California Milk Pricing as a Federal Order

One year ago, when California was not yet a Federal Order, a post to this blog "did the math" to show that de-pooling would probably be very significant in the California Federal Order.  A quick review of this prior post will help in understanding how de-pooling works and what is changing in California now that it is a Federal Order.  When California was not a Federal order, all milk had to be pooled.  In the Federal Orders, de-pooling is allowed except for Class I milk.  California became a Federal Order in October 2018 and data is now available for six months. The data shows that de-pooling was immediately implemented and at least one-third of the California milk is routinely being de-pooled.  With rising cheese prices, the amount of de-pooled milk could easily rise to over fifty percent.

De-pooled milk is not reported in the Federal Order statistics.  Typically, de-pooling occurs when the Producer Price Differential (PPD) goes negative.  To date, in the first six months of the California Federal Order, the PPD has not been negative.  Nevertheless, significant de-pooling has occurred.  With rising cheese prices, the California PPD could go negative and increase de-pooling. 

Chart I shows the data for the first six months of the California Federal Order.   The Data is shown as a percent of total pooled milk for November 2018 through April 2019.  Class I beverage milk in California is displayed in green in Chart I and is stable.  Class II, the yellow line, is also very stable.  However, Class III milk, the red line, was 50% de-pooled in April 2019.   Class IV milk was de-pooled by as much as 95% in December 2018 and January and February 2019.

Chart I - Percent of Milk Pooled by FMMO Class

The Upper Midwest Federal Order has typically de-pooled more than any other Federal order.  It is not unusual for the Upper Midwest to de-pool one-third of their milk.  When cheese prices are rising, the Class III price can be higher than the Class I price.  The Class I price is set weeks in advance of the Class III price and with rising cheese prices, the Class III can therefore be higher than the Class I price.  The Upper Midwest Order has over 80% of its milk utilized for cheese and very little Class IV milk.  When the Class III price is higher than the Class I, the uniform (average) price will be lower than the Class III price and thus PPD will be negative.  The negative PPD can be avoided by de-pooling and this is typically done in the Upper Midwest.

California's milk mix is very different (Chart II) than milk mix in the Upper Midwest.  For the last full year as a California based payment system, 46% of California milk went to Cheese and 33% went to Nonfat Dry Milk (NDM).  Much of that NDM is exported.  Class II milk volume is very small and Class I milk volume is also relatively small and is shrinking.  That provides a very different profile than the Upper Midwest. De-pooling in California could be much deeper and more frequent than the Upper Midwest.

Chart II - California Milk by FMMO Class for 2017

Table I shows the California Order prices for its first six months.  Producers are initially paid at the Class III price and the PPD is paid a few weeks later to ensure that all pooled producers are paid the same.  In three of these months, the Class IV price was higher than the Uniform price.  While the PPD was still positive, the Class IV price was better than the Class III plus the positive PPD.  Therefore, during December 2018 and January and February 2019, most of the Class IV milk was removed from the pool.  Those Class IV prices are highlighted for those three months in Table I below.

In March and April 2019, the Uniform price was higher than the Class III price plus the PPD.  Therefore, it made more sense for those delivering milk for Class IV use to stay in the pool.  As a result, de-pooling of Class IV milk was phased out as can be seen in Chart I above.

Table I - California Milk Prices by Class

However, the Class III price increased substantially in April and much of the Class III milk was therefore de-pooled.  With the higher Class III price of $16.38/cwt. in May, more Class III will be de-pooled.

WHAT DIFFERENCE DOES IT MAKE?  WHO CARES?

De-pooling, which is allowed under the FMMO rules, only redistributes the payment for producer milk.  It allows some producers to make more money and some make less money.  The original purpose of the PPD was to make producer milk payments the same regardless of the utilization of the milk.  However, that happens only for the milk that is pooled.  Producers producing milk for Class I cannot de-pool.  Producers producing milk for Classes II, III, IV can de-pool within certain rules.  De-pooled milk is paid at a rate established by agreement between the producer (or his cooperative) and the milk processor and it is typically paid at the FMMO price for the class of milk that was delivered for processing.

