Late last year, the Secretary of California Department of Food and Agriculture (CDFA) reduced the minimum Class I price plants must pay by 35 cents. This decision followed a prior hearing where CDFA also reduced producer income when it increased transportation allowances and credits for milk delivered to Class I, II and III plants.

In contrast, last year the USDA increased the assessment that plants paid for transportation credits in the three southeastern orders (Appalachia, Southeast and Florida). It also increased the Class I differentials in those orders resulting in increased pool revenue of more than $70 million dollars per year. For Florida it meant increases in blend prices in excess of a dollar, lesser increases in the other two orders.

In late 2007 and 2008, producers serving both of those regions were incurring ever-rising costs for feed and fuel. Both were demanding higher minimum prices under the order. Both regulatory systems responded, one that helped producers and the other that hurt producers. Though one could characterize the difference as one of philosophy or even as a pro- or anti-producer viewpoint, such simplistic over-characterization misses the most important difference – one has power and the other is powerless. Both responded in the only way they could.

In the Southeast, the milk plants pay the costs of moving milk to the market through transportation assessments, location differentials, and over-order premiums. As fuel costs rose, the need for higher transportation credits increased and, with that, the funds to cover them. Without raises in the location differentials and hauling credits, producers would be receiving less and less as they covered the cost to supply the market out of their own pockets. The USDA responded with a decision that raised both of these, effectively shifting the cost of transportation to the market rather than letting producers absorb that risk without compensation.

Higher feed and fuel costs pinched California producers in the same way. But due to the nature of California order’s structure, CDFA responded to the same economic forces as those in the Southeast by shifting the added costs of moving milk to the producers. Powerless to control the market, CDFA was also forced to reduce the Class I contribution to the producer prices. Although not a popular decision among producers, the situation in California left CDFA little choice.

In response to higher transportation costs to supply fluid markets, CDFA held a hearing and increased the transportation allowances and credits. Transportation allowances, funded by producers, partially compensate for the cost of hauling milk from the producers to the plants in certain areas. Transportation credits reduce what buyers must pay for Class I milk to partially compensate for the cost of hauling milk between certain counties. The California system puts the transportation cost on the producers; increases in fuel costs naturally and inexorably resulted in lower producer returns every time.

To offset lower producer margins, some California producers petitioned CDFA for an increase in Class I, II and III pricing formulas. The processors responded with an alternative formula to reduce minimum prices of these classes by a dollar. After the hearing process concluded, the panel recommended adopting the processors’ proposal to drop the Class I price a dollar per hundredweight. The Secretary implemented, instead, only a 35-cent reduction.

The difference in results between the federal and state programs to the same economic forces is not a difference in policy towards producers. Rather it represents the relative impotency of the California system to protect minimum prices in its market compared to the federal system. The U.S. Supreme Court ruled several years ago that California could not regulate the price of milk out of state. The USDA has the power to regulate all prices in the marketing areas regardless of where it came from. Thus, if it felt that producers deserved more money and the market could bear it, it could impose that price. Buyers of the milk, though disappointed with higher prices, are assured that no competitor competes with lower costs. In short, the USDA had the ability to make all of the buyers play by the same rules.

Not so in California. Milk, either produced out of state or produced in California but processed out of state, is not subject to CDFA rules. Thus instead of one set of pricing rules throughout the market, there are two – regulated prices and unregulated.

The differences are more than prices. In the regulated scheme, plants pay a higher price for milk for use while the producer receives a lower, blended price regardless of price. In the unregulated market, what the plants pay and the producers receive are the same price. The spread between the use price and the blend price creates economic opportunity for plants and producers outside of state regulations. The plants pay less, the producers get more. Cheaper milk at the plant attracts more sales for out-of-state plants and less sales to the in-state regulated plants. The opportunity is real, and plants and producers have taken advantage of the situation. In the nation’s No. 1 milk-producing state, and one with a severe milk surplus problem, only 75 to 80 percent of bottled milk consumed in the state is subject to its pricing regulations. More seriously, pricing of that 75 to 80 percent must respond to the lower prices, the remaining 20 to 25 percent pay for milk.

An uneasy peace had existed in the marketplace until early in 2008, when a California producer was denied markets in California. He sold his milk to a Nevada plant at prices reported to be near or below overbase. The cooperative previously selling to the plant had to move its milk elsewhere. To accommodate the contract, the Nevada Milk Commission reduced the minimum prices for its Class I. Reportedly the packaged sales stayed in Nevada, but the milk it displaced came back into the California system at the lowest price. This was not the case with another Nevada plant.

Further north in Nevada, along the border of the two states, just outside of Reno, a plant began to purchase milk produced in California, process it and sell packaged milk into California’s Central Valley. The economics were quite favorable. At the hearing, testimony showed that a producer near Sacramento was shipping milk to the Nevada plant, receiving a price at or above the California overbase price for milk less hauling, and the plant sold the packaged milk in the Sacramento market at a lower price than California plants could purchase, process and supply the same market. This was when fuel prices were at their peak. Today with significantly lower fuel prices, the competitive situation favors the out-of-state plant even more.

