How did 2020 Compare to 2018 & 2019?

This post will show how 2020 YTD is compared to 2018 and 2019 for the dairy industry.  Although not all data is in for 2020, there is enough available data to show how 2020 was different than the prior two years.  There were differences in volatility for some parameters and minimal changes for other statistics.  Most productivity factors continued to show improvements while one was stagnant.  The parameters reviewed will cover pricing, productivity, and growth in production.  Much of the data is based on 12-month averages to minimize the impact of seasonal changes.

PRICING

There are four commodities that are used to price producer milk.  They are cheese (blocks and barrels), butter, Nonfat Dry Milk (NDM), and dry whey.  Charts I though V show the Agricultural Marketing Service (AMS) weekly prices of these commodities.

Cheese prices have been the most volatile of any commodity in 2020 and they were heavily influenced by COVID -19.  The price of cheese as used by the Chicago Mercantile Exchange and AMS is based on the price of cheddar cheese between 3 and 30 days of age.  In the early stages of COVID-19, when a lot of dining changed from restaurants to grocery stores, the market was unprepared for such a shift and and there was a lot of outages and uncertainty.  As a result, cheese prices dropped drastically.  With the low prices there were significant buys for both domestic use and exports.  Buyers reduced the supply of available cheese and prices skyrocketed to record highs.  That same scenario was repeated in the third quarter.  The COVID-19 stimulus programs like CFAP also contributed to the volatility. 

As the impact of COVID-19 has lessened and cheese producers have adjusted to the new demands, cheese prices now appear to be approaching more normal levels.  

Block and Barrel prices followed very similar patterns (Chart I and II).  Cheese prices heavily influence the Class III skim milk price and the milk protein price.

   Chart I - AMS Weekly Block Cheese Prices

Chart II - AMS Weekly Barrel Cheese Prices

Butter prices began falling in mid 2019 with a greater supply of butter available.  Butter inventories have grown by 28 percent in the last year.  While butter is a domestic growth category, much of the growth is filled by the growth of imported Irish butter.  Butter followed the pattern of drastic price declines at the initial stages of COVID-19 but recovered quickly and then went into a continuance of the declining price which started in 2019 (Chart III).

Chart III - AMS Weekly Survey of Butter Price

NDM is primarily an export product and is priced on global conditions.  The international NDM prices fell a little earlier than the domestic prices for cheese and they have recovered more slowly.   They have not reached the highs achieved in 2019 (Chart IV). The 2021 futures prices are not showing significant changes from the current prices.  NDM is the basis for pricing Class IV and Class II skim milk and it is also the partial basis for pricing of Class I skim milk.  With the new Class I pricing formulas, the price of NDM has become very influential on the Uniform price and the Producer Price Differential. 

Chart IV - AMS Weekly Survey of NDM Prices

Dry whey prices do not appear to be influenced by COVID-19 (Chart V).  Dry Whey is primarily an export item and pricing is based on international markets.  The price of dry whey is used to price "Other Solids" in the Class and Component pricing formulas.

Chart V - AMS Weekly Survey of Dry Whey Prices

PRODUCTIVITY

Milk Productivity has not been influenced by COVID-19 in 2020.  The trend of producing more milk per cow has continued and the percent of butterfat and milk protein have continued to show gains.

Milk per cow has been increasing consistently over the last three years, increasing from 62.9 pounds/day at the beginning of 2018 to 64.7 pounds/day in November 2020 (Chart VI).  

Chart VI - Milk Pounds per Cow per Day

The percent of butterfat in milk has shown continuing improvement over the last three years.  It is increasing by .027 percent butterfat per year and over the last three years has grown from 3.83 percent to 3.91 percent (Chart VII).  This represents an increasing rate of butterfat production of .7 percent per year. There was no COVID-19 impact on the gains in butterfat production. 

Chart VII - Percent Butterfat in Milk

The price of milk protein hit a new record in 2020, but the gains in milk protein productivity have not been strong.  Milk protein percent has gone up and down over the last three years and is showing only an increasing rate of .2 percent per year over the last three years (Chart VIII).  This is an economic opportunity.

Chart VIII - Percent Protein in Milk

Included in this section is Somatic Cell Count (SCC).  A lower SCC does increase cheese yields and therefore does increase productivity in processing.  This is a long-term trend which just keeps getting better and better.  The year 2020 was a strong year for further decreasing SCC (Chart VIII).

Chart IX - SCC for the Four FMMOs with Incentive Payments for Lower SCC  

MILK PRODUCTION

Milk production must keep in sync with domestic consumption trends and exports.  As covered in a prior post, fluid milk (Class I) consumption is down, Yogurt is down (Class II),  Cheese is up (Class III), and butter and NDM is up (Class IV).  In total the growth factor in domestic consumption and exports as measured by butterfat is about a 1.5 percent annually.

Milk production is increasing by about one percent annually (Chart X). The year 2020 was a strong year for increasing milk production.

Chart X - Milk Production

Beginning in the middle of 2020, the number of cows began increasing again.  They had dropped by three percent in 2018 and 2019, but they are again increasing.  This is signaling a possible period of overproduction which causes price declines.