Producers supplying milk for utilization in Class III and IV, will de-pool when their class is priced higher than the Uniform price.  If they did not, they would owe money to the pool to be spread to other producers who provide milk to other Classes.  By de-pooling, their higher priced milk will not be included in the pool average price.  Therefore, other producers who remain in the pool will get a lower PPD and thereby a lower milk price.

Because California is "different" from other Federal Orders, primarily because of the large volume of milk utilized in Class IV, de-pooling will be very common.  That can happen even with a positive PPD.  When producers who de-pool for financial reasons, that means that producers remaining in the pool will make less money.

When do Class III producers de-pool?  They will de-pool when cheese prices are rising.  Cheese prices dictate the Class III price.  The Class I price is partially determined by the Advanced Class III price.  Therefore, when cheese prices are rising, the Class I price will be based on a lower cheese price and, in-turn, a lower Class III price.  The Component pricing calculations are done many weeks later than the Advanced pricing calculations.  Therefore, the Class III price may be higher than the Class I price.  In that case, producers sending their milk to cheese plants will de-pool.  In California, due to the huge Class IV volume, a lower Class IV price may also lower the average price and set the stage for Class III de-pooling.

All of these events provide an opportunity to "game" the pricing system.  Combined with the quota payment system, which is still in effect in California, significant amounts of the producer milk will be the lowest paid milk in the U.S.  (The Quota system price reduction for non-quota milk, has since October 2018, been set at $.38/cwt.  It is now being reduced to $.325/cwt. and in about one year will move to $.35/cwt.) 

The combination of de-pooling and the price reduction for non-quota milk will make some of the milk in California the lowest paid in the United States.  This could cause some significant reduction in milk production in California as some producers struggle with low revenue.

What Makes Producer Milk Prices Move?

After nearly five years of low producer milk prices, there is optimism of higher prices in the future.  During the last five years there have been increases in milk production that have outstripped the need for milk.  There have been decreases in domestic consumption of fluid milk as "alternate" plant-based "milk" products have taken market share.  Other products like yogurt have also seen declines in consumption.

The excess milk produced has gone primarily to cheese because it can be held in cold storage for a longer time than fresh milk products like drinking milk.  In 2019, cheese production has remained at 2018 levels and has not increased.  However, there are still excessive milk supplies that are being used for cheese and cheese inventories have continued to build.  A fundamental law of supply and demand is that as a commodity builds excess inventories, prices will decrease.

This post will review some of the fundamentals that move the price of producer milk.  This will include a review of the formulas used to calculate producer milk prices and will specifically review the relationship between cheese inventory levels and the price of producer milk.

For 2018, the four Classes of milk had production levels as shown in Table I.  This data is based on milk which has been delivered for processing under the pricing rules of the Federal Milk Marketing Orders (FMMO).  There is milk that is not included in these numbers for areas not covered by FMMOs and also in FMMO areas where producers have elected to not have their milk included under the FMMO jurisdiction, typically referred to as de-pooling.  Nevertheless, the FMMO data provides a good basis for what producer milk is being used for.

Table I - 2018 Milk by FMMO Class

Class III, milk for hard cheese is clearly the leader in milk utilization claiming 43.5 percent of milk produced.  Class I, milk for drinking, is second, at 28.9 percent utilization of milk produced.  The Class III price is based primarily on the price of cheese.  The Class I (fluid milk) skim price is based on 50% of the Class III price and 50% of the Class IV price.  That means that 58% of the milk produced is valued based on the price of cheese.  Therefore, the overall (uniform) price is very dependent on the Class III price, which, in-turn, is dependent on the cheese price.

