TOBACCO YEARBOOK December 23, 1999 December 1999, ERS-TBS-245 Approved by the World Agricultural Outlook Board -------------------------------------------------------------------------------- TOBACCO YEARBOOK is published annually by the Economic Research Service, U.S. Department of Agriculture, Washington, DC 20036-5831. This release contains only the text of the TOBACCO YEARBOOK -- tables and graphics are not included. Printed copies of this YEARBOOK are available from the ERS-NASS order desk. Call, toll-free, 1-800-999-6779 and ask for stock # SUB-TBS-4031, $21. ERS-NASS accepts MasterCard and Visa. -------------------------------------------------------------------------------- Total U.S. cigarette production in 1999 is expected to slip about 7 percent from 1998 levels to 635 billion pieces. Both exports and domestic consumption are expected down. According to Bureau of Alcohol, Tobacco, and Firearms data, taxable removals were down 9 percent through March, the last month available. Nontaxable removals slipped 6 percent during the same period. During January to September 1999, cigarette exports declined 26 percent to 116 billion pieces. Calendar 1999 exports are likely to be about 150 billion pieces, nearly 100 billion below record 1996 shipments of 243 billion pieces. Since 1996, increased overseas production by U.S. manufacturers has reduced U.S. exports. Furthermore, cigarette consumption in some nations that are major buyers of U.S. cigarettes has declined. Domestic consumption is expected to slide to 435 billion pieces. Per capita cigarette consumption in 1999 is estimated at 2,146 pieces, 173 pieces below 1998. The cumulative effects of higher wholesale prices, on top of higher State taxes, restrictions on smoking, and increased awareness of links between smoking and disease continue to dampen demand for cigarettes. In 1999, higher retail prices will be the major factor in declining consumption. U.S. tobacco leaf production for 1999 is expected to be 14 percent less than a year earlier. Total tobacco acreage fell 9.6 percent from a year earlier, and the average yield for all tobacco fell about 100 pounds per acre. Effective quotas plunged 18 percent for flue-cured and 20 percent for burley. Flue-cured yields fell 2 percent, and burley yields are estimated down 7 percent. Total leaf disappearance in 1998 was 1.44 billion pounds, slightly lower than in 1997. Higher ending stocks in 1998 were offset by lower 1999 production, resulting in a 5-percent decline in supply for 1999. Producer sales of flue-cured tobacco for the 1999 season were the lowest in 58 years. Prices for desirable leaf were steady, but lower quality leaf prices declined compared with last year. Lower quota, disease in the Georgia crop, very hot and dry weather during July and August, and floods from Hurricane Floyd all contributed to lower quality and value. Despite these problems, loan receipts were high. Prices for the 1999 flue-cured crop declined 1 percent from 1998. With much reduced volume, the value of producer sales fell about 20 percent from a year earlier. Loan placements surged to 136.4 million pounds, compared with 82.4 million pounds in 1998. Loan receipts were 22 percent of net sales, about double 1998. U.S. cigarette manufacturers submitted purchase intentions of 286 million pounds (farm-sales weight) for the 2000 flue-cured tobacco crop. Purchase intentions for the 1999 crop year were 327 million pounds. Unless substantial purchases are made from loan stocks, the 2000 basic quota will be below 500 million pounds, the lowest since poundage quotas were introduced. The 1999-2000 burley tobacco marketing season was delayed because processing plants in North Carolina were recovering from damage and delays in resulting from Hurricane Floyd. Markets opened on November 29, 1999. During the year ending September 30, 1999, burley disappearance totaled 520.5 million pounds, 5 percent below the previous year. Domestic use fell 8 percent, and exports rose 2 percent. This season's burley supply, 1.44 billion pounds (estimated marketings plus carryover), is 1 percent below a year earlier. January-September 1999 exports of flue-cured, the principal export class, fell 14 percent. Exports of burley--the second most important export class--were down 9 percent. Marketing year exports of flue-cured for 1998/99 (July-June) were 235 million pounds, nearly the same as the previous year. Burley marketing year exports (October-September) were down 4 million pounds to 107 million pounds. During January to September 1999, total U.S. imports for consumption (duty paid) reached 381 million pounds, 6 percent below a year earlier. January-September arrivals of tobacco leaf (general imports) declined 15 percent (by weight) to 384 million pounds. Cigarette leaf imports fell 9 percent overall. U.S. stocks of foreign-grown cigarette tobacco fell over the last 12 months. On October 1, 1999, foreign cigarette leaf stocks in the United States totaled 930 million pounds (farm-sales weight), 13 percent below a year earlier. Tobacco Products Cigarette Production, Consumption, Exports Slip U.S. cigarette production in 1999 is expected to slip about 7 percent from 1998 levels to 635 billion pieces (table 1). Both exports and domestic consumption are expected down. According to Bureau of Alcohol, Tobacco, and Firearms data, taxable removals totaled 167 billion pieces through March, the last month available. Nontaxable removals slipped 6 percent during the same period. Per capita cigarette consumption in 1999 is estimated at 2,146 pieces, 173 pieces below 1998. During the first three-quarters of 1999 cigarette exports declined 26 percent to 116 billion. Calendar 1999 exports are likely to be as low as 150 billion pieces, nearly 100 billion below 1996 shipments of 243 billion. Since 1996, overseas production by U.S. manufacturers has reduced exports. Furthermore, consumption in some major buyers of U.S. cigarettes has declined. The sale of the R.J. Reynolds overseas operations to Japan Tobacco is likely to reduce shipments further. Cigarette imports through September are nearly double the previous year. Grey market imports have boosted import numbers. Calendar 1999 imports may exceed 8 billion cigarettes. Domestic consumption is expected to slide about 6.5 percent to 435 billion pieces. The cumulative effects of higher prices, higher State taxes, restrictions on smoking, and increased awareness of links between smoking and disease continue to dampen demand for cigarettes. However, in 1999, higher prices will be the major factor in declining consumption. The effects of the 1998 global settlement are being felt by smokers, as wholesale prices made unprecedented leaps in November 1998 and August 1999. Smokers will react to higher prices and taxes by reducing consumption. Cigar Consumption Continues Rising, But More Slowly Consumption of large cigars is expected to decline slightly in 1999. Cigar imports during the first 9 months of 1999 were 9 percent behind 1998. Although output and imports fell in 1999, taxable removals advanced, resulting in consumption of just over 3,500 million. First quarter cigar removals reached 757 million cigars, 1 percent over first-quarter 1998. Large cigar exports for January-September 1999 are 6 percent below the same period in 1998. Exports are expected to reach 150 million for calendar 1999. Imported premium brands continue to be the driving force behind the cigar market. Small cigar consumption, as indicated by domestic invoices, is expected to increase by 14 percent to 1.8 billion. Small cigar exports gained 21 percent. Imports gained 18 percent during January-September 1999, compared with the same period in 1998. Other Tobacco Products Mixed Based on 9 months of data, production of chewing tobacco is expected to fall 4 percent in 1999, and smoking tobacco is expected to fall 29 percent. Gains in smoking tobacco sales reflect roll your own (RYO) sales that have risen because of sharp increases in cigarette prices. Consumption of smoking tobacco, as indicated by domestic invoices, is up 21 percent for the January - September period, twice the gain from 1997 to 1998. Snuff output in calendar 1999 should increase 2 percent to 66.7 million pounds, about the same rate as the previous years' rise. Consumption of snuff (as indicated by invoices to domestic customers) is expected to rise 2 percent during the 9-month period, about the same as last year. Moist snuff is the predominant type of snuff, accounting for about 94 percent of snuff output. The remainder is dry snuff. Moist snuff output and domestic invoices increased, while dry snuff output and domestic invoices fell. On December 1, the U.S. Supreme Court heard oral arguments on the Food and Drug Administration's (FDA) right to regulate cigarettes and tobacco products. The dispute began in 1996 when the FDA announced its intention to regulate tobacco products and restrict their availability to young people. Last year a U.S. Court of Appeals ruled that Congress, not the FDA should regulate tobacco products. A ruling is expected by June 2000. U.S. Exports and Imports Leaf Exports Slide Exports of unmanufactured tobacco (by weight) are expected to slip in calendar 1999, ending at slightly over 400 million pounds, compared with last year's 467.2 million pounds. Shipments through September are 9 percent below the same period in 1998. Exports of 460-480 million pounds are expected on a