Part II - How a Producer can Increase Revenue, Profit, and Cash Flow

In part one of this two part series, the impact of changes in cheese and butter prices were analyzed economically.  The analysis showed that butter, and therefore butterfat price changes have little impact on the Class III milk price.  However, cheese price changes have a huge impact on the Class III milk price.  Increases in butter prices simply shift payment from milk protein to butterfat with little impact on the Class III price.

However, there is not much a producer can do to impact Federal Milk Marketing Order (FMMO) milk prices. This post will cover a subject that a producer does have control over and can impact his revenue, profit, and cash flow.

There are many variable such as nutrition, genetics, cow comfort, etc. that can influence the productivity of a herd.  Due to the complexity of comparing actions and results, some actions that seem appropriate, may actually have a negative impact on profitability and cash flow.  One of the often-sited mistakes is cutting all possible costs.  In some cases the changes can reduce milk component productivity.  Some specific cost cuts may seem appropriate, they may reduce revenue by more than the cost savings.  If so, cash flow will be reduced.

There is another often seen practice that can hurt cash flow.  In many cases, producers and their nutritionists try to constantly adjust nutrition with the ever-changing FMMO prices.  When many variables are changed at once, it is difficult to determine which have a positive impact on cash flow and which have a negative impact on cash flow.  While this may occasionally work, staying with and fine-tuning specific practices can produce more accurate measurements of any changes.

To illustrate this, the analytics below measure the economic impact of changes in milk component levels at different cheese and butter prices.  The changes in component levels used in this analysis are based on a recent publication by Dr. Brian Sloan.   The data used by Dr. Sloan is based on precisely calculated changes from many past trials involving nutritional changes.  It covers many years of trials in various geographical locations and in summary averages results from thousands of cows.  His combined results show an average increase of .14% in milk protein and .16% in butterfat with his suggested nutritional changes.  The economic analysis shown below compares the change in revenue when milk protein increases from 3% to 3.14% and butterfat increases from 3.5% to 3.66%.

The tables below measure the economic impact of achieving higher component levels as cheese and butter prices fluctuate.   In Table I it shows the economic results at the component levels discussed in the previous paragraph.  Table II shows what the top component increases can produce.  In other words, the first table uses precisely the averages from Dr. Sloan's trial compilation and the second table shows what the better herd can achieve.

Table I shows that the increase in milk revenue can vary from $.50/cwt. to $1.00/cwt. when components increase from the nutritional changes Dr. Sloan analyzed.  The impact is much smaller when cheese prices are low, but doubles when cheese prices are high.  The change in butterfat prices has very little impact on the increase in revenue.   This is consistent with the analysis in Part I of this series.

Table I - Increase in Milk Revenue with Increases of
.14% in Milk Protein and .16%in Butterfat

Table II shows the potential increase for the best performing herds.  It is not a "dream" table but a accurate portrayal of what has happened at the best performing herds.

Table II - Increase in Milk Revenue with Increases of
.21% in Milk Protein and .24%in Butterfat

The increases in milk revenue with the nutritional changes studied by Dr. Sloan may increase feed costs.  However, in many cases there is no increase in feed cost.  Quoting Dr. Sloan, "If care is taken to not over supply some key nutrients and if the power of non linear optimizers in modern software programs are used, it will ensure that revenue will increase sufficiently to provide a positive and continuing increase in cash flow."  Chasing the market prices with constantly changing nutritional diets is not a best practice.   

Some nutritionists have tried minor nutritional changes to increase butterfat only.  Although these nutritional changes may a cost little less, the results are significantly less as well.   As shown in Table III, the only time this might be slightly advantageous is at the extreme when butter is at $3.00/lb. and cheese is at $1.20/ lb.  This has  never happened.  

Table III - Increase in Milk Revenue with Increases of
 .16% in Butterfat

Milk component increases are the heart of the future for dairy.  The growth categories in dairy are all dependent on components.  Therefore, chasing components is key to success in the dairy business.  This is not a seasonal concept or a concept that will change with FMMO prices.  The amount of improved cash flow may change, but increasing components will always be economically advantageous.

How to Increase Milk Revenue and Profit

This subject will be covered in two parts.  The first will deal with FMMO pricing and market movements.  The second will deal with how a producer can improve his income.  Because both subjects are linked, and are also a little complicated, they will be separated in two consecutive posts.

The first part, which will be covered below will explain why high butter prices are not much of  a benefit to producers. The second part, to be posted next week will show how a producer can improve his income and profit with changes he can control.

