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.