Chart VI - Number of Dairy Cows in the U.S.

PUTTING IT ALL TOGETHER

The year 2020 was certainly a strange year primarily because of COVID-19.  The year of 2021 should be a more typical year.  Dairy commodity pricing and particularly cheese pricing should return to a less volatile state.

We do have the possibility of milk overproduction as cow numbers are increasing, milk per cow is increasing, component levels are increasing, and SCC is dropping.  The addition of more cows that are more productive will increase milk availability beyond that needed.  When that happens, there is usually a decrease in milk pricing.

When 2020 in completed, an update will be posted to this blog.  Hopefully 2021 will minimize the COVID-19 influence as vaccines are administered. 

HAPPY HOLIDAYS to the many readers of this blog.  The year 2021 is almost here.

 

  

 

The Impact of De-pooling and the Impact of Changing Consumption Trends on the Producer Price Differential

Producer Price Differentials (PPDs) are complicated and confusing. They also have a major impact on milk payments to producers. The prior two posts covered the negative PPDs in California and the five reasons for negative PPDs.  One of the difficulties in understanding fluctuations and negative PPDs is that there are five factors at work all moving in different directions at different times.  Based on comments from the post on the five reasons for negative PPDs, the explanations for two were difficult to understand and will be further explained in this post.  They are the following:

• A significant amount of Class III is being de-pooled.  That increases the amount of a negative PPD and lowers a positive PPD.   When Class IV is de-pooled, it lowers a positive PPD.

• As less fluid milk is consumed, there is a smaller percentage of Class I milk in the mix.  Because Class I pricing is formulated to be the highest paid milk, when there is a smaller percentage, the "Uniform" or average price will be lower.

Class I milk cannot be de-pooled and Class II milk is small enough to be inconsequential.  Therefore, the de-pooling examples deal only with de-pooling of Class III and Class IV milk.

The Class III milk price paid to a producer is based on the value of milk protein, butterfat, and Other Solids in the delivered milk.  That is the basis for the initial payment to producers in a Class and Component Federal Order.  At the end of a month when the receipts are complete, a weighted average of the four Classes at their specific pricing formulas is calculated.  This is known as the Uniform price.  The PPD is the difference between the Uniform price and the initial payment based on components.

To better explain the reasons for the two events listed above that can lower a negative PPD, examples have been prepared below.  In these examples, only one variable is changed at a time.  All other variables are held constant to better understand the impact of each event.  In the examples below Class III milk is de-pooled when it is high, and Class IV is de-pooled when it is high.  Milk is de-pooled to avoid paying a negative PPD.

DE-POOLING WHEN CLASS III PRICE IS HIGHER THAN THE UNIFORM PRICE

Table I below shows the base case. In this example The Class III price is lower than the Uniform price causing a negative PPD.  This happens when the Class IV milk is significantly lower than the Class III.

Table I - Negative PPD for base case

Table II shows what happens as all the Class III milk in this example is de-pooled.  The negative PPD doubles, going from -$.31 to -$.60 per cwt.  While the Class III milk that was de-pooled has avoided the negative PPD, the balance is made up by those that are still in the pool.

Table II - Impact of de-pooling Class III milk

LONG-TERM IMPACT OF PPD WITH CHANGING CONSUMER CONSUMPTION

Table III shows the long-term impact of changing domestic consumption.  Fluid milk, Class I, is declining by about 2 percent annually.  Cheese consumption, Class III milk, is increasing by about two percent annually.  This table shows the impact of these changing consumer patterns on PPDs over five years.  Class I milk has gone from making up 24 percent (Table I) to making up just 21 percent (Table III).  During these five years, the Class III milk has increased from 48 percent to 52 percent of the total milk.  With less of the high-priced Class I milk, the negative PPD has increased from -$.30 to -$.35.  In this example, nothing has changed except for the mix of the four milk Classes.

This is perhaps a small factor, but as the consumption trends of less fluid milk continue, that will continue to lower the Uniform price of milk and thereby make negative PPDs larger and positive PPDs smaller.

Table III - impact of changes in Domestic Consumption

DE-POOLING WHEN CLASS IV PRICE IS HIGHER THAN THE UNIFORM PRICE

Occasionally, the Class IV milk price may be higher than the Class III milk price.  In this case, some Class IV milk would likely be de-pooled to avoid the paying a negative PPD.  In this example, it is assumed than all of the Class IV milk is de-pooled. Table IV shows the base case with no de-pooling and Table V shows the impact of de-pooling.

Table IV - Class IV milk is priced above Class III milk

De-pooling the higher priced Class IV milk has reduced the Uniform price and thereby has reduced the positive PPD from $2.09 per cwt. to $1.89/ cwt.

Table V - Impact of de-pooling Class IV milk

SUMMARY

Everything about the PPD is both complicated and confusing, but it is also very impactful on producer pricing. The chances of a high positive PPD are slim under the existing conditions.  The short-term issue is the significantly lower price of Class IV milk compared to Class III milk.  This is not likely to change in the short-term.  

