Here is the charge: “The Chicago Mercantile Exchange cash cheese market is responsible for the failure of milk prices over the last several years.” Those making the charge claim the CME is “thin” with less than 1 percent of cheese priced through its market. Other charges include shady prices when there is no trade (unfilled higher bids and uncovered lower offers) and few market players. Those two elements combined result in the opportunity, if not actuality, of cheese price manipulation and, through that, milk. The CME and its supporters respond that the cash cheese market represents a perfectly honest method to handle the spot market needs by being a market of last resort for buyers and sellers of cheese. It reports actual activity and represents a price for spot cheese and nothing more. What others do with the information is their choice.

The USDA responds that it does not use CME. Instead it uses a survey of 10 to 15 percent of the cheese actually sold in the U.S. and translates that into a minimum milk price.

What the charge misses, and all those who spend their breath making it, is that the CME cheese price is not the milk price and that the path from cheese prices (spot or survey) to milk prices is neither direct, obvious, nor even the result of natural market forces. A cheese price, any cheese price, does not have to result in the kind of milk prices currently being generated in the system. But it does and how we get from a cheese price to the milk price is ignored.

How a product price becomes a milk price – milk pricing – has more impact on milk prices than events on the CME trading floor, imagined or real. Unfortunately, all of the noise and thunder on milk prices has focused on the CME, not what happens between it and the milk prices. History tells us this is important. The headlines, speeches by politicians, news releases by producer organizations and statements at producer meetings mimic if not repeat the same kind of statements made about the National Cheese Exchange (NCE) prior to April 1997 when it closed – it was thin, it was subject to manipulation, and it represented too little cheese. The NCE closed its doors, the CME took its place as well as the NASS, and today we hear the same thing. If the CME cash cheese market ceased today, what replaces it will be similarly slammed and damned. Producer prices as a function of cheese prices are lower today than before the NCE was closed.

For the remaining part of this discussion, assume any cheese price and assume that it is good, bad or even ugly. For the purposes here, it is what it is.

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The connection between the CME and NASS is much tighter than the USDA argues. While it is true that it only captures actual sales and not unfilled bids or uncovered offers, it does nonetheless capture the CME and prove through overwhelming detailed data that the connection between the market value of cheddar cheese in actual sales and the reported CME price is tight. According to research, the NASS has a 98 percent correlation with the CME. Those who are in the market for cheese, or counsel those who are, can and do with amazing accuracy, “predict” NASS-reported prices based upon the CME price. The FMMO formula does in fact derive its monthly variations mathematically from corresponding changes on the CME cash price for cheese. What that means is a one-cent change in the CME price, up or down, will correspond with an approximate 10-cent change in the milk price in the same direction. California milk order formulas openly use the CME price.

We now have the product price. How then do we get to the milk price? To avoid losing the argument in the weeds, I will focus on the root formula – product price less make allowance times yield equals the milk price. In the final formulas, values for butterfat and dry whey play roles, but those roles are unchanged by what the CME price does or does not do and are ignored here for that reason.

The Class III price is not just for milk to make cheddar cheese such as sold on the exchange or all American style cheeses, it is the price for all varieties of cheeses – mozzarella, Swiss, blue cheese and others. In January of this year, manufacturers produced 841.6 million pounds of cheese. Of that, 494 million were non-American style. (The prominent portion of non-American style cheeses are the Italian-style cheeses including mozzarella.) For five weeks NASS reported cheddar sales of 109.7 million or 13 percent of the total cheese produced.

The replacement of market dynamics with a fixed determination in the milk pricing that cheddar cheese will serve as the proxy for all cheese milk magnifies by an eight-fold increase in the importance of cheddar cheese prices. This imposition has no validity in today’s cheese market. Even in January 2000 when the current milk pricing went into effect, cheddar-style cheese represented a minority of cheese made. Italian and other non-American cheeses amount to more cheese made, and these have completely different yields, make allowances, supply demand and price levels. If an end product price were derived based upon those cheeses, it would generate a different milk price than the current formula does. But the market reality is ignored, and the milk pricing system dictates that commodity cheddar stand for all of cheese for milk pricing.

