Structure and Coordination Systems: An Assessment of the U.S. Potato Industry

Structure and Coordination Systems: An Assessment of the U.S. Potato Industry By Phil Kaus Prepared for Presentation Agricultural Markets October 12, 1999

Introduction The U.S. potato industry has experienced major changes during the last half of the twentieth century. Consumption patterns have changed dramatically from primarily fresh table consumption to primarily frozen processed products. Production patterns shifted from the northeast U.S. to the northwestern states as the major potato-producing region. Changes in technology and consumption patterns have resulted in a broadening of the industry. This divestiture into different segments resulted in specific marketing channels for the individual segments: fresh, dehydrated, frozen and chipping (Figure 1). The linkages between major divisions in the sector are based on the intended use; however, there is some overlap between some of the segments. In the past, potatoes for fresh consumption sold on the spot market and there were few contractual agreements. Today, processors rely on contracts to ensure even production schedules. The bulk of frozen processed potatoes are marketed via contract to the fast food industry and other food services. A smaller portion is sold through brand-named products through retail outlets. The purpose of this paper is to examine the structure of the industry focusing in particular on the market linkages for the various segments of the potato industry. Although there is some overlap between segments, the variety and quality specifications are different for each segment. The paper concludes with a section analyzing strategic issues and how changing consumption patterns will require diligence in the future. Industry Structure Overview Production There is a potato crop for every season of the year. Crops are classified according to the time of year they are harvested. The four seasonal groups and harvest period are as follows:

Season Usual Time of Harvest Winter January through March Spring April through June Summer July through September Fall September through November (USDA, Potatoes, 9/2/99) The fall potato crop typically comprises ninety percent of yearly production (International Trade Commission (ITC-332-378), 1997). The fall crop is produced in a band of states from the Northeast through the North Central to the Northwest (Marion, 1986). The Northeast was the major growing region during the 1950 s, comprising 29 percent of U.S. production in 1950. By 1984 the production regions had shifted to the Northwest (47 percent), away from the Northeast (12 percent) (Marion, 1986). In recent years, over 90 percent of production occurred in the western U.S. with Idaho (29.7 percent), and Washington (18.7 percent) being the largest producing states. Specific potato types and varieties require different farming techniques. Specific requirements like water, fertilizer, pest control and overall management greatly influence yield and quality. Development of irrigation resulted in production shifting to the western U.S. Potato varieties favor the warm days and cool nights, the well-drained volcanic soils, and low humidity (ITC, 1997). Potato yields that were stagnant in the northeast between 1950 and 1984 increased by 75 percent in the Northwest. Processing Prior to development of efficient transportation systems and processing developments, potatoes were grown close to metropolitan areas for table consumption (Peterson, et al., 1997). In the early 1950 s, engineers for the J.R. Simplot Company discovered a method to effectively freeze potato products through blanching and compressing. In 1959, production of frozen potatoes was 9.9 million cwt., by 1994 frozen potato production had

grown to 162 billion cwt. Frozen french fry production has increased from 8.7 million cwt. to 139 million cwt. over the same time period (Figure 2). This process enabled crop production to concentrate in regions conducive to production. Typically, frozen potato processing facilities are located near the production source. The U.S. Northwest maintains about 70 percent of North American capacity. The rest of the U.S represents 16 percent and Canadian plants are 14 percent of capacity (Peterson et al., 1997). Leading processors in order of capacity for 1996. Table 1 Company Raw Capacity Percent Capacity Lamb-Weston 73.0 m cwt. 29.5% McCain 58.8 23.9 Simplot 52.0 21.1 Nestle 14.5 5.9 Ore-Ida 12.0 4.9 Cavendish 9.0 3.7 All others 27.1 11 TOTAL 246.4 100% (Peterson et al., 1996) The dehydrated and fresh markets tend to be more closely related then other subsectors. Several of the largest dehydrators are also packers of fresh potatoes. Fresh packers use contracts for some of their supply. The potatoes are sorted with those meeting specifications being packed for the fresh market and the remainder going to the dehydrator. Since they can use most varieties and lower qualities, it serves as the residual market. The growth in the dehydrated market (Figure 3) has compensated for the decline in the starch and cattle feeding markets. Dry products are typically used in the food service industry with a small share going to retail markets.