The driver of a long-term mix with less Class I fluid milk and more Class III milk for cheese will also have a negative impact on PPDs.  This is also not likely to change in the short-term and will become more impactful in the long-term.

Negative Producer Price Differentials - What makes them negative and when will it change?

Negative Producer Price Differentials (PPDs) are killing producer income.  What is a PPD and what is its purpose?  This post will examine why PPDs are negative and what it will take to make them positive.  Some examples in this post will use data from three of the largest Federal Milk Marketing Orders (FMMOs), California, the Upper Midwest, and the Northeast, to illustrate the pricing impact of the PPD.  The factors involved in a negative PPD are complex, and the explanation below is therefore a bit longer than most posts to this blog.

The current payment system for producer milk was implemented in the year 2000.  It kept many of the legacy policies from the past.  At that time, dairy was all about fluid milk.  Today it is primarily about cheese.  The payment system implemented in 2000 embraced the philosophy that fluid milk must be paid a premium to make sure it moves from the rural farms to the big cities where there are no cows.  Fifty years ago, every major city had a processing plant to pasteurize and bottle milk.  Today, that picture has changed.  When Walmart built their new processing plant for fluid milk in Fort Wayne, Indiana, it was designed to process milk for 500 Walmart stores in the geographical area of Indiana, Illinois, Michigan, Ohio and Kentucky. 

The PPD was designed to level the playing field for all milk producers to see that they were paid uniformly regardless of the end use of the milk.   Under the Class and Component system, processors first pay producers for the components in their milk based on Class III formulas for butterfat, milk protein, and other solids.   As complete data for the month is available, a weighted average or "Uniform" price of the all four classes is calculated.  Because Class I is paid higher, that typically keeps the average or "Uniform" price higher than the payment based on components.  The difference between the initial payment and the "Uniform" price is the PPD.

Chart I illustrates the progression of the PPD for the three biggest FMMOs.  The three are quite different.  California has a lot of low-priced Class IV milk in their mix, the Upper Midwest is all about cheese and Class III, and the Northeast has a fairly even distribution of milk in all Classes.

California has had a negative PPD for 12 of the last 13 months.  The Upper Midwest typically has a very small PPD as most all their milk is Class III milk for cheese so the average or "Uniform" price is very close to the Class III price.  The Northeast has provided producers with a positive PPD most of the time until the impact of COVID-19.

Chart I - PPDs for California, Upper Midwest and the Northeast FMMOs

There are five situations than can make a PPD negative:

1. An escalating cheese price which has been the major cause of negative PPDs in the past.
2. A mix of milk Classes with a lot of the lowest paid milk, Class IV milk, can lower the "Uniform" price.  (See Table I in the prior post for data illustrating this.)
3. The new formula for Class I milk implemented in May 2019 has changed the dynamics of Class I pricing.  Under the current circumstances of a high Class III price and a low Class IV price, based on the new formula, a negative PPD is likely.  This did not happen with the old Class I formula
4. A significant amount of Class III is being de-pooled.  That increases the amount of a negative PPD. 
5. As less fluid milk is consumed, there is a smaller percentage of Class I milk.  Because Class I pricing is formulated to be the highest paid milk, when there is a smaller percentage, the "Uniform" or average price will be lower.

1. ESCALATING CHEESE PRICES

First, the impact of an escalating cheese price will be examined.  High Class I milk prices are intended to keep the "Uniform" price above the Class III price.  Class I milk is priced by the Advanced system.  The name sounds like it is a forward-looking price, but the opposite is the case.  It is called Advanced but the price is determined for milk that has not yet been produced and is based on historical data.  It is announced in advance of milk production and hence it is called the Advanced system.

The time line for pricing producer milk is shown in the graphic below for the month of October 2020.  The Advanced Class I price is based on two weeks of data for September 11 and 18 and announced on September 22, 2020.  Skim Class II milk is also priced in the Advanced system.  The Class and Component pricing for all other Classes of milk is based only after the month's production of milk has been delivered to the processors.  The Class and Component price for October was announced on November 4, 2020, six weeks later than the October prices for Class I milk and Class II Skim milk were determined.

Graphic I - Timing of Advanced vs. Class and Component Pricing

During the month of October, as the price of cheese increased, the Class I milk was based on a lower priced cheese than that used for Class III priced by the Class and Component system.  The cheese price is the most important variable used to calculate the Class III price and the Advanced Class III price is part of the Class I price basis.  The Cheese price used to calculate the October Class I price of milk was $1.75 per pound.  The cheese price used for Class III milk announced six weeks later was $2.29 per pound.  The escalating cheese prices set up a situation where the Class III milk price is higher than the Class I price.  In that case, the "Uniform" price will likely be lower than the Class III price causing a negative PPD.  Chart IV below shows how the Class and Component cheese price leads the Advanced cheese price by about six weeks.

Chart III - Cheese Prices for the Advanced and Class and Component pricing.

The impact of an escalating cheese price became a smaller factor in PPDs after the change in the formula for Class III pricing.  More on that later in this post.

2. IMPACT OF A LARGE SECTOR OF LOW-PRICED MILK

The mix of Classes produced can also have a big impact on a positive or negative PPD.  California and the Upper Midwest are at very opposite ends of this situation.