In addition, for most months, the Class I price is based on the Class III price. For January 2010, cheese utilization was 42 percent of the milk and bottled milk was 36 percent. For that month, the cheddar cheese price drove 78 percent of producer blend prices.

Between the CME-NASS price and the milk price are two other variables – make allowances and yields. These vary month to month depending on market conditions and clearly between plants and varieties. There is no “standard” for these. The government changes these variables to fixed factors through regulatory change. As fixed factors and not variables, their market dynamics, which could offset much of the product price volatility, is removed. Again, these factors are related to cheddar cheese, which generally has a lower yield than non-American style cheeses, and ignores the change in the makeup of the varieties actually sold.

The impact of making these pricing factors cannot be overstated. In two instances in the few years immediately leading up to the drop in prices in 2009, the USDA raised the make allowances in these formulas. The combined result was about 50 cents a hundredweight in the milk price due to the change in the milk pricing. It is not a question of whether it was good or bad or right or wrong. It happened. It could happen in any direction again. To understand the magnitude of this change, payments for MILC and the supplemental MILC payment in 2009 were less than this change in the relative value of milk prices received by producers. The market value of those changes in the aggregate exceed by factors of two or more the market value of the entire budget for MILC and price support and proposed market allowance fees.

In an ordinary market, the cheese plant and producer would negotiate a price. To have a long-term supply, the plant has to pay enough to make the producer profitable and the producer has to provide milk at a price the plant can be profitable. Cheese plants do not have to index off of the CME. They could negotiate prices with their buyers on their own. By incorporating its own product prices, not the CME-NASS, its own make allowances and its own yields, it has a completely different price than what the USDA offers and could negotiate that price with producers. In this way, producers could capture the extra value from supplying Italian style cheese plants, or specialty cheeses, or high-end cheddar plants. With forward contracting, the reality that there are truly no minimum enforceable prices for manufacturing grade milk in the FMMO system, why is this not happening?

The pricing system replaces thousands of individual price decisions with one massive one. Consider a group of people with teaspoons stirring water in a wash basin. There would be splashing and a lot of movement. But fasten the spoons together in a line and let one person move the same surface area as all of the spoons, but as one movement, and you can create waves big enough to nearly empty the basin. There is destructive volatility!

The milk pricing system is not one-way. It goes both ways. The milk pricing system drives cheese processors to sell and buyers to price off the CME. The reason is simple. Regardless of competition, the yields and make allowances are designed to insure that plants of less-than-average efficiency and better can purchase milk at the Class III price and sell the cheese at the NASS-adjusted CME price or above for a profit. The major raw product and the finished product prices rise and fall together. All the plant has to do is focus on manufacturing quality and efficiency.

The disconnection between reality in 2000 in the relationship between product prices and milk prices has grown. In 2000, non-American cheeses represented 54 percent of cheese production. Today those valuable products represent 58.7 percent of production. The pricing captured absolutely none of that extra value.

The ability of plants to transfer market conditions other than spot cheddar prices to producers have been shut off. The only variable with any connection to market value used in milk pricing is the spot cheese prices. These spot prices in cheese or any commodity are the first to fall or rise and do so the furthest and the fastest. By fixing in stone what are otherwise variables and blocking out alternative pricing mechanisms, the milk pricing system magnifies and intensifies the CME volatility inherent in spot pricing onto producer milk prices.

We need to focus on what is the real issue in milk prices – the milk pricing, not cheese prices. By going to truly competitive pricing for milk to cheese plants, this distortion and unnatural focus would be eliminated, much of the volatility toned down and a milk price that is truly relevant to the market it is in, and one producers could live with, would be established. PD

Ben Yale