The chipping market has grown in raw equivalents from 20 million cwt. in 1959 to 49.9 million cwt. in 1994 (Figure 4). Chippers tend to be located near the consumer market for both freshness reasons and transportation costs. Although there are a few national recognized brands (Frito-Lay), there are many regional brands that these national brands compete with. Whereas the majority of frozen potatoes are sold to the foodsevice industry, the majority of chips are sold through retail food outlets. Consumption Total per capita potato consumption has increased from 106 lbs./year in 1960 to 140 lbs./year in 1995. During the same time period, fresh consumption has declined from 81 to 50 lbs./year. Frozen potato consumption increased from 7 to 58 lbs./year over the same time period (Figure 5). This indicates a major shift in consumption patterns. Fresh consumption has decreased over the 1960 to 1995 period from 58 to 21 percent while frozen processed consumption had increased from 23 to 67 percent of total consumption (USDA, Potatoes, 1996). Other minor categories of consumption are feed use, starch, and shrinkage and loss. Market Structure and Coordination Potato production at the farm level has followed the same trend as other commodities. The number of farms producing potatoes has decreased significantly over the past 30 years. During the same period, the size of farms has increased significantly and become more specialized. Also, potato production has become more regionally centralized. The National Potato Promotion Board is the national industry organization. Federal marketing orders in the western states set and maintain high size, quality and cosmetic standards for table stock.

There are three principal markets for potatoes in the U.S.: seed, fresh table stock, and processing (Zepp et.al. 1995). In the following, we will describe the last two. Fresh Table Stock Before advancements in the Russet Burbank, the primary table-stock potato, regional markets provided the bulk of consumption needs. Potato quality used to vary with the season, and storage facilities were unable to keep potatoes fresh for extended periods of time. Packer-shippers would obtain fresh potatoes from regional markets that were in season. This caused great variability in spot market prices both seasonally and regionally. During short crop years prices would shoot exceptionally high and during big crop years prices would drop through the floor. Genetic advancements in the Russet and technology advancements in storage now allow storage of up to a year before potatoes spoil. These advancements allowed western producers to capture a large share of the fresh market. This was helped by strong advertising and consumer perception that the Russet is superior for table consumption. The Russet is well suited for the climate in the western states and is one of the primary varieties produced in that region. The spot market remains the coordination in the fresh table market. The fresh market is more lucrative than the processing sector. This is because there is a premium placed on potatoes that meet the size, quality and cosmetic specifications for table consumption. Some mid-west and northeast producers and packer-shippers specializing in the fresh market have integrated growing-packing-shipping operations; however, the use of contracts in minimal except for the potatoes purchased by dehydrators (Marion, 1986).

Industry experts indicated there is minimal use of contracts between shipper-packers and dehydrators for the potatoes that don t meet specifications for fresh table usage. Processing Markets The processing industry is most concentrated in the northwest, where various sources estimate 65 to 70 percent of the Idaho crop and 85 to 90 percent of the Washington crop is processed (Zepp et al., 1995). Most of the processed potatoes from the Northwest are frozen fries. The processing sub-sector consists of three segments: frozen, chipping, and dehydrated. Potatoes for frozen processing primarily are for frozen french fry production. The majority of frozen fries are sold to the fast food industry with McDonalds, Burger King and Wendy s being the major players. Other purchasers of frozen fries are other foodservice and retail outlets. Table 1 showed the major processors, of the major processors the top three all serve the frozen french fry fast food service sector. Ore-Ida and Nestle are the only ones with brand name recognition that serve the retail market. Processor contracts with growers accounts for the majority of processor purchases. Contracts generally determine quantity and price and are signed prior to planting. The term is generally for the production year. A base price is specified with premiums and discounts for variations in quality (Marion, 1986). Industry sources indicated quality discounts include tare (rocks and excess dirt), disease, and bruising (1-cent increase in price per cwt. for every 1- % decrease in bruising below a base level). These contracts typically are not as lucrative as potatoes sold for fresh table consumption but generally

processing potatoes are of lower quality. Grower costs of production are usually less for processing potatoes. Processors typically operate under annual longstanding ongoing agreements with their fast food service customers. Processors are very reliant on the contractual agreements with the their food service customers. Processors that lose a plant contract can result in closure of the plant. These contracts are so important to processors that they typically agree to house company representatives in the plant. This assures the company the processor is meeting quality specifications. Processors of potato chips generally use the same type of production contracts as frozen processors. However, where frozen processors have adequate on-site storage space, chippers generally specify quantity and delivery dates. Location and space constraints of chippers does not allow for the building of large storage facilities. This requires greater coordination with suppliers in order to maintain constant production flows. The flip side is, it increases the storage risk for producers. Instead of the processor suffering storage losses the producer must absorb them. Intra season market swings can greatly affect the base price in the contract and, depending on the delivery date specified in the contract, producers now are more exposed to price swings. Trends in chip processing indicate processors are moving to fewer but larger suppliers. Some producers have formed consortiums in order to provide adequate supplies to chippers; however, this is the general trend in potato production and in most agricultural sectors. It is not clear whether the trend in potato production is any faster than other agricultural sectors.