As covered in the prior post, in 2019 California had 40 percent of their pooled milk going to Class IV milk.  In October 2020, Class IV milk made up 61 percent of the FMMO pooled milk in California.  California also has a low percentage of the higher priced Class I milk.  In 2019 California had just 22 percent of their milk in Class I compared to the average of the Federal Orders which had 28 percent Class I in their mix.

Class IV skim milk price is based entirely on Nonfat Dry Milk price which have traded in a tight and low-price range for 2019 and 2020 averaging around $1.00 per pound.

Chart IV - NDM Prices

The futures prices for NDM are expected to increase to around $1.10 in 2021.  At $1.10 per pound for NDM, Class IV skim would be worth $8.30 per cwt.  By comparison, Class III skim is currently running around $16.00 per cwt.  A lot of the higher priced Class III milk in California and other FMMOs is being de-pooled, and therefore are not included in the "Uniform" price.  Because the Class IV skim price is based strictly on the price of NDM, and influences the Class I price which is half based on the price of NDM, there is little hope for a positive PPD in the coming year in California. 

3. FORMULA CHANGE FOR CLASS I

The Formula change for Class I did make a difference.  See the October 11, 2020 post to this blog for details on the formula change.  Two charts have been updated from that post and are shown below as Charts V and VI.

The change in formula was implemented in May, 2019.  Chart V shows the difference between the two formulas going back in history to the beginning of 2012.  Until late in 2019, the change seemed to have a minimal impact on the Class I price.  However, when the COVID-19 hit, things went astray.  The impact of a high cheese price and therefore a high skim Class III price vs. a steady price for NDM and the skim Class IV price caused a major drop in the Class I price.

Chart V - Impact of Formula Change for Class I

The "normal" spread between the Class III and Class IV price is the basis for having a $.74 adjustment in the new Class I formula.  Chart VI shows what happened to the spread between the Class III and the Class IV prices in 2020.  The spread went as high as $10.96 per cwt. in August 2020.  It remains high.

For the new formula to mimic the old formula, the spread between Class III and Class IV should average $1.48.  As explained above, the Class IV milk price will probably remain within in a limited range.  Therefore, the only way for the new formula to mimic the old formula under current conditions, is to drop the cheese price and therefore the Class III price.   This would lower producer milk prices.

Chart VI - Spread between the Advanced Skim Price of Class III and Class IV prices

If NDM increased to $1.10 as now predicted by CME future data for 2021, skim Class IV would go to $8.30 per cwt.   To match the intent of the new formula, then the Class III price would have to drop from its current level of $15.58 to $9.78 per cwt.  Class III milk is the biggest category of milk and dropping by almost $6 per cwt. would negatively impact the price paid to producers.

4. DE-POOLING

When higher priced Class III milk is de-pooled, it increases the amount of a negative PPD.  When there are fewer producers with high priced Class III, the Uniform price will drop and the PPD will decrease and/or become more negative.  FMMOs like California and the Upper Midwest have seen a huge amount of Class III milk de-pooled. In California, nearly 100 percent of the Class III milk is currently being de-pooled. In the Upper Midwest, as much as 80 percent of the Class III milk is being de-pooled.

5. THE IMPACT OF LESS CLASS I BEVERAGE MILK

Cheese consumption is growing and fluid milk consumption is declining.  As there is less Class I in the mix, the Uniform price will be lower.  In turn, that reduces the PPD.

HOW LONG WILL NEGATIVE PPDs CONTINUE?

For now, to reduce or eliminate negative PPDs, cheese prices would have to drop drastically.  While the FMMO cheese price will likely decrease some from current record high levels, it will probably not be a drastic drop.

In an earlier post to this blog, it was suggested that only the Class III price be used to calculate the Class I price.  To match the old formula there would still have to a positive adjustment to make up for the infrequent times that the Class IV is higher than the Class III.

The way the formulas are calculated, currently the price of NDM determines the skim Class IV and Class II milk prices.  Class IV milk determines the Class I price when averaged with the Class III price. In total, the price of NDM which is determined by international supply and demand and currency exchange rates, now influences 59 percent of the price of U.S. milk.  By comparison, the value of dairy exports makes up only 13 percent of milk production.  The low price of NDM may keep the PPDs low or negative for some time.

The PPD is the same for all pooled milk in each Federal Order but different between Orders. It is not under the control of a producer.  But the higher components, as covered in the prior post, are under the control of the producer and will increase revenue and cash flow.

California is Different!

California is different in many ways.  Today's post will deal with the issue of negative Producer Price Differentials (PPD) and component payments and how they do and do not impact California producer milk payments.  California became a Federal Milk Marketing Order in November of 2018.  With that came many changes.  With the change to a Federal Order came a new pricing system that paid for milk protein specifically.  It also brought a change allowing de-pooling for all milk except beverage milk.  

The de-pooling began immediately after California became a Federal Order.  A Producer Price Differential (PPD) levels the value of all Classes of milk to a Uniform or average price for all. When the Uniform price is less than the first payment based on Class III prices, the PPD will become negative.  De-pooling brought the opportunity to avoid a negative PPD when it is advantageous.   

