New Instruments For Co-Ordination And Risk Sharing Within The Canadian Beef Industry

EXECUTIVE SUMMARY The Canadian beef industry has stated objectives of improving beef quality and consumer satisfaction while reducing unit costs of production. Suggested methods for achieving these goals include working towards value based marketing and improved information flows between different market levels through systems such as a birth to plate information system. These initiatives are designed to provide a more direct link between consumer product needs and breeding and management decisions at the farm level. The industrialization of agriculture has introduced a number of changes to the structure of livestock production (Boehlje 1996); from vertical integration (arrangements such as packers feeding cattle) and forward contracting to increasing concentration (of packers and feedlots) within the marketing structure. In the past emphasis was placed on marketing what was produced. Today the challenge is to find value added markets for products. This has promoted changes to the way in which beef and beef products are priced and sold. Vertical coordination has been suggested as a means of dealing with such pricing aspects and information transmission. Grid pricing for finished cattle is also proposed another method to improve the industry by providing more information to all levels of the industry. This research evaluates several areas in coordination, pricing and risk for cattle. These areas are: *Introduction to theory of vertical coordination *Risk tools to manage market risk in the cattle industry *Sources of risk in the cattle industry *Review of the Alberta beef cattle industry structure *Level of use of risk tools by the cow-calf sector in Alberta *Math models and evaluation for new derivative tools *Evaluation of Value-Based-Marketing using Alberta cattle research data *Case studies in vertical coordination and managing risk This report addresses the issues in risk and vertical co-ordination in the beef industry. It provides information, new research and suggestions for moving the beef industry in Alberta forward. The original research proposal planned to develop math models and pricing contracts that can be used by cow-calf, backgrounder, processors and feedlot sectors. These models are developed and simulated but not extended. Preliminary research showed them to be useful but the use would be limited. Traditional risk tools would be more relevant in most cases. Instead, further risk management might be achieved by evaluating different marketing channels for the beef industry through more co-ordination and the risks surrounding grid pricing. These extensions were pursued in this study. Theory Consumer taste and behavior has triggered the production of consumer-driven food products (through vertical coordination), to fit with the new consumer demand. The food industry in general is offering a wider variety of food products of consistently higher quality. But some economists also contend that although consumer preference is a factor that promotes vertical coordination, market power and especially transaction costs are the driving forces behind it. There is an extensive theory surrounding vertical coordination and two branches are briefly examined in this report. A number of standard risk tools, derivatives, exist. Futures contracts, basis, options and forward contracts are risk tools. These can be used to build a number of different risk management strategies for price risk. Sources of Cattle Risk Market price risk is one major source of risk. This can be composed of overall price risk, basis risk and currency risk. The conversion of live cattle into meat introduces two more components of variability into the equation; yield and grade risk. Yield risk reflects the conversion from pounds of live animal into pounds of beef in the "carcass equivalent". Quantifying the degree of risk faced by cattle feeders and processors and determining the effectiveness of the risk management tools is a task of identifying the type of risk, who currently bears this risk, and determining whether there are mutually advantageous ways of transferring this risk. Grid pricing or related concepts of Value-Based-Marketing/Value-Based-Pricing (VBM, VBP) are similar concepts considered for managing yield and quality risk. Derivative Use in the Cow-Calf Sector AAFRD surveyed over 1700 cow-calf producers in Alberta in 1999. The two main ways cow-calf producer market calves are selling as weaned and retaining ownership. The most preferred marketing method for those who sold as weaned is the ring auction method. The most popular marketing method adopted if ownership is retained is background and plan to sell to feedlots. Forwards, futures and options contracts hedging strategies are not popular among farmers in the Alberta and their use by the cow-calf sector are almost zero. Finally, most farmers are not currently receiving carcass data. However, most will be interested in receiving these data which is important if the industry is to move beyond value-based-pricing. Standard market based risk management tools are not used by the cow-calf sector. This suggests that alternative arrangements will be required to manage market risk in a marketing system that uses more vertical