oversight

Commodity Programs: Impact of Support Provisions on Selected Commodity Prices

Published by the Government Accountability Office on 1997-02-21.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                 United States General Accounting Office

GAO              Report to the Chairman, Committee on
                 the Budget, House of Representatives



February 1997
                 COMMODITY
                 PROGRAMS
                 Impact of Support
                 Provisions on Selected
                 Commodity Prices




GAO/RCED-97-45
      United States
GAO   General Accounting Office
      Washington, D.C. 20548

      Resources, Community, and
      Economic Development Division

      B-275856

      February 21, 1997

      The Honorable John R. Kasich
      Chairman, Committee on the Budget
      House of Representatives

      Dear Mr. Chairman:

      The momentum for change in U.S. agricultural policy began with the
      passage of the 1985 farm act, when efforts were made to make federal
      farm programs more market-oriented and to reduce the amount of support
      that the government guarantees producers for their commodities. The 1990
      and 1996 farm acts continued to build on these efforts and introduced
      additional changes.

      However, the Congress retained a number of income- and price-support
      provisions as a safety net for producers. In particular, nonrecourse loans
      with marketing loan provisions continue to be available for a number of
      commodities, including upland cotton (hereafter referred to as cotton),1
      rice, wheat, feedgrains, and oilseeds. Through nonrecourse loans,
      producers pledge their commodities as collateral and upon forfeiture
      receive guaranteed minimum returns based on prices known as loan rates.
      The marketing loan provisions, which allow producers to repay their loans
      at alternative repayment rates that are lower than the loan rates, were
      added to nonrecourse loans, in part to prevent the loan rates from serving
      as price floors while protecting producers’ income from the effects of low
      market prices. In addition, for cotton, peanuts, and sugar, other
      mechanisms are in place to help support producers and related industries.
      Under the cotton program, domestic mills and cotton exporters receive a
      payment—known as the step 2 payment—to help defray the higher cost of
      U.S. cotton and make it more competitive in world markets. Similarly, the
      peanut and sugar programs have price-support features. For example, the
      peanut program has domestic marketing restrictions and the sugar
      program has a tariff-rate import quota.2

      Concerned about how these remaining support provisions affect U.S.
      commodity prices in comparison with world prices, you asked the
      following questions: (1) Do marketing loan provisions prevent loan rates

      1
       Two major types of cotton are produced in the world: upland and extra-long staple. About 98 percent
      of the cotton grown in the United States is upland cotton.
      2
       The tariff-rate import quota permits a limited level of imports at a low tariff rate, set at 0.625 cent per
      pound. Any additional imports beyond that level are assessed a higher tariff rate that makes imports
      prohibitively expensive.



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             from acting as price floors and do they allow U.S. prices to fall to levels
             that are closer to world prices? (2) What effect would lower loan rates
             have on the relationship between U.S. and world prices? (3) How would a
             lower loan rate affect step 2 payments for cotton exports and what impact
             have recent changes in the timing of payments had on the program’s
             effectiveness? (4) What steps could be taken to make the peanut and sugar
             programs more market-oriented?


             Nonrecourse loans have long been the government’s major price-support
Background   instrument and provide operating capital to producers of commodities,
             including cotton, rice, wheat, feedgrains, and oilseeds. Producers store
             their commodities under loan until later in the marketing year, when
             prices are usually higher than they are at harvest. Producers have the
             option either to repay their loans with interest at any time or, at the end of
             the loan period, to forfeit their commodities to the government and have
             their interest payments forgiven. The government has “no recourse” but to
             accept the commodities as payment. In the past, when market conditions
             would have led to U.S. prices falling below the loan rates, the loan rates
             supported U.S. prices.3 This happened because producers preferred to
             forfeit their commodities to the government rather than sell them at lower
             market prices that would have given them less than the face value of the
             loans. Under these market conditions, U.S. prices were supported and the
             government accumulated large and costly stocks.4

             For cotton, rice, wheat, feedgrains, and oilseeds, the Congress added
             marketing loan provisions to nonrecourse loans5 to eliminate the price
             floors created by the loan rates while protecting producers’ income from
             the effects of low market prices. The intent was to minimize loan
             forfeitures and the accumulation of government stocks and to lower U.S.
             prices to levels closer to world prices. The marketing loan provisions
             allow producers to pay back nonrecourse loans at alternative repayment
             rates when these rates are lower than the loan rates.


             3
              For this review, when we refer to U.S. prices, we mean the prices that producers receive when selling
             their commodities in local cash markets.
             4
              Before the 1996 farm act, once commodities were forfeited to the government, they typically remained
             off the market for a long time, thereby supporting prices. The government was not allowed to sell the
             commodities it had acquired unless U.S. prices rose to statutorily established release prices. The 1996
             farm act eliminated the release-price restrictions on the sale of government-held commodities, which
             could have the effect of limiting the price-supporting ability of nonrecourse loans.
             5
              Marketing loan provisions have been available for rice and cotton since 1986, for oilseeds since 1991,
             and for wheat and feedgrains since 1993.



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To establish alternative repayments rates, the U.S. Department of
Agriculture (USDA) first determines a proxy for the world price for each
commodity. These proxies for world prices are based on price data
obtained from international markets for cotton and rice and from major
U.S. terminal markets for wheat, feedgrains, and oilseeds. Next, USDA
adjusts the proxies for world prices (these proxies are hereafter referred
to as world prices) for quality differences and for transportation costs6 to
arrive at the relevant alternative repayment rates. For cotton and rice
loans, the alternative repayment rates are set weekly and are known as
adjusted world prices. For wheat, feedgrain, and soybean loans, the
alternative repayment rates are set daily and are known as posted county
prices. For minor oilseeds, (such as flaxseed, sunflower seed, and canola)
these rates are set weekly and are known as regionally calculated prices.

When alternative repayment rates are below the loan rates, producers can
repay their nonrecourse loans at these lower rates. Because producers
keep the difference between the loan rate and the alternative repayment
rate, which is known as a “marketing loan gain,” they should be able to sell
their commodities at market prices and receive a total return—market
price plus marketing loan gain—that is at least equal to the loan rate.7
Alternatively, producers who do not take out loans may still receive
government payments equal to marketing loan gains. These amounts are
called loan deficiency payments. (See app. I for more information on how
program benefits are calculated.)

For some commodities, certain program factors have kept U.S. prices
higher than world prices. These factors vary by commodity program, and
we have reported on them for cotton, peanuts, and sugar.8 For example,
several features of the cotton program, such as import restrictions and the
availability of government-paid storage when the adjusted world price is
below the loan rate, reduced producers’ incentives to sell cotton to the
market and thereby kept U.S. prices above world prices. High U.S. cotton
prices, coupled with import restrictions, adversely affected cotton

6
 For cotton, world prices are adjusted for transportation costs from a designated central location in
the United States to Northern Europe. For rice, world prices are adjusted for transportation costs from
the United States to selected Asian markets. For wheat, feedgrains, and oilseeds, world prices are
adjusted for transportation costs from the county where the commodity is grown to the terminal
market.
7
 Producers’ total return will be less than the loan rate only if they sell at a market price that is below
the alternative repayment rate.
8
 Cotton Program: Costly and Complex Government Program Needs to Be Reassessed
(GAO/RCED-95-107, June 20, 1995). Peanut Program: Changes Are Needed to Make the Program
Responsive to Market Forces (GAO/RCED-93-18, Feb. 8, 1993). Sugar Program: Changing Domestic
and International Conditions Require Program Changes (GAO/RCED-93-84, Apr. 16, 1993).



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                   exporters and domestic mills that had to purchase higher-priced U.S.
                   cotton. Consequently, the 1990 farm act included a provision for step 2
                   payments to be made to exporters and domestic mills to offset higher U.S.
                   prices. These payments were continued in the 1996 farm act. USDA recently
                   changed its procedures for making step 2 payments. Under the new
                   procedures, exporters will receive the step 2 payment rate that is in effect
                   during the week the cotton is shipped instead of the week in which cotton
                   sales were contracted. For peanuts and sugar, the programs’ price-support
                   features, such as domestic marketing restrictions for peanuts and the
                   tariff-rate import quota for sugar, have continued to keep U.S. prices high.
                   The Congress changed these programs in the 1996 farm act to help lower
                   U.S. peanut and sugar prices, decrease the government’s costs, and reduce
                   production and consumption inefficiencies created by the programs’ past
                   features.


                   When alternative repayment rates, which are derived from USDA’s proxies
Results in Brief   for world prices, are near or below the loan rates, the marketing loan
                   provisions may prevent the loan rates from serving as price floors. For
                   example, during the last 10 years, when marketing loan provisions were in
                   effect for rice, the price data suggest that when the adjusted world price
                   was substantially lower than the loan rate, the marketing loan provisions
                   prevented the loan rate from serving as a price floor, and the U.S. price fell
                   below the loan rate. For cotton, the price data are inconclusive, and,
                   therefore, it is less certain whether the marketing loan provisions have
                   prevented the loan rates from acting as a price floor. For wheat,
                   feedgrains, and most oilseeds, since marketing loan provisions went into
                   effect, U.S. prices have generally been higher than the loan rates. As a
                   result, the price data needed to assess the effectiveness of the marketing
                   loan provisions are limited, which makes it difficult to test whether the
                   marketing loan provisions are preventing the loan rates from serving as
                   price floors. However, even if the marketing loan provisions allow U.S.
                   prices to fall below the loan rates, U.S. prices will remain higher than
                   adjusted world prices for some commodities, such as cotton and rice. This
                   is because the marketing loan provisions cannot overcome the effects of
                   other program features and market factors that have kept U.S. prices
                   higher than adjusted world prices. In contrast, when U.S. and adjusted
                   world prices are above the loan rates, as they have been in recent years,
                   producers would not use marketing loan provisions, and these provisions
                   therefore would have no effect on U.S. prices. According to USDA’s 1996
                   forecast, these market conditions could continue for some commodities
                   over the 7-year duration of the 1996 farm act.



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Lowering the loan rates has little if any effect on U.S. prices when
alternative repayment rates are above the loan rates. However, when
alternative repayment rates are near or below the loan rates, the effect on
U.S. prices of lowering the loan rates differs by commodity. For cotton and
rice, the availability of nonrecourse loans, in combination with other
program and market factors, keeps U.S. prices significantly higher than
adjusted world prices. Therefore, lowering the loan rates is likely to allow
U.S. prices to fall to levels that are closer to adjusted world prices. For
wheat, feedgrains, and oilseeds, most experts assert that the marketing
loan provisions will work as intended to overcome the price-supporting
effects of the nonrecourse loans. For these crops, lowering the loan rates
would have little if any impact on U.S. prices. On the other hand, a few
experts assert that the marketing loan provisions may not work as
intended and U.S. prices will continue to be supported by the loan rates. In
this case, lowering the loan rates may have some downward effect on U.S.
prices.

To the extent that a lower loan rate results in lower U.S. cotton prices,
step 2 payments would be reduced but not eliminated. Step 2 payments
would continue to be made because the marketing loan provisions have
not been able to overcome the cotton program’s other features—such as
government-paid storage—that help keep U.S. cotton prices higher than
adjusted world prices. However, because of recent changes in how USDA
makes step 2 payments to exporters, these payments may no longer
directly offset higher U.S. prices and therefore may be less effective in
enhancing exports.

Further changes can be made to make the peanut and sugar programs
more market-oriented. While the 1996 farm act changed the peanut and
sugar programs to help make them more market-oriented, U.S. prices will
continue to be higher than world prices because some income- and
price-support features remain. Additional reductions in the quota support
price for peanuts will lower U.S. prices and increase economic efficiency.
An increase in the tariff-rate import quota for sugar (allowing more sugar
to be imported at the lower tariff rate), or its elimination entirely (no
import restrictions), would result in lower U.S. prices. Once prices fall to
the level of the loan rate, reductions in the loan rate would be necessary to
reduce prices further.




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                       When alternative repayment rates are near or below the loan rates, the
Marketing Loan         marketing loan provisions may prevent the loan rates from serving as price
Provisions May         floors. In the past, these market conditions have occurred for some
Eliminate Price        commodities, and producers received marketing loan gains or loan
                       deficiency payments. Although the historical price data9 were inconclusive
Floors, but U.S.       or limited for cotton, wheat, feedgrains, and oilseeds, the data for rice
Cotton and Rice        suggest that the marketing loan provisions have prevented the loan rate
                       from serving as a price floor when the adjusted world price was
Prices Will Remain     substantially lower than the loan rate. (See app. II for our detailed
Higher Than Adjusted   analyses of the impact of the marketing loan provisions on U.S. prices for
World Prices           each of these commodities.)

                       For rice, during the last 10 years, when the marketing loan provisions were
                       in effect, the adjusted world price was below the loan rate in 81 months.10
                       During 21 of these 81 months, when the adjusted world price was
                       particularly low, the U.S. price was also below the loan rate. This suggests
                       that the provisions worked as intended, and the loan rate did not act as a
                       price floor for rice. While USDA officials generally agreed that the historical
                       price data support this view, they stated that it is hard to separate out the
                       effects of other changes made to the rice program during this period (such
                       as the acreage reduction program) that may also have had an impact on
                       lowering U.S. prices.

