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Is our milk pricing system broken?

Matt Gould for Progressive Dairyman Published on 25 August 2016

This question is being asked at industry meetings, policy workshops and is now a recurring topic among company executives. The answer to this question will affect the future of our industry and, as such, demands significant reflection.

Milk in the U.S. is valued using class pricing, marketing orders, formulas, rules and exceptions, which vary by region. Taken together, this is a complex national system and difficult to understand in its entirety. Increasingly, however, it is looking like the time has arrived for a new solution. The system has finally broken down, and it is now causing problems that cannot be ignored.

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Nearly eight decades ago, when federal orders were developed, dairy farmers were experiencing specific pressures that required certain policies. At that time, milk was not shipped over long distances, which meant farmers were at the mercy of the local capitalistic processor.

In addition to achieving other Great-Depression-era policy objectives, regulated pricing was implemented to protect dairy farmers from local monopolies.

Following improvements in transportation and significant structural change in the industry, it appears today that the regulated pricing system is now outdated and is holding back many American dairy farmers. In some regions, the system is preventing dairies from re-investing and expanding. In others, it is directly reducing farm-level cash flows.

In areas including Michigan and the I-80 corridor, which runs through Iowa and Nebraska, farmers have been trying to solicit new dairy plant investment for years, but manufacturing margins for new plants have been too low to entice private suitors.

In the Northeast, which is also under a marketing order, manufacturing capacity is not keeping pace with growth in the milk supply. In fact, during each month in 2015, milk was dumped. Already in 2016, Federal Order 1 reports 118 million pounds of milk were sent down the drain. Even still, no announcement of a major plant expansion or addition in the region.

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Another measure of the industry’s health, which points to an issue with our pricing system, is cheese exports. During the first five months of 2016, cheese exports were down 29 percent, butterfat exports were down 74 percent, and nonfat dry milk exports were down 10 percent, compared to two years ago. This is not a positive sign.

Those companies that have invested in the infrastructure essential for our industry’s long-term source of growth are still struggling to make profitable overseas sales.

Now to cope with these issues, organizations are adapting – and not necessarily in progressive ways. In fact, at least one U.S.-based cooperative has created their own supply management program. In some regions of the country, where premiums used to be paid above class prices, cooperatives are now deducting from milk checks to pay these excessive balancing costs.

Some exporters have also become importers, which means while our industry is dumping milk on the ground, European and New Zealand dairy farmers are selling their milk into our market.

We have to ask: Is this really the best we can do? We can look to other regions of the world, including New Zealand, Australia and Europe, to see if a better system is out there.

In New Zealand, the milk pricing system is regulated to protect against Fonterra’s monopoly power. Farm-gate milk prices, paid on the basis of butterfat and protein (called milk solids), are calculated from Fonterra’s sales.

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A “fair value” price for milk is determined using actual revenue from the following five commodity-grade products: whole milk powder, skim milk powder, butter milk powder, butter and anhydrous milkfat. Then manufacturing and capital costs are subtracted out so that the processor can make a profit.

In the U.S., we refer to this margin as a “make allowance,” and it is built into the class pricing system. However, unlike the scheme in New Zealand, this margin is fixed and has declined over time due to inflation and other factors. The New Zealand version is updated each year to reflect actual costs. For a New Zealand processor, there is an incentive to build capacity. For a New Zealand farmer, the opportunity to expand is available so long as farm-level economics allow it.

This pricing system also creates a more level playing field for dairy farmers because most of the country’s milk supply receives the same price. Hedging instruments are also available, linked directly to Fonterra’s milk price, which provide farmers with a tool to protect their revenue risk.

One of the largest drawbacks of this New Zealand-based scheme is that it hamstrings their industry into producing those five products in the pricing formula (skim, whole, and buttermilk powders, butter and anhydrous milkfat).

Manufacturing a different product – cheese, for example – carries the risk of negative margins. There will be periods where the manufacturer is losing money by buying high (a milk price derived from higher-valued milk powders and fat) and selling low (lower-valued cheese).

This problem may sound familiar. In the U.S., for example, those companies trying to export whole milk powder face the same risk: buying higher-priced milk tied to butter and nonfat dry milk; selling lower-valued whole milk powder. While some look at this structure as a positive (guaranteed margins for selected products), others see it as a negative (restricted opportunity).

In Europe and Australia, this is mostly a non-issue, as processors compete with one another to attract milk supplies and generate profit. Instead of a product-based pricing system, milk prices in these regions are determined on the free market. A farmer in these regions will ask, “Who can give me the best price?” and then will make a decision and contract their milk with a company for a year or longer.

Milk tends to flow into its highest-value use because processors have an incentive to seek out the greatest return for the milk they buy. Sometimes this means processing it using their own manufacturing assets.

Sometimes this means reselling it. As you can imagine, at times, the pricing system can seem enormously unfair in the eyes of the dairy farmer (whenever it appears that downstream businesses are making too much money). In Europe, this frequently results in civil unrest, including protests by dairy farmers and sympathy organizations.

There are also other problems in a less-transparent system that depends on the invisible hand. This year in Australia, for example, Murray Goulburn, the largest processor in the country, surprised its farmers when it adjusted the season’s milk price substantially lower at the end of the season. This announcement reversed expected margins from positive to negative and left its dairy farmer suppliers in tough financial shape.

Another issue due to milk prices that are not uniform across all of these global regions is risk management. To cope with this in Europe, the industry still depends on government subsidization. Most recently, the European regime has returned to a form of supply management and is now paying farmers to reduce production. This after spending hundreds of millions of dollars this year supporting milk prices by buying skim milk powder.

Back in the U.S., our system is too complicated. Our industry leaders spend too much of their time fighting over pricing formulas and pooling rules instead of directing their efforts toward growing our market. This puts the U.S. dairy farmer at a disadvantage relative to its global competitors, who are able to focus on more market-oriented issues.

The takeaway is that no system, in current existence, is without its trade-offs. The question is: Which trade-offs are dairy farmers willing to accept?  PD

Matt Gould is a dairy market analyst. Email Matt Gould.

 

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