Why is Class III milk dependent on the price of cheese?  The Class III price formula has been covered in detail in prior posts to this blog.  Reduced to its simplest terms, the Class III price is shown below.  For more details, see this prior post.

Class III Milk Price = 9.6 x Cheese Price + 5.9 x Dry Whey Price + 

0.4 x Butter Price - $3.20

Cheese is, by far, the most important variable in the above equation.  The Class III price is based on 9.6 times the price of cheese and only 0.4 times the price of butter.  The dry whey price in the above formula is a very small factor because dry whey has a low value.  The $3.20 subtracted is made-up of a combination of make allowances and yields.

As further proof of the pricing relationship between cheese and Class III milk, Chart I below shows the comparative price of cheese and Class III milk.  The correlation between the two is 94%, meaning that the price of Class III milk can be determined with 94% accuracy based on the price of cheese.

Chart I - Correlation Between NASS Cheese Price and Class III Price

With those points made, the post will now examine what changes the price of cheese which is the key component of the Class III price formula.

Chart II below shows the Cheese price vs. the days' supply of cheese held in cold storage.  In this chart, inventory is shown in red and the cheese price is shown in blue. The inventory of cheese is expressed as days of inventory to meet domestic disappearance as well as exports.  In 2014, cheese inventories were a 30-day supply and cheese prices were over $2.30/lb.  In the last five years, cheese inventories have increased to over a 40-day supply, and, as a result, cheese prices have dropped as low as $1.40/lb.  As of the end of April 2019, cheese inventories were still at a 39-day level.

Chart II - Cheese Inventory and the Cheese price

Because the cheese price and the Class III milk price are mathematically linked, Chart III below compares a similar relationship between the inventory of cheese and the Class III milk price.  The higher the inventory level, the lower the price of Class III milk.  In 2014, Class III milk prices reached $24/cwt. as inventories tightened to a 30-day supply.  In the last five years, as inventories increased to a 40-day supply, Class III milk prices have dropped as low as $14/cwt.  As stated above, at the end of April 2019, cheese inventories were at a 39-day high.

Chart III - Cheese Inventory and the Class III Milk Price

So far in 2019, inventories of cheese have continued to grow at a rate of 4% per year as shown in Chart IV.  The inventories in the last four years has been high enough to depress cheese prices.  In 2019 YTD, inventories are continuing to grow by 4% annually, while the increase in consumption is closer to 2%. That means the cheese inventory level is getting proportionally higher, not lower.  Higher inventory levels bring lower cheese and Class III milk prices.

Chart IV - Cheese Inventory by Year

SUMMARY

As mentioned in the opening paragraph, the statements about milk prices improving are encouraging.  However, the continually increasing cheese inventories are concerning.  There is a very strong link between cheese inventories and cheese pricing.  There is an indisputable mathematical link between the cheese price and the Class III milk price.  The Class III milk price is the most important element in overall producer milk prices.

Increasing cheese inventories indicate that there is still too much milk being produced.  Changes that can influence future producer milk prices will be closely followed in this blog.

Domestic Consumption of Fluid Milk and Cheese

The two largest uses of milk are for cheese and drinking milk.  Cheese is a growth sector while drinking milk is a declining sector.  This post will review the most recent data from the first quarter of 2019 on consumption/disappearance of these products and the potential trends for the future.

Monthly consumption data is extremely volatile.  It is difficult to see where changes are occurring and where trends are going.  For that reason, data in this post will be primarily annual and the most recent data will be reviewed as 12 month rolling averages.  The 12 month rolling averages do eliminate a lot of the month-to-month volatility, however they do not fully reflect the most recent events because they are partially based on data that is up to 12 months old.  Future posts will update this data on domestic consumption quarterly.

Drinking milk, often referred to as fluid milk, will be reviewed first and in some detail because it is a declining category with significant changes in the sub-categories of organic, flavored, and reduced fat milk.