                       For cotton, the price data are inconclusive on the effectiveness of the
                       marketing loan provisions in preventing the loan rate from serving as a
                       price floor because the adjusted world price has not fallen significantly
                       below the loan rate since the marketing loan provisions went into effect.
                       Until market conditions cause the adjusted world price to drop
                       significantly below the loan rate—low enough to overcome the effects of
                       other program features and market factors that keep the U.S. price above
                       the adjusted world price—it cannot be conclusively determined whether
                       the loan rate will still act as a price floor for cotton under the marketing
                       loan provisions.

                       In commenting on a draft of this report, USDA officials told us that there is
                       substantial evidence that the loan rate for cotton has not served as a price

                       9
                        We recognize that one limitation of using historical data is that some programs (such as the
                       farmer-owned reserve and acreage reduction programs) that affected U.S. prices in the past have been
                       eliminated by the 1996 farm act.
                       10
                        We did not include as part of our analysis the period from January 1986 through October 1987
                       because over this period the government was releasing excess rice stocks that it had accumulated in
                       previous years. This excess supply drove U.S. prices below the loan rate. The 81 months occurred from
                       November 1987 through July 1996.



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floor since the marketing loan provisions went into effect. They base their
view on a comparison of loan forfeitures and the accumulation of
government stocks both before and after the marketing loan provisions
went into effect, for those times when the U.S. price was only a few cents
per pound above the loan rate. We agree that the data on forfeitures and
stock accumulation merit consideration in determining whether the loan
rate is serving as a price floor, but we found that forfeitures have
continued to occur in some years, although the quantity forfeited is lower,
since the marketing loan provisions went into effect. Therefore, we believe
that it is necessary to observe what happens to U.S. prices during a period
when the adjusted world price falls significantly below the loan rate in
order to confirm that the marketing loan provisions prevent the loan rate
for cotton from serving as a price floor, despite the effects of other
program features and market factors that keep the U.S. price above the
adjusted world price.

For wheat, feedgrains, and oilseeds, the historical data are limited because
during the short time that these provisions have been in effect, U.S. prices
and alternative repayment rates have generally been above the loan rates.
Even if additional data were available, they might be inconclusive because
of the way in which the alternative repayment rates are set. (This issue is
discussed in more detail in app. II.) Nevertheless, many USDA officials,
including agricultural economists, and other agricultural economists we
spoke to expect that the marketing loan provisions for wheat, feedgrains,
and oilseeds will prevent the loan rates from serving as price floors when
alternative repayment rates fall below the loan rates. They base this
position on both theoretical expectations of producers’ profit-maximizing
behavior and experience with the generic commodity certificate program
in the past,11 which was similar in concept to the marketing loan
provisions. However, a few agricultural economists and commodity
analysts offered several reasons why the loan rates may at times provide
some price support for these commodities despite the marketing loan
provisions. (See app. II for additional details on these views.)

Even if the marketing loan provisions allow U.S. prices to fall below the
loan rates, some program features and market factors will keep U.S. prices
higher than adjusted world prices for some commodities, such as cotton
and rice. The program features include (1) import restrictions that reduce
foreign competition in the United States, (2) the availability of the

11
 The 1985 farm act authorized USDA to issue generic commodity certificates to make in-kind
payments to producers participating in government commodity programs. Producers receiving
certificates could exchange them at the posted county prices for commodities placed under loan,
exchange them for government-owned commodities, or sell them for cash.



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                      nonrecourse loan, and (3) for cotton, government-paid storage that makes
                      it easier for producers to hold cotton off the market while waiting for
                      prices to rise. The market factors include quality, reliability, and
                      transportation advantages that allow U.S. producers to receive higher
                      prices than some foreign producers. To the extent that higher U.S. prices
                      are due to market factors that reflect the desirability of U.S. cotton and
                      rice, then higher U.S. prices do not necessarily impede the marketability of
                      these commodities. Therefore, adjusted world prices will typically be less
                      than U.S. prices because (1) the marketing loan provisions cannot
                      overcome the effect of all program features that support prices and (2) in
                      setting the adjusted world prices, USDA does not fully account for all the
                      market factors that result in higher U.S. prices. (See app. II for a detailed
                      discussion of these factors.)

                      According to USDA’s 1996 forecast, U.S. and world prices are expected to
                      remain above the loan rates for some commodities, as they are now, for
                      the 7-year duration of the 1996 farm act. This forecast suggests that for
                      these commodities the marketing loan provisions will have no effect on
                      U.S. prices or how they compare with world prices. Under these
                      conditions, producers would not use the marketing loan provisions to
                      repay their loans at the higher alternative repayment rates. Instead, they
                      would repay their loans at the loan rates. However, some agricultural
                      economists have suggested that over the next several years U.S. and world
                      prices might be below those in USDA’s 1996 forecast. If market conditions
                      change and alternative repayment rates fall below the loan rates,
                      producers may use the marketing loan provisions when redeeming their
                      loans.


                      For all commodities, when U.S. prices and alternative repayment rates are
The Effect of Lower   above the loan rates, lower loan rates will have little if any effect on U.S.
Loan Rates on U.S.    prices because producers can earn more by selling their commodities on
Prices Will Vary by   the market than by forfeiting them to the government.12 However, when
                      alternative repayment rates are below the loan rates, the effect of lowering
Commodity             the loan rates on U.S. prices will vary by commodity.

                      For cotton and rice, when adjusted world prices are below the loan rates,
                      lower loan rates are likely to have some downward effect on U.S. prices.
                      This is because producers who use nonrecourse loans with marketing loan
                      provisions have the option to hold their commodities under loan while

                      12
                       In the long run, lower loan rates may increase producers’ risks and decrease their expected returns,
                      which could lead to reduced production and higher domestic commodity prices.



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waiting for prices to rise. This option has a value, known as the option
value of the loan, which varies among producers at any given point in time
and varies for any individual producer over time. Unless producers are
offered a premium price that compensates them for giving up their option
to keep their commodity under loan, they have little incentive to take the
commodity out of loan. The option value is one of several factors that
cause U.S. cotton and rice prices to be higher than adjusted world prices.13
 To the extent that a lower loan rate reduces the option value of the loan
because it reduces producers’ guaranteed minimum returns upon
forfeiture, a lower loan rate will have some downward effect on U.S.
prices, thereby bringing them closer to adjusted world prices. However, a
lower loan rate will not by itself eliminate the price premium paid for U.S.
cotton and rice, and U.S. prices will continue to remain higher than
adjusted world prices because of other program features and market
factors. For example, for cotton, a lower loan rate, combined with the
elimination of government-paid storage, would result in a larger
downward effect on U.S. cotton prices.

For wheat, feedgrains, and oilseeds, USDA officials, including agricultural
economists, and many other agricultural economists told us that lower
loan rates will have little if any impact on U.S. prices when alternative
repayment rates are below the loan rates. According to these USDA officials
and economists, when producers use the marketing loan provisions and
sell their commodities earlier in the marketing year, they generally benefit
by saving on storage costs. The potential savings from avoiding storage
costs are relatively greater than the option value of the loan. Consequently,
these officials told us that lowering the loan rates will have little if any
effect on U.S. prices because marketing loan provisions will keep the loan
rates from supporting prices.

In contrast, a few other agricultural economists and commodity analysts
told us that the option value of the loan may be a significant factor in
producers’ marketing decisions and that this and other market factors may
cause the loan rates to continue providing price support despite the
marketing loan provisions. According to these experts, if the loan rates are
supporting prices, lowering the loan rates may have some downward
effect on U.S. prices. The degree to which prices will drop depends on




13
  The 1996 farm act reduced the maximum time that producers could keep their cotton under loan,
thereby reducing the option value of the loan in the future. (See app. II for additional discussion.)



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                        how the option value of the loan compares with the potential value of
                        avoiding storage costs while receiving marketing loan benefits.14

                        In commenting on a draft of this report, USDA officials disagreed that lower
                        loan rates would reduce U.S. prices. Their detailed comments and our
                        response are presented at the end of this letter.


                        U.S. cotton prices have historically been higher than world prices, in part
Lower Loan Rate         because of import restrictions and other program features that the
Would Not Eliminate     marketing loan provisions have been unable to overcome. Higher U.S.
the Use of Step 2       prices made U.S. cotton less competitive on the world market, to which
                        the United States exported its cotton as a residual supplier when world
Payments, and Recent    supplies were low. To help keep U.S. cotton competitively priced in world
Changes to the Timing   markets, the 1990 farm act added a subsidy in the form of step 2 payments
                        to exporters and domestic mills. Exporters use the step 2 payment to
of Step 2 Payments      reduce the price of U.S. cotton offered to foreign buyers, and domestic
May Diminish Their      mills use the step 2 payments to offset the cost of purchasing higher-priced
Effect on Exports       U.S. cotton. Step 2 payments are made when two conditions are met for 4
                        consecutive weeks: the (1) adjusted world price is less than or equal to
                        130 percent of the loan rate and (2) U.S. price in Northern Europe exceeds
                        the average price in Northern Europe by more than $0.0125 per pound.
                        The payment per pound is equal to the difference between the U.S. price in
                        Northern Europe and the sum of the price in Northern Europe (average
                        across five countries) and $0.0125. Figure 1 shows a hypothetical example
                        of how the step 2 payment is calculated.




                        14
                         Transaction costs associated with using the marketing loan provisions may also influence a
                        producer’s marketing decision.



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Figure 1: Calculation of the Step 2
Payment

                                        Condition 1:
                                        Loan rate                                                             $0.50/pound
                                        Adjusted world price                                                  $0.55/pound
                                        130 percent of the loan rate                                $0.50 x 1.30 = $0.65

                                        In this example, the adjusted world price ($0.55) is less than 130
                                        percent of the loan rate ($0.65). This condition must be met for 4
                                        consecutive weeks.



                                        Condition 2:
                                        U.S. price in Northern Europe                                         $0.63/pound
                                        Average price in Northern Europe                                      $0.60/pound

                                        The difference between the U.S.                             $0.63 - $0.60=$0.03
                                        price in Northern Europe and the
                                        average price in Northern Europe

                                        In this example, the difference ($0.03) is greater than $0.0125. This
                                        condition must also be met for 4 consecutive weeks.




                                        Step 2 payments to be made in the 5th week:
                                        $0.63 - ($0.60 + $0.0125) = $0.0175/pound


                                      Note: Step 2 payments are not made during those times when special import quotas are in effect.




                                      USDA  made a total of $701 million (in 1995 dollars) in step 2 payments from
                                      fiscal years 1992 through 1996. Currently, the adjusted world price is
                                      sufficiently above the loan rate to preclude the use of step 2 payments. If
                                      the adjusted world price drops to within 130 percent of the loan rate in the
                                      future, step 2 payments may be used again. As discussed previously, when
                                      the adjusted world price is below the loan rate, a lower loan rate is most
                                      likely to have some downward effect on U.S. prices. To the extent that U.S.




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                     prices decrease because of a lower loan rate, step 2 payments will be used
                     less often and the payment rate will also be reduced. However, since other
                     program features (such as government paid-storage and import
                     restrictions) and market factors contribute to making U.S. prices higher
                     than world cotton prices, lowering the loan rate alone will not eliminate
                     the use of step 2 payments.15

                     Recent changes in the timing of USDA’s step 2 payments to exporters may
                     diminish this tool’s effectiveness in enhancing exports. In the past,
                     exporters received the step 2 payment rate that was in effect during the
                     week they contracted for cotton sales.16 As a result, exporters could use
                     step 2 payments to reduce the price of U.S. cotton offered to foreign
                     buyers. An unintended consequence of the step 2 provision was that many
                     contracts for future sales were made during weeks with high payment
                     rates. This practice was known as “bunching,” and many of these sales
                     represented internal transactions between U.S. firms and their foreign
                     affiliates. Bunching increased the cost of the step 2 provision to the
                     government and placed domestic mills and exporters without foreign
                     affiliates at a price disadvantage. To prevent bunching, USDA changed step
                     2 procedures so that exporters receive the step 2 payment rate that applies
                     during the week the cotton is shipped instead of the week in which the
                     sales are contracted. Consequently, when exporters agree to a sale, they
                     do not know what step 2 payment rate, if any, will be in effect during the
                     week the cotton is shipped. Step 2 payments have not been made since
                     USDA changed its procedures. This change should reduce the occurrence of
                     bunching but could also make it more difficult for exporters to reduce the
                     higher price of U.S. cotton when it is offered for sale to foreign buyers.