There is a lot of publicity in the dairy news as to how the current high butterfat prices are making a big contribution to the milk check.  In fact, while high butter prices can help a little, the key word is little.

The FMMO price formulas vary in their complexity.  A simple formula like the conversion of butter prices to butterfat prices is pretty simple.  The National Agricultural Statistics Service (NASS) does a through sampling of butter prices and averages them for the entire United States.  By the formula below, the butter price is converted into the butterfat price.   The "make allowance" ($.1715/lb. in the formula) is an estimate of the cost to churn butter from butterfat.   The cost of butter less the make allowance is then adjusted by 1.211 to recognize that there is more than butterfat in butter.   The primary added ingredient is water.

Butterfat Price = (Butter Price − 0.1715) x 1.211  

The most complex formula is for milk protein.  The first part of the formula below, ((Cheese price - $.2003) x 1.383), mirrors the formula converting the butter price into the butterfat price.  However, the rest of the formula is a little more difficult to understand.  It is easiest to explain this part of the formula, ((((Cheese Price − 0.2003) x 1.572) − Butterfat Price x 0.9) x 1.17), when cheese prices are higher than butter prices.

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 second part of the formula gives credit to price of milk protein when the butterfat is more valuable when it is in cheese, not butter.  In other words, if butterfat is worth $1/lb. when used for butter, but when that butter becomes a part of cheese, it is worth $1.50/lb.  That incremental $.50/lb. is given to the value of milk protein for its impact on making the butterfat more valuable.  The rationale is that cheese cannot be made without milk protein. which is coagulated to capture the butterfat and not let it pass through the cheese cloth.

However, when butterfat is worth more in butter than it is in cheese, that "adjustment" becomes a big negative.  Currently, butterfat is worth more in the form of butter than it is in the form of cheese.  As a result, as the butter price goes up, butterfat goes up in value and milk protein goes down in value.  As an extreme example,  if the cheese price was $1.20/lb. and the butter price was $2.80/lb., the value of milk protein would become negative.

There is more information on the impact of the FMMO formulas in this prior blog post.

As another example, the table below shows the Class III price change when the butter price doubles and when the cheese price doubles.   When the butter price doubles from $1.50/lb. to $3.00/lb., it changes the Class III price by only $.62/cwt.  However, when the cheese price doubles from $1.20/lb. to $2.40/lb., the Class III price increases by $11.60/cwt.  When the price of butter escalates as it has done recently, it primarily increases the value of butterfat and lowers the value of milk protein, but has very little impact on the Class III price.

Table I - Changes in the Class III Price Caused by Changes in the Price of Butter and Cheese

The two charts below show the price of butter and cheese over the last 17 years.  The run-up in the butter price over the last five years has increased the butter price by a little less than $1.00/lb.  The impact on the Class III price is a little less than the $.50/cwt.  Some recent articles have claimed much more, but that is not the case.  Cheese prices have fallen since 2014 from highs near $2.40 to the current prices around $1.60/lb.

Chart I - NASS Price of Butter

Chart II - NASS Price of Cheese

What moves the Class III price is the price of cheese.  Chart III below shows the tight correlation between the price of Class III milk and the NASS price of cheese.

Chart III - Cheese and Class III Prices Over 18 years

Currently cheese inventories are high and the price is low.  The only way to quickly deplete the excess inventory is to drastically increase cheese exports.  

The price of milk protein and butterfat are not in any way controllable by a producer. A producer has little ability to change domestic inventories or the many other factors that influence the FMMO value of producer milk.  The above information is provided for background for the next post that shows how a producer can have more control over improving his revenue and profit.  Don't miss the next post.  Reminders can be sent by email by filling in the "subscribe via email" in the upper right hand corner of this blog.

Exports Show Improvement

Export and import data for August is now available.  There were many positive events in August.  There were again improvements in exchange rates, which will aid in future exports, as a weaker USD makes U.S. exports more financially competitive.  Cheese exports were up (Chart I), and nearly matched the record levels of 2014 for the month of August.  Nonfat Dry Milk (NDM) exports (Chart II) were up compared to the prior month and imports were down.  To meet and exceed the export positions of 2014, there is additional work needed, but August was certainly a positive move toward that goal.

Chart I - Cheese Exports

Chart II - NDM Exports

Mexico remains the strongest market for U.S. cheese, but exports to South Korea and Japan are also showing strength.  Due to trade restraints, there are very small amounts of cheese exported across the border to Canada (see Chart III).  With NAFTA re-negotiations in process, there may be an opportunity for more dairy trade with Canada.

