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The Federal Milk Marketing Order’s advanced payment system

John Geuss Published on 10 December 2015

Editor’s note: This is the third of four articles explaining producer payment systems for milk in the U.S.

This article will analyze the Federal Milk Marketing Order’s “advanced” payment formulas and orders.

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There are four of these federal orders, which make up approximately 9 percent of U.S. milk production, but the impact of these formulas goes well beyond these orders and influences the payments in the much larger “component” payment system. The four orders paid on the advanced system, by size, are the Appalachian, Southeast, Arizona – Las Vegas and Florida orders.

In part one of this article series, an overview of the payment systems was reviewed, and in part two, the six orders that pay on the component system were reviewed. The orders paid on the advanced system, which are discussed here, are unique. Three of the advanced orders produce primarily fluid milk. The volume and usage of milk for these orders are shown in Table 1. Most all of these orders are shrinking because of their dependence on Class I fluid milk, which is a shrinking category in general. Arizona – Las Vegas is the exception.

Table 1

The Appalachian order includes the Carolinas and parts of Virginia, Tennessee, Kentucky and a tiny bit of Georgia. The order is very dependent on the shrinking fluid milk category as about two-thirds of the milk produced goes to fluid milk.

The Southeast order is comprised of Georgia, Alabama, Mississippi, Arkansas, Louisiana and parts of Tennessee, Missouri and Kentucky. The Southeast order is also shrinking due to its dependence on fluid milk. About three-fourths of the produced milk goes to fluid milk.

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The Arizona order covers only Arizona and receives its milk primarily from southern Arizona. A small amount of the Arizona milk also comes from southern California. Of the four orders discussed here, Arizona is unique. Only about a quarter of their milk production goes to fluid milk. The largest category in this order is Class IV milk for nonfat dry milk (NDM) production. Arizona is a convenient location for exports of NDM to Mexico. They also use about a quarter of their milk for cheese – and perhaps the most important statistic is that this order is growing while the other three orders paid on the advanced system are shrinking. Based on the current production statistics for the Arizona order, a good case could be made that this is an order that should be paid on the component system.

The Florida order is the smallest and is the most dependent on Class I fluid milk, with 85 percent of their milk going to fluid milk. Florida has the largest Class I fluid milk differential at $5.40 per hundredweight. Because of this, Florida has the highest-paid milk in the country, but it is also the fastest-shrinking order. Even the makeup of their fluid milk is unique. The largest category is whole milk, while 2 percent is the favorite nationally.

The payment system is called advanced because prices are announced before the milk is ever produced. It may seem like an advantage if you know the value of what you are making in advance of making it, but for producers, this has little impact.

The prices are based on the same commodities used for the component pricing system: cheese, butter, dry whey and NDM. The NASS data from the two weeks proceeding the month are used for the calculations. Producers are paid based on the skim milk and butterfat prices. No specific payment for protein or other solids is included.

For the entire federal order system, Class I fluid milk is the second-largest category, and Class II is the third-largest category. Combined, they represent a little less than half of the federal order milk. The prices established by the advanced system for Class I and II skim milk are the prices used for producer payments in both the advanced system and the component system. For that reason, the advanced payment system is very important to all producers paid in the Federal Milk Marketing Order system.

The formula for Class I skim milk has an interesting twist.

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Skim milk price for Class I = higher of advanced Class III or IV skim milk pricing factors + Class I differential

Because of the “or” in the formula above, cheese, butter and NDM prices can influence the Class I milk price. In 2014, NDM reached record prices as international demand outstripped production. As a result, the Class I skim price was based on the Class IV skim advanced price. This was unusual because, typically, the Class III advanced price is higher than the Class IV price.

This influences the four orders paid on the advanced system directly and also influences payment in the six component-paid orders because the Class I skim price established in the advanced system is also the Class I skim price for those paid on the component system. In turn, the Class I price in the component system influences the producer price differential paid in the component system, as explained below.

The Class I differential in the above formula varies by county and federal order and recognizes the extra effort and transportation needed to deliver Class I milk.

The Class II advanced price is based on the Class IV price and, once calculated, also becomes the price for the component system as well. There is a differential of $0.70 per hundredweight added to the Class IV price to recognize the additional effort needed to produce suitable milk for Class II usage.

Class II skim milk price = advanced Class IV skim milk pricing factor + 0.70

The advanced formulas for Class III and Class IV skim are exactly the same as those used for the component system. However, they are based on the commodity prices for the last two weeks of the prior period, whereas the component system uses the four or five weeks in the current period.

Advanced Class III skim milk pricing factor = (protein price x 3.1) + (other- solids price x 5.9) or

Advanced Class IV skim milk pricing factor = nonfat solids price x 9

The timing of these price announcements can significantly impact the producer price differential paid in the six orders on the component system. The producer price differential is the difference between the average of the four milk classes and the Class III price. In the typical scenario, Class I skimmed milk price would be valued based on the Class III skimmed price from the advanced pricing calculation.

When cheese prices are escalating, the Class III skimmed price for the component calculation can be higher than the Class I skimmed price for the advanced system. Therefore, the Class I price used in the component system will be lower than the Class III price, which can create a negative producer price differential. This typically leads to de-pooling to avoid a negative charge to the producer.

Why is all this important to a producer? While the majority of producers are paid on the component system, an understanding of the advanced system is needed to fully understand the payments made to producers in the component payment system. All producers paid under the federal orders are influenced by the advanced payment system.

As more producers increase the financial sophistication of their management practices and consider hedging or other risk management practices, a thorough understanding of the formulas and their inter-relationship is needed. To just ignore the entire revenue payment system, or leave it in the hands of others, is leaving a lot of the business management in the hands of others.

In the next article, the California producer payment process will be explored. PD

Click here to read the first article "Producer milk payment systems in the U.S.

Click here to read the second article "How the FMMO's component payment system works"

Click here to read the fourth article "California vs. FMMO milk pricing"

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