                     As we have reported in the past,17 the peanut and sugar programs have not
Peanut and Sugar     been market-oriented because they have kept U.S. prices higher than
Prices Will Remain   world prices and resulted in production and consumption inefficiencies.
Above World Prices   As a result, these programs have cost users of peanuts and sugar and the
                     government hundreds of millions of dollars annually. The Congress made a
Despite Recent       number of changes to both programs through the 1996 farm act to reduce
Program Changes      U.S. prices and some of the economic inefficiencies in order to make the

                     15
                      This conclusion assumes that the loan rate is not lowered so far that the adjusted world price
                     exceeds 130 percent of the loan rate.
                     16
                      Domestic mills receive the step 2 payment rate in effect during the week they open the bales of
                     cotton.
                     17
                      Peanut Program: Changes Are Needed to Make the Program Responsive to Market Forces
                     (GAO/RCED-93-18, Feb. 8, 1993). Sugar Program: Changing Domestic and International Conditions
                     Require Program Changes (GAO/RCED-93-84, Apr. 16, 1993).



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          programs more market-oriented. However, these changes did not eliminate
          the difference between U.S. prices and lower world prices because the
          domestic marketing quota for peanuts and the tariff-rate import quota for
          sugar continue to restrict supply. As we recommended in the past, greater
          market orientation could be achieved through (1) further reductions in the
          support price for peanuts and (2) a reduction in the loan rate for sugar and
          an increase in the tariff-rate import quota. These changes would help
          lower U.S. prices and increase economic efficiency, but one tradeoff
          would be a potential reduction in producers’ revenue.


Peanuts   The peanut program controls the domestic supply and protects producers’
          income by (1) setting a national poundage quota that determines the
          amount of peanuts that can be sold domestically and (2) restricting
          imports. The national poundage quota is set at a level based on the
          estimated quantity of edible peanuts used in the United States at the
          support price. Prior to the 1996 farm act, the quota could not fall below
          1.35 million tons.18 Generally, only producers holding a portion of the
          assigned quota may sell these “quota peanuts” domestically. Quota holders
          who choose not to grow peanuts can sell or lease their quota within the
          county it was assigned or return it to USDA for redistribution to other
          producers. Producers without assigned quota and those who exceed their
          quota cannot sell these peanuts in the domestic edible market except
          under certain conditions,19 but they may export them as “additional
          peanuts.”

          The program protects producers’ incomes through a two-tiered system
          that sets minimum support prices for both quota and additional peanuts.
          The support price for quota peanuts guarantees producers a price in U.S.
          markets that is higher than world prices. Prior to the 1996 farm act, the
          quota support price was adjusted upward annually when the cost of
          production rose but was left unchanged when the cost of production fell.
          (This adjustment was known as the “escalator clause.”) The support price
          for additional peanuts is generally set lower than the world price and plays
          a limited role in domestic peanut marketing.




          18
            In this report, tons refers to “short” tons. A short ton equals 2,000 pounds.
          19
            Under a provision known as “buy-back,” additional peanuts, which are usually exported or crushed
          for oil and meal at prices lower than the quota support price, can be purchased for use in the domestic
          market if U.S. prices start to rise significantly. However, buyers of these additional peanuts must, at a
          minimum, pay the higher quota support price plus other mandated fees.



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Higher U.S. prices result in increased costs to consumers. The world price
for peanuts in 1995 averaged $415 per ton,20 while the support price for
quota peanuts was $678 per ton. Therefore, U.S. consumers paid more for
items containing peanuts than they would have if U.S. processors had
purchased peanuts at the lower world price. In addition, higher U.S. prices
could create a consumption inefficiency because the quantity of peanuts
purchased at the higher U.S. price is less than what would have been
purchased at the lower world price—the price that would have occurred if
there were no program.

The government also incurs costs when producers cannot sell their
peanuts at a price greater than or equal to the support price and instead
forfeit them to the government at the support price. The government pays
to have these peanuts crushed and sells them at a price lower than the
support price. To prevent forfeitures, USDA strives to set the annual quota
at a level that does not exceed the expected quantity that would be
demanded at the support price. If USDA sets the quota too high, the
government will incur costs from forfeitures. For example, in fiscal years
1995 and 1996, the government incurred costs of $124.7 million and
$127.4 million, respectively, because the legislatively set minimum quota of
1.35 million tons was greater than the quantity of peanuts demanded at the
support price in those years. On the other hand, if USDA sets the quota too
low, forfeitures will not occur, but U.S. prices will rise because the supply
marketed under the quota is not adequate to meet the quantity demanded
at the support price. In order to share program costs with the government,
producers and buyers of peanuts pay a fee to the government, known as a
marketing assessment, per ton of peanuts sold.21

The government also incurs indirect costs when it purchases higher-priced
peanuts and peanut-containing products for its food assistance programs.
In 1993, we reported that USDA paid the quota support price, instead of the
lower world price, for peanuts and peanut-containing products that it
purchased, leading it to incur greater costs than without the peanut
program.

The 1996 farm act made several changes to the peanut program to reduce
its costs and make the U.S. peanut industry more market-oriented. One
change in particular will help make U.S. peanut prices somewhat closer to

20
 The world price is derived from the price quoted for U.S. peanuts in Rotterdam, adjusted for the cost
of shelling and transportation back to the United States.
21
 The 1996 farm act set the marketing assessments for peanuts at 1.15 percent of the loan rate for the
1996 crop and 1.2 percent of the loan rate for the 1997-2002 crops.



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world prices—a lower quota support price. Under the 1996 farm act, the
peanut quota support price was reduced from $678 to $610 per ton and
fixed through the year 2002—the remainder of the life of the farm act. As a
result of this change, the quota support price is no longer linked to the
cost of producing peanuts and will not increase with inflation because the
escalator clause has been eliminated.

In addition to reducing the quota support price, the 1996 farm act made
other changes to the peanut program to increase economic efficiency.
These changes included eliminating the minimum level to which the
national poundage quota could fall, authorizing marketing assessment
increases, eliminating provisions allowing the carryover of unfilled quota
from year to year (undermarketings), redefining the peanut quota to
exclude seed peanuts, limiting disaster transfers requested by quota
holders whose commodity is damaged, and adding marketing
requirements to maintain program eligibility. These changes should enable
USDA to better control the quantity of peanuts marketed at the quota
support price, thus reducing government costs associated with the
program. Moreover, people who live outside of the state in which the
quota is allocated or who are not peanut producers, as well as government
entities, can no longer hold quota; and the annual sale, lease, and transfer
of quota is now permitted across county lines within a state, up to
specified amounts of quota. These changes will improve the equity and
economic efficiency of the peanut program. (See app. III for additional
details on these changes.)

Although the lower quota support price of $610 will help reduce U.S.
peanut prices, it is still substantially above the average U.S. cost of
producing peanuts and world prices. In 1995, the average cost of
producing peanuts in the United States was $369 per ton and the world
price was $415 per ton,22 while the support price was $678 per ton. In 1993,
we recommended that the quota support price be reduced so that over
time U.S. prices would more closely parallel the cost of producing peanuts
and world prices. Lowering and fixing the quota support price at $610 per
ton was a good first step. This price could be reduced further, which
would result in lower U.S. prices that would be closer to world prices and
would also result in reductions in government costs. While USDA officials
agreed that a lower quota support price will lower U.S. prices and
government costs, they pointed out that it will also reduce producers’
revenues.

22
  This estimate of the cost of production was derived from a USDA estimate of variable production
costs per acre. This estimate however, does not include fixed costs of production, such as the cost of
land.



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Sugar       The sugar program guarantees producers (growers and processors) a
            minimum price for domestic sugar through the nonrecourse loan program
            and controls the domestic supply of sugar through the use of a tariff-rate
            import quota. The nonrecourse loan program sets a guaranteed minimum
            price for domestic sugar through the loan rate. However, the 1996 farm act
            restricts the availability of nonrecourse loans to times when the tariff-rate
            import quota is at or above 1.5 million tons. USDA adjusts the tariff-rate
            import quota on the basis of the (1) estimated domestic production and
            demand and (2) level of supply needed to maintain domestic prices at
            levels high enough to discourage forfeitures.23 Prior to the 1996 farm act,
            under certain market conditions, USDA could also limit the domestic
            marketing of sugar by assigning marketing allotments to processors to
            maintain the support price.24 USDA assigned marketing allotments twice, in
            fiscal years 1993 and 1995.

            The 1996 farm act made the following changes to the sugar program to
            reduce U.S. sugar prices and some economic inefficiencies of the program:

        •   Loans are to be recourse under certain circumstances. When the tariff-rate
            import quota is established below 1.5 million tons on the basis of
            estimated domestic production and demand, loans are issued as recourse
            rather than nonrecourse to eliminate potential forfeitures. If loans are
            recourse, then there is effectively no price support and U.S. prices could
            fall below the loan rate.
        •   The loan rates were fixed. The loan rates were fixed for refined beet sugar
            at the 1995 level of 22.9 cents per pound and for raw cane sugar at 18 cents
            per pound. USDA has maintained the loan rate for raw cane sugar at 18
            cents per pound since 1981, although in the past it had the authority to
            raise the rate. A fixed rate means that over time the real value of the loan
            rate, and therefore the real value of government support, will fall because
            of inflation.25 If prices fall near the loan rates, inflation-adjusted market
            prices may be lower.


            23
             In the past, the sugar program was designed to operate at no net cost to the government, which,
            according to USDA, meant no forfeitures of sugar to the government. USDA adjusted the tariff-rate
            import quota to prevent loan forfeitures. However, the no-net-cost provision only applied to the direct
            costs of operating the sugar program, not to other indirect costs incurred by the government when it
            bought food products for its food assistance programs.
            24
              Under the 1990 farm act, foreign sugar producers and domestic cane refiners were ensured that
            estimated imports of lower-priced sugar would not fall below 1.25 million tons. If estimated imports
            were less than 1.25 million tons for the fiscal year, USDA was required to activate marketing
            allotments, which limit the domestic marketing of sugar.
            25
             To the extent that over time there are productivity gains in sugar production, the real cost of
            producing sugar will also decline.



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•   The no-net-cost requirement was discontinued. In the past, the sugar
    program was designed to operate at no net cost to the government. The
    1996 farm act did not renew the no-net-cost provision of the program, and
    therefore this provision is no longer operative. Without the no-net-cost
    provision, USDA could in the future choose to set the tariff-rate import
    quota at a higher level to allow greater imports, which would result in
    lower U.S. sugar prices. However, it is not yet clear whether USDA will
    choose to increase the tariff-rate import quota and increase the chance of
    forfeitures under the nonrecourse loan program.
•   Marketing allotments were eliminated. The 1996 farm act eliminated USDA’s
    authority to use marketing allotments, which may result in a more efficient
    allocation of resources in the sugar industry. More efficient producers will
    no longer have to limit their level of production and marketings in favor of
    less efficient and higher-cost producers. Any reductions in the costs of
    production because of increased efficiency may be passed on to users in
    the form of lower sugar prices.
•   Penalties were imposed on forfeitures. The 1996 farm act required that
    sugar processors be assessed a 1-cent penalty on every pound of raw cane
    sugar and a 1.07-cent penalty on every pound of refined beet sugar
    forfeited to the government. This penalty will reduce the effective
    guaranteed price that processors receive from the government. Because of
    this penalty, USDA can now support the price of sugar at a level that is 1
    cent lower than under the prior farm act without causing processors to
    forfeit.

    The 1996 farm act did not eliminate the tariff-rate import quota, which
    continues to be the key mechanism by which total domestic supply is
    restricted and U.S. sugar prices are supported. As long as USDA continues
    to use the tariff-rate import quota as it has in the past to restrict imports
    and support U.S. prices above the level necessary to prevent forfeitures,
    the 1996 farm act’s changes (such as limits on the availability of
    nonrecourse loans) will have little if any impact on U.S. prices. However,
    these changes could result in lower U.S. prices if there are significant
    increases in domestic supply (or similarly large decreases in domestic
    consumption) that prevent USDA from maintaining a tariff-rate import
    quota of 1.5 million tons while supporting prices at their current level. In
    commenting on a draft of this report, USDA officials pointed out that such
    an increase in beet sugar production occurred in fiscal year 1995. If a
    similar increase in domestic supply occurred under the 1996 farm act, USDA
    could either (1) keep the tariff-rate import quota at or above 1.5 million
    tons, which would result in lower sugar prices because of increased
    supply, or (2) set the tariff-rate import quota below 1.5 million tons, which



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would result in producers not being eligible for nonrecourse loans, and
which could result in lower U.S. sugar prices.

If USDA’s implementation of the sugar program continues to insulate the
U.S. sugar market from the world market, U.S. prices are likely to remain
higher than world prices.26 For fiscal years 1991 through 1995, the average
annual world price of raw cane sugar ranged from 9.22 to 13.86 cents per
pound, and the average annual U.S. price ranged from 21.39 to 22.76 cents
per pound. In addition, according to some sugar analysts who are familiar
with trends in world sugar prices, world prices are expected to decline in
the short run and, because of the sugar program, U.S. sugar users will
continue to pay premium prices. Finally, by supporting the price of U.S.
sugar, the sugar program also indirectly supports the prices of other
sweeteners, such as high-fructose corn syrup.

