume of sales will they attract?

•	What changes will the survivors adopt to attract buyers and growers?

•	How many buyers will participate?

•	How many sales per year?

•	Will auction markets become a market for primarily low quality tobacco?

•	How will auction market prices be affected by contract prices?

As this transition period unfolds, it remains unclear how this revolutionary change will

ultimately affect many other grower and industry issues including:

•	What will be the typical size of the future contract grower?

•	Will all growers who want a contract be able to obtain one?

•	Will contract production eventually be concentrated in certain geographic areas?

•	What will be the degree of producer independence in making future management decisions?

•	Will contracting producers be obligated in the future to make large capital investments?

•	What will be the degree of buyer competition in awarding contracts?

•	How will the distribution and overall average of prices change?

•	Will the higher prices initially induced by contracting result in long-term losses in exports and encourage more imports?

•	Will a changing production and marketing system continue to improve the quality and integrity of U.S. burley? If so, how will this affect future quota levels?

•	Will grading be done by a third-party or company representatives, or both?

•	Will grading evaluations vary depending on current supply/demand conditions?

•	How will the contracting firms respond to a very low quality crop?

•	Will contracting firms continue to commit to contract the farmer's entire crop?

•	Will contracting companies in the future offer grower financing and/or other inputs?

•	Will the industry experience a reduction in public market information on prices, quantities, grade distributions, etc., as a result of contracting?

The answers to many of these questions remain unclear as the industry moves into its second year of contracting. Obviously farmers, farm groups, warehouse operators, policy makers, and tobacco companies will be closely monitoring, evaluating, and responding to the developments of this alternative marketing system. Furthermore this rapidly changing marketing system will likely spawn additional changes in the current tobacco program and the current auction marketing system in an effort to enhance the efficiency and competitiveness of the U.S. burley tobacco industry. Following this transition period, U.S. burley tobacco will likely remain an important enterprise for many entities, but the structure of the U.S. burley tobacco production and marketing system will be considerably different from what the industry has been accustomed to in the past.