How Should the Producer Milk Payment System Change?

The current system of formulas and procedures for producer milk payments is now 22 years old.  It was developed in 1999 and implemented in January 2000.  Much has changed in that 22 years.  The system is soundly based on a supply and demand capitalistic system. Producer milk prices are based on the price of wholesale dairy commodities, adjusted for the cost to process the milk and yields.  When supplies are limited, prices are higher, and when supplies are plentiful prices are lower.   The system keeps the thousands of milk producers in balance with demand and also keeps the production of milk competitive in both quality and cost.  While the system is harsh on less productive producers, it is effective in keeping the dairy industry competitive and modern.

One of the weaknesses of the system is the extreme milk pricing volatility that it produces which often creates overproduction when inventories are low and prices are high.  Many of the ideas in this post are aimed at measures to reduce producer milk price volatility.  The price of cheese is the most important variable in the pricing of producer milk. Near the end of this post there is a chart of cheese monthly prices since 2000.  The volatility is so great that one wonders why anyone would stay in the business of producing milk.

There have been significant changes in dairy markets since this system was developed 22 years ago.  Some of these changes are as follows:

• Much of the system that originally was developed nearly a century ago is still in place.  The system was designed to make sure that drinking milk was available in cities where there were no cows.  It was also designed to provide a minimum price that processors paid for milk to help stabilize the milk prices.  Today, milk for drinking is plentiful and modern transportation does not require milk to processed in every densely populated area.  There is no need to prioritize the processing and delivery of fluid milk to ensure a supply in the dense population areas of the country where there are no cows.

• Cheese consumption continues to grow as consumption of fluid milk declines.  Cheese production now uses over half of the milk produced.  Cheese is a much denser product than drinking milk which allows it to be transported at a lower cost.

• Milk pricing is largely dependent of the price of cheese.  The price of cheese is determined by the wholesale price of newly made Cheddar cheese which historically was the largest type of cheese produced and consumed.  But today, Cheddar cheese is no longer the largest cheese consumed.  Mozzarella has taken that lead.

• The current pricing formulas and policies have created significant volatility in producer milk prices which has in turn caused significant de-pooling of the Federal Milk Marketing Orders where the minimum prices are established. 

• Formula changes during the 22 years the system has been in place have been implemented with good intentions, but some have resulted in some unexpected consequences.  The most recent change was in the formula for Class I milk and will be reviewed later in this post.

• Originally only fluid milk required Grade A milk.  Other "manufactured" products could use Grade B.  Today, with almost no exceptions, all milk used for human consumption is Grade A.

This post will examine some of the possible changes that could be made in producer milk pricing.  Comments are encouraged and welcomed.  Arguments for and against some of the comments below are essential to facilitate changes.  New ideas are welcome.

CLASS I DRINKING MILK PRICING

Historically, milk for drinking has been the driver of milk production and consumption.  The entire system was developed to ensure that there was sufficient beverage milk in all parts of the U.S. to ensure the health of the population.  As a result, there was an elaborate process of beverage milk pricing to ensure that all areas could receive adequate drinking milk.

Today, fluid milk is used primarily for cold cereal.  Little milk is consumed as a beverage to accompany meals.  Fluid milk is produced is large, automated plants and with cost effective distribution the milk may travel thousands of miles.  The new Walmart milk processing plant in Ft. Wayne, Indiana is a good example of this. 

Below is the current complex chart of the districts for the pricing of drinking milk.  A lot of things have changed since this map was developed.

Locations for Price Adjustments to Class I Milk 

Until two years ago, skim Class I milk for drinking was based on the higher of the skim price of Class III milk for cheese or Class IV milk for butter and Nonfat Dry Milk (NDM).  This changed to an average of the two with an addition of $.74 per cwt. in May 2019   This change allowed processors to better hedge future prices without the uncertainly of which form of milk will be used to price Class I milk. See the October 11, 2020 post to this blog for a review of the impact of this change.

OLD FORMULA

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

NEW FORMULA

Skim Milk Price for Class I = ((Advanced Class III Skim Milk Pricing + 

Advanced Class IV Skim Milk Pricing) / 2) + $0.74 

However, with butter consumption growing and increased demand for butter, that left more NDM to sell primarily on the international markets.  This has brought about a significant spread between the price of Class III skim and Class IV skim and resulted in lower Class I producer milk prices.  In turn this has brought significant negative (PPDs) lowering producer milk prices on average.  The October 20, 2021 post also has details on this.

Reflecting on the current pricing models, raises the question of why Class I milk pricing is based on cheese and NDM pricing.  There is no rational linkage that makes sense for this pricing formula.  If producer milk pricing is linked to something that will manage supply and demand, tying the price of Class I milk to the retail price of fluid milk would accomplish that.  While this is a very disruptive idea, fluid milk is very different from other milk usage.  Shelf life is very limited and there is no real wholesale pricing of milk for drinking.  The good news is that linking Class I milk values to retail prices requires no new data sets as the retail pricing of drinking milk is already monitored.  However, the reporting for milk pricing would require more timely availability.