There is considerable controversy about the size of the premium paid for
U.S. sugar and, therefore, the total cost of the sugar program to domestic
sweetener users. The size of the premium is controversial because it is not
a simple difference between current U.S. and world sugar prices. Instead,
the size of the premium depends in part on assumptions about how much
the world price would rise if the United States did not have a sugar
program. The premium could also be based on an estimate of what the
world price would be if all countries eliminated programs that support
their sugar industries. Nevertheless, as we and others have shown, higher
U.S. sugar prices result in increased costs of hundreds of millions of
dollars per year to U.S. sweetener users.27 USDA has not officially
determined the size of the premium that users pay for U.S. sugar.
However, in a 1995 report,28 USDA stated that for every 1-cent-per-pound
premium paid for U.S. sugar, the cost to consumers is $178 million (in 1995
dollars).

Higher U.S. sugar prices also result in a production inefficiency—the cost
of shifting resources from other economic sectors to pay for more

26
 In this report, the world price for sugar refers to the Number 11 contract price as traded on the New
York Coffee, Sugar, and Cocoa Exchange, (f.o.b. Caribbean) for raw cane sugar.
27
  While we recognize that the cost of the program varies from year to year, we estimated in our 1993
report that the sugar program cost domestic sweetener users an average of about $1.4 billion per year
(in 1991 dollars) between 1989 and 1991. This estimate was based on an estimated long-run,
free-market world price of 15 cents per pound for raw cane sugar. Although USDA officials disagreed
with our methodology and assumptions, they told us that they used an approximation of our
methodology and estimated that the costs to sweetener users averaged about $900 million annually (in
1991 dollars) for 1992-94. In addition, other studies using different assumptions and methodologies
have estimated that the sugar program results in substantial costs to U.S. sugar or sweetener users.
28
  Lord, Ron. Sugar: Background for 1995 Farm Legislation (USDA/ERS, Washington, D.C., Apr. 1995).



Page 18         GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
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                  expensive domestic production instead of importing lower-cost sugar. A
                  consumption inefficiency also arises when the quantity of sugar purchased
                  at the higher U.S. price is less than the quantity that would have been
                  purchased at the lower world price.

                  The government incurs indirect costs of millions of dollars a year as a
                  result of the sugar program when it purchases higher-priced sugar and
                  sweetener-containing products for its food assistance programs. On the
                  other hand, the government receives marketing assessments from sugar
                  processors on each pound of sugar that they market.29

                  In order to reduce U.S. sugar prices, we recommended in our 1993 report
                  that the loan rate be reduced gradually and the tariff-rate import quota be
                  adjusted accordingly. Changes made in the 1996 farm act should help
                  reduce U.S. prices if there are significant increases in domestic supply or
                  similar decreases in domestic consumption. However, if domestic market
                  conditions do not change, reductions in U.S. prices could be achieved only
                  by increasing the tariff-rate import quota or eliminating it (no import
                  restrictions). Once increases in the tariff-rate import quota result in U.S.
                  prices dropping to the loan rate, reductions in the loan rate would be
                  necessary to reduce prices further. However, one tradeoff of an increase in
                  the tariff-rate import quota and a lower loan rate would be a reduction in
                  U.S. producers’ revenues. Moreover, according to an official of the
                  American Sugar Alliance, making these changes would adversely affect the
                  long-term viability of the U.S. sugar industry because U.S. sugar
                  production would be replaced by lower-priced imports, most of which
                  receive some form of government support, such as export subsidies. Other
                  sugar industry officials told us that further reductions in domestic sugar
                  production will result in the deterioration of the specialized
                  infrastructure—processing mills, machinery, seeds, and
                  chemicals—necessary to support a domestic sugar industry.


                  We provided copies of a draft of this report to USDA for review and
Agency Comments   comment. We met with officials of the Department, including USDA’s
                  Deputy Chief Economist; the Farm Service Agency’s Assistant Deputy
                  Administrator, Economic Policy Analysis Staff, and 10 other officials
                  representing various commodity divisions within this agency; and an
                  official representing the Commercial Agriculture Division of the Economic


                  29
                    The 1996 farm act increased marketing assessments on processed raw cane sugar from 1.1 to
                  1.375 percent of the raw cane sugar loan rate, and for refined beet sugar from 1.1794 to 1.47425 percent
                  of the raw cane sugar loan rate.



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    Research Service. These officials expressed concern with our findings in
    the following five areas:

•   USDA  officials told us that in their opinion the marketing loan provisions
    have prevented the loan rates from acting as price floors in the past and
    will be similarly effective in the future if market conditions warrant their
    use. They base this position on (1) the strong theory behind the concept of
    the marketing loan provisions; (2) USDA’s past experience with the generic
    certificate program, which they said was similar in concept to the
    marketing loan provisions; and (3) the data that are available for
    sunflower seeds and cotton. We disagree with USDA that a conclusion
    about the effectiveness of the marketing loan provisions for all
    commodities is warranted. While we agree that the marketing loan
    provisions appear to have prevented the rice loan rate from serving as a
    price floor, we believe that the evidence is insufficient to reach similar
    conclusions for the other commodities. For cotton, we disagree that the
    data on forfeitures and stock accumulations, along with theoretical
    expectations, are sufficient to reach a conclusion. For wheat, feedgrains,
    and soybeans, the provisions remain largely untested because U.S. prices
    and alternative repayment rates have generally been higher than the loan
    rates; and for minor oilseeds, the data necessary to analyze the provisions’
    effectiveness are unavailable or, as USDA acknowledges, “anecdotal.” For
    cotton, wheat, feedgrains, and oilseeds, we believe that more price data
    are needed to confirm that the marketing loan provisions prevent the loan
    rates from serving as price floors.
•   USDA officials were also concerned about our reliance on historical data in
    analyzing the effectiveness of the marketing loan provisions and projecting
    to the future, particularly when major program changes were made in the
    1996 farm act to increase the market orientation of U.S. commodity
    programs. They stated that in the future there will be a different
    combination of domestic government commodity programs and a different
    mix of international trade policies. Therefore, if the effectiveness of the
    marketing loan provisions are analyzed using historical data, these results
    should not be projected to the future. In our report, we have added
    language to recognize that one limitation of using historical data is that
    some programs that affected U.S. prices in the past have been eliminated
    by the 1996 farm act. In addition, our report recognizes that marketing
    loan provisions may prevent the loan rates from serving as price floors in
    the future, only under certain market conditions.
•   USDA officials were concerned that our draft report implied that higher U.S.
    prices always meant that U.S. commodities were not competitive on world
    markets. They said that price premiums are justifiable if they reflect the



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    desirability of U.S. commodities over foreign commodities in world
    markets; they acknowledged that price premiums deriving from program
    provisions that keep U.S. prices artificially high and pose an impediment
    to free trade are undesirable. We agree that some price premiums resulting
    from market factors may be justifiable and do not indicate a lack of
    competitiveness. Throughout the report, where appropriate, we have
    changed any reference to “making U.S. prices more competitive” to
    “lowering U.S. prices to levels that are closer to” alternative repayment
    rates or world prices.
•   USDA officials disagreed that lower loan rates would reduce U.S. prices.
    They stated that lowering the loan rates would have little if any effect on
    reducing U.S. prices when the marketing loan provisions are available.
    While they did not disagree that loans have an option value, they told us
    that if prices fall to levels significantly below the loan rates, the option
    value of the loans will have at best a marginal impact on U.S. prices. The
    option value will only influence the seasonal variation of prices, with no
    significant effect on annual average prices. Furthermore, they told us that
    if producers obtained commercial loans instead of government loans,
    producers would still be able to keep their commodities off the market for
    some period of time. Specifically, for cotton, officials told us that the
    option value of the loan will be less of a factor in the future because the
    1996 farm act eliminated the 8-month loan extension, which in the past
    allowed the loan to span 2 crop years. For rice, officials stated that the
    level of the loan rate is irrelevant to producers’ decisions to plant; instead,
    the main factor is the high cost of rice production. Because of this, USDA
    officials stated that lowering the loan rate for rice will have little if any
    impact on U.S. prices. For wheat, feedgrains, and oilseeds, USDA officials
    hold the view that marketing loan provisions will prevent the loan rates
    from serving as price floors and therefore lower loan rates will have little
    if any impact on U.S. prices.

    Despite USDA’s disagreement, we continue to believe that for cotton and
    rice, when adjusted world prices are below the loan rates, lower loan rates
    will likely have some downward effect on U.S. prices. This is because the
    option value of the loan may be a significant factor affecting U.S. cotton
    and rice prices. For cotton, while we agree that eliminating the 8-month
    extension reduces the option value of the loan, we believe that the
    availability of government-paid storage and import restrictions continue to
    play a role in affecting the option value of the loan and keeping U.S. cotton
    prices higher than adjusted world prices. To the extent that lowering the
    loan rate for cotton reduces the loan’s option value, there will be some
    downward effect on U.S. prices. For rice, although the price data suggest



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    that the marketing loan provisions have prevented the loan rate from
    serving as a price floor, U.S. rice prices have remained higher than
    adjusted world prices. To the extent that these higher prices are caused by
    the availability of nonrecourse loans, we believe that lowering the loan
    rate for rice will reduce the loan’s option value and will have some
    downward effect on U.S. prices.

    For wheat, feedgrains, and oilseeds, we do not take a position on the likely
    effect of lowering the loan rates on U.S. prices. The report recognizes that
    most experts expect the marketing loan provisions to work as intended
    and prevent loan rates from serving as price floors. In this case, lower loan
    rates will have little if any impact on U.S. prices. However, if marketing
    loan provisions do not prevent the loan rates from supporting prices, as
    some others have suggested, then lowering the loan rates may have some
    downward effect on U.S. prices.

•   USDA  officials expressed their strong disagreement with our estimates of
    the cost of the sugar program to domestic sugar users as reported in 1993
    and cited in this report. This is in contrast to USDA’s official comments on
    our 1993 report, in which USDA stated that our report was reasonable and
    had no major data problems. At that time, USDA stated that the costs and
    benefits derived using assumptions of hypothetical policy alternatives
    were well within the range of most research. However, in commenting on
    a draft of our current report, USDA officials told us that since our 1993
    report was issued, they have changed their position and now strongly
    disagree with our 1993 estimate of the average annual cost to users of
    $1.4 billion. They stated that the 1993 report did not adequately consider
    the complexities and dynamics of the U.S. and global sugar markets. They
    said that the report overestimated the cost of the sugar program to U.S.
    users, some data were used incorrectly, and important sugar market issues
    were not considered. Furthermore, they said that using our methodology,
    different welfare cost impacts could be obtained by selecting prices in
    different time periods. We continue to believe that our 1993 report
    provided a reasonable estimate of the cost of the sugar program to U.S.
    sugar users for the period analyzed. More importantly, we believe that
    while the precise level of price premium is subject to debate, the program
    and policy problems that we identified in 1993 are still relevant.

    USDAofficials also suggested a number of technical revisions to our draft.
    Where appropriate, we have incorporated these revisions into the report.




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In conducting our review, we interviewed USDA officials from the
Commodity Credit Corporation, Economic Research Service, Farm Service
Agency, Foreign Agricultural Service, National Agriculture Statistical
Service, Office of the Chief Economist, and county offices. We also spoke
to officials of the World Bank, academic experts, industry and trade
representatives, and agricultural commodity consultants. We also obtained
data from USDA, and we reviewed various economic and international trade
studies conducted by universities, management consulting groups, USDA,
and international agencies. We did not independently verify the data used
in this report. We conducted our review from July 1996 through
January 1997 in accordance with generally accepted government auditing
standards. A detailed discussion of our overall scope and methodology is
provided in appendix IV.

We are sending copies of this report to the Senate Committee on
Agriculture, Nutrition, and Forestry; the House Committee on Agriculture;
other interested congressional committees; the Secretary of Agriculture;
and other interested parties. We will also make copies available to others
on request.

If you or your staff have any questions about this report, please contact me
on (202) 512-5138. Major contributors to this report are listed in appendix
V.