Chart III - Cheese Exports by Country

Dairy exports and imports between the U.S. and Canada are primarily between butter and NDM.  With the global consumer increase in butter consumption, a glut of NDM is developing.  Canada is perhaps an example of where other countries may be going.  For over a decade, Canada has struggled with an excess of milk protein in the form of NDM.  When butterfat is used for churning butter, the remaining skimmed milk is typically dried. Because of the high cost structure of the Canadian dairy industry, it has been difficult to export the excess NDM profitably.  The Canadian managed system has used various formula revisions to encourage butterfat production and minimize milk protein.  Current technology has very limited tools to make this happen.  As a result they have typically struggled with high inventories of NDM.  Charts IV and V below show the increased exports of butter to Canada from the U.S. and the increased imports of NDM from Canada to the U.S. that result.  Although dairy trade with Canada is excluded from NAFTA, where there is a need, Canada has allowed imports of butter and exports of NDM.

Chart IV - U.S. Butter Export by Country

Chart V - NDM Imports to the U.S. by Country

Dry whey exports (Chart VI) also showed improvement over the prior month and established a 2017 record month.

Chart VI - Dry Whey Exports

As mentioned above, exchange rates continue to move in a positive direction adding support to the competitiveness of U.S. Exports.  Europe is the biggest international competitor and the exchange rate has now changed from a low of $1.08 USD/Euro at the beginning of 2017 to nearly $1.20.  Hopefully this trend will continue.

Chart VII - Exchange Rates - USD/Euro

Exports of cheese to Japan improved in August and certainly the exchange rate between the USD and the Japanese Yen helped that.  The stronger Yen is still a short term event, but hopefully this will continue and support future exports to Japan.

Chart VIII - Exchange Rates - USD/Yen

One of the important exchange rates is with the U.S. neighbor, Canada.  Again, the impact of this will probably be known only after further NAFTA negotiations as dairy exports to Canada are currently limited by exclusion from the current NAFTA agreement.

Chart IX - Exchange Rates - USD/CAD

While the Export/Import data was only mildly positive for August, it is good to see things moving in the right direction.

PRIOR POST COMMENTS

There has been a lot of interest generated from the October 7 post to this blog concerning the proposed change to the Class I formula..  An addendum has been added to express comments from the Farm Bureau.  They have not taken a position on this change, but are continuing to evaluate the impact.  The Farm Bureau comment is appreciated as it clarifies their position. 

Milk Prices are Down - Here's Why

On October 4, 2017, September Class and Component prices were released.    Chart I below shows a lot of red as prices fell from the prior month.  The only positive change was in the price of milk protein, and that increased only because butter prices fell (see why in this post).  All of the commodity prices, which are used to calculate the component prices were down.  This includes cheese, butter, dry whey, and nonfat dry milk (NDM).

Chart I - Monthly Change in Dairy Prices

This changed the long-term trends only slightly.  Note that the price of milk protein was higher than butterfat for the first 14 years of the Chart II.  Only when consumption of butter began to increase globally did the value of butterfat exceed the value of milk protein.  That change has remained in place since 2014 and there is no short-term change expected.

Chart II - Long-Term Trends in Component Prices

Inventories of three of the four commodities used to price milk are high, pushing prices low at least for the near term.   The inventory of cheese, shown in Chart III below, continues to be significantly high.  The growth of cheese inventory since 2013 is three times higher than the growth of consumption.  Compared to 2013, current cheese inventories are 30% plus above the levels of just four years ago.

Chart III - Cheese Inventories

Chart VI shows the inventories levels over the last 17 years.  There is a trend line that shows the normal grow consistent with cheese consumption and exports.  The recent month's cheese inventory is well above the growth trend line and is near all time highs as compared to the trend line.  These high cheese inventory levels are a place to park excess milk production, but they also impact pricing as there is more cheese for sale than there are buyers for cheese.

Chart IV - Long-term Trends in Cheese Inventories

The high level of domestic cheese inventories will continue to keep cheese prices low.  The extreme size of the inventory cannot be corrected through consumption.  It can only be corrected, through reduced production and/or increased exports.  Chart V below shows cheese production for the last five years.  As long as there is excess milk, cheese production will probably remain high.  In the last three months, there has been a reduction in cheese production, but it is not enough to bring inventories in line. 