In May of 2019, the formula for pricing Class I beverage milk was changed.  That change has had a great impact on the California Federal Order.

The interactions of the pricing formulas and processes are complicated.  However, understanding the elements of payment is very important in order to develop a program that will maximize revenue and cash flow for a producer.  Some of the elements in maximizing revenue are directly related to the actions of the producer.  Other elements result from items not under the control of the producer.

When a producer delivers milk through his "handler," the milk is analyzed for component levels and quality.  This quantity of the components is directly under the control of the individual producer.  The producer is paid nothing for the water in his milk.  He is paid only for the three components in the milk; butterfat, milk protein, and "other solids".  The milk that is delivered is tested for component levels and paid at the announced monthly prices at the end of the month.  The check is based on pounds of milk protein, pounds of butterfat, and pounds of "other solids."  The prices paid are based on the Federal Orders prices for all producers in the U.S. that are in a Federal Order.

The revenue paid for components is based on the pounds delivered for each individual producer.  The standardized Class III price is based on three percent protein, 3.5 percent butterfat, and 5.7 percent "other solids." The Class III price is an index and is not what the producer is paid!  He is paid based on his actual levels of components in his milk.  This is true for all producers paid on the Class and Component pricing in the U.S.

What makes California different from other Federal Orders is the calculation of the Uniform price and the PPD.  As mentioned above, the Uniform price is the weighted average of all milk that is pooled.  The weighted average Uniform price is different in each Federal Order because of the mix of the four Classes of milk is different in each Federal Order.  Class IV milk is typically the lowest paid milk (Table I) and California makes a lot of it (Table II).  (The Class I price in Table I is based on the base Class I price.  The Federal Orders pay an additional amount to encourage Class I availability.  As an example, in the month of September 2020, the Class I differential brought the California Class I price to $20.54 per cwt. while the base price was $18.44 per cwt.)

Table I - Five Years of Milk Class Prices

As shown in Table II, in California, 40 percent of the milk included in the Federal Order is Class IV milk, the lowest paid Class.  That is double the overall average of all FMMOs which is 19.5%.  Class I milk, the highest paid, at 21.9 percent is near the bottom of all Federal Orders.  This mix of milk Classes with a lot of the lowest paid milk makes it easy to generate a negative PPD.

Table II - Milk Class Utilization by FMMO

Class IV skim is priced based on the price of Nonfat Dry Milk (NDM).  NDM is mostly exported and California is geographically positioned to be a low-cost provider to Mexico and other destinations touching the Pacific Ocean.  The price of NDM is dependent on the international supply and demand.

The Class I formula was changed on May 2019, seven months after California became an FMMO.  NDM prices are now consistently part of the basis for Class I skim milk prices.  Based on the mix in Table II, 62% of the California milk is now priced based at least partially on the value of NDM.  For more details on the formula change, see the October 11, 2020 post to this blog.

Below are scenarios showing the impact of amino acid balancing which increases components.  In the first scenario, the PPD is set at zero.  In the second example, the September California PPD of a negative $1.96 per cwt. was included.  In both examples below the FMMO prices for September 2020 are used.  

The scenarios below were based on a herd of 1000 cows producing 80 pounds of milk per cow per day with butterfat levels of 3.8 percent and milk protein of 3.1 percent.  The impact of amino acid balancing was based on an increase of two pounds of milk per cow per day, an increase in butterfat content of 1.8 percent, and an increase in milk protein of 1.4 percent. A 10 cent per cow per day increase in feed cost to balance for amino acids was used.  Based on individual situations the costs and increases in productivity will be different.

Both scenarios were evaluated using the website milkpay.com.  The functionality is available in apps for iPads, iPhones, and Android devices as well as the web format.

SCENARIO A

Chart I shows the parameters used for Scenario A.  The PPD is set at zero and the increases for amino acid balancing are as defined above.

Chart I - Parameters for Scenario A

The results for Scenario A are shown below in Chart II.  For this case, amino acid balancing will increase revenue by $354,190 annually for this herd.

Chart II - Financial Impact of Amino Acid Balancing

SCENARIO B

In Scenario B, the same cost and production increases used in Scenario A were used and the California PPD for September 2020 was added.  It was a negative $1.96 per cwt.

Chart III - Parameters for Scenario B

The results changed as shown in Chart IV.  The negative PPD has a significant impact on the pay per cwt., but the increased revenue from amino acid balancing was only slightly impacted, reducing the increased revenue in Scenario A from $354,190 annually to $339, 882 annually in Scenario B.

Chart IV - Financial Impact of Amino Acid Balancing with a Negative PPD

WHAT DOES ALL THIS MEAN?

May things have changed in the milk payment methods for California over the last 2 years.  Although not mentioned above, the quota payment system which is unique to California is also a significant element of milk payment.

One of the most major changes for California as a FMMO was the specific payment for milk protein.  The numbers in the above scenarios are based on component prices for September 2020.  Milk protein in September was valued at $3.39 per pound.  October numbers were just announced and milk protein for October is $5.01 per pound.

