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.