So favorable has this relationship become, that a major retailer of milk in the Central Valley has begun to shift its supply from long-time California processing plants to Nevada. It is reported that this spring the volume will approach 4 million gallons per month. This represents more than 40 million pounds of milk not subject to the minimum prices of California and not paid into the pool. For California producers it represents a loss of 6 to 7 percent of Class I sales and a loss to the pool of millions of dollars. Other buyers of milk in California will want the same kind of price from their bottlers.

This adds to the woes of in-state processors, particularly those in the center of the state. They had already come off of a year in which their balancing costs had mushroomed. Last year, too much milk and too few plants resulted in highly discounted, even free, milk. Bottling plants that had their own supply were forced to pay minimum prices for milk that they gave away or deeply discounted. In response, they terminated their independent producer contracts. These producers had nowhere to go. Cooperatives in response to the same dynamic of extremely low or no returns on excess milk, instituted base programs. These base programs spawned controversy within the existing members of the cooperatives but there was one agreement – no new members.

The result was now a new, lower price for producer milk in California. Producers who no longer had contracts with plants and producers who were members of co-ops but with large amounts of the cheaper milk would be pleased to receive overbase or even a little less, either was an increase in income. More and more milk is freely floating around California, ready to sell almost at any price. One estimate is that as many as 60 loads of milk per day fit into that category.

Some of the producers have entered into tolling agreements that allow them to “rent” facilities to turn the excess milk into powder, only powder, and then sell the powder themselves. In today’s market, that results in deep discounts. Although producers cannot toll cheese processing, they can give up their Grade A status, “market milk” in California-speak. This frees the plant and producer from the minimum pricing restraints of CDFA. With some exceptions, Class 4b prices have averaged at or above the overbase price and clearly exceed to deeply discounted milk not under contract. It is the same price opportunity between regulated pricing and unregulated markets found in interstate commerce. Just like the loss in Class I sales reduces the prices producers receive in California, the reduction in volumes of higher-value 4b milk pooled with cheese plants also reduces the overbase. This in turn increases even more the spread between what higher Class I plants pay and the overbase producers receive, according to CDFA. Coupled with these reductions in higher-value Class I and Class 4b milk contributions to the overbase price is the ever-growing amount of milk used in the lower-valued Class 4a production. These promise less and less value in the pool. The overbase is lower. The Class I-to-overbase spread increases. Unregulated, out-of-state bottled milk opportunity grows. Cheese plants buy cheaper Grade B milk. Ever lower overbase is the result, and the cycle repeats slowly, screwing the pool price lower and lower. It is not a question of whether CDFA wants to stop it – it simply cannot.

Today, the price driving the California system is the unregulated milk. CDFA cannot regulate that milk and remove it as competition. Instead in can only reduce the opportunity price created by the Class I-to-unpriced spread. That meant reducing Class I prices.

This serious hit on the California pool has not gone without notice. Formally and informally, the state legislature, CDFA, processors, producers and cooperatives are considering solutions to the problem. The options are limited – go unregulated, modify the state order or use the Federal Milk Marketing Order system. Class I usage is now in the low teens and getting smaller. Deregulation of pricing is not out of the question. Idaho, in similar percentages, deregulated several years ago. The Upper Midwest, where similar low Class I utilizations has large portions of milk moving in and out of regulation, indicates that such a program is not absolutely necessary there.

The federal program can regulate the interstate milk, but because the Milk Regulatory Equity Act prohibits including Nevada in a marketing area, federal regulation in California will be less than complete. Going from the state order to a federal order will have other challenges. The federal milk order will be vastly different from the state order. For example, by law, producers and processors can negotiate their own price for all classes but Class I. But the real deterrent to the California dairy industry adopting a federal order is California’s “quota system. Federal law prohibits that in milk orders.

“Owning quota” is now a key component to the California program. Holders of quota get the first $1.70 per hundredweight out of the producer pool. Only a minority of the milk is entitled to receive quota (about 20 percent). The value of quota on the balance sheets of producers who own quota rights goes into the billions of dollars. Termination of the state order would no doubt end quota and remove that value.

The California industry has to find a solution. As a starter it will need to decouple the obligations of quota from its pooling and pricing. That means satisfying, or denying, the quota holders independent of the milk price. That is a decision that California producers have to make. It is between them and them alone. Then it can decide whether to be regulated or not. If regulated, it will have to be under some form of federal regulation. In the meantime, the Constitutionally limited state system will have no choice but to respond to economic forces by leveraging them against the industry it is supposed to protect, resulting in more and more unregulated milk. In time, economic forces may decide how milk is priced in California.

Ben Yale
Attorney at Yale Law Office
ben@yalelawoffice.com