farm-sales weight basis. Lower prices at the flue-cured markets and export sales out of loan stocks may boost export sales in 2000. January-September 1999 exports of flue-cured, the principal export class, fell 14 percent. Exports of burley--the second most important export class--were down 9 percent. The recovery in Brazil has resulted in larger global supplies of both flue-cured and burley. Not including China, world production in 1999 is not expected to decline much. Exports of cigar leaf fell over 33 percent during the 9-month period as cigar-producing nations reduced output of premium cigars, mostly destined for the United States. Exports of Kentucky-Tennessee and Virginia fire-cured and "other leaf" fell, while Maryland and Virginia sun- and air-cured types gained. Among major markets, shipments to Asia and Europe, which account for the bulk of shipments, advanced. Through September, the Netherlands, Japan, and Germany, were the major buyers of U.S. leaf, accounting for just over half the leaf shipped. In 1999, the United States is expected to rank second behind Brazil among world tobacco exporters. Imports Down During January-September 1999, total U.S. imports for consumption (duty paid) reached 381 million pounds, 6 percent below a year earlier. During the same period in 1998, imports had fallen 23 percent from 1997. Imports declined, despite lower U.S. stocks of imported leaf, because of lower cigarette production, and abundant U.S. stocks. Imports of cigarette leaf totaled 281.4 million pounds for the 9-month period, and cigar leaf totaled 38.2 million pounds. Imports for consumption of Oriental leaf, the major import class, fell 33 percent in January - September 1999, compared with the previous year. Stemmed flue-cured advanced 100 percent; and other stemmed cigarette leaf (NSPF, mostly stemmed burley) gained 10 percent. Cigar wrapper and filler advanced. Imports of stems fell by 38 percent. January-September arrivals of tobacco leaf (general imports) declined 15 percent (by weight) to 384 million pounds. Cigarette leaf fell 9 percent overall. Only stemmed cigarette leaf, mostly burley, advanced. Imports of stems fell 29 percent. Cigar wrapper and filler arrivals advanced. U.S. stocks of foreign-grown cigarette and smoking tobacco fell over the last 12 months. On October 1, 1999, foreign cigarette leaf stocks in the United States totaled 30 million pounds (farm sales weight), 13 percent below a year earlier. Flue-cured and Oriental leaf stocks were down 14 percent, and burley stocks slid 12 percent. October 1 cigar leaf stocks gained 7 percent compared with October 1, 1999, to reach 127 million pounds. Tariff-Rate Quota Update The volume of tobacco imports for consumption under the tariff-rate quota (TRQ), primarily flue-cured and burley, during the period from September 13, 1998, through September 12, 1999, the latest data available, reached 162 million pounds, 49 percent of the 332-million-pound quota. U.S. Tobacco Leaf Situation and Outlook------1/ --------- 1/ All weights in this section are farm-sales weight, unless otherwise indicated. ------- Total U.S. leaf production for 1999 is expected to be 14 percent less than a year earlier. Total acreage fell 9.6 percent from a year earlier, and the average yield for all tobacco fell about 100 pounds per acre. Flue-cured yields fell 2 percent, but burley yields fell 7 percent (table 9). As measured by official grades, the overall quality of the flue-cured crop was slightly better than the 1998 crop. Flue-cured supplies are lower. In addition, much of the flue-cured tobacco was destroyed by Hurricane Floyd during post-marketing processing and storage. Although beginning stocks are higher, poor weather and the low effective quota will limit supply gains. Burley quality is probably down due to poor growing and curing conditions. Nonetheless, higher carry-in is expected to boost supplies. For other kinds, supplies of Maryland, fire-cured, and dark air-cured are up, and supplies of cigar leaf are down. The average price for U.S. tobacco will likely not reach last year's level. Declining demand in both domestic and foreign markets dampened prices at the markets. This year over 20 percent of the flue-cured crop went under loan. Through the first 11 days of the burley market, loan takings were over a third of net sales. Marketing Quota and Allotments in 2000 The five domestic cigarette manufacturers (those with more than 1 percent of U.S. production and sales) are required to submit a statement of flue-cured and burley purchase intentions to the Secretary of Agriculture 15 days before the national quota announcement deadline. Purchase intentions submitted by manufacturers totaled 286 million pounds, 13 percent below last year. Burley purchase intentions are due by January 15, 2000. Marketing quotas for flue-cured and burley in 2000 are set by totaling (1) intended purchases by domestic cigarette manufacturers from the 2000 crop; (2) average exports for 1997/98, 1998/99, and 1999/2000 marketing years; and (3) an adjustment to maintain loan stocks at the specified reserve-stock level of 15 percent of basic quota, or a minimum of 100 million pounds of flue-cured or 50 million pounds of burley. Flue-cured loan stocks are about 250 million pounds and at this level would result in a 150-million pound downward adjustment in the quota. The Secretary of Agriculture may adjust this three-part total up to 3 percent. The basic quota could very well be below 500 million pounds. When undermarketings and overmarketings from 1999 are added, the effective quota (sum of individual quotas) is expected to fall also. By February 1, 2000, the U.S. Department of Agriculture (USDA) will announce the 2000 burley poundage quota, and by March 1, USDA will announce the 2000 acreage allotments for other kinds of tobacco. Shortly after the announcements, growers of Virginia fire-cured and Kentucky-Tennessee fire-cured (types 21and 22-23), and Kentucky-Tennessee dark air-cured (types 35-36) will vote in separate referenda for or against marketing quotas on their next three crops (2000, 2001, 2002). Growers of flue-cured tobacco approved marketing quotas for the 1998, 1999, and 2000 marketing years in a referendum held January 12-15, 1998. In a referendum held February 23-27, 1998, burley growers voted to continue marketing quotas on a poundage basis for the 1998, 1999, and 2000 marketing years. Growers of Maryland, Pennsylvania filler, and Connecticut binder (types 51-52) have no price supports because they turned down marketing quotas in referenda held March 1998. Growers of Wisconsin and Ohio filler and binder voted in March 1999 to accept quotas for the next three crops (1999, 2000, and 2001). Growers of Virginia sun-cured (type 37) voted on March 23-26, 1998, to approve quotas for the 1998, 1999, and 2000 crop years. Growers of Maryland, Pennsylvania filler, and Connecticut and Massachusetts binder turned down marketing quotas in their last referenda (1998), so government price support is not available for their 2000 crops. Pennsylvania filler has never had marketing quotas. For Maryland, quotas last applied to the 1965 crop, and for Connecticut and Massachusetts binder, quotas last applied in 1983. Price Supports in 1999 Support levels for 1999 average $1.632 per pound for flue-cured and $1.789 for burley. Grade loan rates for flue-cured range from $1.14 to $1.85 per pound. And for burley, they range from $1.09 per pound to $1.98. Price supports for kinds other than flue-cured and burley average from $1.212 per pound to $1.681 in 1999. The 2000 price supports for flue-cured and burley (not available at publication) are the preceding year's support adjusted by changes in the 5-year moving average of prices, excluding the highest and lowest years (two-thirds weight) and changes in a cost-of-production index (one-third weight). Costs include variable expenditures, but exclude costs of land, quota, risk, overhead, management, marketing contributions, and other items not directly related to tobacco production. The Secretary of Agriculture has discretionary authority to adjust the price support between 65 and 100 percent of the calculated increase or decrease. The 5-year moving average of prices and changes in a cost-of-production index increased the price support for flue-cured. The 1999 flue-cured support was raised by 100 percent of the formula increase. Price supports for other types of tobacco have not been set for 2000. For types other than flue-cured and burley, maximum increases in supports will continue to be based on changes in the average parity index during the 3 previous years compared with 1959. But loan associations can request reduced support if market conditions warrant. For the 1999 flue-cured price support calculation (omitting high and low years), the 1995-98 prices averaged 1 cent a pound, the same as the 1994-97 average. Using 10-year average yields to minimize the effects of weather, the cost of production in 1999 is estimated to have increased 2.5 cents per pound. U.S. Industry To Buy 286 Million Pounds of 2000 Flue-cured Tobacco U.S. cigarette manufacturers plan to purchase 286 million pounds (farm-sales weight) of 2000-crop flue-cured tobacco. Major domestic cigarette manufacturers are required by statute to report annually to USDA their intended purchases of flue-cured tobacco from U.S. auction markets and producers. Data on intended purchases, average