The dehydrator sub-sector is about one-fourth the size of the frozen processed subsector. The major dehydrator is General Mills (Marion, 1986). Industry sources suggest dehydrators rely on production contracts for about 70 percent of their potato requirements. The other 30 percent are acquired from the spot market and rejects from the fresh market. Again, the production contracts are similar to those previously mentioned. Dehydrators use smaller scale marketing agreements for their product because of the differing scales of food service operations they deal with. Summary The spot market remains as the coordination in the fresh table stock sub-sector. Production contracts are used extensively in the processing sector to plan production schedules. The contracts are signed before planting and specify a base price, quantity and quality. Processing plant viability relies upon long-standing contractual agreements with major fast food service companies. Future Trends The potato industry appears to be maturing. The major U.S. processors have been operating at about 75 percent of capacity for the past four to five years. Growth in consumption of processed goods has slowed dramatically in the last few years. Fresh table stock consumption continues to decline. Import pressure and paltry exports have dampened prices. Most sub-sectors are heavily concentrated; however, the chipping sector still maintains a high number of regional brand named chippers. Consumers value of time has become a very important factor in maintaining a strong potato industry. A large number of consumers come from households where both parents work. Many are raising young families that are active in many sporting and community

events. Meal preparation time has decrease and many families have turned to various food service institutions to meet their consumption needs. This trend will continue and the processed potato sector has positioned itself well. There will be a future demand for high quality prepared meals that the consumer takes home and warms up. The potato industry needs to step into agreements with developers in this area to expand their presence. The demand for American style food is growing in various regions of the world. Fast food chains have attempted to capture some of this market. The ability to adapt fast food frozen potato products to ethnic tastes may be a viable method in expanding consumption in these markets. Conclusions The use of contracts has increased coordination within the sector. This has lead to an increase in efficiency of processors (especially in the chipping sub-sector) as well as producers. Processors are able to plan production schedules according to quantity and quality of inputs they are expecting for the upcoming season. Producers can vary input costs if they know before the season which market they are producing for. Consumer preferences are better transmitted through the chain. Although efficiencies have been improved, spot market prices have probably become more volatile. The spot market has probably become thinner as demand for potatoes for fresh consumption has declined. Also, the potatoes that were sold to processors via the spot market now are sold on contract, dramatically decreasing the volume traded. This could become a future issue because contract base prices typically operate off a quoted spot market price.

The potato industry is maturing. Consumption is declining or growth is slowing for potato products. The expanding prepared meal segment is an excellent opportunity for the industry to capture market share and expand growth in that area. American food has growing demand in many foreign countries. Adapting the potato to ethnic tastes could be a good avenue of growth for the potato industry.

Bibliography International Trade Commission (ITC), Fresh and Processed Potatoes: Competitive Conditions Effecting the U.S. and Canadian Industries, Washington D.C. ITC Report 332-378, July 1997. Interviews with Industry Analysts and Experts, October 1999. Marion, B. The Organization and Performance of the U.S. food System, D.C. Heath and Co., Lexington, MA. Chaper 2, 1986. Peterson, C., David Schweikhardt, Michael Masterovsky, Jon Phillips, and Mary Schultz, Demand and Supply Assessment for the Michigan Frozen Potato Industry, Staff Paper 97-41, Michigan State University, September 1997. Phillips, Jon C., Globalization and the Potential for Frozen Potato Processing in Mexico, Staff Paper 98-04, Michigan State University, April 1998. USDA/NASS, Potato Statistics, Various Tables. USDA/NASS, Potatoes, Various Issues. Zepp, G., Charles Plummer, and Barbara McLaughlin, Potatoes: A Comparison of Canada-U.S. Structure, Canadian Journal of Agricultural Economics, Special Edition 1995. Pp. 165-175. Appendix

Figure 1. Marketing Channels Fresh Market Dehydrated Frozen Chipping r Growing Growing Growing Growing Storage Storage Storage Storage Sorting & Packing Sorting & Packing Processing & Storage Chipping Brokers Wholesaling Processing & storage Wholesaling Wholesaling Retailing Foodservice Retailing Foodservice Retailing Foodservice Retailing Foodservice

Figure 2. Frozen Fry Production 1,000 cwt. 140,000.0 125,000.0 110,000.0 95,000.0 80,000.0 65,000.0 50,000.0 35,000.0 20,000.0 5,000.0 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 Frozen Fry Production

Figure 3. Per Capita Dehy Consumption Pounds per person 20.0 16.0 12.0 8.0 4.0 0.0 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 Dehy Consumption

Figure 4. Per Capita Chip Consumption Pounds per person 20.0 19.0 18.0 17.0 16.0 15.0 14.0 13.0 12.0 11.0 10.0 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 Potato Chip Consumption

Figure 5. Per Capita Frozen Consumption Pounds per person 60.0 50.0 40.0 30.0 20.0 10.0 0.0 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 Frozen Potato Consumption