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Changing market conditions don’t quell concern over Class I price formula

Progressive Dairy Editor Dave Natzke Published on 21 September 2021

Editor’s note: This article has been updated from the original to include additional comments from the American Dairy Coalition.

As calls for reforms to the Federal Milk Marketing Order (FMMO) system grow louder, one “hot button” issue remains under fire. At least one dairy organization wants to keep producer pressure on that issue to ensure a long-term equitable outcome.

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The change in the FMMO system “Class I mover” pricing formula has drawn the ire of dairy producers for more than a year and was a topic of concern during a recent Senate Ag Committee subcommittee hearing. (Read: Senate hearing focuses on FMMOs, reforms.)

As a quick review, the change in the Class I milk pricing formula was made through the 2018 Farm Bill rather than through a formal FMMO hearing process. Implemented in May 2019, the change converted the calculation of the FMMO advanced Class I base price from the “higher of” the monthly Class III and IV advanced skim milk prices to the “average of” of those prices and adding an adjustment factor of 74 cents.

Based on historical prices, the formula change, with the 74-cent adjustment, was seen as “revenue neutral” to the milk price received by farmers, while providing Class I processors the ability to hedge risks associated with volatile Class III and Class IV prices.

With milk marketing disruptions caused by the COVID-19 pandemic, however, revenue neutrality quickly became extreme revenue losses for dairy producers marketing milk through the FMMO system, especially within federal orders with high Class I utilization. Government food box purchases, with a heavy emphasis on cheese, drove the Class III price higher while leaving butter and Class IV prices in the doldrums. The “average of” formula failed to capture the Class III value in the Class I price, a situation which was further impacted by depooling the Class III value from FMMO pools and uniform or blended prices.

The National Milk Producers Federation (NMPF) has estimated losses to producers reaching about $750 million. Testifying at the Senate subcommittee hearing Sept. 15, Catherine H. de Ronde, vice president for economic and legislative affairs for Agri-Mark Cooperative and a member of the NMPF economic policy committee, estimated about $142 million of the total occurred in the Northeast, where Agri-Mark has approximately 720 members marketing about 3.3 billion pounds of milk annually.

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Mike Ferguson, owner of the 150-cow Ferguson Dairy Farm near Senatobia, Mississippi, noted the southeast U.S. was among those hardest hit by the change in the pricing formula due to high Class I utilization rates. “Across the three southeastern federal orders [Appalachian, Florida and Southeast], the economic impact was more than $150 million in foregone revenue on the milk we pooled on the federal order,” he said.

Based on that estimate, losses in those three FMMOs represent about 20% of the $750 million total, even though the percentage of milk produced in the three marketing areas represents just 5.5% of FMMO total milk marketings.

In an attempt to reimburse dairy farmers for some of those losses for the period July-December 2020, the USDA has created the Pandemic Market Volatility Assistance Program for Dairy. The USDA has set a cap of $350 million for that program. Read: Dairy pandemic assistance: The devil is in the details.

The tipping point

Where is the tipping point in the “higher of” and “average of” formula debate? Testifying at the Senate subcommittee hearing, Christopher Wolf, Cornell University dairy economist, estimated that when the difference between the Class III and IV advanced skim milk prices exceeds $1.48 per hundredweight (cwt), “the resulting Class I price built from this new formula is less than it would have been using the ‘higher of’ the two prices.” The pandemic resulted in a wide and prolonged divergence in Class III and Class IV prices in 2020, Wolf noted.

According to USDA FMMO data, the difference in Class III-IV advanced skim prices exceeded $1.48 per cwt in eight months in 2020: May and July through December. The difference surpassed $10 per cwt in three months, resulting in Class I milk prices that were $4.25-$5.01 per cwt less than would have been received under the average-of formula.

The Class III-IV skim milk price spread relationship continued to a lesser extent through the first six months of 2021, ranging between $1.87 in May to $3.31 in June, and adding to the losses on producer milk checks.

