Marin Bozic, dairy economist at the University of Minnesota, identified those gorillas during a presentation at the 2021 Dairy Financial and Risk Management Conference, hosted by the Pennsylvania Center for Dairy Excellence. More than 100 lenders, financial consultants and others attended the September 2021 conference, held in Harrisburg, Pennsylvania.
Bozic shared results of research conducted with Christopher Wolf, a Cornell University dairy economist. The study, recently published in the Journal of Dairy Science, took a comprehensive look into factors driving changes in producer price differentials (PPDs) in FMMOs.
FMMOs created in different era
“The federal orders of today are not the same federal orders that were designed many decades ago,” Bozic said. “The orders came about in the 1930s when the Class I utilization, or the share of all milk pooled used for fluid beverage, was very high – upwards of 70 percent.”
Bozic explained that as FMMO Class I utilization has declined, the federal order system’s central promise of providing a similar price to all dairy farmers in a specific order is getting broken. “In some parts of the country, the orders are breaking down,” he said.
PPDs have been a major focal point in the breakdown, especially over the past 18 months. The research conducted by Bozic and Wolf took an even longer look back, outlining factors that have contributed to the general decline in PPD levels in all federal orders over the past 10 years.
“Often, Class I reform gets blamed for the negative PPD levels in 2020,” he said. “While Class I reform was part of it, there were much bigger problems there than just that.”
Factors contributing to negative PPDs
In their research, Bozic and Wolf isolated several factors that contributed to declining PPDs. Those included:
- Ongoing trends in the dairy industry, including lower Class I utilization and higher producer protein levels.
- The spread between Class III and Class IV milk prices and how that affects what is paid into and paid out of the FMMO pool.
- Rallies and crashes that occur in the cheese market between when advanced prices come out and announced prices are released.
Class I utilization
Class I utilization levels have dropped substantially in many parts of the country over the past decade. In their model, Bozic and Wolf isolated how that change impacted PPDs by keeping all other factors – including the Class III-IV spread, component levels and advanced versus announced prices – consistent.
With everything else being consistent, the drop in Class I utilization and corresponding increase in other class prices alone caused a significant change in the PPDs farmers receive – ranging from as high as a 48% drop in PPDs in the Pacific Northwest #124 to a 23% decrease in the Southwest #126. Without any other influences, the PPD rates in the Northeast #1 would have fallen 25%, or 47 cents per hundredweight (cwt) in the past 11 years, due solely to the change in Class I utilization. Bozic predicts those trends will continue over the next 10 years.
“This has nothing to do with policy changes or what happened with the virus or before any other effects related to the turmoil occurring in the past 24 months,” he explained.
Protein changes: Two channels
Another trend influencing PPDs is rising milk-protein levels. “There are two channels in which these higher protein levels are contributing to lower PPD levels,” he said.
Bozic explained that Class I handlers pay into the FMMO pool based on skim milk, which has a standardized protein test, but they take money from the pool based on the actual protein test. “So if protein levels are higher than the standardized test, Class I handlers are paying the same but taking more out now,” he explained.
He said the second channel is through Class IV pool accounting. “A Class IV plant will pay to the pool based on the nonfat solids price, but they take money from the pool based on the protein price,” he said. “So if protein levels are higher, they take more money out than they put in.”
Class III-IV price spreads
Bozic explained that as the spread between Class III and Class IV milk prices widens, PPDs decline in almost a linear relationship. Class III handlers pay into the pool based on protein and nonfat solids, but they take money out of the pool based on protein prices. As the spread gets wider, there is less money left over for PPDs.
In 2020, when demand for cheese spiked due to USDA food box purchases, Class III prices went through the roof. So why didn’t all milk go into cheese production? Bozic explained that it was because there isn’t additional capacity for cheese production in the U.S.
“When you operate a cheese plant, you want to keep it full all of the time because that is the only way you can make any money making commodity cheese,” he said. “That is why around the country we don’t have a lot of slack capacity for cheese, and that is why when there is a huge spike to cheese demand, it’s a huge shock to the industry.”
Advance pricing
Bozic added that the FMMO advanced pricing schedule can also impact PPD levels. “The price of milk is determined at two different points of the month. Before the month starts, we set the prices for retailers, and for manufacturers, we set prices at the end of the month. So when there is a rally in the cheese prices, PPD prices go down,” he explained.
Finally, Bozic said the change in the Class I milk price formula has impacted PPD levels. “The plan was to make it easier for the new channels for Class I milk to hedge, so we went from the ‘higher of’ to the ‘average of plus 74 cents’ to calculate our Class I price.
“When the industry came up with the plan, the formula was based on a backwards revenue-neutral look,” he said. “As long as the spread [between Class III and Class IV skim milk price] was less than $1.48, it had a neutral to positive impact on PPDs.”
What happened in 2020 was that the spread was larger than $1.48 per cwt. “The most that PPD can be higher under the new formula than the old is 20 to 25 cents. But when Class III is much higher, like in 2020, the downside risk to PPDs is much greater.”
Bozic shared his research on how each of these factors influenced PPD levels, using 2010 as a baseline. For July 2020, he showed how if all factors were the same as in 2010, the baseline PPD would have been $1.94 per cwt. The trends in lower Class I utilization and higher component levels that occurred between 2010 and July 2020 reduced that by 65 cents, while the spread between Class III and IV reduced it by another $3.95. The rally in the cheese price that occurred between the date the advanced price came out and announced prices were released contributed another $1.75 to the decline, while Class I reform added another 84 cents to the decline. The resulting PPD for July 2020 was -$5.46 in the Northeast #1.
“In August 2021, it was much less of an issue,” Bozic said, adding that all of the factors combined resulted in a PPD that was only slightly lower than what it would have been in 2010.
“The gorilla in the room, though, is not what has already happened, but what we are going to see happening in the next 10 years,” he said. “The continued decline in Class I sales will continue to drive PPD levels down, so that you will lose another 25 cents in the next 10 years.
“We have built the federal order system around a declining category – fluid milk sales – and we have not taken into account the increasing category, which is our export markets. So as we contemplate what to do with federal orders, we need to keep in mind what to do with these exports and with these other gorillas.” 
-
Jayne Sebright
- Executive Director
- Pennsylvania’s Center for Dairy Excellence
- Email Jayne Sebright