coordination. New Derivative Risk Instruments The basic math models for window contracts and spread contracts are evaluated. Window contracts are a new and growing over the counter price risk tool in the hog industry used to set floor and ceiling prices. Applications to the beef industry would use similar mathematical and numerical models. These instruments provide a mechanism which protects users partly from decreasing market prices but provides greater flexibility in gaining from upward market moves than hedging or forward contracts. Window contracts can be priced as a portfolio of long European puts and short European calls using special combinations of standard option models. They provide a floor price and a ceiling price. Short-term window contracts are not without their problems. Selection of the price floor and ceiling is not a trivial issue. The relationship between futures prices and production costs are such that a short-term window contract that will guarantee no losses cannot always be offered. The window widths vary extensively over time, the price floor moves with changing price conditions, and the risk properties of the contract change with this variation. Thus, short-term window contracts produce more volatile price protection than their long-term -- several years in length -- counter parts. Commodity pricing contracts are being used for managing risk in long term producer-processor contracting relationships. These contracts include long-term window contracts and cost plus contracts. These contracts can be also be decomposed into portfolios of puts and calls. With the cost-plus price contract the producer buys a spread between input prices and output price and sells a spread between input prices plus cost and output prices. These spread alternatives can be valued as puts and calls on the spread. In theory these puts and calls can be valued. However, several valuation constraints exist with long-term contracts that are lessor issues with shorter term contracts. A key input or assumption to value these contracts is the stochastic process used for the price distribution. Window and spread contract values were simulated assuming either a random walk stochastic process or a mean reverting stochastic price process. A random walk process, a non-stationary series, can be difficult to distinguish from a stationary process, a mean reverting series. The different assumptions on the stochastic process have very different implications on the option values contained in window contracts and cost plus contracts. Mean reverting processes, where the mean is correctly identified, lead to lower valued implied options in both window and spread contracts. Different strike prices may be required for different times to maturity if the value of floor price (put option) is to equal the value of the ceiling price (call option) for window contracts. The floor and ceiling prices for window contracts and the cost plus portion of spread contracts need to change with the expected delivery date. Window contracts can be fairly priced at the opening of the contract, however under the random walk hypothesis, it is highly likely that one party will end up substantially ahead. With a mean reverting process, if the mean is correctly identified and the floor and ceiling prices correctly placed then the window contract appear to hold lower risk. Identifying the mean can be very difficult. Ad hoc adjustments to the contract may be required to keep the contract "fair" to all parties. These types of long term contracts may have relatively low use by the cattle industry. However, these models could be used to help set initial prices if parties enter into long term pricing arrangements. The arrangements will need to be periodically reviewed to make sure that both parties are satisfied with the arrangement. Alberta Grid Pricing Study Data from two Alberta research trials are used to examine grid pricing for finished cattle. The pricing grid used in this analysis is a quality grid that rewards top quality animals within a specified weight range. Over- and under-weight carcasses are discounted. The variation in animal value in this study is based on variations in quantity (weight and dressing percentage), quality (lean meat yield and marbling grades), and the variation in prices offered at sale. A model was used to simulate prices for live weight, dressed weight, and grade and yield revenues using data from two research trials in Alberta. The most notable difference between the two trials is the opposite direction returns take when cattle are individually priced on a grid. Steers on feed in Trial 1 were larger yearlings that dressed out at much higher end-weights. The grid used in this analysis would have produced lower average returns compared to either a live weight or dressed weight pricing method. The steers and heifers placed on feed in Trial 2 were in general much lighter calves that dressed out to lighter end-weights. Weight and the presence of "out-type" steers and heifers largely influence the variability of pen revenue when price is set according to a visual representation of the average carcass traits of a pen of cattle. In a grid that rewards for quality the results are consistent with expectations. The "quality" heifers gained from grid pricing