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Be careful what you call it

Ben Yale Published on 12 November 2010

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The 1940 Republican candidate for president, Wendell Willkie, said, “A good catchword can obscure analysis for 50 years.” The name of a then-new program called “Social Security” made it harder to oppose. Do you oppose social security?

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Or, stated differently, by opposing Social Security are you promoting social insecurity? Catchwords can and do effectively keep us from focusing on what is really going on, and in the process we miss the real issues and opportunities for solutions.

In the face of complex issues such as dairy economics, it is common to resort to simple catchwords. One of the catchwords in dairy is “volatility” or “price stability.” These are in response to the current period of too- low milk prices. But do these terms properly describe the issue and lead us to solutions, or do they blind us to the real problem? A look at milk pricing and profit history over the last decade can help answer that question.

In 2003, the average all-milk price for California was $11.40 per hundredweight (cwt), Wisconsin was $12.98, and the national price was $12.57. In 2009, the all-milk price was $11.52, $13.10 and $12.80 respectively, or more or less the same as 2003. While 2003 was considered a bummer, it followed an even worse 2002. 2009, on the other hand, followed two of the highest years ever in prices. The average all-milk price for California in 2003 was only 70 cents lower than the average the three prior years. On the other hand, the average price in 2009 was almost $4 less than the average of its prior three years. Based on these prices alone, 2003 should have placed dairy producers in a worse position than 2009. But it did not.

The quick answer, and the one now driving the debate, is that the suddenness in this price drop in 2009, its volatility, was the root cause of the level of deep pain experienced in 2009. Because 2003 came less violently, with less volatility, it was not so damaging. By naming the demon, we can call it out. Eliminate volatility, eliminate pain. That is the summary of the argument, and it is one that has dominated the discussion for almost a year.

At least one noted dairy economist questions whether the use of the term “volatility” sufficiently describes the 2009 experience. He identifies three different characteristics of milk price series variability which are commonly labeled as “volatility” – certainty/uncertainty, stability/instability and adequacy/inadequacy.

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Price uncertainty, instability and inadequacy were all present in 2009, but the lack of an adequate price trumped the uncertain and unstable price we experienced. A certain and stable price alone cannot be the answer. For example, the dairy price support series is certain and stable at a range of $9.50 to $9.90, but clearly inadequate. In all of the discussions about price volatility, they all circle back to whether the price was high enough or not.

Our almost exclusive focus on milk price level is due to our history of considering dairy farm profitability. For a long, long time, milk price alone could properly identify the economic state of producers. Price adequacy was having enough in the milk price to pay the bills. With low and stable feed costs, the profitability, or not, of the dairy farmer could be almost completely expressed in terms of the milk price. Prior to 2005, knowing the changes in milk price was sufficient to determine potential for profit or loss. Uncertainty in the milk price or its instability only became a concern with the level as compared to the costs being too low. While feed prices varied, such changes in feed prices were manageable and they were always low enough to provide some margin.

We were able to focus and define dairy profit based upon price because feed costs were not so volatile. That has changed.

According to the USDA’s ERS site for cost of production, the average dairy feed cost for California was $7.19 per cwt in 2003 and more than double that, $14.60, in 2009. The CDFA’s audited cost of production shows lower prices, but the same trend. During the years 2006 through 2008, feed price rose dramatically, but these higher costs were generally masked by also higher milk prices. In other words, between the higher milk prices and feed prices, there was still price adequacy.

The parallel movements of grain and milk prices ended in late 2008. While grain prices continued to rise to record levels, milk prices fell to near-record lows. What was a squeeze on profitability in 2003 at those same prices was now an explosion of losses as the cost of feed expanded beyond the value of milk. There was no longer any “added value” to grain. There was a full $7 cost increase in grain prices in the intervening years. The University of Wisconsin, in its website Understanding Dairy Markets, a table for California’s “Milk Revenue Net of Feed Costs”, reports a positive margin of $4.20 in 2003 – but for 2009, with virtually the same milk price, a negative $3.05. The other quarter represents small changes in other costs of operation.

The end of this reliance on a single measure of economic health came not in late 2008 or 2009, when it first was felt, but in 2005. That year the government mandated the use of corn-based ethanol in gasoline. As the usage of ethanol grew, the appetite for corn grew as well. In 2010, corn used to make ethanol will consume approximately one-third of a near- record corn crop.