annual flue-cured exports for the preceding 3 years, and the amount of tobacco needed to attain reserve stock levels are used to determine the annual flue-cured marketing quota. Flue-Cured Lowest Marketings in 58 years. Flue-cured sales (producer) for the 1999 season were the lowest in 58 years. Prices for desirable leaf were steady while lower quality leaf prices declined compared with last year. Loan receipts totaled 136.4 million pounds, about double 1998. Lower quota, disease in the Georgia crop, very hot and dry weather during July and August, and floods from Hurricane Floyd all contributed to lower marketings. Despite these potential shortfalls, loan receipts were high. Auction Prices Fell in 1999 Prices for the 1999 flue-cured crop declined 1 percent from 1998. With much reduced volume, the value of producer sales fell about 20 percent from a year earlier. Loan placements surged to 22 percent, or 136 million pounds, compared with 82.4 million pounds in 1997. Compared with the 1998 season, changes in prices of tobacco by grade and production areas varied. The season-average price, $1.736 for gross sales (including resales), is 1.9 cents below last year. Average prices were down .9 cent per pound in the Georgia-Florida belt; .8 cent in the old and middle belt of North Carolina and Virginia; 2.9 cents in the eastern North Carolina belt, and 2.1 cents in the North Carolina-South Carolina border belt. Among the 46 markets having sales, season averages ranged from $1.79 to $1.48 a pound. With a smaller effective quota, producer marketings were 21 percent below last season. Auction and nonauction sales totaled 645.0 million pounds, 118 million below 1998. Sales were only 5.1 million pounds short of the effective quota of 1,019.4 million pounds. Auction Sales The Georgia-Florida markets (type 14) opened on July 27 and closed on October 21. The South Carolina and border North Carolina (type 13) opened August 3 and closed on November 1. North Carolina (type 12) opened August 4 and closed on November 8; while the North Carolina-Virginia (type 11) ran from August 10 to November 16. Resales (leaf which was purchased at auction from a grower and sold at auction a second time by the buyer) averaged 9 percent of gross sales, about the same as 1998. Again this season, there were no provisions for the Flue-Cured Stabilization Cooperative or warehouses to handle carryover tobacco. Export Volume May Fall Export prospects for the 1999 flue-cured crop are lower than last year. July-September shipments were down 20 percent and total 1998/99 flue-cured exports may fall by a similar amount. Large world supplies, lower priced leaf from competitor countries, stagnant or declining cigarette consumption in major importing countries, and reduced leaf use per cigarette all constrain leaf exports. Supplies Decline in 1999/2000 Lower marketings and smaller carryin diminished domestic flue-cured supply to 1.88 billion pounds, 9 percent below last year (table 16). Marketings in 1999 were about 21 percent lower than in 1998. Harvested acreage fell 17 percent, and yields slid 2 percent. The total effect of Hurricane Floyd on supplies has yet to be determined. During the first 3 months of the flue-cured marketing year (July-September 1999) total disappearance of flue-cured tobacco was 327 million pounds, 34 percent below the same period in 1998. Both domestic and export disappearance may decline because of reduced cigarette production in the United States and lower demand overseas due to abundant supplies. Foreign Flue-Cured Production and Sales According to the Ontario Flue-Cured Tobacco Growers Marketing Board, 1999 flue-cured production in Canada is estimated at 25.4 million pounds, 4 percent below last year. Auctions opened in mid-October, and after 19 days, sales averaged US$1.04 per pound, about 3 percent below a year earlier. Brazil's flue-cured production is expected to increase 28 percent in 1999, rebounding from last year's low production. Output in China is likely down, but output in India is expected to increase. The 1999 flue-cured crop in Zimbabwe was 11 percent smaller than the year before (table 19). Markets closed on September 24. During the first 21 weeks, 378 million pounds of flue-cured tobacco were sold at an average price of U.S.$.80 per pound. At the same time last season, 383 million pounds had sold at an average of U.S.$.80. Burley Burley Auction Prices Slightly Lower Than Last Season The 1999-2000 Burley tobacco marketing season was rescheduled to begin November 29, 1999, as Hurricane Floyd caused flue-cured processing to continue longer than usual. Burley auction sales through December 15 (11 days) totaled 307.3 million pounds (gross) and averaged $1.903 per pound. The loan level for the 1999 crop has been set at $178.90 per hundredweight--up $1.10 from 1998. Loan rates by grades range from $108 to $197 per hundred. No-net-cost assessments have been set at 6.0 cents per pound for the 1999 crop. The fee is shared equally between producers and purchasers. Disappearance Down in 1998/99 During the year ending September 30, 1999, burley disappearance totaled 520.5 million pounds, 5 percent below the previous year. Domestic use fell 8 percent, and exports rose 2 percent. October 1998-September 1999 exports were 168.8 million pounds, less than 1 percent over the previous year. Supplies Down This season's burley supply, 1.44 billion pounds (estimated marketings plus carryover), is 1 percent below a year earlier (table 17). The 1999 crop, estimated at 534.8 million pounds as of November 1, is 9 percent below last year's marketings. Growers harvested about the same acreage as in 1998, but yields were 8 percent lower than a year earlier. This season's effective farm poundage quota of 692 million pounds was 20 percent below last year. With 1998 marketings exceeding use, carryover on October 1 jumped 8 percent from a year earlier due to higher loan stocks. Both manufacturer and dealer holdings also increased. Carryover next October 1 will likely rise also. The 1999/2000 supply is about 2.8 times the probable disappearance, above traditional benchmark levels. In addition, manufacturers and dealers held 286 million pounds of foreign-grown burley on October 1, 1999, 12 percent less than a year earlier. Decision on 2000 Quota Due By February 1 The 1999/2000 outlook for burley hinges partly on the quota decision USDA is required to announce by February 1. Legislation requires that the national marketing quota be set by totaling (1) intended purchases by domestic cigarette manufacturers (to be submitted by January 15, 2000), (2) the average exports for 1997/98, 1998/99, and 1999/2000 marketing years, and (3) an adjustment to maintain loan stocks at the reserve stock level. At USDA's discretion, the three-component total can be adjusted up or down no more than 3 percent. Because this year's marketings are expected to fall short of the effective quota, undermarketings carried to the 2000 marketing year will bolster the 2000 effective quota. Southern Maryland The 1999 crop of Maryland tobacco is estimated at 14.4 million pounds, 7 percent below 1998. Production is expected to decline in both Maryland and Pennsylvania, with the greater shortfall in Pennsylvania. The 1981 farm act prohibits growing and marketing Maryland tobacco in quota areas. However, quotas are not applicable to Pennsylvania seedleaf tobacco, so with seedleaf's usually lower prices, some growers have changed to Maryland production. About 37 percent of total Maryland production will be grown in Pennsylvania in 1999. Marketing year 1998 exports of type 32 tobacco reached 6.2 million pounds, 4 percent below 1997. Disappearance in 1998 increased 29 percent, reaching 18.9 million pounds. Disappearance may be overstated due to on-farm carryover. Stocks on October 1, 1999, are 15 percent below the previous year. Fire-Cured Fire-cured tobacco is mainly used in making plug and twist chewing tobacco and snuff. About half the crop is usually exported. During the last three out of four seasons, production and use have rebounded. Strong demand has boosted prices. Disappearance Slides Disappearance of Kentucky-Tennessee fire-cured (types 22-23) during the 1998/99 marketing year (beginning October 1, 1998) was down slightly at 35.5 million pounds. Both domestic use and exports declined. Carryover increased slightly. In 1999, Kentucky-Tennessee fire-cured production is expected to slide due to fewer planted acres and lower yields. Disappearance of Virginia fire-cured (type 21) is projected to increase in 1998/99 partly because of higher snuff production and exports. Production of Virginia fire-cured (type 21) in 1999 is expected to increase, reaching 2.5 million pounds. Kentucky-Tennessee tobacco (types 22-23) exports reached 13.2 million pounds during the 1998/99 marketing year, slightly below last season. Export demand for Virginia fire-cured has been lower this season. Fire-Cured Price Supports and No-Net-Cost Assessments for 1999 The 1999 price support loan rate for Kentucky-Tennessee fire-cured tobacco has been set at $1.716 per pound. Grade loan rates will range from 63 cents per pound to $2.40 per pound. No-net-cost assessments for Kentucky-Tennessee fire-cured tobacco was set at 0 cent for types 22 and 1 cent for type 23. The assessment for type 21 is 2 cents per pound. Dark Air-Cured Dark air-cured (types 35-37) is used in blackfat, plug and twist chewing tobacco, snuff, and