while the "weight" steers were penalized. Looking at the distribution of these returns, cattle in the first trial were penalized for overweight carcasses when priced on a grid schedule. A large percentage of cattle were outside the target weight parameters and were subsequently discounted. By examining only the gross revenue generated by the three pricing methods, live weight, dressed weight or grid, the question of overall profitability still remains. Although these Trial 1 cattle were "net" discounts on a grid it is entirely feasible that the additional weight generated by these carcasses may result in lower profits for a live and dressed weight pricing system. If the incentive, or disincentive in this case, is large enough then additional pounds may well prove to generate even less profits. Feeding costs and the impact on quality and yield grades are key inputs to determining a relationship between weight gain and grid performance. While packers ostensibly reward feedlot operators for removing the degree of uncertainty surrounding their final product, pricing the characteristics of individual carcasses means greater variability in market price to cattle feeders as compared to an average price - instead of one price there are many prices. The results here (in the study) indicate that while individual animal values may be more volatile under the grid pricing system, the pattern is not consistent across all trials. However, one should not expect the variation in total pen values received over numerous pens to be any different under the pricing systems. Different grids for different points of the year reflecting the type of cattle in the market may be required. Profitability in the Alberta cattle feeding sector is influenced by many factors. Carcass merit has been examined as one of those factors affecting feedlot revenue and revenue variability. Determining carcass merit also emphasizes a shift away from average pen-based pricing to valuing slaughter cattle on an individual animal basis. Methods of pricing slaughter cattle on an individual carcass basis can also provide an economic signal to cattle producers about preferred carcass characteristics. Price plays a dual role - establishing transaction value between packers and cattle feeders as well as conveying important information about consumers preferences for different quality beef products. Results from the Alberta study indicate that grid pricing is an effective method for transferring information about animal value from the packer to the feedlot operator. Grid pricing does not always mean the highest average pen or animal revenue. Trying to match cattle to the pricing grid, however can still be beneficial from a short-term revenue perspective for individual cattle feeders. The key to success of value-based marketing programs is to use the economic signals created by the grid price to effect longer-term improvements in beef quality characteristics through beef cattle genetics and management. One topic that warrants further examination is the issue of basis risk. Valuing cattle on the merit of individual carcasses transfers the risk of animal quality (yield and quality grades) from the packer to the seller. Graff and Schroeder (1998) propose that this transfer of risk adds a component to basis risk; transaction price variability. While the local cash price may be an important element of the base grid price, cattle sold on a grid formula are penalized and rewarded for specific carcass traits above and below the base. The authors found that basis variability increases under grid pricing primarily due to the uncertainty surrounding animal quality, carcass dressing percentages, and variability in local packer premiums and discounts. This is significant in trying to first, assess the difference in pricing methods, and second, in trying to forecast basis levels as part of a risk management program. Case Studies on LCC, SLB, Ralphs and WF Moving the beef industry toward a marketing system that will provide better tenderness, consistency, and flavorful meat is a formidable challenge. This challenge is most noteworthy given that two pieces of meat with the same "label" at most retail counters could easily have come from strikingly different genetic and management paths. Lamb and Beshear describe a) pricing innovations, b) producer cooperatives and marketing alliances, and c) supply chains as three different forms of "vertical integration" that might eventually prevail for the beef industry to address their quality challenge. Schroeder, et al. also provides a summary of research issues that agricultural economists can address for this beef industry issue. The conclusions of these two studies are integrated into the insights we obtained from our seedstock, feedlot, packer, and retail companies to formulate the following industry action steps and policy considerations related to value-based-pricing The companies contacted or reviewed provide insights into the major challenges facing the beef industry and potential ways to manage these challenges. Leachman Cattle Co. (LCC), a large US based beef seedstock company, provides insights on the genetic side of the beef quality and production equation. Western Feedlots (WF), a large feedlot company in Western Canada is implementing a value based