While each producer's calculations must be specific to his own operation, there is very little doubt that balancing for amino acids is a way to increase revenue and cash flow.  While the calculations and the payment system are complex, the milkpay app can simplify the evaluation process.  Running a business by precise numbers is the routine business process.  Running a dairy operation is no different.

The Impact of COVID-19 on Dairy Pricing. - A look in the Rear-View Mirror

COVID-19 has changed most every aspect of life around the globe.  This post will examine the impact on the U.S. dairy industry.  The analysis below reflects primarily the impact on producer pricing of milk.

The first item to be reviewed will be the deaths in the U.S. that are related to COVID-19.  Chart I below shows a 7 day rolling average of COVID-19 deaths starting in March 2020 through the most current available data.  As reported by the CDC, the majority of these deaths result from underlying health conditions complicated by COVID-19.  The largest spike was in April with another increase in August.  Since the beginning of August to the present there is a downward trend in deaths.

Chart I - U.S. COVID-19 Related Deaths

Much of the disruption in daily life has resulted from measures such as quarantines and closing of restaurants, intended to reduce the number of deaths involving COVID-19.  Demand for dairy products changed with the closing of restaurants, schools, and other places normally frequented by people.  This led to a massive change from reduced food service demand to increased retail demand.   For instance, retail cheese sold in grocery stores is usually branded and in small packages bearing brand names such as Kraft, Borden, etc.  Cheese for food service is packaged by non-retail companies and is typically packed in large containers without consumer branding.  Because of the overnight change in demand, there were brief shortages and excesses causing significant pricing changes. The structure for providing the appropriate product for each channel is significantly different and the rapid change caused major disruption in supply and demand and thereby it caused extreme volatility in commodity dairy product prices. 

As a result, the wholesale price of commodities which are used to price producer milk changed quickly and drastically.   What is amazing is that the dairy industry changed in a matter of months to service the new high demand channels.  There are four commodities that are used to price producer milk in most of the U.S.  They are cheese, butter, Nonfat Dry Milk (NDM), and dry whey.  Cheese and butter are primarily consumed domestically while NDM and dry whey are primarily export products. 

In this post, cheese and butter parameters will be covered first as they are the most significant commodities used to price Class III milk, milk protein, and butterfat.  Some of the charts below use moving averages as they level some of the seasonal changes and month-to-month "blips."

During this time NASS prices for cheese and butter followed a similar pattern.  In April, as COVID-19 deaths spiked and quarantining was implemented, the prices of both cheese and butter first took a major drop and then increased to higher prices than before the drop. The cheese prices that followed were record setting highs for cheese.  Chart II shows the progression of cheese prices from a low of $1.12 per pound to $2.63 per pound within a few weeks.  The low prices brought some major buys at bargain prices which then resulted in shortages in some channels leading to the record setting prices.   

Chart II - NASS Cheese Prices

The butter price shown in Chart III follows a similar pattern but without record setting high prices.  The reason for this will be coved later in this post.

Chart III - NASS Butter Prices

The prices of NDM and dry whey follow different patterns from cheese and butter.  Chart IV shows a major drop in NDM prices in May with a fairly steady increase to its current price.  These prices result from international supply and demand and are only slightly impacted by domestic supply and demand.  NDM prices are used to price Class IV skim milk.

Chart IV - NASS NDM Prices

The prices of dry whey took an entirely different pattern with highs during the first four months of COVID-19 in the U.S.,  but then prices fell by nearly 20 percent. Dry whey prices are used to set the value of "Other Solids" in the Class III milk price.

Chart V - NASS Dry Whey prices

What did not change?  

The product used to represent the NASS cheese is Cheddar cheese.  USDA data separates cheese into two categories, American Cheese and "Other" cheese.  Cheddar cheese is considered an American cheese.  Chart VI shows the production of Cheddar cheese and other American cheeses.  Unlike many of the above charts, this chart shows no variation during the time of COVID-19 lifestyle changes.

Chart VI - Production of American Cheeses

Production of Butter is shown in Chart VII.  This is shown as a 12-month moving average as there are annual cycles of butter production that make trends more difficult to follow.  Butter production has been increasing in 2019 and 2020, after years of minimal changes in butter churning.  In 2020, the increases have been very significant, and with little impact from COVID-19.  

Chart VII - Production of Butter

The "bottom line is that the COVID-19 pandemic had little impact on the production of cheese and butter.

Inventories and prices of cheese and butter have made some major increases and decreases during the COVID-19 pandemic.  The changes for cheese are shown in Chart VIII.  As shown in Chart VI above, production of American Cheese has not changed much in the last three years.  In early 2019, American cheese inventories were high and cheese prices were low.  In late 2019, American cheese inventories fell, and prices increased.  In 2020, American cheese inventories found a bottom and have increased during the COVID-19 restrictions.  The current prices are likely to continue as long as American cheese inventories do not significantly increase in the near future.