to some extent, smoking tobacco. Production and use have declined by more than half over the last two decades. Exports usually account for 10 to 20 percent of total use. Disappearance Falls Disappearance of dark air-cured (types 35-36) tobacco totaled 8.1 million pounds during October-September 1998/99, 1 percent below 1997/98. Domestic use fell but sharp declines in Blackfat exports almost eliminated exports. Dark air-cured leaf is mostly used in snuff production. Disappearance of sun-cured tobacco (type 37) is about the same as last year at nearly 100,000 pounds. Production Gains The November 1 estimate of 1999-2000 dark air-cured (types 35-37) tobacco production is 10.3 million pounds, 6 percent above last season. Next season's supplies represent about 4.2 times this season's estimated use. Dark Air-Cured Price Supports and No-Net-Cost Assessments for 1999 Loan rates for 1999 Kentucky-Tennessee dark air cured tobacco have been set at $1.481 per pound. Grade loan rates range from 58 cents per pound to $2.27. Loan rates for Virginia sun cured tobacco (type 37) were set at $1.38 per pound and range from 93 cents to $2.02 per pound. The assessment for type 37 is 2 cents per pound. Cigar Tobacco Cigar leaf (types 41-61) is classified according to its traditional use: filler, binder, and wrapper. Most cigar wrapper is exported, but loose leaf chewing tobacco takes most of the filler and binder. Exports of filler and binder are negligible. Cigar Leaf Use Down for 1998/99 During the 1998 marketing year for filler and binder types (October 1998-September 1999) and wrapper (July 1998-June 1999), total cigar leaf disappearance declined 7 percent. Disappearance for all types declined except Connecticut Valley Broadleaf binder and wrapper. Cigar leaf disappearance for the entire 1998/99 marketing year (October-September for filler and binder, July-June for wrapper) is expected to fall below 1997/98's 21.9 million pounds to about 21.4 million pounds. Export volume gained 3 percent. For 1998/99, filler and binder supplies are down and wrapper supplies are up. As of October 1, 1999, 527,000 pounds of cigar binder were held by cooperatives. Supplies for 1999 Expected To Fall Cigar tobacco production in 1999/2000 is expected to fall to 15.8 million pounds from 1998/99's 19.1 million pounds. Lower production and carryin resulted in reduced supplies of 46.7 million pounds, about 11 percent below the previous year. Filler Marketing year 1998/99 (October-September), disappearance of U.S. cigar filler tobacco (types 41-46) totaled 11.0 million pounds, slightly higher than the previous year. As of November 1, the 1999/2000 Pennsylvania filler crop was indicated at 5.9 million pounds, about 37 percent less than 1998. The new crop, plus estimated carryover, will provide a supply that is about 5 million pounds below last season. Production of Ohio filler has ceased because of high no-net-cost assessments. Puerto Rican filler is no longer included in the program, as production has ended. Binder Cigar binder disappearance (Wisconsin and Connecticut) declined in 1998/99 as supply fell. Production in 1998 declined and carryin was lower. For Wisconsin binder tobacco (types 54-55), loose leaf chewing and smoking tobacco is the major outlet. Output of loose leaf chewing, the major use for binder tobacco, is expected to fall 4 percent in 1999. Total binder production is expected to fall to 7.0 million pounds in 1999. Disappearance of Wisconsin binder tobacco will again exceed production, resulting in a 12-percent drop in beginning stocks for 1999/2000. Disappearance is expected to decrease in 1998/99 due to reduced cigar production. Disappearance of Connecticut Valley binder is expected to be short of production, resulting in higher beginning stocks in 1999/2000, production is expected up by 16 percent. Production of Connecticut Valley binder (type 51) increased by 43 percent in 1999/2000. Wisconsin binder production is expected to fall by 26 percent to 2.8 million pounds in 1999/2000. Acreage planted was reduced, and yields increased. Carryover is expected to continue to decline as use exceeds production. As of November 1, 1999, Wisconsin binder production is projected at 2.8 million pounds, down 21 percent from 1998. Wrapper For the June 1998-July 1999 marketing year, shade-grown cigar wrapper (type 61) disappearance increased, reaching 2.4 million pounds, compared with 2.3 million pounds last season. Production in 1998 was up slightly at 2.4 million pounds. Much of the shade-grown cigar wrapper is shipped overseas for processing, either to foreign buyers or to subsidiaries of U.S. firms in the Dominican Republic. Acreage of Connecticut Valley wrapper is expected to be up in 1999 with production estimated at 2.8 million pounds, 541,000 pounds higher than the previous year due to higher acreage and better yields. Supply will likely increase in 1999 due to higher disappearance. Disappearance is expected to continue at elevated levels due to strong demand for premium cigars. Special Article U. S. Tobacco Import Update Tom Capehart ------1/ --------- 1/ Senior economist, Market and Trade Economics Division, Economic Research Service, USDA. -------- Abstract: U.S. imports (arrivals) of foreign-grown leaf and stems fell from 681.4 million pounds in 1997/98 (July-June) to 527.3 million pounds during 1998/99 (July/June), a decline of 23 percent. Cigarette and cigar leaf imports both declined, while imports of stems were nearly steady. Use of foreign-grown flue-cured, burley, and Oriental tobaccos slipped during this period, reflecting lower imports and some withdrawals from stocks. Lower use and abundant loan stocks in the United States may further dampen 2000 imports, although the proportion of foreign-grown leaf used in cigarette production may not change much. Under the tariff-rate quota currently in place, imports of leaf are not severely restricted. Keywords: Imports, arrivals, Oriental, flue-cured, burley, tariff-rate quota. Introduction This article updates a series published annually in the September 1992-98 issues of the Tobacco Situation and Outlook report. During 1998/99 (July-June) arrivals or general imports of unmanufactured tobacco fell by 23 percent compared with a 9-percent decrease during 1997/98. Unstemmed leaf, including Oriental, and stemmed flue-cured imports rose, but other stemmed imports (NSPF) declined. U.S. leaf imports for consumption had climbed from 413 million pounds in 1990 to more than 1 billion pounds in 1993. The main reason for this surge was the rising popularity in the United States and abroad for low and mid-priced cigarette brands (discounts). To meet this demand, manufacturers imported an increasing amount of lower cost foreign tobacco. After imports reached 44 percent of domestic disappearance, Congress acted to restrict imports by implementing the Domestic Marketing Assessment (DMA). The DMA was in effect from January 1, 1994, to September 13, 1995. If foreign leaf content of U.S. cigarettes exceeded 25 percent, a penalty was assessed on the manufacturer for calendar 1994 only. The DMA was eliminated on September 13, 1995 (retroactive to January 1, 1995), when President Clinton proclaimed a tariff-rate quota (TRQ) for cigarette leaf tobacco, mainly flue-cured and burley. The proclamation also eliminated duties on Oriental and cigar wrapper, binder, and filler tobacco. Imports of cigarette leaf tobaccos which exceed predetermined quota levels will be subject to an import duty of 350 percent ad valorem. A draw-back provision allows most of the duty to be refunded if the same leaf that is imported is re-exported as product. Tariff-Rate Quota Activity For the period September 13, 1998, through September 12, 1999, U.S. leaf imports within the TRQ totaled 161.9 million pounds. Only 48.8 percent of the total quota allocation of 332.0 million pounds has been imported. Under the TRQ, the volume of tobacco imports for consumption under nine harmonized tariff subheadings, primarily flue-cured and burley, are limited during the period from September 13 in any year to September 12 the following year (table A-5). Use of Imported Leaf Slips Relative to Domestic Use in 1998/99 Foreign leaf use by U.S. manufacturers of cigarettes and other products slipped in 1998/99 (July-June). Total disappearance of cigarette-type tobaccos in 1998/99 was 1,390 million pounds, of which 38.3 percent was of foreign origin. In 1997/98, total disappearance rose slightly to 1,536 million pounds, with imports at 39.6 percent. On a farm-sales weight basis, estimated U.S. use of imported flue-cured tobacco fell 11.5 percent from 1997/98 to 1998/99 (tables A-1 and A-2). This, combined with a 9-percent drop in domestic disappearance during the same period, caused the import share of total flue-cured use to slip from 29.5 percent to 28.9 percent. During the same period, foreign-grown flue-cured stocks held by U.S. tobacco dealers and manufacturers fell 16 percent (table A-3). Estimated use of imported burley leaf fell 1 percent from 1997/98 to 1998/99. Domestic use slipped 8 percent and total use was down 6 percent. The import share of total burley used rose from 35.4 to 37.0 percent. Foreign-grown burley stocks declined 7 percent to 280 million pounds from July 1, 1998, to July 1, 1999. Based on arrival data (adjusted for stock changes), Oriental leaf use plummeted 26.9 percent in 1998/99. Stocks on hand declined 3.4 percent from July 