pricing program for both WF and their custom feeder clients, which provides insights on reducing animal variability. Sun Land Beef (SLB), a beef slaughter and packinghouse, provides insights on everything from feedlot contracting to the inputs needed to produce a wholesale product that is uniform, safe, and competitively priced. Ralphs Grocery Co., a major California supermarket chain, has had a successful branded beef product since 1992 using Holstein genetics, contract feeding through SLB, and SLB as their main processor. The following are key conclusions from the case studies. Derived Demand Education. If producers wish to participate in any value-enhancing attributes of beef they need to recognize that their derived demand will only improve if they participate in adding product value to the final consumer. More education is needed for producers to better understand the derived demand process. Also, it is important to note that gains can be realized in every sector from producing and developing the market for a better beef product. Changing Beef Quality. While several studies have used aggregate data to analyze the issue of "changing consumer demand for beef" (e.g., Eales and Unnevehr, 1993, Moschini and Meilke), no studies have looked at the "changing palatability of beef for consumers". Admittedly, secondary data are not readily available for even proxies on beef quality characteristics over time. But Ralphs has listened to their consumers on a regular basis through time, albeit informal. Ralphs perceived that "health consciousness" (e.g., Chavas) and "convenience" (e.g., Eales and Unnevehr, 1988) were not significant factors in contributing to any decline in the demand for beef. Rather, the most significant factor that can be attributed to any decline in the demand for beef has precipitated from a steady decline in beef palatability and consistency. Ralphs concluded that these quality declines have largely been driven by an increase of "exotics" in breed mixes that started in the early 1950's. In 1950, less than ten breeds of purebred cattle were used for converting grain into beef and the number of breeds has increased at least ten-fold since then. Given that most commercial herds are a mixture of several breeds, the genetic lineage that comprises the current beef herd probably exceeds the number of cow-calf producers. LCC also feels that breeding has largely occurred without a plan since over two-thirds of all cattle miss the target of at least a Choice grade and Yield 2 grade or better. More primary research that quantifies the quality of beef, much like the National Tenderness Survey, should be undertaken by the beef industry. Demand Chain Communication. As noted by Schroeder et al., there is a need for more information regarding consumers' willingness to pay for meat products that are more customized to match their demand. While more formal research regarding consumer demand for different beef attributes would undoubtedly be very helpful, it is interesting to note that Ralphs did not conduct any formal demand study before they launched their program. Their program was largely undertaken as a response to the complaints and comments that they received from their consumers. The beef industry could easily set up a web site that would enable consumers to voice what they dislike and like about their beef purchases. This feedback could then be used to develop a "knowledge data base" that would help target beef attributes that should be improved by region. Clearly, the beef industry would be better served by paying more attention to the consumer than trying to change grading standards. More Targeted Genetic and Management Paths. The supply chain structure and producer marketing alliances described by Lamb and Beshear are essentially two forms of narrowing genetic and management paths. Holsteins were the only breed Ralphs found available to supply consistent, acceptable quality, and steady supplies of fresh beef throughout the year. While programs like Certified Angus Beef, Farmland Supreme, and Certified Hereford Beef narrow genetic diversity, their genetic requirements are still rather loosely defined and limited. A requirement of 50 percent black hides does not even insure that Angus genetics are from top beef quality lineage. Given consumer demand for consistency and palatability, every sector from seedstock to retail should try to come together and establish a few standardized quality targets and acceptable genetic-management paths for those targets. For example, an age limit and percentage ranges for Continental, English, and other characteristics (e.g., maximum percentage of 15 percent Brahma for heat tolerance) could be set before animals could be classed as Tender. With Artificial Insemination, producers could use semen or first generation bulls from 10 to 15 endorsed semen alternatives on approved cows, similar to what LCC does for their cooperators. More objective measurement of meat characteristics is another possibility, but it is doubtful that measurement can account for the same level of quality attributes that could be built into an identity preserved marketing system. Identity Preservation. In addition to building predictable quality and consistency into a consumer product, identity preservation can serve as a