Economics of The U.S. Wine Industry

By Chris Swann
NABE Board Member
Economist
U.S. Bureau of Economic Analysis

The session on “The U.S. Wine Industry – Its Future in U.S. and Global Markets” featured Barbara Insel, managing director, MKF Research LLC and NABE member, and Tracy Genesen, a partner in Kirkland & Ellis LLP.  Insel, who has held senior positions in the investment banking industry, has long been involved in wine-related investments and transactions from Latin America though Eastern Europe.  Genesen engineered the legal action that led to the Supreme Court ruling on Michigan and New York statutes that restricted out-of-state wine shipments.

Insel gave an overview on the structure of the U.S. wine industry, its economic impact, and how the market is evolving.  To be sure, there are a number of large, corporate, and in some cases, publicly held wine producers.  Typically, these large entities produce lower-end wines at lower price-points.  However, from a production standpoint, she described the wine industry as dominated by small, family-owned businesses that are intimately involved in the local, agrarian communities where they are located.  There are nationally an estimated 24,000 grape growers and more than 5,400 wineries directly employing nearly 70,000 workers.  However, the overall impact on the U.S. economy is substantially larger –on the order of $160 billion–when taking into account the direct and indirect effects of the supply chain, including retail sales, restaurant, and hospitality sales.  Import penetration has tended to occur at the lower end of the market in wines with up to a $10 to $15 price range.  The average market price is $15 to $20 and moving up.

Substantial Risks Relate to Production Process

Romance aside, the wine-producing business is not without substantial risks.  Insel pointed out that wine is increasingly viewed as a luxury or fashion good and, therefore, subject to the same consumer shifts in taste as other fashion goods.  Marketing costs are a nontrivial portion of distribution costs, particularly for the lower-end, mass market distributors.  Wineries and growers incur high fixed costs, given the investment in land and capital.  Moreover, the growing time and vintage requirements impose a longer cycle (up to seven years) than typical agricultural commodities and result in even greater inventory risks.  Indeed, the glut in growing and de novo entry in the 1990’s led to lower grape prices, accentuated in some regions, which squeezed many growers and has led to slow growth in planting relative to demand growth in recent years.

But demand has grown and consumer interest in wine has led to a proliferation of new labels.  Insel reviewed interesting demographics underlying demand growth including the fact that wine refrigerators can be found in the aisles of discount houses such as Target and Costco.  Insel pointed out there were 5,425 wineries in 2006, more than double the number of wineries that existed in 1999.  The total shipping value of wine sales was over $11 billion in 2005, including $700 million in exports and $1.8 billion in winery direct sales.  The total retail value of wine sales exceeded $23 billion in 2005 and grew to $28 billion in 2006.  Interestingly enough, most of this growth was in smaller wineries: fewer than 50 wineries produce more than 500,000 cases.  While California clearly dominates the national wine landscape, every state now has at least one winery, with noticeable growth in Iowa, Virginia, North Carolina, and Washington.

Human Capital, Weather Pose Challenges

Two issues that the industry faces are human capital and weather.  There is a shortage of trained labor, including farm workers, vineyard managers, and winemakers.  There are few viticulture programs available nationally and there continues to be an underfunding of these programs from the public sector.  Farm workers in this industry are viewed as skilled by the industry.  Unfortunately, a substantial number of these workers are undocumented and the direction of immigration programs exacerbates the supply risk.  Global warming presents another risk.  European wine producers have already begun to see how the average rise in temperatures has affected grapes, creating a fruit that ripens quicker, much like those in California.  Temperature change across the globe could very well affect the choice of location for grape growing and winemaking.

Genesen addressed the interstate shipment restrictions the wine industry continues to face.  Put in historical perspective, the 21st Amendment repealed Prohibition but rendered direct interstate liquor delivery without in-state distributors illegal.  The “three-tier system” composed of wineries, wholesalers, and retailers grew from a fear of vertical integration and resulted in strong regulation of liquor distribution.  While the system generates economies of scale in distribution of mass-market products, and is simple to regulate, it is not conducive to providing a variety of wines and enables wholesalers to form a bottleneck in the distribution of wine.  Wholesalers have had the ability to choose which labels to market and with consolidation, have had increasing control over product distribution in the face of growth in the number of small wineries and wine retailers.

Historically, some states have had reciprocity rules in place – free trade agreements that enable state-to-state shipments – but many states have imposed heavy restrictions on direct importation including felony legislation.  Litigation against these restrictions began in earnest in 1996 with several suits filed by consumers against states.  Consumers and wineries jointly sued based on the “dormant commerce clause” that discriminated in favor of in-state wineries.  In its 2005 decision, the Supreme Court held that states can regulate but cannot discriminate, thereby opening the door to direct sales by wineries and incremental improvements in direct shipments are occurring.  A model direct shipping bill based on nondiscrimination had been crafted in the late 1990’s in response to felony legislation and forms the basis for ongoing state-by-state negotiations.

Unfortunately, the three-tier mechanism is still in place, many state monopoly protection laws remain, and some states have imposed capacity limits.  Therefore, the wholesale distribution of wine within the states still presents a bottleneck problem for out-of-state wine distribution.  Consequently state-by-state legislative battles are still necessary to challenge the three-tier system or to challenge in-state distributors whose market power is unchecked and supported by regulatory authority within the state.