MILK PROTEIN PRICING

The current formula for pricing milk protein is shown below:

Protein Price = ((Cheese Price – 0.2003) x 1.383) + 

((((Cheese Price – 0.2003) x 1.572) – Butterfat Price x 0.9) x 1.17)

The first part of the formula is pretty straight forward.  It is the cheese price minus the make allowance times the yield.

 (Cheese Price – 0.2003) x 1.383

The second part of the formula is slightly different.  It is intended to increase the price of protein when the value of butterfat is greater in cheese than in butter.

((((Cheese Price – 0.2003) x 1.572) – Butterfat Price x 0.9) x 1.17).

While there is logic in this formula, the way the formula works, when butterfat is more valuable in butter than it is in cheese, it reduces the value of milk protein.  There is no logic that makes sense that when butterfat is worth more in butter than in cheese, it should reduce the value of milk protein.  Milk protein and especially casein protein are necessary to manufacture cheese.  Just because butter prices are high, it should not devalue the price of milk protein.

If anything should change in the formula, it should be to eliminate the second part of the Protein Price formula when it becomes negative.  When butterfat is worth more in cheese than in butter, it will contribute to the protein price and thereby in turn contribute to the Class III milk price.

CHEESE PRICING

Cheese pricing that is used for milk pricing is based on the Agricultural Marketing Service (AMS) survey of cheddar cheese. It measures sales of only Cheddar cheese between 4 day and 30 days of age.  Cheddar cheese represents less than one-third of the total cheese produced, yet, it is the standard to represent all cheese.  Wholesale cheese prices fluctuate with the size of the inventory.  When just Cheddar is in short supply, "cheese" prices used in the FMMO pricing formulas will be high and so will the protein and Class III milk values.   When just young Cheddar is in ample or over supply, the price of "cheese" will be lower and thereby milk protein and the Class III milk price will be lower.  This small sample of cheese pricing has a huge impact of producer milk pricing. Again, this does not make good sense today as new and sophisticated data processing systems have created the availability of larger data sets.

What might be considered is a pricing based on the weighted wholesale price of Cheddar and Mozzarella combined.  Together, they would represent almost two-thirds of the cheese manufactured.  To accomplish this, AMS would have to do a survey of wholesale Mozzarella like they do for Cheddar cheese.  This would reduce some the volatility in cheese prices that are based on Cheddar only.

Also, why would Cheddar pricing be limited to just 4 to 30 days old cheese?  Extending this to 4 to 60 days should help reduce volatility because sales would be based on a broader market.  The same could be said for Mozzarella.  Pricing would still be based on cheese sold during the monthly timeframe, but it would be sales from a larger inventory thereby reducing volatility.  One of the issues with implementing this change is that both AMS and the Chicago Mercantile Exchange use the current process for setting cheese values.  Both would have to change their standard, 

CLASS II MILK PRICING

Class II milk is used for products like yogurt and ice cream.  The skim Class II milk is currently priced based on Class IV skim milk price plus $.70.  Does this make any sense?  Class IV skim milk is primarily priced based on the international price of NDM.  However, the products produced by Class II milk are sold domestically.

It would make more sense to price the Class II skim milk at Class III skim prices.  Both Class II and Class III milk are consumed by the same people in the U.S.  Why should the price be any different if the milk goes to cheese or yogurt?

"MAKE ALLOWANCES" USED IN FMMO FORMULAS

All the formulas used to price producer milk have "make allowances".  This is intended to bridge the difference between raw milk and processed milk products.  The last changes to the "milk allowance" occurred in 2007 and 2008.

There is talk about increasing the "make allowances" to accommodate increases in costs of processing milk.  When "make allowances" are increased, the processor gets more of the pot and the producer gets less of the same pot.  There is no overall increase in the value of producing and processing milk.  Inflation impacts all aspects of life, so why should the money from wholesale dairy prices impact one sector positively and one sector negatively? 

Manufacturing plants are expected to reduce costs over time by automation, economics of scale and location changes, better management, etc.  The same capitalistic system expects producers to lower costs with economies of scale, location changes, improved nutrition, genetics, management etc.  It does not make sense to favor one sector with higher prices and punish the other sector.

The changes made in 2007 and 2008 are shown in the chart below.  At that time cheese prices had increased and dividing the increases between producers and processors made some sense because the increases in the "make allowance" allowed a sharing of the wealth from increases in the price of cheese as reported by the AMS.

However, as shown by the trend line in the cheese price chart below the price of cheese has not really changed in the last decade.  Therefore, there is no additional wealth to share.

The Cheese Price from 2000 to February 2021

SUMMARY

Many of the changes described above may not be practical and there are most certainly other changes to the payment system for milk producers that merit consideration.  Comments are welcome and encouraged.