valuable tool for tracking food safety problems and the genetic-management path of a piece of beef that a consumer is unsatisfied with. Regional Demand. LCC is developing seedstock so that at least 70 percent of their animals hit the grid target of at least Choice grade and Yield 2 grade or lower. Although this target reflects the higher end of quality for current grading criteria and price premiums, it may not necessarily be the highest value for all consumers. Both Ralphs and SLB indicated that the Southwest is more of a Select than Choice market. The Select grade from properly fed and tender beef has the highest value for consumers in the Southwest. Research related to a better understanding of regional demand differences should be considered with retail and seedstock sectors sharing a common vision for this effort. Development of a "knowledge data base" described above could be a start for better identifying regional demand differences. Ethnic Markets. Hispanics, African Americans, and Asian Americans currently make up 28 percent of the U.S.'s population and estimates are that they will account for 44.5 percent by 2040 (Silver). Since 1990, overall U.S. buying power has increased 56.7 percent while Hispanic, African American, and Asian American buying power has increased 72.9, 84.4, and 102 percent, respectively (Humphreys, 1998a, 1998b, 1999). Ethnic marketing is much more than translating English labels into another language. More research related to the willingness to pay for attributes in ethnic markets should be considered along with regional demand studies. The Alberta cattle industry must follow these changes in ethnic backgrounds in the United States and take advantage of these opportunities in their largest export market. Vertical Verification. While USDA does all the grading of carcasses at SLB, Ralphs still has one of their employees on the packing line in SLB's plant making selection decisions. Dietrich noted that this was a key component for making the California Beef program work because it insured credibility of the program to Ralphs. If the beef industry moves to identify more targeted meat products, retailers will need to have input into seedstock selection decisions for any program to work. Likewise, seedstock, cow-calf, and feeder input will be important to insure that production parameters are reasonable. Math Game. As noted by LCC, it takes a lot of cattle to have high selection criteria and a lot of capital to own cows. If an identity preserved marketing system was put in place, a global data base could be established to better identify superior bulls and cow herds for quality and yield attributes targeted. Attributes would need to be objectively measured and compared under similar management conditions. Individuals that participate in such a program should have the opportunity to objectively evaluate how their animals perform relative to other animals from the same geographic region. Although the cost and logistics of putting together a large scale data base would need to be overcome, the issue deserves attention. Captive Supplies. In the California Beef program, captive supplies were deemed necessary at the beginning to insure that consumers could always go into a Ralphs store and make a repeat brand purchase. Captive supplies were also noted as being important for improving cost efficiencies and profit variability at both the feedlot and packer levels. In the California Beef program, SLB was contracting with feeders for cattle on behalf of Ralphs. A contracted feedlot, SLB, or Ralphs were only required to give a 30 day notice to end their participation in the program. However, cattle in the feeding program prior to a 30 day notice would have to be purchased by Ralphs through SLB, provided they meet contract specifications. A "see how it goes" approach was initiated from the beginning and appears to have worked for the long-term benefit of the relationships involved. When problems come up each partner gains a new perspective for each other's operation and through joint problem solving each relationship gains a new level of trust and confidence (Kay, 1994). Given the nature of their contracts, one could easily argue that they were more of a vehicle to assure quality and consumer availability rather than exercise market power. When the program was first initiated SLB had to purchase Holsteins outside of what they had contracted for due to bad weather. If the beef industry can identify more targeted genetic and management paths, a "see how it goes" approach between any contracting parties would probably be wise. Pricing / Risk Management. While cow-calf producers often find themselves at the end of the "whipping stick" with feedgraim and fed cattle price fluctuations, the focus of any pricing system should be on economic efficiency rather than income stabilization. While contracts can aid in planning and cost efficiencies, a long-term pricing contract that fails to predict the mean accurately enough will be doomed for failure. SLB would rather not guess the longer-term trends for the industry. Coming up with the capital to cover losses for when the market steadily moves against SLB's contracted position is a risk they would rather not take. Technologies and policies can change the underlying structure of an