Sincerely yours,




Robert A. Robinson
Director, Food
  and Agriculture Issues




Page 23     GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
Contents



Letter                                                                                                  1


Appendix I                                                                                             26
                       Calculation of Net Amount Received From Nonrecourse Loans                       26
Calculating the          Without Marketing Loan Provisions
Benefits From Using    Marketing Loan Provisions Were Intended to Eliminate Price                      27
                         Floors
the Marketing Loan     Benefits Can Differ, Depending on Market Conditions                             28
Provisions
Appendix II                                                                                            30
                       Cotton                                                                          30
Detailed Analyses of   Rice                                                                            35
the Impact of the      Wheat, Feedgrains, and Oilseeds                                                 38
Marketing Loan
Provisions on U.S.
Prices for Cotton,
Rice, Wheat,
Feedgrains, and
Oilseeds
Appendix III                                                                                           45
                       1996 Farm Act Changes to the Peanut Program                                     45
Additional Changes     Economic Analysis of the Effect of a Reduced Quota Support                      47
Made to the Peanut       Price on the National Poundage Quota and on the U.S. Market
Program in the 1996
Farm Act and Their
Impact on the U.S.
Peanut Market
Appendix IV                                                                                            50

Scope and
Methodology




                       Page 24    GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
                        Contents




Appendix V                                                                                              52

Major Contributors to
This Report
Tables                  Table I.1: Calculation of Net Amount Received From the                          27
                          Nonrecourse Loan When Forfeited at Maturity Without Marketing
                          Loan Provisions
                        Table I.2: Total Returns That Producers Receive at Harvestime                   29
                          Depend on the Relationship Between the Market Price and the
                          Posted County Price
                        Table II.1: Marketing Loan Benefits for Wheat, Feedgrains, and                  40
                          Oilseeds, Crop Years 1993-94


Figures                 Figure 1: Calculation of the Step 2 Payment                                     11
                        Figure II.1: Relationship Between the Adjusted World Price, U.S.                31
                          Price, and Loan Rate for Cotton, 1986-95
                        Figure II.2: Relationship Between the Adjusted World Price, U.S.                36
                          Price, and Loan Rate for Rice, August 1986 Through August 1996
                        Figure III.1: Effect of the Peanut Program on the Market                        48




                        Abbreviations

                        ERS        Economic Research Agency
                        GAO        General Accounting Office
                        USDA       U.S. Department of Agriculture


                        Page 25    GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
Appendix I

Calculating the Benefits From Using the
Marketing Loan Provisions

                     This appendix provides an (1) explanation of how to calculate the net
                     amount that producers receive from the government when they use
                     nonrecourse loans without marketing loan provisions, (2) analysis of how
                     the marketing loan provisions are intended to operate and prevent the loan
                     rates from acting as price floors,1 and (3) illustration of the differences in
                     marketing loan benefits under various market conditions and the
                     relationship between the alternative repayment rates and U.S. prices.

                     Throughout this appendix, we use prices and the loan rate for corn in our
                     examples to show how calculations are made. The specific calculations for
                     cotton, rice, wheat, feedgrains, and oilseeds may vary to some extent. For
                     example, for cotton and rice, the adjusted world price would be used as
                     the alternative repayment rate and not the posted county price, and for
                     cotton, storage costs would not be included because the government pays
                     storage costs when the adjusted world price is below the loan rate.
                     However, the overall process is the same.


                     Under the nonrecourse loan without marketing loan provisions, producers
Calculation of Net   who kept their commodity under loan for the full 9 months would, upon
Amount Received      forfeiture, receive the loan rate (less a service fee) minus the storage costs
From Nonrecourse     they incurred. Producers were not required to pay interest when they
                     forfeited their commodities to the government. However, if they repaid the
Loans Without        loan, they had to pay interest charges. The hypothetical example in table
Marketing Loan       I.1 shows that when the loan rate for corn was $1.89 per bushel, the net
                     amount producers received from the nonrecourse loan upon forfeiture at
Provisions           maturity was $1.70 per bushel.




                     1
                      This analysis focuses on how the marketing loan provisions are intended to operate. Therefore, it
                     does not take into account several reasons presented in appendix II on why the loan rate may at times
                     provide some price support despite the marketing loan provisions. These reasons include the option
                     value of the loan, which may be large relative to the potential savings from storage costs by using the
                     marketing loan provisions.



                     Page 26         GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
                                       Appendix I
                                       Calculating the Benefits From Using the
                                       Marketing Loan Provisions




Table I.1: Calculation of Net Amount
Received From the Nonrecourse Loan                                                                              Benefits and charges per
When Forfeited at Maturity Without     Factors in calculating amount                                                      bushel of corn
Marketing Loan Provisions              Loan rate for corn                                                                                $1.89
                                       Less service fee                                                                                      0.01a
                                       Effective loan rate                                                                                   1.88
                                       Less storage costs of 2 cents/month for 9 monthsb                                                     0.18
                                       Total amount received                                                                             $1.70
                                       a
                                        The loan processing fee charged for taking out a loan may vary from county to county. This fee is
                                       not an interest charge.
                                       b
                                        The relative value of storage costs may be higher if the opportunity cost (in the form of interest
                                       foregone) is also included.




                                       Before the marketing loan provisions were available, the loan rate
Marketing Loan                         determined the effective level of price support, which increased during the
Provisions Were                        marketing year to reflect storage and interest costs that producers
Intended to Eliminate                  incurred while holding the corn under loan. The forfeiture option always
                                       allowed them to net $1.70 at the end of 9 months. To be better off selling at
Price Floors                           any time during the 9-month loan period, producers needed to receive an
                                       amount that made them at least as well off as forfeiting at the end of the
                                       loan period. Producers had to receive an amount that allowed them to
                                       repay the loan amount of $1.89 plus accrued interest, minus the amount of
                                       refunded prepaid storage costs. (Producers who choose to keep their
                                       commodities under loan are responsible for paying storage costs in
                                       advance for the full term of the loan.) For example, after 3 months,
                                       producers would have had to receive at least $1.80 ($1.89 plus 3 cents for
                                       interest minus 12 cents for refunded storage costs) to be better off selling
                                       rather than leaving the commodity under loan for another 6 months and
                                       then forfeiting it to the government. At 9 months, producers would have
                                       had to receive at least $1.98 ($1.89 plus 9 cents in interest, without any
                                       refund for storage) to be better off selling rather than forfeiting the
                                       commodity to the government. In this example, when prices fell below
                                       $1.98 at the end of the loan period, producers forfeited their commodities
                                       and government stocks rose.

                                       The marketing loan provisions were added in part to eliminate the price
                                       floors created by the loan rates. When the alternative repayment rate is
                                       below the loan rate at the time of harvest, the marketing loan provisions
                                       provide a producer who holds a nonrecourse loan with two options:
                                       (1) redeem the loan at any time at the alternative repayment rate (for corn,




                                       Page 27         GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
                       Appendix I
                       Calculating the Benefits From Using the
                       Marketing Loan Provisions




                       this is the posted county price) and sell the commodity at the market price
                       or (2) forfeit the commodity after 9 months at the loan rate. Under the first
                       option, the difference between the loan rate and the alternative repayment
                       rate represents a marketing loan gain to the producer. In addition,
                       producers who repay their loans at the alternative repayment rate do not
                       have to pay accrued interest on the loan. (Those producers who choose to
                       forego loans can receive government payments equal to the marketing
                       loan gains. These amounts are known as loan deficiency payments.)

                       When the alternative repayment rate is below the loan rate, producers are
                       better off by choosing the first option because they can obtain the full
                       value of the loan rate without incurring the full 9 months of storage costs
                       associated with forfeitures and are relieved of the interest costs on the
                       loan. For example, if the alternative repayment rate at the time of harvest
                       is $1.60 per bushel, producers are eligible for marketing loan benefits of 29
                       cents per bushel (the difference between the loan rate of $1.89 and the
                       posted county price of $1.60). The producer sells the corn at $1.60 (this
                       example assumes that the posted county price remains unchanged and
                       equals the market price) and receives a total return of $1.89 (market price
                       of $1.60 plus the marketing loan benefit of 29 cents), which is the full value
                       of the loan. Because producers can receive the full value of their loans
                       even when marketing their commodities at prices below the loan rates, the
                       marketing loan provisions can prevent the loan rates from serving as price
                       floors. The longer producers hold their commodities under loan, the more
                       their benefit is reduced by storage costs. Producers have an incentive to
                       use the marketing loan provisions early in the marketing year to avoid the
                       greatest amount of storage costs.


                       The analysis in the previous section assumes that the posted county price
Benefits Can Differ,   and the price offered to the producer (hereafter known as market price)
Depending on Market    are the same. However, because the posted county price is based on the
Conditions             previous day’s terminal prices and lags behind the market, it could be
                       lower or higher than the market price. The total benefit that a producer
                       receives depends on the relationship between the posted county price and
                       the market price. As shown in table I.2, producers benefit more when the
                       posted county price is lower than or equal to the market price than they do
                       when the posted county price is above the market price. According to USDA
                       officials, marketing loan gains are most likely to be made to producers
                       when the posted county price is lower than or equal to the market price.
                       When the posted county price is above the market price, producers would
                       generally be expected to wait until the U.S. price rose or the posted county



                       Page 28       GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
                                             Appendix I
                                             Calculating the Benefits From Using the
                                             Marketing Loan Provisions




                                             price fell before they redeemed their loans. However, the amount of time
                                             producers are willing to wait for higher prices will depend on the tradeoff
                                             between their expected price gains, additional storage costs, and their
                                             expectations about future market prices.


Table I.2: Total Returns That Producers Receive at Harvestime Depend on the Relationship Between the Market Price and
the Posted County Price
                                                                           Posted county price is     Posted county price is
                                                 Posted county price is     lower than the market    higher than the market
Factors in calculating the benefit            equal to the market price                     price                     price
Loan rate for corn                                                   $1.89                           $1.89                    $1.89
Posted county price for corn                                          1.60                            1.60                     1.60
Market price for corn                                                 1.60                            1.65                     1.55
Producer redeems the loan at the posted
county price and receives a marketing loan
gain of                                                 0.29 = (1.89 - 1.60)            0.29 = (1.89 - 1.60)     0.29 = (1.89 - 1.60)
Producer then sells the commodity at the
market price and receives                                             1.60                            1.65                     1.55
Total returns
(marketing loan gain plus market price)                $1.89 = (0.29 + 1.60)           $1.94 = (0.29 + 1.65)   $1.84 = (0.29 + 1.55)




                                             Page 29       GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
Appendix II

Detailed Analyses of the Impact of the
Marketing Loan Provisions on U.S. Prices
for Cotton, Rice, Wheat, Feedgrains, and
Oilseeds
               This appendix provides our detailed analyses of the effects of the
               marketing loan provisions on U.S. prices for cotton, rice, wheat,
               feedgrains, and oilseeds.


               Over the last 10 years, when the marketing loan provisions were in effect,
Cotton         U.S. and world cotton prices were above the loan rate for all but 35
               months,1 and producers did not use the marketing loan provisions to
               redeem their loans. During the 35 months when the adjusted world price
               was below the loan rate, producers received about $2.6 billion in
               marketing loan gains and loan deficiency payments. Figure II.1 shows the
               relationship between the adjusted world price, the U.S. price, and the loan
               rate for this period.




               1
                We did not include marketing year 1986 as part of our analysis because during that period the
               government was releasing excess cotton that it had accumulated in previous years. This excess supply
               drove U.S. prices below the loan rate.



               Page 30         GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
                                               Appendix II
                                               Detailed Analyses of the Impact of the
                                               Marketing Loan Provisions on U.S. Prices
                                               for Cotton, Rice, Wheat, Feedgrains, and
                                               Oilseeds




Figure II.1: Relationship Between the Adjusted World Price, U.S. Price, and Loan Rate for Cotton, 1986-95
Cents/lb.

   110



   100



    90



    80



    70



    60



    50



    40



    30



    20



    10
         Aug-86    Aug-87      Aug-88      Aug-89    Aug-90     Aug-91    Aug-92     Aug-93    Aug-94    Aug-95
                                                    Months
              Loan rate
              U.S. spot price for cotton
              Adjusted world price

                                                                                                              (Figure notes on next page)




                                               Page 31        GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
    Appendix II
    Detailed Analyses of the Impact of the
    Marketing Loan Provisions on U.S. Prices
    for Cotton, Rice, Wheat, Feedgrains, and
    Oilseeds




    In 1995 cents per pound

    Source: GAO’s analysis of USDA’s data.




    As shown in figure II.1, U.S. prices fell below the loan rate for only 5 of the
    35 months that world cotton prices were below the loan rate, and in only 2
    of the 5 months was the U.S. price below the loan rate by more than 1 cent
    per pound. These price data might suggest that the marketing loan
    provisions were not working and that the loan rate was creating a floor for
    U.S. prices. However, this conclusion may be premature because during
    the last 10 years, several other program features, some of which no longer
    exist, and market factors contributed to keeping U.S. prices higher than
    adjusted world prices and the loan rate. These program features include
    the option value of the loan resulting from the availability of the loan at a
    particular loan rate, the availability of government-paid storage, quotas on
    imports, and, in the past, the availability of a loan extension and
    restrictions on production. These features have allowed producers to store
    their cotton under loan until either price conditions become more
    favorable or they can forfeit the cotton to the government. To overcome
    the disincentives created by the program features and to get cotton out of
    storage and to the market, cotton buyers (domestic textile mills and
    exporters) have had to pay premium prices. These premiums have kept
    U.S. prices higher than the adjusted world prices. In addition, U.S. cotton
    producers receive premium prices because of a number of market factors,
    such as confidence that the terms of the contract will be fulfilled (known
    as contract sanctity/reliability), high-quality standards, and transportation
    advantages. These program features and market factors are discussed
    below.

•   Option value of the loan. The option to hold cotton under a nonrecourse
    loan has a value known as the option value of the loan. The loan rate
    guarantees producers a minimum price and makes it easier for them to
    keep cotton off the market while waiting for prices to rise. Therefore,
    unless producers are offered a premium price that compensates them for
    giving up their option to continue to keep cotton under loan, they have
    little incentive to take cotton out of loan. Buyers are willing to pay a
    premium price because when they acquire cotton, they can continue to
    keep the cotton they acquire under loan, retaining some of the option
    value.2 The option value of the loan increases at higher loan rates (or

    2
     Buyers retain less than the full option value of the loan because they have to pay producers a
    premium to acquire the cotton that is under loan.



