CONTRACT TOBACCO ISSUES WITHOUT A PROGRAM
R.W. Sutton, Extension Ag Economist

The question is currently being asked about production changes and the price level which companies would pay for tobacco without a program. This issue is based on the possibility that producers may soon be operating without a tobacco program. This is because: (1) some recent buy-out legislative proposals eliminate the program, or (2) if no legislative action is soon forthcoming and the present program is not changed, it could encounter survival problems.

Although U.S. flue-cured tobacco is produced under the tobacco program, within the past two years, more than 80 percent of all production has come under contract. This is a marketing contract and for lack of better information, it is presumed a continuation of these type contracts. Without a program, there should be as much or more production contracted. In the past, the program support price for each grade has been the floor or minimum price; this would not be present in the absence of a program. In the absence of a program, there would be no minimum price levels nor annual quantity restrictions. What does this industry have as a basis to guide them in the future? Possibly one standard would be the poultry industry. Although differences exist between these industries, the poultry sector has had many years of successful operation with contract production.

There is not much published literature on the underlying assumptions and actual planning of contracts by the poultry industry. Over the years, this author has been involved with a few companies in the Southeast in developing their contracts - some large and some small but all employed similar principles. Using this knowledge, an attempt was made to apply some of these elements in estimating flue-cured tobacco non-program contract prices.

First, the establishment of the poultry contract has generally been based on the contractor instituting a system of contract payments for the growers to receive sufficient returns on their investment to remain in business and make a profit over the long-term. Every contractor worked with has stated that their own existence has depended on this principle. This has meant the development of a detailed budget, cash flow, balance sheet and income statement analysis over a ten year or more period (for broilers.) The reason for this length of analysis was to account for start-up and across the primary loan period. It may also be a reason poultry contract price levels have not changed much over time.

The second principle was to reward those efficient producers according to the value of their production ability. These "premiums" are paid only to the efficient growers and are based on improvement in net returns back to the contractor. The premium schedule determination could be very different for tobacco than broilers. Other factors such as competition were not considered.

In general, the major financial measure that most companies have considered has been "Return on Investment" or ROI. Usually, the "Return on Equity" or ROE has also been included. The ROI has traditionally been calculated as the "Return to Total Capital" divided by "Total Assets." The usable ROI has been an average of the annual ROI's over the analysis period. From experience, most have started with a level of ROI that is equivalent with other agricultural enterprises and this has often been around three percent; thus, this may be considered as the "contract base" ROI goal. Although varying by company, maximum premium payment ROI data results ranged from 15 percent to 18-19 percent. A premium mid-level was also chosen and was 7.5 percent ROI.

For tobacco, a broiler template was utilized and the period was for 10 years. The basic budget and asset data were from the 2002 Clemson University Tobacco Multi-Pass Machine Harvest analysis. A 75 acre production system was considered and yield was changed (along with inputs) from 2,200 pounds per acre to a range of 2,500 to 2,800 pounds. There were some modifications to the data such as removing rent/program costs, estimating ownership/loans of assets, and beginning current assets and balance sheet net worth. In reality, several aspects of these assumptions were not based on hard scientific data. However, a wide range of possible assumptions was tested and the outcomes were reasonable. When considering the lower than present price ranges in the table, one should keep in mind that about $1,100 per acre of rent along with program costs are removed.

Given these assumption issues, the following results were obtained:

Contract Return Level	Average ROI	Range Average $/Lb. Received
None	0.0 %	$1.56 - $1.65
Base	3.0 %	$1.58 - $1.68
Medium w/Premium	7.5 %	$1.62 - $1.72
High - Max Premium #1	15.0 %	$1.69 - $1.80
High - Max Premium #2	18.5 %	$1.72 - $1.83

This is not to imply that tobacco contractors will pay these levels but that if these assumptions hold, costs remain rather constant and contractors were to develop similar ROI or other financial goals, then long-term contract prices could settle around these levels. There are some important differences between these two industries that could affect tobacco contractors adopting such a system. New poultry contracts normally deal with a start-up operation while tobacco is presently ongoing - this makes the tobacco analysis more complex and variable. Both start-up and ongoing situations were considered here for tobacco; the major difference was in the early years of the start-up model.

Tobacco is a crop and yield could become much more important without a program or an annual production quantity. For example, attempts to change yields in this analysis and holding quality constant (which was likely wrong), had a definite effect on returns. In other words, the financial results were positive and sensitive to increases in yields. From the old acreage program, it was found that tobacco producers could significantly affect yields but at the expense of quality.

Broilers are produced in a more controlled environment than tobacco and their quality premiums are more precise than tobacco quality measures (at least to date). If tobacco quality standards (premiums) cannot be as specific, one would expect a payment structure of fewer extremes than poultry. This would mean there would not be near the range from the base to the maximum premiums and this range would likely be somewhere in the middle of returns for the poultry payment system.

The second point about quality is that the contractors could strive for consistency of quality across years and therefore use this as partial basis for premiums/discounts. There may be some payment scheme like the board pricing of livestock where the payment level (premium) is part based on historic quality. In addition, if more rigid quality standards become the foundation for premiums, one would expect practices such as irrigation to become a common production practice and thus change production costs.

If future tobacco is contract produced without a program, one could expect: (1) changes in the standards for quality, thus payments, and changes in production; (2) possibly a lowering of average prices but not profitability; (3) yield vs. quality could become more important; and, (4) the payment system depending largely on the accuracy of measuring quality and the ability to reflect these differences in returns to the contractor. It seems the major issue is the contractors ability to accurately determine base price levels and incentives that will allow producers to be motivated to produce quality tobacco and make a reasonable long-term profit.