Dairy farmers banking on the surge in cheese prices to have an immediate and equally explosive impact on their milk checks should rein in expectations. Analysis by leading U.S. dairy economists warn that negative producer price differentials (PPDs) and depooling will sharply limit any price increases many dairy farmers will receive in their milk checks this summer.
Natzke dave
Editor / Progressive Dairy

“For the next few months, producers will very likely be frustrated by seeing that Class III prices have rebounded dramatically from the pandemic-induced lows but that their milk check doesn’t reflect all of the optimism from dairy headlines,” according to Mark Stephenson, director of dairy policy analysis at the University of Wisconsin – Madison, and Andrew Novakovic, professor emeritus of agricultural economics emeritus at Cornell University.

(Download Stephenson and Novakovic’s informational letter, posted on the Dairy Markets and Policy website: Making Sense of Your Milk Price in the Pandemic Economy: Negative PPDs, Depooling and Reblending.)

“These negative PPDs are expected to offset recent price increases in some dairy farmers' milk checks to the effect of $5 to $7 per hundredweight,” said John Newton, chief economist with the American Farm Bureau Federation (AFBF). “Subsequently, these negative PPDs are likely to lead to large volumes of manufacturing milk being depooled from FMMO revenue-sharing pools.”

(Download Newton’s article, posted on the AFBF Market Intel website: Negative PPDs to offset milk price rally.)

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How’d we get here?

In simplest terms, Federal Milk Marketing Orders (FMMOs) pool both milk and money. Milk producers supply milk to a pool and draw out money. Milk processors supply money to a pool and draw out milk.

Dairy producers are paid based on an average or blend price of all four classes of milk, with adjustments for milk components and quality. Processors pay a different price for milk based on its end use, i.e. Class I (fluid products);, Class II (soft products like creams, yogurt, ice cream), Class III (cheese and whey), products and Class IV (butter and milk powders). (From there – due to numerous factors, including timing – things get more complicated, so download the articles above if you want to dive in.)

The bottom line is that the milk and money pools have to be in balance, and PPDs are an accounting means to bring FMMO pricing and pooling functions into equilibrium.

In normal conditions and historically speaking, the monthly Class I milk price is the highest and, with the addition of regional differentials, processor payments create a money pool that is slighter more than the total paid out to producers based on the value of the components of their milk in the pool. In that case, PPDs are positive and producers might receive a premium.

We are not in normal times, mainly the result of the coronavirus and its impact on the dairy supply chain, resulting in a sharp decline in milk prices earlier this spring. With FMMO advanced pricing, the market lows experienced in late April are used to price fluid (Class I) milk in June. The June 2020 Class I mover just is $11.42 per cwt.

Meanwhile, with restaurants reopening and the USDA buying large quantities of dairy products, cheese prices skyrocketed and the Class III milk price began to rally in May. The FMMO Class III price for June (announced July 1) is $21.04 per cwt, the highest since November 2014, and creating a Class I-Class III price difference of more than $9.60 per cwt.

That extreme price inversion means, based on pricing and pooling formulas, that more money is going out of the pool than coming in. To keep things in balance, PPDs turn negative and money is deducted from milk checks.

The inversion will extend to July milk, even though the July 2020 Class I mover jumps to $16.56 per cwt. As of the close of CME trading on June 30, the Class III futures milk price on July contracts was $22.35 per cwt, a difference of $5.79 per cwt. That means the July PPD is likely to be substantially negative, and it’s possible PPDs could be negative in August and September in some FMMOs, depending on milk class utilization.

Another factor contributing to negative PPDs is the modification to the Class I milk price formula approved in the 2018 Farm Bill. The economists address that issue in their respective articles.

Depooling impact

That brings us to depooling. For the most part, the only milk that is required to participate in the FMMO pool is milk delivered to a regulated Class I milk processor. Pooling of milk in manufacturing classes (Class II, III and Class IV) is optional, with some restrictions.

Given the current price relationships, there is an economic incentive to keep Class III milk out of the pool, so those handlers do not have to “share” the higher Class III proceeds with other producers. Depooled milk is also not subject to FMMO minimum price enforcement.

If the Class III handler is a dairy cooperative, the higher proceeds from the Class III market would belong to their producer-owners. Dairy co-ops are not required to pay FMMO minimum prices, so the additional Class III revenue could be used to offset operating, marketing or balancing costs, COVID-19-related revenue declines, used as retained equity or used to pay higher milk prices to their members, Newton explained.

Stephenson and Novakovic provide simplified calculations to estimate statistical uniform prices and PPDs in all 11 FMMOs through the end of the year and indicate even deeper negative PPDs with widespread depooling.

In a separate email, Stephenson said depooling could have a cascading effect: If the uniform or blend price is lowered through depooling of Class III milk, it could create incentive for depooling Class IV milk, pushing PPDs even more to the negative.

Implications on risk management

While the current extreme situation is somewhat unique and relatively short-term, attempting to manage through it using risk management tools would be difficult, according to Newton. The price risk associated with the PPD can only be managed through the terms of a forward contract.

Commercial exchanges cannot entirely cover PPD-related price risk. In addition, Dairy Revenue Protection (Dairy-RP) and Livestock Gross Margin for Dairy (LGM-Dairy) federal crop insurance policies are based on the announced USDA prices – and do not include the PPD.

“It’s unclear at this point what the impact of large negative PPDs will be on the U.S. all-milk price and the Dairy Margin Coverage payments that will be based on that price,” Newton wrote. “As a result, the large negative PPDs are unlikely to be fully offset by federal risk management programs.”

Direct payments through the Coronavirus Food Assistance Program will help to offset a portion of the negative PPD – but it is based on first quarter 2020 production only.

Methods to prevent or mitigate negative PPDs – such as eliminating the advanced pricing component, reconsidering the higher-of pricing formula (but with forward contracting of Class I milk), requiring mandatory pooling of milk in all classes or consideration of decoupling the Class I milk from the price of manufactured milk products – would require FMMO reform, Newton wrote.

One effort to limit the full impact of negative PPDs was proposed earlier this year, establishing a temporary price floor for Class I milk at $15.68 per cwt, which would have narrowed the Class I mover-Class III price difference. However, that proposal was seen as benefiting some orders with high Class I utilization more than others and failed to gain national consensus.  end mark

Dave Natzke