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Ethanol blenders have a favored government status, including a mandate that every gas-powered vehicle in the U.S. use some ethanol, tax incentives to ethanol blenders and protectionist tariffs against importation of ethanol to reduce foreign competition. The combination of these extra market forces means ethanol blenders will consume corn at almost any price and that the demand will grow as the price of oil grows. The increased demand has stripped grain warehouses of surpluses. With no real reserve supply and barely enough grain to meet all needs, prices will be high and subject to extreme volatility. That is the prognosis after a very good national harvest. There is no guarantee weather will be so kind in future years. A short crop could mean as much as half or more grain would go to higher-valued ethanol production. The high price for corn drives cropland into corn, forcing other grains and oilseeds, such as soybeans, and cotton to also rise in price.

This reality of higher feed prices, now coming again in the fall of 2010, and forecast well into the future, represents a game-changing shift in dairy farm economics. Because of this shift, the discussion on dairy policy must respond accordingly.

Under the old way of looking at things, when milk price was the dominant if not the only factor in dairy profitability, it was logical to consider ways to bend the milk price series to protect against price inadequacy. Ethanol has changed all of that. Nine years in the first decade of this century were survivable, some very profitable, some boomers, but in the end survivable. The terrible year of 2009 was the exception; it was not even close to profitable. Eliminating volatility would not have fixed that. The average California all-milk price for those ten years was $13.40. Had that price stayed at that level (that is, there was no volatility) for the entire period, it still would not have generated enough money to pay the average feed bill of $14.60 cwt for 2009.

The new reality is that dairymen who purchase feed (the typical Western dairyman) compete with a new demand for corn from a new priority buyer. As much as dairymen and livestock producers do not like the ethanol factor in feed prices, it is here for a long time. Although Congress may modify some of the provisions that so favor the ethanol industry, its demand as an oil substitute will remain unchanged and it will be the price-setting buyer of large quantities of corn for a long time.

This dramatic change in the economic landscape should see an equally dramatic change in focus in dairy policy. For years the USDA and California, when setting minimum prices, have relied upon models and projections that consistently showed that the resulting producer milk prices would exceed cost of production and thus assure a continued supply of a good and wholesome product. Those models were confirmed as milk continued to be produced and, until 2009, at a profitable level for a sufficient volume to promise enough milk. Current pricing can no longer do that in major milk-producing regions, especially California. In one year, the equity from a decade or more of profitable marketing in this confirmation was lost, undermining the long-term policy of milk pricing.

Dairy farmers no longer have the equity they did several years ago. Even though they survived the last major battle, such a fact does not confirm the validity of milk pricing models, but rather shows the toughness and persistence of dairymen in the face of incredible odds. When the next wave of inverted margins comes, unfortunately likely due to the ethanol policy, that equity will no longer be there to protect the milk supply. This is not just equity in the farm, but their landlords, feed supplier, equipment seller and repairer, veterinarian and other vital parts of the dairy infrastructure.

Whenever there is a game changer, there is a realignment of who are the winners and losers. In this case, the change is towards those who pasture their cows or raise their own feed. While Wisconsin producers, for example, also saw their feed costs increase, the increase was much less dramatic – from $5.71 cwt in 2003 to $9.41 in 2009. The total costs have changed as well. The long-standing total cost of production advantage for California over Wisconsin as recently as 2006 was $6.17. In 2009 it was seventy cents!

The real paradigm shift is that buyers of milk – cooperatives, producers, and regulatory agencies – can no longer focus on milk prices as an index of farm health. It is not an issue of changing production trends, or buying up powder, cheese and other dairy products to increase dairy demand. Those are all focused on milk price, but the issue now is feed cost, and they do not address that. To ensure a continuation of dairy life, there has to be price adequacy, which is now a two-variable equation of sales and feed costs. Milk prices that at least recognize that extra cost will have to come to maintain a sufficient supply of milk, let alone any surplus. The catchword should be “profitability.”

NOTE: Most of the numbers listed here can be obtained at Understanding Dairy Markets, Dairy Data, Input Costs, http://future.aae.wisc.edu/tab/costs.html#16. Monthly milk costs of production for selected states are available at http://www.ers.usda.gov/Data/CostsAndReturns/testpick.htm#milkproduction. PD

Ben Yale

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