Cheese exports did increase in August.  More detail on exports and imports will discussed in the next post to this blog.  However, it will take time to reduce the cheese inventories, which in turn will bring higher cheese prices and higher Class III milk prices. 

Chart V - Cheese Production

Nonfat Dry Milk/Skimmed Milk Powder (NDM/SMP) is the largest dairy export product.  Recently exports of NDM/SMP have lagged prior months, and inventories are starting to build.  NDM and especially SMP are primarily export products whose price is determined on the global market.  The high inventories shown in Chart VI mean that international traders must compete hard to move these inventories.  That means, lower prices.

Chart VI - Inventory of NDM/SMP

The same can be said about dry whey inventories.  Higher inventories mean lower prices.  Nearly half of dry whey is exported so prices are very dependent on the international markets.

Chart VII - Inventory of Dry Whey

All of the current low prices result from over production compared to domestic consumption and exports.  When exports began to fall, milk production did not decrease, and that has created excesses that are keeping prices low.  In a future post milk production will be compared to demand.

Proposed Change to FMMO Milk Price Formulas: Updated 12/4/2017

There is currently a proposal to change the method of calculation for Class I milk.  Class I milk is the second largest milk category with Class III being the largest.  Therefore any change in the method of calculating the Class I price will have a significant impact on producer milk prices.

Chart I - Milk Production by Utilization Class

Currently, the Class I base price is based on the higher of Class III or Class IV milk.  The proposal under consideration would average the higher one with the lower one and add an adjustment to minic the current Class I price

Chart II below shows 17 years of of Class III and Class IV prices.  Obviously, the Class III and Class IV price move in a similar pattern.  In  the first half of 2017,  the Class III price was not high, but the global glut of nonfat dry milk has kept the Class IV price lower than the Class III price.

Chart II - Class III and Class IV Milk Prices

The rationale for this is that it would allow processors to more precisely hedge the price paid for Class I milk because the current hedging tools require processors to choose between hedging with  Class III or Class IV prices.  If they choose the wrong one, the hedge may not precisely fit the final price.  If the processor choses to hedge using the Class III price, and international events drove up the price of nonfat dry milk which would increase the Class IV price,  their hedge would be lower than the actual price.

For producers, the same can be said, but there are very few producers who use hedging tools.  Most all processors do use hedging to minimize fluctuations in cash flow and profits.  Those that use hedging (primarily processors) would benefit from a simplified method of hedging.

The rationale is that more processors would be willing to produce fluid milk products if they could accurately hedge the price of milk and minimize they risk of inaccurate hedging.  In that way, more Class I milk would be produced and producers would gain by having a greater market for Class I milk.

It's not hard to see the folly in the logic of the above paragraph.  Milk consumption is not constrained by processing capacity.  The decrease in per capita consumption of fluid milk has been going on for nearly a century.  It is influenced primarily by competition from the many other choices in available drinks.  Because consumption decreases every year, processing capacity is more an issue of which processing plants should be closed, than what new ones should be built.  There are no grocery stores in the U.S. that do not carry milk because of a lack of processing capacity.  See a recent post to this blog covering U.S. consumption of dairy products.

How would this change impact producer prices?  The most impacted Federal Order would be Florida.  Their milk is primarily Class I fluid milk.  A formula change that would change the price of Class I milk would simply change the producer income.  This would be true of the other three orders paid on the "Advanced" pricing system, although the impact would be less.

For the six Federal Orders paid on the component system, the proposal would be seen in a changed producer price differentials.  The impact will be minimal for Orders like the Upper Midwest, where fluid milk makes up a very small part of milk usage.  It would be greater in areas like the Northeast Federal Order, where a significant part of overall milk usage is Class I.

In 2018, California will likely become a Federal Order paid on components. If the new Class I pricing formula is approved, the proposed formula change could influence the upcoming vote of California producers and their cooperatives.

It is frankly surprising that the Farm Bureau is supporting this change.  There is no obvious improvement for producers.  One would expect them to protect farmers.  I encourage the staff of the Farm Bureau and the Farm Journal's publishers of "Skimmed Milk" to add comments to this blog to defend their positions or debate this analysis.  What has been published is certainly not “fair and balanced.”

ADDENDUM

On October 12, Dr. John Newton, Director, Market Intelligence for the American Farm Bureau Federation asked that an addendum by added to this blog.  He stated that "The Farm Bureau has not taken a position on the proposal to change the FMMO Class I formula."  He also stated that "The proposal is currently under evaluation by the Farm Bureau."