1, 1998, to July 1, 1999. Cigar leaf imports declined 27 percent to 65.7 million pounds (farm sales weight) during July 1998-June 1999 compared with the previous year. They represented 79.3 percent of cigar leaf disappearance (use) in the United States, compared with 82.2 percent during the previous year. Total imported cigar use (imports for consumption adjusted by changes in stocks) was 52.8 million pounds for 1998/99 compared with 97.8 million pounds in the previous year. Special Article The Changing Tobacco User's Dollar By Tom Capehart 1/------- ------- 1/ Senior economist, Market and Trade Economics Division, Economic Research Service, USDA. ------ Abstract: Consumers increased their total spending on tobacco products about 1.3 times from 1991 to 1998. About 93 percent of expenditures were for cigarettes, and these expenditures advanced because price hikes offset declining consumption. The proportion of expenditures on cigarettes declined slightly, mostly due to higher expenditures on cigars. Wholesale cigarette prices have jumped 29 percent since 1991. Excise taxes have increased 27 percent. The farmer's share of the tobacco user's dollar declined from 1991 to 1998 because domestic cigarette consumption fell and use of imported tobacco increased. The manufacturers' share shrunk while the wholesaler-retailer share advanced. The excise tax share rose slightly. Despite continued reductions in consumption, consumer expenditures are likely to rise in the coming years as prices increase. Keywords: Tobacco expenditures, tobacco user's dollar, cigarette prices, cigarette consumption, excise taxes, and tobacco products. Expenditures on tobacco products in the United States trended upward for many years, reaching a record high $57.3 billion in 1998. Higher cigarette prices and increasing State excise taxes have offset declining cigarette consumption, boosting total expenditures (table A-1). These expenditures comprised .95 percent of consumer disposable income and about 1.7 times the amount spent on tobacco products in 1990. About 93 percent of expenditures were for cigarettes, 2.8 percent for cigars, and 4.2 for other tobacco products (smoking tobacco, chewing tobacco, and snuff). During the 1920's, cigarettes emerged as the leading form of tobacco consumption, and by the mid-fifties and early sixties accounted for 85 to 90 percent of expenditures on tobacco products. Rising expenditures on cigarettes during the last decade reflect rising prices and taxes. After peaking at 640 billion in 1981, consumption declined steadily to 465 billion cigarettes in 1998. This decline occurred despite increases in both the smoking age population and disposable income. Consumption declined further in 1999. Retail prices for cigarettes increased sharply over the last decade primarily because of rising wholesale prices. However, increases in Federal, State, and local excise taxes also contributed to the increase. Wholesale prices of branded filter-tipped cigarettes (excluding excise taxes) have more than doubled since January 1990. During the early and mid-1990's, consumers shifted to generic cigarette brands in the face of rising prices. However, in August 1993, cigarette manufacturers lowered wholesale prices for premium cigarettes and have been steadily regaining market share since. Tobacco Taxes In 1998, excise taxes represented 26 percent of consumer expenditures on tobacco products, slightly higher than in 1991. Although State excise tax collections increased due to higher rates, Federal collections fell as consumption declined. State tax collections have exceeded Federal collections since 1986, notwithstanding Federal tax increases of 4 cents per pack (of 20 cigarettes) in 1991 and 1993. In fiscal year 1998, tobacco accounted for .3 percent of total Federal tax receipts and represented 42 percent of all Federal excise tax collections. Federal excise taxes totaled $5.6 billion in calendar 1998, compared with $4.6 in 1991. Since 1991, with two increases in the Federal excise tax, and numerous increases by State and local jurisdictions, Federal excise taxes as a proportion of total expenditures on tobacco products declined. State and local taxes rose to $8.0 billion, up from $6.2 billion in 1991, while total excise tax collections rose from $10.0 to $13.6 billion. About 98 to 99 percent of tobacco tax revenue is from cigarettes. However, Federal excise tax applies to cigars, snuff, chewing tobacco, and pipe smoking tobacco. Forty-four States tax both cigarettes and other tobacco products, compared with 35 in 1991. Iowa imposed the first cigarette tax in 1921. By 1950, 40 States and the District of Columbia taxed cigarettes, and by 1970, all 50 States taxed them. Taxes currently range from 2.5 cents per pack in Virginia to $1.00 per pack in Alaska and Hawaii. State cigarette excise taxes, weighted by sales, averaged 34.75 cents per pack as of July 1998. Currently, the weighted average State excise tax rate is 34.19 cents. Nineteen States and the District of Columbia currently have tax rates over 40 cents per pack. The Federal excise tax remained at 8 cents a pack from 1951 until it was doubled on January 1, 1983. From 1983 to 1986, the Federal tax collections exceeded State taxes as it did during the 1950's. Since 1986, State collections have exceeded Federal revenues from tobacco. The Federal excise tax is scheduled to increase to 34 cents per pack of 20 cigarettes on January 1, 2000, and will increase another 5 cents per pack in 2002. The Tobacco Dollar While tobacco manufacturers and distributors shared in the increase in spending on tobacco products from 1991 to 1998, farmers received less. In 1991 U.S. growers received 4 cents of the consumer tobacco dollar. In 1998, they received less than 3 cents. In contrast, manufacturers and wholesalers-retailers received 67 cents in 1991, and about the same in 1998. The distributor's share totaled 15 percent in 1991 and increased to 19 percent in 1998. Excise taxes took 68 cents of the consumer's dollar in 1998 compared with 25 percent in 1991, and 34 cents in 1980. The Federal tax share remained unchanged at 11 percent in 1998, from 1991. State and local taxes increased to 15 percent in 1998, up from 14.4 percent in 1991. The farm value of domestic tobacco used in cigarettes sold in the United States was $1.05 billion, 2 percent below 1991. Although farm prices increased, fewer cigarettes were sold in the United States, and the domestic leaf use per cigarette declined, as imported leaf displaced some U.S.-grown leaf. Wholesale cigarette prices increased 1,500 percent since 1950, and rose about 13 percent since 1991. Average farm prices have risen only 5.5 cents per pound since 1991. The average retail price of a pack of cigarettes rose from $1.53 to $1.95 during the same period. Cigarette Marketing Bill The U.S. marketing bill for cigarettes totaled $10.3 billion in 1998, compared with $6.6 billion in 1991. It represented about 68 percent of consumer spending on cigarettes in both years (table B-4). The marketing bill is comprised of manufacturing and distribution costs. It is the difference between farm value and consumer expenditures for cigarettes, less excise tax. During 1991-98, the manufacturers' share of consumer spending on cigarettes slipped from 53 to 49 percent. In contrast the wholesaler-retailer portion increased from 15 to 19 percent. The manufacturing bill includes charges for assembling, stemming, redrying, storing, aging tobacco, converting tobacco (including foreign-grown tobacco) to cigarettes, and distributing them to wholesalers and retailers. Cigarette excise taxes are included in the retail price. The excise tax portion of expenditures has advanced slightly during the last decade with the State and local tax share rising more than the Federal share. Taxes and Prices Will Continue To Advance During the Next Decade Spending on tobacco products likely will continue to rise during the first decade of the next century. The effects of the November 1998 settlement will continue to be felt by cigarette consumers in the form of higher prices. The possibility of a major increase in the Federal excise tax remains. Manufacturers face continued falling domestic volume and export demand, and wholesale prices will be forced up by settlement costs and the need for profits. Tax rates of State and local governments will continue to rise, but perhaps not as quickly as during the nineties. During the next decade, income of cigarette manufacturers is likely to grow due to the inelastic nature of cigarette demand. As cigarette prices increase, demand will fall by a lesser proportion. Taxes are likely to increase, but whether their share of consumer expenditures on tobacco products or cigarettes will change is uncertain. During the coming decade, changes in how leaf tobacco is marketed, the Federal tobacco program, and dependence on imported tobacco are likely to affect the farm share of the cigarette user's dollar. Special Article Contracting in Tobacco? Carolyn Dimitri and Edward Jaenicke --------1/ --------- 1/ The authors are an economist with the Economic Research Service, USDA and an Assistant Professor at the University of Tennessee, respectively. --------- Abstract: Philip Morris surprised the tobacco community this year by issuing a press release stating that it was considering offering tobacco growers production contracts. Major questions currently held by the tobacco