    Page 32         GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
    Appendix II
    Detailed Analyses of the Impact of the
    Marketing Loan Provisions on U.S. Prices
    for Cotton, Rice, Wheat, Feedgrains, and
    Oilseeds




    decreases at lower rates) because the level of the loan rate determines the
    degree of price protection.
•   Government-paid storage. For cotton alone, the government pays storage
    costs when the adjusted world price nears or drops below the loan rate. As
    a result, producers can keep cotton off the market at no cost to them. This
    government-paid storage increases the option value of the loan and
    therefore increases the price that buyers will pay for cotton. In the past,
    the government also paid storage costs for up to 60 days prior to the time
    the cotton was placed under loan. However, beginning with the 1996 crop
    year, the U.S. Department of Agriculture (USDA) has changed its
    regulations so that government-paid storage costs will be limited to the
    period of time when the cotton is actually under loan. Producers will be
    responsible for all storage charges that accrue prior to that time.
•   Import quotas and transportation costs. Import quotas and high
    transportation costs largely inhibit domestic textile mills from importing
    cotton. Therefore, except under certain conditions when the U.S. price is
    significantly higher than the adjusted world price, U.S. producers have a
    captive domestic market and do not have to compete against foreign
    producers who are selling cotton at lower world prices. For example, the
    step 3 provision allows specified amounts of cotton imports when the U.S.
    price is substantially above the adjusted world price for a significant
    period of time.
•   Contract sanctity/reliability. USDA officials told us that foreign buyers of
    U.S. cotton are willing to pay a premium price because less risk is
    associated with this purchase. Buyers can expect the terms of the contract
    to be fulfilled and the product, as specified, to be delivered as promised.
•   High-quality standards. USDA officials told us that the reliable quality of
    U.S. cotton is one of the market factors that results in a premium price for
    U.S. cotton. High-quality standards and strict grading procedures applied
    to U.S. cotton reduce the buyer’s risk that is frequently associated with
    purchasing cotton in a foreign market.
•   Loan extension. The 1996 farm act eliminated the provision that had
    allowed producers to extend their loans for an additional 8 months, which
    had provided a total loan period of 18 months. The elimination of the
    extension will reduce the option value of the loan in the future because
    producers will have less time to keep their cotton under loan while waiting
    for prices to rise. USDA officials told us that the elimination of the
    extension is particularly important because the loan will no longer span 2
    crop years.




    Page 33       GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
    Appendix II
    Detailed Analyses of the Impact of the
    Marketing Loan Provisions on U.S. Prices
    for Cotton, Rice, Wheat, Feedgrains, and
    Oilseeds




•   Production restrictions. Prior to the 1996 farm act, production
    restrictions—acreage set-asides and the 50/85/92 program3—reduced
    supply to some extent, and prices were higher because less cotton was
    available on the market. The 1996 farm act eliminated these production
    restrictions. This change should have a downward effect on U.S. cotton
    prices in the future.

    Furthermore, U.S. cotton prices are higher than the adjusted world price
    because the adjusted world price is based on the cost of transporting U.S.
    cotton to Northern Europe. USDA estimates the world price for cotton from
    average prices quoted in Northern Europe, adjusts the world price for U.S.
    quality differences, and subtracts the cost of transporting cotton from the
    United States to Europe—about 12 cents per pound—to arrive at an
    adjusted world price. Domestic buyers incur only a 5-cents-per-pound cost
    of transporting cotton to domestic mills. As a result, domestic buyers gain
    a price advantage of 7 cents per pound on the value of the cotton they
    purchase. This price advantage contributes to the price premium that
    buyers offer to cotton producers to persuade them to take cotton out of
    storage and sell it rather than hold it and eventually forfeit it to the
    government.

    In addition, because USDA sets the adjusted world price weekly and U.S.
    prices change daily, buyers and producers can take advantage of the
    fluctuating differences between the two prices and further increase their
    returns from the program. Finally, because the adjusted world price is a
    price based on a formula rather than a market-determined price, cotton
    industry officials we spoke to stated that it may not accurately reflect
    actual world cotton prices and therefore may not be a good measure of
    U.S. competitiveness.

    Because all the factors mentioned above result in premium prices for U.S.
    cotton, it cannot be determined whether the loan rate will still act as a
    price floor under the marketing loan provisions until market conditions
    cause the adjusted world price to drop far enough below the loan rate to
    overcome the price premium. During the last 10 years, for 33 of the 35
    months when the adjusted world price was below the loan rate by at least
    1 cent, the adjusted world price would probably have had to fall even
    further below the loan rate to counter the effect of the premium and cause
    U.S. prices to fall below the loan rate. It is not possible to predict whether

    3
     Under the 50/85/92 program, producers who planted at least 50 percent of the acres enrolled in the
    program (less acreage reduction program and other program requirements) and devoted the rest to
    conservation practices were allowed to receive payments on either 85 or 92 percent of their eligible
    acres.



    Page 34         GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
       Appendix II
       Detailed Analyses of the Impact of the
       Marketing Loan Provisions on U.S. Prices
       for Cotton, Rice, Wheat, Feedgrains, and
       Oilseeds




       market conditions during the life of the 1996 farm act will result in the use
       of the marketing loan provisions and whether the adjusted world price will
       fall low enough to fully counter the premium and allow the U.S. price to
       fall below the loan rate.4


       During the last 10 years, when the marketing loan provisions were in effect
Rice   for rice, the adjusted world price was below the loan rate in 81 months.5
       During 21 of these 81 months, when the adjusted world price was
       particularly low, the U.S. price fell below the loan rate. Unlike the
       inconclusive cotton data, the data for rice suggest that when market
       conditions result in an adjusted world price that is substantially lower than
       the loan rate, the marketing loan provisions prevent the loan rate from
       serving as a price floor. Figure II.2 shows the relationship between the
       adjusted world price, U.S. price, and loan rate for rice for August 1986
       through August 1996.




       4
        USDA does not publish forecast prices for cotton.
       5
        We did not include as part of our analysis the period from January 1986 through October 1987 because
       over this period the government was releasing excess rice stocks that it had accumulated in previous
       years. This excess supply drove U.S. prices below the loan rate. The 81 months occurred from
       November 1987 through July 1996.



       Page 35         GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
                                               Appendix II
                                               Detailed Analyses of the Impact of the
                                               Marketing Loan Provisions on U.S. Prices
                                               for Cotton, Rice, Wheat, Feedgrains, and
                                               Oilseeds




Figure II.2: Relationship Between the Adjusted World Price, U.S. Price, and Loan Rate for Rice, August 1986 Through
August 1996

Cents/lb.
12




10




 8




 6




 4




 2
     Aug-86    Aug-87     Aug-88      Aug-89     Aug-90     Aug-91     Aug-92     Aug-93    Aug-94    Aug-95
                                                           Months

         Loan rate
         Rice prices received by farmers
         Adjusted world price
                                                                                                             (Figure notes on next page)


                                               Page 36       GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
    Appendix II
    Detailed Analyses of the Impact of the
    Marketing Loan Provisions on U.S. Prices
    for Cotton, Rice, Wheat, Feedgrains, and
    Oilseeds




    In 1995 cents per pound

    Source: GAO’s analysis of USDA’s data.




    Regardless of the availability of the marketing loan provisions, the U.S.
    price will generally remain higher than the adjusted world price because of
    several factors that cause buyers to pay a premium for U.S. rice. In
    addition to the option value resulting from the availability of the loan at a
    particular loan rate, other factors that result in a premium price include
    contract sanctity/reliability, high-quality standards, and significant tariffs
    and transportation costs that limit imports. Moreover, the method used to
    calculate the adjusted world price may contribute to keeping the U.S. price
    higher than the adjusted world price. Each of these factors is discussed
    below.

•   Option value of the loan. As in the case of cotton, the option to hold rice
    under loan has a value because the loan rate guarantees producers a
    minimum price, making it easier to keep rice off the market. In addition,
    under the marketing loan provisions, interest that has accrued on the loan
    is forgiven when the loan is repaid at the adjusted world price. According
    to one rice industry official, because the adjusted world price for rice has
    been below the loan rate for long periods of time, the loan has essentially
    become interest-free. Domestic rice millers and exporters recognize the
    value of this “interest-free loan” and are willing to pay premium prices to
    producers.
•   Contract sanctity/reliability. USDA officials and industry representatives
    agree that U.S. rice buyers are willing to pay a premium price for U.S. rice
    because less risk is associated with this purchase. Buyers can expect the
    terms of the contract to be fulfilled and the product, as specified, to be
    delivered as promised. Sellers from other countries are generally not able
    to back their products with the same level of contract sanctity and
    reliability.
•   High-quality standards. High-quality standards and strict grading
    procedures applied to U.S. rice reduce the buyer’s risk that is frequently
    associated with purchasing rice in a foreign market. Industry officials told
    us that the quality of U.S. rice is consistently better than the same type of
    rice produced by any other country. This quality advantage is reflected in a
    higher price for U.S. rice.
•   Import tariffs and transportation costs. Even though rice does not have an
    import quota like cotton, it does have an import tariff of up to 35 percent,




    Page 37        GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
                     Appendix II
                     Detailed Analyses of the Impact of the
                     Marketing Loan Provisions on U.S. Prices
                     for Cotton, Rice, Wheat, Feedgrains, and
                     Oilseeds




                     depending on the country and/or quality of rice. In addition, according to
                     industry officials, significant transportation costs are incurred when
                     shipping rice to the United States. Because of both the tariff and the
                     transportation costs, as well as concerns about quality and reliability, only
                     a small quantity of rice is imported into the United States. Consequently,
                     the lack of competition in the U.S. market from lower-priced imports helps
                     keep the U.S. price higher than the adjusted world price. In commenting
                     on a draft of this report, USDA officials disagreed with the importance of
                     tariffs in protecting the U.S. rice market. Currently, the rice that is
                     imported is almost exclusively rice varieties not grown in the United
                     States. However, these officials did not address the question of how much
                     rice similar to U.S.-grown rice might be imported if the tariff were not as
                     high.

                     As in the case of cotton, the adjusted world price may not consistently
                     reflect actual world prices. Since there is no readily available source of
                     world market prices for rice, USDA has to calculate a world price for rice on
                     the basis of actual transaction prices in international rice markets. This
                     world price is then adjusted for transportation costs and some quality
                     differences. Even though the adjusted world price is based on market data,
                     it is still a formula-based price and may not represent actual world market
                     conditions. Moreover, the formula USDA uses to determine the world price
                     and adjusted world price for rice is not publicized, as it is for cotton.
                     According to one USDA official, the formula is not publicized to prevent
                     price manipulation by foreign competitors and domestic producers.
                     However, the formula’s confidentiality has led experts to question its
                     validity. Some industry officials we spoke to stated that the adjusted world
                     price for rice is set too high, while some agricultural economists stated
                     that it is set too low. Setting the adjusted world price too low would
                     increase the premium paid by domestic buyers for U.S. rice.

                     The forecasts of USDA and others indicate that while U.S. prices are
                     expected to remain above the loan rate for the 7-year duration of the 1996
                     farm act, world prices are predicted to be lower than the loan rate in some
                     of those years. If the adjusted world price falls far enough below the loan
                     rate, producers’ use of marketing loan provisions should allow U.S. prices
                     to also fall below the loan rate.


                     For wheat, feedgrains, and oilseeds, the historical data needed to assess
Wheat, Feedgrains,   the effect of the marketing loan provisions are limited. Unlike the cotton
and Oilseeds         and rice programs, which have over a decade of experience with the



                     Page 38       GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
Appendix II
Detailed Analyses of the Impact of the
Marketing Loan Provisions on U.S. Prices
for Cotton, Rice, Wheat, Feedgrains, and
Oilseeds




marketing loan provisions, oilseeds have had these provisions in effect
only since 1991 and wheat and feedgrains only since 1993. Moreover, since
the marketing loans were authorized for these commodities, U.S. prices
have generally been above the loan rates, and the federal government has
spent only a limited amount on marketing loan gains and loan deficiency
payments. The marketing loan provisions were used only in crop years
1993 and 1994 for wheat and feedgrains, and gains were realized on only a
small percentage of the total U.S. production of these commodities.
However, for oilseeds, these provisions were used for crop years 1991
through 1994. Table II.1 provides information on the total quantity of
wheat, feedgrains, and oilseeds produced in crop years 1993 and 1994; the
percent of total production realizing marketing loan benefits; and the
average marketing loan gain or loan deficiency payment received.