Chart VIII - Inventories and NASS price of Cheese

Butter inventories and prices have taken a different path. As shown in Chart VII, butter churning has increased.  Butter disappearance from cold storage has been steady through the COVID-19 pandemic and the increased churning has therefore increased cold storage supplies.  With increased inventories, lower prices have prevailed and will probably continue for some time.

Chart IX - Inventories and NASS price of Butter

In conclusion, the "crisis" of COVID-19 has had a very significant impact especially on cheese prices.  Cheese prices are the most influential variable in producer milk prices.  While the COVID-19 pandemic continues to be a threat to the U.S. lifestyle, it appears that the worst of deaths and price volatility is behind us.  American cheese inventories are at a 50 to 55 days' supply which is "normal."  

The CFAP program has delivered some nice cash support for the dairy industry.  Now the problem that may arise will likely be the familiar one of too much milk.

This blog will continue to monitor the changes as we begin to exit the COVID-19 pandemic in 2021.

The Pricing of NDM and Class I & IV Milk

In May of 2019, the formula for Class I was changed.  The change was covered in the January 2020 and July 2020 posts to this blog.  The change in formula was intended to make hedging by processors more accurate by improving the accuracy of hedging the Class I skim8price.  The prior formula left uncertainty in hedging as it chooses the higher of Class III or Class IV skim prices as the basis of Class I skim pricing.  

BEFORE MAY 1, 2019

Base Skim Milk Price for Class I = Higher of Advanced Class III or Advanced Class IV Skim Milk Pricing Factors 

EFFECTIVE MAY 1. 2019

Base Skim Milk Price for Class I = ((Advanced Class III Skim Milk Pricing Factor + Advanced Class IV Skim Milk Pricing Factor) / 2) + $0.74

The Class III skim price is driven by the price of cheese and the Class IV skim price is driven by the price of Nonfat Dry Milk (NDM).  Because the cheese price is driven by domestic supply and demand, it is not subject to international competition and currency rate changes.  NDM is primarily an export product and is subject to international competition, currency exchange rates, and international supply and demand.  Prior to May 2019, the volatility in NDM prices had a minimal impact on the Uniform milk price as the Class IV category is the second smallest Class of milk and the Class IV skim milk price was typically the lower than the Class III skim milk price.  With its inclusion in determining the Class I skim price on a regular basis, NDM has become a more important commodity in dairy pricing.

Because the Class IV skim price has been lower than the Class III skim price most of the time there is a $.74 adjustment in the new formula shown above.  The new formula does diminish highs in producer milk prices caused by high Class III skim milk prices because it is now always diluted by the Class IV skim price.

During 2020, the volatility caused by Covid-19 combined with the new formula changes sent producer prices in a spin.  Chart I is updated from prior posts and illustrates the variations in the price of Class I skim caused by the new formula.  During the first 13 months of the new formula, the variation was "as expected."  In July, August, and September of 2020, the impact was huge and disastrous to Class I pricing, the "Uniform" price, and the Producer Price Differential.  Because the new formula averages the Class III and Class IV prices, the impact on the Class I price did not take advantage of the high Class III prices during this time period.  

Chart I - Impact of the Class I Formula Change

This post will focus on the Class IV skim milk price which is based on the NASS NDM price.  Some of the data will include Skimmed Milk Powder (SMP) which is similar to NDM but with some differences in specifications..  NDM is a U.S. term defined by the FDA in the Federal Code of Regulations.  SMP is a World Trade Organization term defined in the Codex Alimentarius.

In 2019, 65 percent of the U.S. production of U.S. NDM/SMP was exported.  Therefore, the pricing is primarily determined by global pricing.  Chart II below shows the export price of NDM compared to the NASS price for NDM.  The two lines on the Chart II are nearly identical.  This confirms that the NASS price is really determined by global events as mentioned above.

Chart II - NDM export prices vs. NASS prices for NDM

NDM and SMP are so similar that the prices for the two products are very close.  Unfortunately, the international price of NDM is typically a little lower than the international value of SMP.  Chart III plots the global prices of SMP from Europe and New Zealand.  The "European" prices are based on export prices from Germany and the "Oceania" prices are based on exports from New Zealand.  As shown in this chart, NDM commands a lower price than SMP, however the prices do have a tight correlation.  When one goes up, the other goes up and vice versa.  All data in Chart III is based on the price at the point of origin.

Chart III - Global prices for SMP and NDM

Charts IV and V illustrate the comparison of production of SMP/NDM and production of just SMP by the three leading exporters.  Chart IV shows that the U.S. is second to the E.U. in total production of SMP/NDM.  New Zealand is a much smaller producer.

Chart IV - Production of NDM/SMP

However, as shown in Chart V, the U.S. is a small player compared to the E.U. and New Zealand in the global market for SMP specifically.

Chart V - Production of SMP

Chart VI illustrates the growth of U.S. production of NDM and SMP.  During the last five years, the U.S. has grown the production of SMP by 8 percent annually while the U.S. production of NDM has increased by only .5 percent annually.  When combined, the annual increase in SMP/NDM is two percent.

Chart VI - U.S. Growth of SMP/NDM Production

How has this impacted U.S. pricing of NDM and the Class I and Class IV milk prices?