community is what impact contracting would have on growers, consumers, and the tobacco program. While this article can not answer each of these questions, it provides some structure for a discussion of contracting. The article defines different kinds of agricultural contracts, provides an economic explanation for selling and producing agricultural commodities under contract, and discusses the experience of contracting in two industries: broilers and grains. Keywords: Contracting, tobacco, production, and marketing contracts. In a surprising press release earlier this year, Philip Morris stated its intention to begin contracting directly with U.S. tobacco farmers. Currently, of the major foreign producers, only Brazilian tobacco is grown under contract. In the United States, most tobacco is sold through a government-sanctioned auction, and so this announcement would dramatically alter the way tobacco is grown and marketed in the United States. The release created a stir as many wondered about the impact of contracting on the U.S. tobacco industry. Farmers questioned whether their profits would decline. Health advocates speculated that tobacco prices might fall and increase tobacco consumption. And everyone wondered if it would be possible for the tobacco program to remain intact if Philip Morris began contract production. Contracts, while new to tobacco growers, are widely used in the production and sale of many agricultural commodities. For example, broilers, hogs, and cattle are produced under contract, some grain is produced under contract, vegetables for processing are generally produced under contract, and fresh fruits and vegetables are sometimes sold under contract. Specialized products - such as organic vegetables intended for processing, or a particular variety of wheat needed for pasta - are often produced under contract. The experience of the past suggests that contracts are here to stay and are likely to be used more frequently over time. Many researchers believe that consumer preferences are driving the proliferation of agricultural contracts, in particular, production contracts. The rationale underlying this belief is that consumers have developed stronger preferences for specific qualities (Drabenstott). In response, manufacturers and other intermediaries have begun directly contracting with growers to ensure that they receive exactly the quality and quantity desired. For example, cigarette production requires a particular blend of different tobaccos, specifically "narrowly defined grades and styles of flue-cured and burley tobacco to produce very flavor-specific blends for our high quality cigarettes" (Philip Morris). In this light, Philip Morris' announcement is not surprising, since one proven way for manufacturers to get inputs of a desired quality is by writing production contracts with growers. Producers and consumer advocates often question the value of producing agricultural commodities under contract, particularly during the period that an industry is transitioning from spot market sales to production contracting. Frequently raised questions include - will only large producers have access to production contracts? What happens to growers who do not produce under contract? What impact does production contracting have on rural communities? Are contracts fair to producers? Admittedly, this paper does not answer all of these questions. We try, however, to provide some context for contracting by first presenting a general overview of the use of contracts in agriculture. We next try to provide insight into the costs and benefits of producing under contract by examining contracts in two industries, grains and broilers. 2/-------- -------- 2/ Neil Hamilton, in his article "Why Own the Farm If You Can Own the Farmer (and the Crop)?: Contract Production and Intellectual Property Protection of Grain Crops," has completed an extensive legal/economic analysis of grain production contracts. Steve Martinez, in the ERS report "Vertical Coordination in the Pork and Broiler Industries: Implications for Pork and Chicken Products" has done a similarly impressive job with broilers. We rely on these two reports for much of our factual information about the form of grain and broiler contracts. --------- The prevalence of contract production in the two industries differs in that almost all broilers are produced under contract and only a small share of grains are produced under contract (ERS). At this point in time, it is not clear which model the tobacco industry would be more likely to follow if contract production began. While thinking about these issues, it is useful to keep in mind that benefits and costs of contracting are industry-specific. Thus the impact of production contracting on tobacco growers will differ from the impact on producers of broilers and grains. Production and Marketing Decisions Historically, agricultural producers have made most production and marketing decisions. They have decided what to produce, how much to plant, and what production techniques to use. The quantity and quality of output depended on the grower's efforts and choices, and some random elements (for example, weather). Production risk arises from systemic risk, which affects all producers, as well as individual risk, specific to a particular farmer. After harvesting, growers would market their products through an intermediary (for example, a wholesaler or auction market.) Buyers would choose from the available quality and quantity, and prices would be determined by supply and demand. Thus, at planting time, producers would be uncertain of the quantity and quality of their output and the price their commodities will receive. When purchasing, buyers' choices were constrained by the available quantity and quality. Contracting can overcome some of these drawbacks inherent in the production system. From a producer's perspective, contracting can reduce some of the price and production risk. From a buyer's perspective, contracting can reduce the cost of obtaining the desired quantity and precise quality. These are two of the driving forces behind contracting. Once the two parties enter a contract, a third kind of problem Arises--one termed moral hazard in the economics literature, most easily understood by illustration. For example, the sharecropping contract is between a landowner and a grower who farms the land. Both parties realize that production is random (subject to systemic risk) and that it also depends on the grower's efforts. The grower knows if low output is the result of his low effort, or if low output results from some random factor beyond his control. The landowner only observes output and cannot discern if low output is out of the control of the grower or is due to his shirking. One possible payment system in this contract is that the grower receives a flat fee for farming the land and the landowner gets all of the output. In other words, the landowner is the residual claimant in the contract. The grower is guaranteed the flat payment regardless of the level of output. Since the contract does not provide incentives to increase output, the grower is likely to exert low effort, or to shirk. This contract shifts all production and price risk from the grower to the landowner, but in doing so, creates incentive problems. An alternative contract might provide the grower a fixed payment plus a per-unit price for each pound of output produced. Some, but not all, production risk is shifted from the grower to the landowner, and the incentives for moral hazard are lower than in the first contract. Thus, contracts trade off risk sharing and incentives for moral hazard. Another contracting issue the economics literature discusses is the relationship between price and quality. Speaking generally, buyers are willing to pay higher prices for higher quality. And all else equal, it costs more to produce higher quality. Akerlof has shown that when buyers cannot observe quality, only low quality merchandise will be sold in the marketplace. This phenomenon has been observed repeatedly in agricultural markets. In Quebec's dairy market (Dupree) and in the Maryland tobacco market (Schwietzer), low quality merchandise was sold when there was no way to regulate or monitor quality. This same phenomenon led to the legislation of federal grades and standards for fruits and vegetables and grains (Dimitri). This idea is relevant to the tobacco industry since Philip Morris' press release states, "Then there's an additional problem with the excess pool stocks: In grade and style, this tobacco doesn't match what we at Philip Morris need."1 This comment suggests that prices or institutions might have not adapted in such a way to provide growers with incentives to increase the quality or alter the mix of quality they produce and market. As a result, tobacco manufacturers may not be receiving exactly the blend and quality they prefer. The economics literature terms the cost of obtaining specific quality or quantities needed for production as a form of transactions costs. Contracting is one technique for reducing transactions costs. Another possible solution to reducing transactions costs of producing and purchasing a specific commodity is for the contractor (the manufacturer) to vertically integrate with the producer. Many processors and shippers do own farm land. For example, California lettuce shippers own and farm land in different