December, 2003

Fruits of Thought

Contract Solution

What is an “Act of God”? You might think this is a great theological question being discussed in houses of worship and seminaries, but it also is a major debate whether summer heat, which caused a crop shortfall, qualifies as an “Act of God” invalidating the fixed prices called for in many contracts.

It seems like heady stuff, but the issue is actually mundane, more related to poorly drafted contracts than divine intervention. After all, the notion that weather has an effect on produce yields is hardly a shocking surprise.

The decision to not specifically define whether variations in yields caused by weather conditions constitute an Act of God sounds like a case where neither party will budge, but both prefer to do the deal and hope the issue never arises.

On the whole, the history of contracting in the fresh business, particularly at retail, has not been successful. This time it is the buyers who are screaming but, typically, it is the shippers who complain. As market conditions fluctuate, more than a few buyers view contracts as “lids” designed to protect them on the upside but irrelevant on the downside. It has made more than one vendor decline to enter into contracts at all.

Leaving aside the ethics (or lack thereof) of trying to weasel out of an agreement, the propensity of both buyers and sellers to demand relief when a contract doesn’t go their way reflects the fact that both parties would generally like to use the contract to reduce their own risk.

The problem is that contracts can’t really eliminate risk; they just distribute it between parties. In foodservice, this has worked relatively well because produce accounts for a small portion of the food cost at most venues, and most foodservice operations work with fixed menu prices that are changed slowly. So, if lettuce prices tumble and McDonald’s is on contract but Burger King is not, McDonald’s may make a little less than it could have by purchasing at the market price, but it won’t see sales collapse and its reputation tumble because Burger King’s Whopper suddenly becomes much less expensive than McDonald’s Big Mac.

Retail is a different situation. Prices can change almost instantly; the cost of the item is a big factor in its retail price and most retailers don’t want to look overpriced.

So, when the market is substantially below the contract price, a supermarket chain on contract usually feels it must meet its competitor’s price. And no matter how much money the retail organization might have, the department is held responsible for meeting its own gross profit numbers. Thus, we get the squeals for relief.

And the problem will get worse. As key players grow in the market share, contracting becomes an absolute necessity. The surplus of produce in most fields came about in an era in which there was a diversified group of buyers available. As such, the growers ran a pricing risk and a growing risk, but if they grew nice stuff and the market price was adequate, there was little risk they couldn’t find a home for the product.

But, if there are only a half a dozen big buyers accounting for the bulk of the business, nobody will finance a large growing operation that doesn’t have a commitment from these big buyers for the volume.

In effect, you can expect produce growing, especially the capital-intensive sector such as orchards, to become more like the real estate industry. Almost nobody builds a major shopping mall or a skyscraper without a commitment from big department stores or big office tenants to rent a lot of the space.

The old model, in which growers invested millions in planting and packinghouses and then went out to sell, will become a victim of consolidation.

Already, contracts are having major impact on the trade. Several companies that were principally marketing organizations have become reluctant growers because they need to make sure they have the year-round volume called for in the contracts.

In addition, the very existence of contracts causes an enormous increase in pricing volatility because contracts serve to take so much product off the market. A weather incident that reduces volume by 10 percent might have a substantial increase on prices. But, if 80 percent of the expected volume is precommitted on contract, that 10 percent reduction in volume translates into a 50 percent reduction of the produce available for trade – which means prices will skyrocket.

The big problem with contracts is that there are many different risks in growing and marketing produce, and because there are only two sides to a contract, the contract negotiations become inherently adversarial as they are principally about allocating the risks at hand.

What is needed is a way to transfer discrete risks – bad weather, disease, poor prices, etc. – to third parties. It is done every day in the financial markets through all kinds of instruments commonly called derivatives.

Although futures trading in potatoes once ended in disaster, it may be time to revisit the issue. Only a broad market, including many non-produce players, will allow us to price out the different kinds of risks inherent to the produce trade. This would allow growers to focus on growing, and sellers to worry about selling. It is a recipe for both harmony and progress in the produce trade.  pb