Chart VII shows the NASS price of NDM for the last 20 years.  It has hit highs of over $2 per pound in 2007 and 2014, but these are outliers.  Over the last 20 years, the NDM price has averaged $1.10 per pound.  The current price of $.97 per pound is below the average and some improvement can be expected.  However, the increase will be limited as the U.S. has excess NDM to "dump" on international markets.  That will in turn adversely impact the Class I milk price, the Class IV milk price, the "Uniform" milk price, and the Producer Price Differential.   

Chart VII - Long-Term NDM Prices

When the NDM price is at the long-term average of $1.10 per pound, the Class IV skim price would be $9.90 per cwt. and the Class IV price at current butterfat prices would be $14.81 per cwt.  For the long term, that would be as good as it gets.

There is debate as to whether the new formula for Class I pricing should be reversed back to the old formula.  Perhaps a better alternative for producers and processors would be to use only the cheese price as Class III milk now amounts to half of total milk usage.  Processors would be able to hedge the Class I skim price and producers would not have to suffer the volatility of international prices.

Is the Milk Production in Sync with Domestic Consumption?

 In the prior post, the latest statistics on domestic consumption of dairy products was reviewed.  This post will analyze the supply side needed to match this demand.  

The USDA summary of domestic consumption, which is based on percent butterfat in each of the dairy products, indicates an increased need for milk of roughly two percent annually based on the trends from the last five years.  The consumption data for individual sectors showed cheese and butter demand growing while fluid milk and yogurt were falling.

Data for the year 2020 has been extremely volatile as the impact of COVID-19 and quarantining have skewed the numbers significantly.  By 2021, a more normal pattern should evolve.  Unlike the very quick changes brought on by COVID-19, the recovery will likely be a much slower and provide a more manageable transition.  The production of milk has not been significantly influenced by COVID=19 

Milk production over the last ten years in the U.S. is shown in Chart I.  This chart is based on 12-month moving averages over the last 10 years.  The 12-month averages are used to reduce seasonal and monthly variations. 

As can be seen, the increase in milk volume produced has been long-term and steady.  Over the 10-year span shown in Chart I, milk production has increased by 1.4 percent annually.  With these long-term trends, a continuation of this increase is very likely.

Chart I - Milk Production by Month

The number of cows that were used for this level of production is shown in Chart II.  The number of cows increased steadily until 2018.  Between the start of 2018 and mid 2019 the number of cows decreased by 1.3 percent.  Since then the number of cows has started to increase again.

Chart II - Number of U.S. Dairy Cows in the U.S.

Milk per cow is shown in Chart III.  There has been a steady increase averaging about 1.1 percent annually over the last 10 years.  Because this increase is long-term and steady, it can be expected to continue.  The increase in milk production per cow will satisfy about half of the increase in butterfat needed to meet demand as calculated by the USDA based on Butterfat.

The increase in production of milk per cow is an important factor in financial management of dairy farms.  If the same amount of milk can be produced by fewer cows, this creates a very significant opportunity for cost reduction.

Chart III - Milk per Cow

There is one more element in the supply of milk needed to meet demand.  That is the level of components in the milk.  As mentioned in the last post, the demand for milk is increasingly centered around components, not milk volume.  With fluid milk consumption decreasing and cheese and butter increasing, the level of components in milk are an important element in meeting the demand for dairy products.

Chart IV shows the increase in percent butterfat over the last three years.  The average component level of butterfat has increased by .8 percent per year. The combination of increased butterfat per pound of milk and the increase in milk production per cow amount to an increase in butterfat of two percent per year, matching the overall domestic consumption for butterfat with NO additional cows. In fact, to be in balance, fewer cows may be needed.

The expansion of herd size for efficient producers will likely continue.  But it will have to be offset with less efficient herds shutting down.  This has lead to the trend of fewer producers as smaller herds are often less productive than large well managed herds.

During the time of high butterfat prices, the increase in butterfat levels averaged a growth of 1.2 percent annually.  This period covers butterfat from the start of 2018 to September 2019.  This shows what is possible in increasing butterfat levels.  If the 1.2 percent increase in component levels was maintained, fewer cows would be needed than exist today.

Chart IV - Percent Butterfat in Milk

Chart V is perhaps the most important chart in this post.  It is the only chart which does not show a steady increase in productivity.  The spread between the low and high levels of protein production is very small, only .03 percent.  The difference between January 2018 and May 2020 is essentially "no change".  During the time of significant growth, milk protein levels increased by .6 percent annually.  This occurred between mid 2018 and mid 2019.  Milk protein is needed for efficient cheese making and it is typically the highest paying component.

Chart V - Percent Milk Protein in Milk

The fact that butterfat levels quit growing in September 2019 is likely linked to the drop in milk protein levels which occurred during the same time.  When diets are formulated to increase milk protein, they will also increase butterfat.  The milk protein component levels are manageable and are an opportunity.  There is a tendency to reduce amino acid balancing when milk protein price levels are low.  However, with all things considered, protein production, butterfat production, health factors, and other benefits, it always pays to balance amino acids. The Milkpay app for quantifying economics can be a helpful tool.