regions in order to provide lettuce year round (Wilson et al.). One production model consists of shippers and manufacturers owning land (that is, are vertically integrated into production) and also writing production contracts with other growers. Currently, the spectrum of possible ways to produce and market commodities ranges from growers making production decisions and selling on the spot market, to middlemen offering growers production contracts, to middlemen vertically integrating with growers. Which arrangement prevails in the market will depend on both the costs of production and costs of executing each kind of contract. For example, if quality has little impact on profits of growers and middlemen (meaning there are low transactions costs of securing the desired level of quality), independent production decisions and spot market transactions are likely to dominate the market. Changes in any of these costs will probably change the way agricultural commodities are produced and marketed (North and Wallis). If transactions costs of securing the exact grade and size of a product rise, then production and marketing may begin under contract or in a vertically integrated firm. A wide variety of contracts are used in the marketing and production of agricultural commodities. In marketing contracts, growers have ownership of the crop until the crop is harvested and make all or most decisions about production techniques. Production contracts between growers and manufacturers are written before planting and specify price and both quantity and quality to be delivered after harvest. Production contracts are often complex, specifying in great detail methods the grower must use, including time of planting and harvesting and which seed varieties the grower should use. These kinds of contracts are production management contracts (Harwood et al.) For example, a major manufacturer of organic processed tomatoes provides growers with on-farm extension service, and so the contracting growers have assistance with production whenever needed. Contractors gain an increased likelihood of receiving the quality they desire, and growers have a guaranteed market for their output. Resource-providing contracts go a step further, and provide growers with seeds and other production inputs while the grower typically provides labor, land, and other production facilities. The resource-providing contract gives the contractor greater control over the production process, which increases the likelihood of the manufacturer receiving exactly the quality and quantity desired (Harwood et al). It seems likely that if contracting begins in tobacco, production rather than marketing contracts will be used, and consequently, the remainder of this article focuses on production contracts. All production contracts specify division of input provision between the grower and contractor and how the grower's payment is determined. For some commodities, or some regions, specific contract terms are fairly uniform. For other commodities, the terms specified in contracts to growers vary widely (Knoeber, 1998). This variation in contract terms makes it impossible to discuss all of the benefits and costs of production contracting without referring to a particular industry and contractual arrangement. Only one aspect of production contracts appears to be a universal aspect: growers experience loss of freedom in choosing their production methods. The degree of entrepreneurial loss depends on the specific terms of the contracts. It is likely that there is a tradeoff between risk reduction and how much control producers will relinquish to the contractor (Featherstone and Sherrick). Contracting in Agriculture Varies by Commodity According to the 1993 Farm Costs and Returns Survey, 11 percent of all farms had entered either marketing or production contracts. Of the total number of farms entering contracts, 2 percent were involved in production contracts and the remaining farms participated in marketing contracts. The number of farms entering contracts varied with farm size: the larger the farm, the greater the number of contracts. More than half the farms (54 percent) with sales exceeding $500,000 had production or marketing contracts (20 percent had production contracts). Forty percent of farms with sales between $250,000 and $499,999 used either kind of contract (11 percent had production contracts). Of the farms with sales below $49,999, 4 percent had entered a contractual agreement with a buyer, and less than 1 percent had entered a production contract. When examining the prevalence of contracting across commodities, the survey indicates that 89 percent of poultry, 29 percent of dairy, 36 percent of fruit and vegetable, 30 percent of cotton, and 26 percent of corn farms were involved in a contractual agreement. Contracting for Grains In order to gain some understanding of the issues relevant to contracting, we discuss some aspects (rather than provide a comprehensive analysis) of grain contracting. Many grains grown under contract are feed for livestock, such as high-oil corn, high-oleic sunflower, and value-added soybeans. Identity-preservation is cited as one of the major factors encouraging contract production of these kinds of grains. Identity-preserved grains are those with unique characteristics that stay with the product along the marketing chain, and these grains earn a price premium in the market. Examples of identity-preserved commodities are organically grown products, and those that are genetically altered, perhaps tailored to a specific end use (such as high-oil corn) and therefore provide higher value (Hamilton). Usually, production contracts for identity-preserved grains are between seed developers (such as DuPont or Cargill) and growers. By producing identity-preserved grains under contract, the seed developer controls the quantity produced as well as the technology used in production (and consequently the final quality). This makes it possible to standardize product quality and to exert some control over how much is produced (thereby maintaining price premiums) (Hamilton). Grain contracts vary in how much control the contractor has over production methods and how much managerial responsibility the producer retains. The amount of risk shifted to the contractor and how much risk the grower assumes also varies by contract. Hamilton, an agricultural law expert, argues that most grain contracts promise producers an assured market and a price premium. In exchange for the price premium, however, risk from crop loss or increased cost of inputs is borne by the farmer. Contracting, as Hamilton points out, brings producers a whole new set of risks. These include risk of nonpayment by the contractor and risk of having produced a crop that falls below contracted quality requirements. The risk of not having the contract renewed may be costly if a large capital investment was necessary in order to enter the initial contract, while there is an additional risk of locking into a price that may be less than the spot market price at the time of harvest. Hamilton further argues that contracts that share risk are possible, and are the result of negotiations between attorneys of producers and contractor firms. Contract terms are often quite specific, stating the exact requirements for the product to be acceptable and how payment will be determined. Hamilton provides examples of different clauses and statements that contracts contain. For example, a bean contract states that the grower will furnish a crop that passes field inspection, has a certain level of moisture, is free from mold and dirt, and is of one variety, among other requirements. The contract explicitly states "Any soybeans not meeting these standards shall be disqualified from all premiums and [the contracting firm's] option, be released from this contract or purchased on the local grain elevator price schedule." 3/---------- ----------- 3/ Hamilton cites the 1992 Seed Production Contract used by Fairview Farms in his "Why Own the Farm If You Can Own the Farmer (and the Crop)?" ---------- In another contract cited by Hamilton, pea beans without excess moisture receive a price per hundred weight less the cost of drying, a charge for removing damaged beans, a charge for removing corn and other items, and a charge to the bean commission. Other contracts provide growers with a base price plus a premium for meeting specific requirements. These price provisions, either a premium for high quality or a reduction for low quality, provide growers with incentives to sort the grain before delivery. The grain contracts discussed above are between the owner of the seed and producers. The motive driving the seed owners is the preservation of seed identity. In return for maintaining identity, the seed owner offers the grower a price premium. The contracts discussed by Hamilton do not share production risk with growers, but by specifying price in advance they shield growers from price risk. Economics tell us that reducing or eliminating price risk introduces an incentive problem. In this case, the incentive is to supply low quality grain to the market by harvesting the grain and selling without removing damaged and low quality beans. By penalizing growers for low quality or providing premiums for high quality, the incentive to supply low quality grain is removed. Contracting for Broilers In contrast to the diverse character of