Questions and Concerns About -

Contracting the sale of tobacco to buyers would be the fourth major change to affect the industry during the past three years. The other three changes are quota reduction, baling, and installing heat exchangers in curing barns.

A drop in revenue or increased operating costs are the results of the first three changes. 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 general overall move of concentration in the agricultural sector?

Our experiences with both tobacco growers and product manufacturers reveals a sense of frustration. 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 effects transfer to tobacco growers. Buyers want tobacco in bales to facilitate their moving the commodity - and the public wants tobacco cured in barns without exhaust gasses flowing through the leaf.

The current market structure consists of a few manufacturers (buyers) facing a multitude of growers (sellers). The buyers usually have market control in this type situation. But keep in mind that neither of these entities can operate for long 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 the growers from price fluctuations and provided a degree of market stability.
 

...Just over one-third of all U.S. agricultural production is sold via contracts. 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). 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, are often marketed via forward marketing contracts.

But like it or not, contracting is gaining popularity on the demand side as food manufacturing/processing firms attempt to meet 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 (broilers). Marketing contracts generally specify quantity, quality, price and delivery date for products -- grains, cotton, etc.

Contracting is the marketing method used for tobacco in many parts of the world (Brazil, Argentina and Mexico). A company's management control is necessary in areas where there is no Extension Service and producer's lack of access to inputs - primarily financing. Interestingly, no tobacco was produced in Brazil before leaf merchants introduced it in the 1970's.
 

The current tobacco program allows for tobacco companies to directly purchase tobacco from existing growers and bypassing the traditional auction market. Direct marketing can occur with or without production contracts. 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 is likely to continue - at least in the short run. But many growers express the concern that contracting within the program would jeopardize the program.
 

What should a grower ask a potential contractor before making a decision? The following are items for consideration.

** Is it a marketing or production contract? Most likely, at this point in time it will be a marketing contract. But the contract may likely specify the grower 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?

** Is it a one year or a 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 total 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.
 

Items for concern over the long-run 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 contracted prices?
 

If the tobacco program is eliminated, some widespread form of contracting will likely evolve. Unlike other crops, there are no futures markets for tobacco to help offset the price risk that would materialize 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. Elimination of the program would reduce the cost of consolidation, thus increasing economies of scale associated with tobacco production. But the question often asked here is "who will receive the effects of these lower production costs"?

The figures in Table 1 illustrate the current costs and returns for flue cured tobacco. These are U.S. aggregate figures. But it shows that even relatively small reductions in yields and/or quota significantly reduces the gross returns of the crop. But more important, it shows that the input with the most increase in costs in recent years has been quota cost. While not all tobacco producing areas have experienced this cost increase, it does show how increased quota costs coupled with a small decline in yield and/or price can make it near impossible to cover total economic costs of production.

But profits can still be made -- in cases where a grower owns the quota - or those where the grower rents quota but has no debt on capital items.

This points out the risks without a tobacco program. Further it shows that any return above costs generally accrue to the restricted resource of production - in this case the quota. This relationship was shown nearly two hundred years ago by the English Economist, David Ricardo. There is nothing unethical about quota rent. It merely shows the interaction of people and forces in the marketplace - where the objective is to make a profit.

Both tobacco manufacturers and tobacco 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? 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

What would happen to producers who are not awarded contracts? Without the tobacco program, one option would be to set up cooperatives to act as bargaining agents in developing multiple-producer contract for relatively small growers. 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.

And where will contracted tobacco be produced in the event of no tobacco program? Given the existing infrastructure - curing barns, management, potential receiving stations - it is likely that tobacco production will likely remain in current producing areas - at least for a few years. Although Georgia growers are among the most efficient flue cured producers, it is possible tobacco companies may opt to have production spread over several geographic areas to protect against weather and disease risks.

Cigarette manufacturers frrequently contend they are unable to buy tobacco separated by stalk position. 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.

And we hear farmers contend that there is little competition among the leaf merchants during the auction. In return, manufacturers contend they must buy whatever is placed on the auction floor in order 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 of the reasons to institute contract purchases, a more substantial reason may be quality considerations. The restricted supply may lead to price compression among grades of tobacco and contract purchases may help alleviate this. Further, concerns over nitrosamines and pesticides residues, and the difficulty of monitoring these compounds increases the benefits of contracts to tobacco producers.
 

Parties specified as "grower" and "buyer":

The Grower Will -

** -- Own good and marketable title to the tobacco, free from all liens and encumbrances (other than may be specified);

** -- Have unrestricted right to sell and convey to tobacco under the terms of the agreement;

** -- Implement farming practices customarily considered to be the best suited to the production of best quality tobacco;

** -- Use certified seed;

** -- Exclusively use USDA/EPA - approved fungicides, pesticides, herbicides, and growth regulators;

** -- Abstain from using any chemical ripening agents unless authorized by buyer in writing;

** - Harvest the crop no less than ( ) times during each crop year;

** - Comply with all applicable laws and regulations, including the Fair Labor Standards Act and the Migrant and Seasonal Agricultural Workers Protection Act;
 

Delivery, Grading and Title -

** - Grower and Buyer shall coordinate with one another to schedule times of delivery of the contracted tobacco.

** - Tobacco will be delivered by stalk position - and stalk positions will not be mixed.

** - Tobacco will be in suitable marketing condition - free of damage, mildew, mold, decay, parasites, fungi and foreign material - in a uniform grade package, with agreed heat and moisture content.

** - All tobacco will be graded by grower hired personnel at the time of delivery. Price of the tobacco will be determined by stalk position, grade and quality - using USDA standards.

** - In the event the grower is not satisfied with the grade determination with respect to any lot of tobacco, the grower shall have the option to remove such tobacco from the receiving station without default, and neither party thereafter shall have the ongoing obligations with respect to selling or purchasing such withdrawn tobacco. 

** - If the tobacco is to be in bales, the bale specifications will likely be given.

** - Any grower assessments will be specified.

** - USDA grades and corresponding grower grades and prices will be stated.
 

Table 1 U.S. Flue-Cured Tobacco Production Costs and Returns, 1996-99
Year	1996	1997	1998	1999
	Dollars per Acre
Gross Value of Production	3,941	3,922	3,846	3,753
Variable Cash Expenses	1,627	1,707	1,725	1,820
General Farm Overhead	116	150	182	185
Taxes & Insurance	112	123	141	141
Capital Replacement	256	273	284	295
Operating Capital	42	44	42	43
Other Non Land Capital	78	84	80	79
Land & Quota	854	844	974	1,132
Unpaid Labor	190	200	225	236
Total Economic Costs	3,274	3,425	3,652	3,932
Gross Value of Production less Cash Expenses	1,984	1,800	1,630	1,442
Residual Returns to Mgt. & Risk	667	497	194	(-179)
Price (dollars per lb.)	1.84	1.72	1.75	1.74
Yield (pounds per acre)	2,142	2,280	2,198	2,157

Source: Tobacco Situation, ERS-USDA, September, 2000.
Bill Givan and J. Michael Moore

Sources Used:
* Marvin Hayenga and Others. Impact of Increasing Production or Marketing Contract on Access to Competitive Markets, Iowa State University, January, 2000.
* Will Snell. Issues Surrounding the Debate on Direct Marketing of Tobacco, University of Kentucky, June, 1999.
* Tomisalv Yukina and Blake Brown. Introduction to Economics of Flue Cured Tobacco Contracts, North Carolina State University, State of the Business, 2000.

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