Optimal Procurement From Multiple Contracts in Agricultural Processing

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ABSTRACTThis paper examines the procurement decisions of an agricultural processor that sources a commodity input from two quantity flexibility contracts, each of which is characterized by a unit reservation cost and a unit exercise cost, to produce and sell a commodity output under input and output spot price uncertainties. We identify the cost‐flexibility trade‐off faced by the processor when making procurement decisions and examine how this trade‐off in different contracts shapes the optimal procurement strategy. We also investigate how the spot price correlation affects the processor's procurement decisions, profitability, and the value of contract procurement; that is, the difference between the optimal expected profit with and without contract procurement. We find that as spot price correlation increases, the processor increases its total contract reservation volumes and the reservation volume from the contract with a lower exercise cost. We also find that while the optimal profit without contract procurement decreases in spot price correlation, the value of contract procurement increases; that is, contracts provide a hedge against increasing spot price correlation. Using a calibration based on a typical palm oil processor in Malaysia, we show that the hedging value does not eliminate the negative impact of an increasing correlation on the processor's profit; that is, the optimal expected profit with contract procurement also decreases in spot price correlation. We also observe that the value of contract procurement is substantial. Our results have important implications for the procurement strategy in agricultural processing industries.