Fluid milk has been declining on a domestic per capita consumption basis for a very long time.  However, for many decades, the population increases kept overall consumption stable.  In the most recent decade, population increases have slowed down, and overall consumption has started declining as shown in Chart I below.  Chart II shows the same data expressed as an annual percentage change.  The charts both show a decline that is accelerating.

Chart I - Milk Disappearance in the Last 20 Years

Chart II - Annual Percentage Change of Fluid Milk

Charts III and IV, display sales of fluid milk consumption as 12 month rolling averages.  Chart III shows the 12 month rolling averages for 2018 and 2019 in millions of pounds.  The monthly volume decline in Chart III is very consistent month by month.  That means that the percentage change (Chart IV), is accelerating.  The trend line in Chart IV shows the accelerating decline in percentage change for milk consumption.

Chart III - Milk Sales Based on Month 12 Month Rolling Averages

Chart IV - Percentage Change by Month, Based on 12 Month Rolling Averages

The above Charts III and IV indicate that sales of fluid milk are declining, which is well known. That decline is trending to a little over 2.2% annually on a rolling 12 month average for 2019,  The data also shows that the rate of decline is accelerating.

There are also changes in the mix of fluid milk products.  A few categories are stable or growing, but most are declining.  Whole Milk has maintained its volume and the small category of flavored whole milk is growing (Chart V).  The categories of reduced fat milks have all declined.  The reduced fat milk products more closely resemble the plant-based alternative milk products which are generally very low fat.  Therefore, the reduced fat milk products are easy candidates for cannibalization by plant-based "alternative milk" products. 

Organic milk (Chart VI) is down by more than double the decline in consumption of conventional milk.   This is likely caused by the similar customer base for organic and plant-based products.  Customers who want organic products likely have a similar profile to those who want plant-based products.

Chart V - Change in Consumption of Milk products in Q1 of 2018/2019

Chart VI - Change is Conventional and Organic Milk in Q1 of 2018/2019

Cheese is growing in volume long-term and short-term (Charts VII and VIII).  The growth of cheese was especially strong in 2018.  It has previously been shown that there is price elasticity of demand for cheese, and lower cheese prices in 2018 resulted in higher than normal sales.  The percentage increase in cheese consumption shown in Chart VIII is very erratic.  However, on the average, cheese consumption is growing slightly above two percent annually, very similar in percentage decline in fluid milk.

Chart VII - Domestic Cheese Disappearance in the Last Two Decades

Chart VIII - Annual Percentage Growth of Cheese in last Two Decades

Cheese growth from 2018 and 2019 is analyzed based on 12 month moving averages.  The growth is shown in pounds in Chart IX and in annual percent changes in Chart X.  The high 2018 cheese sales discussed above are declining to more normal growth rates of 2 percent in the first quarter of 2019.

Chart IX - Cheese Disappearance in million lbs.
Based on 12 Month Moving Averages for 2018/19

Chart X - Cheese Disappearance Annual Percentage Change
Based on 12 month Rolling Averages for 2018/19

SUMMARY

The percentage growth in cheese consumption is about equal to the percentage decline in fluid milk.  However, cheese is a bigger category.  Using a weighted average of the cheese growth and the fluid milk decline indicates an average increase in the combined demand.  As covered in the prior post, Class IV milk for butter is growing by around one percent.  Class II milk for products like yogurt and ice cream are stable.  Overall, this would provide a needed increase of about one-half percent in the milk supply.  

That increase would be roughly in line with current percentage increases in milk production levels, but the overproduction of the past must still be dealt with.  In 2018, milk production was well above consumption with the excess milk ending up in excessive cheese inventories.  Those inventories have continued to grow at about four percent in 2019. Because 2018 was excessive, the current increase in the milk supply is still too big for the current needs.  Most current predictions are for better milk prices in 2019.  For this to occur, the cheese inventories must be brought in line with consumption and exports/imports.

While tremendous progress has been made in lowering the growth of milk production, additional steps to lower milk production are needed to bleed out the overproduction of prior years.