Page 39       GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
                                          Appendix II
                                          Detailed Analyses of the Impact of the
                                          Marketing Loan Provisions on U.S. Prices
                                          for Cotton, Rice, Wheat, Feedgrains, and
                                          Oilseeds




Table II.1: Marketing Loan Benefits (Marketing Loan Gains and Loan Deficiency Payments) for Wheat, Feedgrains, and
Oilseeds, Crop Years 1993-94
                                                                  Percent of total
                                                             production receiving  Average marketing           Average loan
                                                                  marketing loan loan gain per bushel deficiency payment
Commodity                  Yeara     Total quantity produced            benefitsb              or cwt.    per bushel or cwt.
Wheat                    1993                 2,396 mil. bu.                        0.36                   $0.12                     $0.10
                         1994                 2,320 mil. bu.                       0.005                        0                     0.12
Feedgrains
Corn                     1994                10,103 mil. bu.                       1.020                    0.02                      0.04
Barley                   1993                   398 mil. bu.                       0.005                        0                     0.10
                         1994                   375 mil. bu.                       0.004                        0                     0.10
Oats                     1994                   230 mil. bu.                       0.011                        0                     0.07
Sorghum                  1994                   655 mil. bu.                       0.055                        0                     0.03
Oilseeds
Flaxseed                 1993                 3.480 mil. bu.                       67.13                    0.60                      0.77
                         1994                 2.922 mil. bu.                       23.99                        0                     0.11
Soybeans                 1993                 1,871 mil. bu.                       0.001                    0.03                            0
                         1994                 2,558 mil. bu.                       0.001                        0                     0.02
Sunflowers               1994               48,361,850 cwt.                         1.55                    0.14                      0.15
Canola                   1993                2,524,500 cwt.                        18.25                    1.02                      0.67
Rapeseed                 1993                   74,420 cwt.                         7.24                        0                     1.11
                                          Legend: bu.— bushel
                                          cwt. — hundredweight
                                          mil. — million

                                          Note: No benefits were realized for these commodities in crop year 1995 because U.S. prices and
                                          the alternative repayment rates were above the loan rates.
                                          a
                                            For some commodities, payments were made only in a single year. Therefore, for those
                                          commodities, information is provided for the year when payments were made. bMarketing loan
                                          benefits include both marketing loan gains and loan deficiency payments made in any given year.

                                          Source: GAO’s analysis of USDA’s data.



                                          Generally, marketing loan gains and loan deficiency payments were made
                                          for a small share of the total production during crop years 1993 and 1994.
                                          For example, for corn, total marketing loan benefits (marketing loan gains
                                          and loan deficiency payments) were realized on 1 percent of the total
                                          bushels produced in crop year 1994. Five states (Illinois, Indiana,
                                          Michigan, Ohio, and Wisconsin) received about 95 percent of the total loan
                                          deficiency payments made for corn in crop year 1994. The average
                                          marketing loan gain for corn was $0.02 per bushel in crop year 1994, and




                                          Page 40        GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
    Appendix II
    Detailed Analyses of the Impact of the
    Marketing Loan Provisions on U.S. Prices
    for Cotton, Rice, Wheat, Feedgrains, and
    Oilseeds




    the average loan deficiency payment was $0.04 per bushel. Furthermore,
    50 percent of the loan deficiency payments made to corn producers in
    crop year 1994 occurred when the alternative repayment rate was no more
    than 3 cents below the loan rate. With less than a 2-percent difference
    between the repayment rate and the loan rate, it is difficult to determine
    whether the loan rate was acting as a price floor for corn during that year.

    Even if additional data were available, particular aspects of each
    commodity’s program and market features make it difficult to reach firm
    conclusions about the performance of the marketing loan provisions in
    allowing U.S. market prices for wheat, feedgrains, and oilseeds to drop
    below the loan rates.6 For example:

•   For wheat, only one county loan rate applies to all five classes of wheat,
    but there are five alternative repayment rates. The average county loan
    rate may be set too high or too low for a particular class of wheat. As a
    result, for some classes of wheat, the fact that forfeitures occurred would
    not necessarily indicate that the loan rate was supporting prices but rather
    that the loan rate provided a price advantage not normally supported by
    the market.
•   For wheat, corn, and other feedgrains, the market is becoming more
    specialized because some buyers are willing to pay a premium for certain
    quantities of grain with specific characteristics. Such contractual
    arrangements result in several U.S. prices existing simultaneously, some of
    which could be above the loan rate because of price premiums. It is
    therefore difficult to assess, at any given time, whether the loan rates are
    supporting prices or whether the contractual arrangements are keeping
    prices higher than the loan rates.
•   For oilseeds, since 1991, most payments under the marketing loan
    provisions have been made for minor oilseeds.7 However, little price
    information exists for these commodities because many of the minor
    oilseeds are grown under contract or are thinly traded. For example,
    flaxseed received marketing loan benefits on almost 70 percent of the total
    crop produced in crop years 1991 through 1993. But most of this crop was
    grown under contract and little price information is available, according to
    a USDA official. Moreover, because flaxseed is a thinly traded commodity,
    determining its alternative repayment rates is also difficult. Limited price



    6
     Other government programs, such as the Export Enhancement Program, may also influence U.S.
    prices for wheat, feedgrains, and oilseeds.
    7
     Minor oilseeds include sunflower seed, canola, rapeseed, safflower, flaxseed, and mustard seed.
    Soybeans are not a minor oilseed.



    Page 41         GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
Appendix II
Detailed Analyses of the Impact of the
Marketing Loan Provisions on U.S. Prices
for Cotton, Rice, Wheat, Feedgrains, and
Oilseeds




data make it difficult to assess whether the loan rate is acting as a price
floor.

In addition, for wheat, feedgrains, and oilseeds, the method that USDA uses
to calculate the alternative repayment rates—posted county
prices—hinders an assessment of the marketing loan provisions’
effectiveness in allowing U.S. prices to drop below the loan rates. USDA
determines each county’s posted county price, daily for wheat, feedgrains,
and soybeans, and weekly for minor oilseeds,8 by using the appropriate
terminal price9 from the previous day or week, adjusted for transportation
costs and other factors. Because the terminal price may not reflect local
county market conditions, the posted county price is not always consistent
with local prices. Moreover, because posted county prices measure the
previous day’s or week’s terminal prices, they do not incorporate new
information that may affect prices on a particular day. As a result, in some
instances, the posted county price may be set below the loan rate when
actual market conditions warrant a posted county price above the loan
rate. In these cases, it may appear that the loan rate is supporting the U.S.
price, when in actuality the posted county price may not be reflecting local
county market conditions and prices. (See app. I for more information on
how the relationship between the posted county price and the U.S. price
affects the benefits producers receive under the marketing loan
provisions.)

Lacking conclusive data, USDA officials, agricultural economists, and other
commodity analysts disagree on the extent to which the marketing loan
provisions will prevent the loan rates from acting as price floors for wheat,
feedgrains, and oilseeds. Many USDA officials and agricultural economists
we spoke to expect that the marketing loan provisions for wheat,
feedgrains, and oilseeds will work largely as intended if alternative
repayment rates fall below the loan rates. They expect these provisions to
be most effective when prices fall substantially below the loan rates and
remain there for a significant period of time. For example, one USDA
official told us that producers used the generic commodity certificate




8
 For minor oilseeds, the alternative repayment rate is calculated at a regional level instead of at the
county level.
9
 A terminal price is derived from a terminal market, which is a major U.S. market where commodity
transactions occur. USDA assigns two terminal markets to most counties and calculates a price
differential for each terminal that reflects transportation costs and other factors that influence local
prices. For each commodity, USDA uses the assigned terminals’ closing prices, applies the relevant
differentials, and then uses the higher of the two as the posted county price.



Page 42          GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
Appendix II
Detailed Analyses of the Impact of the
Marketing Loan Provisions on U.S. Prices
for Cotton, Rice, Wheat, Feedgrains, and
Oilseeds




program10 during a period of low prices in the 1980s. Therefore, he stated
that it is likely that producers will use the marketing loan provisions if the
posted county prices fall substantially below the loan rates in the future.
Moreover, these experts stated that when prices are below the loan rates,
it will be to the producers’ advantage to use the marketing loan provisions
because the producers must pay for storage if they choose not to sell.11
Producers would usually gain from using the marketing loan provisions
and selling their crops instead of forfeiting them because they would not
incur the storage costs they would have had to pay if they had held their
commodity for the full term of the loan and then forfeited it. (See app. 1
for further discussion on producers’ marketing loan gains.) These experts
also stated that because producers would be willing to accept lower prices
for their commodities and use the marketing loan provisions, loan rates
would no longer act as price floors, and forfeitures would be unlikely to
occur.

However, a few agricultural economists and commodity analysts offer
several reasons why the loan rate may at times provide some price support
despite the marketing loan provisions. For example, some told us that
when U.S. prices and posted county prices are slightly below loan rates, a
temporary resistance prevents prices from falling further below the loan
rate. This happens because the gain from using marketing loan provisions
may not be enough to overcome the transaction costs12 associated with
using the provisions. In this case, producers may continue to hold their
commodities under loan and temporarily keep U.S. prices above or at the
loan rates. These experts stated that if supply and demand conditions
warrant prices falling further below loan rates, this resistance is most
likely to disappear. Some also stated that the loan rate may at times
provide price support because the option value of the loan is relatively
large compared with the potential savings from avoiding storage costs. If
so, producers may prefer to keep their commodities under loan and forfeit
them if prices remain low despite the marketing loan provisions. In
addition, the greater the option value of the loan, the greater resistance

10
 The 1985 farm act authorized USDA to issue generic commodity certificates to make in-kind
payments to producers participating in government commodity programs. Producers receiving
certificates could exchange them at the posted county prices for commodities placed under loan,
exchange them for government-owned commodities, or sell them for cash.
11
  Except for cotton, producers who place their commodity under loan are responsible for paying all
storage costs. Commodities may be stored on the farm or at a warehouse; on-farm storage may cost
less than warehouse storage. Because USDA requires producers to pay storage costs in advance for
the 9-month loan term when placing a commodity under loan, total storage costs to the producer
include the actual cost of storage as well as the interest foregone on the advance payment.
12
  Producers incur transaction costs when they obtain a marketing loan from USDA. These transaction
costs include both measurable costs, such as a loan service fee, as well as unmeasurable costs, such as
filling out paperwork and visiting the loan office.


Page 43         GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
Appendix II
Detailed Analyses of the Impact of the
Marketing Loan Provisions on U.S. Prices
for Cotton, Rice, Wheat, Feedgrains, and
Oilseeds




loan rates will provide against falling prices. Furthermore, because the
posted county prices are sometimes not consistent with local U.S. prices,
some agricultural economists told us that if posted county prices are
higher than the local county prices, producers may have little incentive to
use the marketing loan provisions and may choose to forfeit their
commodities. The extent to which this may occur depends on the actual
differences between the posted county prices and U.S. prices and the
potential to avoid storage costs by redeeming loans at the posted county
prices.

According to 1996 forecasts by USDA and others, U.S. prices for wheat,
feedgrains, and soybeans are expected to be above the loan rates for the
next several years. Under these market conditions, the marketing loan
provisions will not be used. However, during 1996, prices for wheat and
feedgrains fell substantially. For example, cash prices for corn fell from a
high of $5.25 per bushel on July 11, 1996, to a low of $2.51 per bushel on
November 5, 1996.13 (Some of this difference was due to seasonal
variations.) If prices continue to fall to levels near the loan rate of $1.89,
then producers may use the marketing loan provisions.




13
 These corn prices represent central Illinois daily spot prices. USDA calculates this price from the
midpoint of the high and low prices from a sample of 30 central Illinois elevators.



Page 44         GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
Appendix III

Additional Changes Made to the Peanut
Program in the 1996 Farm Act and Their
Impact on the U.S. Peanut Market
                            The 1996 farm act lowered the quota support price for peanuts to reduce
                            U.S. peanut prices and the cost of the peanut program to the government.
                            This appendix discusses additional changes made to the peanut program
                            and their effect on the U.S. peanut market. This appendix also includes an
                            economic analysis of the effect of the reduced quota support price on the
                            national poundage quota and on the U.S. peanut market.


                            In addition to the reduction in the quota support price, discussed on page
1996 Farm Act               15, other changes were made to the peanut program in the 1996 farm act:
Changes to the Peanut       elimination of the legislatively set minimum national poundage quota;
Program                     authorization to increase marketing assessments; elimination of provisions
                            allowing the carryover of unfilled quota from year to year
                            (undermarketings); redefinition of the peanut quota to exclude seed
                            peanuts; limits on transfer payments (known as disaster transfers) made
                            to quota holders whose commodity is of lesser quality; and added
                            marketing requirements for maintaining program eligibility. These changes
                            should enable USDA to better control the quantity of peanuts marketed at
                            the quota support price, thus reducing the government’s costs associated
                            with the program. In addition, out-of-state nonfarmers and government
                            entities can no longer hold quota; and the annual sale, lease, and transfer
                            of quota is now permitted across county lines within a state, up to
                            specified amounts of quota. These changes will improve the equity and
                            economic efficiency of the peanut program. The following discusses these
                            changes in detail:

                        •   National poundage quota. The 1996 farm act eliminated the minimum level
                            for the national poundage quota, which refers to the quantity of peanuts
                            that can be marketed domestically at the support price. The minimum
                            quota is no longer fixed at 1.35 million tons by legislation. Instead, if
                            conditions warrant, the national poundage quota may fall to lower levels.
                            For crop year 1996, USDA set the quota at 1.1 million tons—0.25 million
                            tons less than the minimum set under the previous legislation. This lower
                            quota is intended to be more in line with the estimated quantity of peanuts
                            demanded at the $610 per ton support price. If market conditions change
                            in the future, USDA now has the ability to match the quota to the changing
                            quantity demanded at the fixed support price. In addition, if the quota is
                            set to equal the quantity of peanuts demanded at the support price,
                            government costs for the program should be minimized. This is because
                            the government would not have to purchase surplus peanuts to maintain
                            the quota support price.