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A call for change; changing markets

Several dairy organizations have called for an immediate return to the higher-of pricing formula.

However, dairy markets have changed since the height of the pandemic, and a switch back to the old formula could end up costing dairy farmers some money. Class III and Class IV milk prices, as well as Class III-IV advance skim milk prices, have moved closer together, eliminating the wide spread. Using the average-of formula plus the 74-cent adjustment factor has yielded a positive, albeit small, Class I pricing benefit to dairy farmers on July, August and September milk marketings. The closer relationship in current Class III-IV milk futures prices indicate that could continue through 2022.

Markets change, of course. So despite the current trend, the American Dairy Coalition (ADC) board recently passed a motion supporting a return to the previous Class I formula while options are vetted through the USDA hearing process, even though the average-of formula may provide some near-term benefits.

Laurie Fischer, the organization’s CEO, said ADC has been hearing from producers and collaborating in conference calls for over a year with momentum building months ago for a call to revert back to the “higher of” Class I pricing formula. “We have known since June that the wide divergences we saw for many months between Class III and IV are now coming together,” she said.

“We know calling for a temporary return to the previous Class I formula – while various ideas about Federal Milk Marketing Orders are sorted out – isn’t going to happen overnight, but the process needs to begin. We are also looking futuristic and beyond a recent short-term shift and what the futures markets currently show us because a lot of dairy farmers have suffered severe loss of revenue due to milk being removed from the federal orders,” said Fischer. 

The new Class I formula, done legislatively and implemented in May 2019, was inadequate for the changing and uncertain markets, Fischer said.

Fischer said there was evidence that the loss of the higher-of milk pricing method significantly undermined farmers’ ability to implement risk management strategies. And the new formula also created winners and losers when it came to the milk prices they received, due to negative producer price differentials (PPDs) and depooling.

“Subsequently, farmers have lost confidence in the functioning of the FMMOs and question the value of purchasing available risk management programs under the average of pricing formula,” she said.

“The previous ‘higher of’ milk pricing formula allowed us to participate in risk management strategies with the confidence they could help protect our business from market shocks. Under the new ‘averaging method,’ risk management results are no longer as predictable. So in addition to living with a milk pricing system that is not as responsive to unexpected market conditions, our experiences over the last 18 months have caused us to lose confidence in using these risk management tools,” said Linda Hodorff of Second Look Holsteins in Wisconsin and Broken Bow Dairy in Nebraska.

Fischer observed that during the Senate subcommittee hearing, panelists agreed to the need for FMMO reform and called for a comprehensive USDA rule-making process that ensures all parties are heard.

"We agree,” said Fischer, “But an immediate solution is needed while the slow and deliberate long-term process takes place. Returning to the previous Class I formula, one that already went through such a deliberative process, is the short-term option that makes sense for producers to be able to navigate price volatility and manage their price risk. Everyone agrees the change was never meant to harm farmers, but unfortunately, it did.”

“Currently, Class I is benefiting from the new averaging method with the 74-cent adjuster,” Fischer explained. “If we include the small benefit ranging 34 to 69 cents for July through September, the net loss across the 29 months of implementation so far is still 720 million dollars, or the equivalent of 67 cents on every hundredweight of Class I milk shipped since May 2019.”

“Right now, Class I does benefit from the averaging of milk pricing method, which can max out at 74 cents on the top side. But if that gap between Classes III and IV widens again, there is no limit to the losses on the bottom side,” said Fischer.

Earlier this year, Jeff Lyon, general manager of FarmFirst Dairy Cooperative, said his organization would recommend a return to the higher-of Class I mover formula if the USDA moved ahead with a formal hearing process. Read: FarmFirst will propose returning to ‘higher of’ Class I price formula.

Read also: Pricing formula change’s unforeseen outcome skims producer profitsend mark

Dave Natzke
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