grain contracts, broiler contracts are fairly uniform across the industry. This may stem from the nature of broiler production, which has several characteristics that differentiate poultry farms from other U.S. farms. For instance, poultry farms are highly specialized: nearly half of all the poultry or eggs produced come from farms that exclusively specialize, and three-quarters of all production comes from farms that produce only one other commodity besides poultry (Perry, Banker, and Green). Poultry production requires relatively little land, with the average poultry farm operating 134 acres, which is approximately one-third the size of the average U.S. farm. In 1950, 95 percent of broiler producers were independent (Roy, 1963; Martinez). Meanwhile, however, technological advances in feed formulations, automatic feeding, and breeding increased the size of flocks and set the stage for integration and contract production. Larger flocks meant larger capital requirements, which - coupled with declining and highly variable broiler prices - made broiler operations a risky business (Martinez). Larger feed companies soon offered and established production contracts with growers, thus assuring a market outlet for feed supplies in exchange for reducing growers' financial risks. The use of production contracts increased quickly: by 1955, only 10 percent of broiler producers remained independent, and by 1994, approximately 1 percent of broiler producers were independent (Martinez). As the use of contracts developed, chicken processors replaced feed suppliers as primary integrators because they stood to gain the most from coordinating supply and demand. Today, most major chicken processors control all the vertical stages in the boiler industry through integrated ownership or production contracts. These processor integrators breed the parent stock, produce the hatching eggs, and provide baby chicks, feed, veterinary services, and technical advice to growers under contract. Growers provide the chicken houses, litter, and labor. While not uniform, production contracts in the broiler industry are now relatively similar. Over the years, however, broiler contracts have evolved to address or correct various economic obstacles--such as risky production, poor incentives to maintain high productivity, and large capital requirements--facing growers. Martinez reports that the earliest broiler contracts, labeled open account contracts, merely eased the growers' capital constraints by extending credit. The integrators (who at the time were usually feed companies) made their profit by feed markups or by a flat service charge. Therefore, these early contracts did not shift any risk from producers to integrators. The next contracts - guaranteed price contracts and flat-fee contracts - guaranteed the grower a certain price or a flat fee per bird when the broilers were sold. The flat-fee contracts, which were widely used in the 1950's and 1960's, also reduced capital requirements because the integrator provided feed and other inputs while retaining title to the broilers. But whereas these contracts succeeded in shifting risks from the grower to the integrator, they also brought about certain incentive problems: specifically, they encouraged shirking by the growers. To deter shirking, share contracts gave growers a share in the proceeds of broiler sales (after integrator costs were netted out). Unfortunately, these contracts encouraged high input price markups by the integrator, and growers still faced large capital requirements and some incentive to shirk. By paying growers a bonus based on the amount of feed they used on a per-bird basis, feed conversion contracts addressed the incentive problem but still left growers vulnerable to production risk and capital constraints. Currently, combination contracts, which involve a flat-fee payment adjusted by a performance bonus, combine desirable risk and incentive properties of previous contracts. In addition, the bonus payment is based on the grower's performance relative to his or her peer growers rather than an absolute standard. Knoeber and Thurman describe two varieties of this last contract type. The first variety, used prior to June 1984 by a small integrator, is called a tournament contract. For each grower, performance is measured by settlement cost, a cost-per-live-pound measure that is based on feed efficiency. Settlement cost decreases - that is, grower performance improves - as the number of pounds of chicken produced per input (in this case, chicks and feed) increases. Growers whose flocks are harvested within a 10-day period were put in the same tournament and ranked by performance. The ranking was divided into quartiles that determined the per-pound payments to growers. The minimum pay for growers ranked in the bottom quartile was set at 2.6 cents per pound (although this minimum pay might be lowered in particularly bad years). Moving up to the next highest quartile increased the per-pound payment by 3.0 cents. The second variety described by Knoeber and Thurman, used after June 1984, is called a linear relative performance evaluation contract. Now settlement costs, which were calculated the same way, were first averaged. Growers whose performance was equal to the average were paid 3.2 cents per pound. Growers who out-performed the average were paid 3.2 cents plus the difference between their own settlement cost and the average. Alternatively, growers who under-performed the average were paid 3.2 cents less the difference. Finally, the minimum pay of 2.6 cents per pound was still guaranteed. The incentives to growers between theses two varieties are subtly different. In the tournament contract, high-ability growers who consistently out-perform the average may not have an incentive to try their best because they might still make the top quartile without putting forth their best effort. The linear relative contract corrects this by giving even high-ability growers the proper reward for trying their best. Concluding Remarks Contract production is a recent phenomenon in the grain industry and, in contrast, a long-standing way to produce broilers. The trend towards contract production differs between the two industries. For example, producing grain under contract appears to be the result of seed companies wanting to preserve seed identity. Broiler production, however, seems to be the result of the need to produce a uniform commodity, able to be manufactured in an automated processing facility. The two industries have different tacks to achieving uniform quality: the grain industry uses price provisions to provide growers with incentives to bring high quality grain to market. In the broiler industry, high quality is encouraged through using relative performance or tournament contracts. Not all aspects of contracting have been viewed positively. During the development of the broiler industry, several critics have expressed concern over the reduction of entrepreneurial activity on the part of growers (Allin; Mighel; Roy, 1958). Absent contract renegotiation growers are limited in the changes they can make in production practices, so innovation may occur at a slower rate than in the absence of production contracts (Perry, Banker, and Green). Another concern is unequal bargaining power: growers could face a decision of accepting an unattractive contract or going out of production. Hence, some observers have suggested that contract risk has replaced price and production risk. What does this say for the tobacco industry? The experience of other industries suggests that contract production would provide manufacturers with the quality of tobacco needed for cigarette production. The experience of other industries also suggests that, over time, contracts would evolve to provide growers with incentives to take specific actions to increase tobacco quality. Again, experience of other industries suggests that growers who enter production contracts are likely to earn price premiums for tobacco that satisfies contract standards. At the same time, these growers will likely take on contract-specific risk--the risk of producing tobacco that does not meet contract standards and the risk of not having their contracts renewed. What is not clear, however, is which growers will be contract growers, and if only a portion of growers produce under contract, what will be the fate of the independent grower. Finally, the tobacco program introduces enormous complexity, thereby clouding any predictions concerning the future use of production contracts. References Akerlof, George A. "The Market for "Lemons": Quality Uncertainty and the Market Mechanism," Quarterly Journal of Economics, 84 (August 1970); pp 488-500. Allin, Bushrod W. "Agriculture's Public Relations," Journal of Farm Economics 40 (1958):187-195 Dimitri, Carolyn, "Order out of Chaos: Evolution of Marketing Institutions," Choices, forthcoming, Fourth Quarter, 1999. Drabenstott, Mark "Industrialization: Steady Current or Tidal Wave?," Choices, pp 4 - 8, 1994. Dupre, Ruth, "Regulating the Quebec Dairy Industry, 1905 - 1921: Peeling off the Joseph Label," Journal of Economic History, 1990, Vol L. No 2, pp 339 - 569. Economic Research Service, "Farmers' Use of Marketing and Production Contracts," AER-747, U.S. Department of Agriculture, Washington DC, December 1996. Featherstone, Allen M. and Bruce J. 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