                            Page 45     GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
    Appendix III
    Additional Changes Made to the Peanut
    Program in the 1996 Farm Act and Their
    Impact on the U.S. Peanut Market




•   Marketing assessments. The 1996 farm act provides USDA with the
    authority to increase future marketing assessments if marketing
    assessments in the current year do not cover all losses incurred from
    operating the peanut loan program. According to USDA officials, this
    provision will help ensure that the peanut program operates at no net cost
    to the Treasury.
•   Undermarketings. The 1996 farm act further enhanced USDA’s ability to set
    the quota by no longer allowing the carryover of quota from year to year
    when producers are unable to produce enough peanuts to meet their
    quota. The amount of peanuts represented by the quota carried over to the
    next year was known as undermarketings. Previously, these
    undermarketings were in addition to the national poundage quota set for
    the year. By eliminating undermarketings, the 1996 farm act improved
    USDA’s ability to control the quantity of peanuts marketed at the quota
    support price.
•   Seed peanuts. For the 1996 through 2002 crop years, producers will be
    allocated a temporary quota for peanuts to be used as seed. Previously,
    producers had to purchase quota peanuts rather than less expensive
    additional peanuts for seed. The new quota for seed in effect reimburses
    producers for the extra expense of using the quota peanuts. Under the
    previous legislation, the national poundage quota was based on domestic
    edible, seed, and related uses. Now the national poundage quota will not
    include seed use. The quota for seeds will be in addition to the national
    poundage quota. Also, the quota for seeds will be temporary and will only
    apply to the seeds used in the year the quota is issued. While the separate
    quota for seeds may increase the total quantity of quota, it ensures that the
    national poundage quota represents more closely only those peanuts
    marketed for edible use.
•   Disaster transfers. Under the previous legislation, quota peanut producers
    who harvested a crop but were unable to market it commercially because
    it had been damaged by weather, insects, or disease were protected from a
    loss in income by disaster transfer payments. To qualify for the transfer
    payment, producers placed their damaged peanuts into the government’s
    additional peanuts loan program and received the support price
    established for additional peanuts. Furthermore, they received the disaster
    transfer payment, which is the difference between the higher quota
    support price and the support price for additional peanuts. These transfer
    payments ensured that quota holders received the quota support price
    regardless of the quality of the peanuts they produced. Under the new
    legislation, disaster transfers are limited to 25 percent of the producer’s
    quota and 70 percent of the quota support price.




    Page 46       GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
                            Appendix III
                            Additional Changes Made to the Peanut
                            Program in the 1996 Farm Act and Their
                            Impact on the U.S. Peanut Market




                        •   Marketing requirements for maintaining program eligibility. Producers
                            who market 100 percent of their quota peanuts through a marketing
                            association loan for 2 consecutive years shall be ineligible for price
                            support the next crop year if during the prior 2 years they received and did
                            not accept a written offer from a buyer for at least the quota support price.
                        •   Reallocation of peanut quota held by out-of-state nonproducers or
                            government entities. Effective with the 1998 crop year, peanut quota may
                            no longer be held by people who are not peanut producers or whose
                            primary residence and place of business is located outside the state in
                            which the quota is allocated. In addition, peanut quota will be forfeited for
                            farms owned or controlled by municipalities, airport authorities, schools,
                            colleges, refuges, and other public entities. The forfeited quota will be
                            allocated to other eligible producers in the state. The change made
                            pursuant to the 1996 farm act will help ensure that peanut producers,
                            rather than peanut quota holders who do not produce peanuts, are the
                            beneficiaries of the peanut program.
                        •   Transfer of peanut quota across county lines. The 1996 farm act allows for
                            the annual transfer of the peanut quota across county lines within the
                            same state for counties with less than 50 tons of quota. For counties with
                            more than 50 tons of quota, the amount of transfer is limited to 40 percent
                            of the quota in the transferring county as of January 1, 1996. The
                            cumulative out-of-county transfers for any state, however, may not exceed
                            15 percent for 1996, 25 percent for 1997, 30 percent for 1998, 35 percent for
                            1999, and 40 percent for 2000. The previous legislation allowed the transfer
                            of quota freely across county lines only in those states that had less than
                            10,000 tons of quota and under certain conditions within contiguous
                            counties in the same state.


                            An economic analysis of the effect of the reduced quota support price on
Economic Analysis of        the national poundage quota and on the U.S. market illustrates that as a
the Effect of a             result of changes made under the 1996 farm act, more peanuts will be
Reduced Quota               available at a lower price than under the previous legislation. Additional
                            reductions in the quota support price may further reduce the price of U.S.
Support Price on the        peanuts. The method by which the support price and national poundage
National Poundage           quota interact is shown in figure III.1.1
Quota and on the U.S.
Market

                            1
                             The following article contributed to this analysis: Martin, Laura L. and A. Blake Brown. “Economic
                            Impacts in North Carolina of a Peanut Support Price and Quota Reduction,” Journal of Agribusiness.
                            14-1 (Spring 1996): 95-108.



                            Page 47         GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
                                     Appendix III
                                     Additional Changes Made to the Peanut
                                     Program in the 1996 Farm Act and Their
                                     Impact on the U.S. Peanut Market




Figure III.1: Effect of the Peanut
Program on the Market



                                                       D1                                S
                                                 D2


                                          P1

                                          P2

                                          Pe




                                                       Q3    Q2 Q1 Qe


                                           P1 = Quota support price under previous legislation
                                           P2 = Quota support price under 1996 farm bill
                                           Pe = Price if there were no peanut program
                                                with current demand (D2)
                                           Qe = Quantity consumed if there were no peanut program
                                                with demand curve D2
                                           Q1 = Quantity consumed at the quota support price P1 on D1
                                           Q2 = Quantity consumed at the quota support price P2 on D2
                                           Q3 = Quantity consumed at the quota support price P1 on D2
                                           S = Supply curve
                                           D1 = Demand curve prior to change in consumer taste for peanuts
                                           D2 = Demand curve after change in consumer taste for peanuts




                                     Page 48       GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
Appendix III
Additional Changes Made to the Peanut
Program in the 1996 Farm Act and Their
Impact on the U.S. Peanut Market




This figure is a simplified economic representation of how the peanut
market operates. The supply curve shows the different quantities of
peanuts that producers will offer at each price. The demand curve shows
the different quantities of peanuts that buyers will purchase at each price.

Prior to the 1996 farm act, the support price was set at a level represented
in the figure by P1, and the minimum national poundage quota was set at a
quantity represented by Q1. In recent years, domestic use of peanuts has
fallen short of the minimum national poundage quota set by legislation.
This decline in use is attributed to changes in consumers’ tastes because of
concern about fat in the diet and is represented by a shift in the demand
curve from D1 to D2. Although demand for peanuts declined and only Q3
quantity of peanuts would be purchased on the domestic market at the
quota support price P1, the national poundage quota was fixed by
legislation at Q1. Therefore, USDA could not reduce the quota and had to
buy Q1 minus Q3 quantity of surplus peanuts, increasing the costs
associated with the program. To reduce these costs while maintaining a
support price of P1, USDA would have had to reduce the quota to Q3
quantity of peanuts—the quantity that would have been purchased at the
quota support price P1.

Under the 1996 farm act, the legislatively set minimum national poundage
quota was eliminated and the poundage quota was reduced. The quota did
not need to be reduced to Q3, however, because the quota support price
was also reduced—from P1 to P2. The new quota was set at Q2, the
quantity that would be purchased by the market at the lower support
price, P2. These changes reduce the possibility that the government will
have to purchase surplus peanuts. Under this scenario, buyers purchase a
larger quantity of peanuts at a lower price than under prior legislation,
even though the quota has been lowered. If there were no program,
however, the quantity purchased would be even greater—Qe—and the
price even lower—Pe. For this reason, further reductions in the quota
support price for peanuts, if made, may lower U.S. prices.




Page 49       GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
Appendix IV

Scope and Methodology


              At the request of the Chairman of the House Committee on the Budget, we
              reviewed seven commodity programs—cotton, rice, wheat, feedgrains,
              oilseeds, peanuts, and sugar—to determine how certain support
              provisions that remain operative under the 1996 farm act affect U.S.
              commodity prices in comparison with world prices. The world price must
              be analyzed on a commodity-by-commodity basis because currently there
              are only proxies for world prices. For this review, we used USDA’s proxies
              for the world price for cotton, rice, wheat, feedgrains, and oilseeds. The
              world price for peanuts is derived from the price quoted for U.S. peanuts
              in Rotterdam, adjusted for the cost of shelling and transportation back to
              the United States. The world price for sugar is the Number 11 contract
              price as traded on the New York Coffee, Sugar, and Cocoa Exchange,
              (f.o.b. Caribbean) for raw cane sugar. For this review, when analyzing U.S.
              prices, we used prices that producers receive for cotton, rice, wheat,
              feedgrains, and oilseeds.

              In conducting our review, we obtained data from USDA on payments made
              under the programs for cotton, rice, wheat, feedgrains, and oilseeds, as
              well as information on how the alternative repayment rates are calculated.
              We also spoke with representatives of USDA’s Commodity Credit
              Corporation, Economic Research Service, Farm Service Agency, Foreign
              Agricultural Service, National Agriculture Statistical Service, Office of
              Chief Economist, and county offices. We also spoke to officials from the
              World Bank, academic experts, industry and trade representatives, and
              agricultural commodity consultants. We reviewed various economic and
              international trade studies conducted by universities, management
              consulting groups, USDA, and international agencies.

              We conducted the following analyses to determine if the marketing loan
              provisions prevent loan rates from acting as price floors and allow U.S.
              prices to fall to levels that are closer to adjusted world prices. For cotton
              and rice, we analyzed USDA’s proxies for weekly world prices for crop
              years 1986 through 1995 and the way in which these prices were converted
              to the adjusted world prices used for the marketing loan provisions. To
              understand how the conversions were made, we spoke to officials at the
              Farm Service Agency. We also analyzed weekly spot market prices for
              cotton and producer prices for rice for the same period to understand the
              relationship between the adjusted world price and U.S. prices. To adjust
              prices for inflation, we used the gross domestic product implicit price
              deflator, which is the generally accepted method for determining real
              prices. We also identified other program and market factors that affect
              U.S. prices for cotton and rice.



              Page 50     GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
Appendix IV
Scope and Methodology




To make the same determination for wheat, feedgrains, and oilseeds, we
obtained data on marketing loan benefits from USDA’s Kansas City
Management Office to determine the level and general distribution of
payments for crop years 1993 through 1995. For corn, we also analyzed
posted county prices, loan rates, and market price information to
understand the relationship between these prices for crop year 1994. We
selected corn for our detailed analysis because this was the only
commodity of this grouping for which meaningful price data were
available.

We recognize that our analysis of historical price data to determine the
effectiveness of the marketing loan provisions may be limited in its
applicability to the future. This is because the 1996 farm act has either
eliminated or changed many of the program provisions that were in place
in the past.

To determine the effect of lower loan rates on the relationship between
U.S. and world prices, we spoke with USDA officials, including agricultural
economists, and other agricultural economists who are specialists in each
of the commodities we reviewed. We also reviewed the literature on this
question.

To determine the effect of a lower loan rate on step 2 payments, we
interviewed and obtained documents from USDA officials and spoke to
officials from the National Cotton Council and the International Cotton
Advisory Committee, and to a cotton industry official. To determine the
impacts of the recent changes in the timing of step 2 payments on the
program’s effectiveness, we reviewed regulations and reports from USDA
and others and spoke to officials at USDA, the National Cotton Council, and
the International Cotton Advisory Committee, and to a cotton industry
official.

To identify additional changes that could be made to make the peanuts
and sugar programs more market-oriented, we reviewed legislation and
regulations, as well as reports from USDA. We also interviewed officials at
USDA, in academia, commodity consulting groups, the American Sugar
Alliance, and representatives of sugar grower and processor associations.

We did not independently verify the data used in this report. We conducted
our review from July 1996 through January 1997 in accordance with
generally accepted government auditing standards.




Page 51      GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
Appendix V

Major Contributors to This Report


                       Juliann M. Gerkens, Assistant Director
Resources,             Jay R. Cherlow, Assistant Director for Economic Analysis
Community, and         Carol E. Bray, Senior Economist
Economic               Barbara J. El Osta, Senior Economist
                       Anu K. Mittal, Senior Evaluator
Development Division   Karla J. Springer, Senior Evaluator




(150920)               Page 52    GAO/RCED-97-45 Impact of Support Provisions on Selected Commodity Prices
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