industry rather quickly. Shared ownership at each level, possibly structured like the cooperator arrangements with LCC, appears to have more promise for reducing risk while yielding economic efficiency than contracts that try to predict the long-term mean price for the beef industry. The companies discussed illustrate several key points with respect to beef production-marketing. Genetics, management and the environment are key inputs for the industry. VBP can directly address many of the management issues associated with beef production but the genetic side is only indirectly addressed through VBP. For example, WF provides information back to cooperating cow-calf producers but no genetic program or programs are explicitly tied to these animals. Further the small size of many cooperating cow-calf owners relative to the selection intensity of a seedstock producer like LCC may not be sufficient for these producers to make adequate genetic progress without pooling their numbers. This may require new alliances at the cow-calf level with a seedstock producer or a third party that could identify superior genetics from a pooled population of smaller producer's herds. Ralphs found desirable palatability and consistent genetics using grain fed Holsteins that would reach slaughter weight in about 13 months. SLB, a packing company, contracts with feedlots for Ralphs to apply feedlot management practices identified for producing quality, consistency, year-round availability, and consumer value. These elements are believed to be key for the consumer loyalty they have developed for their California Beef product. Their branded beef product was tested and re-tested for consumer acceptability before they launched their program. Ralphs selected the Holstein breed from existing genetics largely because of product consistency and the ability to immediately produce year-round supplies. In addition to having a relatively narrow genetic base, a Ralphs employee visually selects animals that will carry their branded beef label. This was identified as a key component for making the California Beef program work. A steady supply of beef through the slaughterhouse was noted by SLB as being very important for keeping their per unit processing costs low. LCC is developing seedstock based on VBP (i.e., targeting over 70 percent of their animals to grade at least Choice with a Yield 2 grade or lower). Their seedstock selection process relies on identifying an elite group of superior outliers from a very large population base. Although LCC considers VBP carcass quality traits (i.e., marbling and yield) for selecting seedstock, limiting their selection process to the quality traits of grid pricing could easily miss key quality attributes. The link between marbling and beef palatability was found to be a poor to moderate link at best by Ralphs for predicting good eating beef. Producing attributes of consistency and tenderness from even a selected sub-set of composites raised in different climatic and range environments presents a formidable challenge to the beef industry. The experience of Ralphs suggests that seedstock selection decisions need to be more focused than just the VBP carcass quality attributes of marbling and yield. Palatability extends beyond grid measures for the consumer and consistency is more than producing animals that hit the same area of the grid. Better information sharing and coordination between seedstock and retail industries could help assure that consumer preferences of palatability and consistency are met while meeting high production standards. In addition, cow-calf, feedlot, and packing industries need to be involved with any genetic plan proposed between seedstock and retail sectors to ensure that management can take full advantage of any genetic-management path targeted. Key conclusions *Theory already exists to explain the potential benefits or reasons for vertical coordination. *There are a number of risk management tools available to manage price risk in the beef industry however these tools are not used at the cow-calf sector. This requires more research. *Math tools are available to price new derivative risk management products such as window or spread contracts however long term contracts having a fixed price may be problematic to price in a fair manner. *Grid pricing (Value-Based-Marketing/Value-Based Pricing) will not necessarily increase producer returns. It will send strong price signals about whether the cattle priced on the grid match that particular grid. Certainly anyone pricing their cattle on a price grid will need to produce cattle designed to meet the grid specifications. *There is some evidence that the herd origin of the Alberta cattle priced on the grid matters and that some cattle from particular ranches better met the particular grid specifications or graded higher. *Grid Pricing or (VBP/VBM) may not be enough to move the industry forward to compete with pork and poultry. The industry can manage their cattle to meet certain grid specifications however genetics is a key ingredient in targeting specific beef markets. Genetics is a numbers game and cannot be easily managed by small cow-calf players in the beef industry. Grid Pricing by itself does not directly address the numbers game required for genetic improvement.