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Selling the curds and whey

Ben Yale Published on 09 February 2012

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A classic nursery rhyme starts like this:

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Little Miss Muffet
Sat on a tuffet,
Eating her curds and whey;

The poem’s main character loved every bit of dairy. But what if this Mother Goose character became a modern, more selective dairy consumer?

What would happen if she only wanted cheese curds and not the whey?

In the early years of the California dairy industry, some California producers applied to the USDA for a federal milk marketing order. Not all wanted it, and its opponents went to court to stop it. The court did stop the process because there was no evidence suggesting milk would move across state lines – interstate commerce.

Opponents said moving bottled milk was impossible because milk jugs would explode as they passed over mountain passes out of California. Separated from the rest of the continent by deserts, mountains and distance, the California dairy industry operated in its own, isolated market.

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As a result, producers formed a state marketing order instead. While it was doing at the state level what it could not do on a national level, federal courts were invalidating state orders in the Southeast because they did interfere with interstate commerce, resulting in federal orders filling the void in that region.

It was just the beginning of California dairy moving in a different direction from the rest of the nation.

As a single state order with a growing population, virtually isolated, Californians could and did design a system that would benefit them. While they, like the FMMOs, had minimum prices, classified pricing and pooling, they had other things – including different ways to price the classified milk.

There is a side-by-side comparison of the differences between California state order and the FMMO at the CDFA Dairy website (“California and Federal Milk Marketing Orders: A Comparison” http://www.cdfa.ca.gov/dairy/pdf/SP_104__FMMO_and_CA_Comparison.pdf ).

Different purposes and policies have resulted in different programs. The federal program is designed to deliver a sufficient supply of a good and wholesome product to a consuming public at a reasonable price. California’s program is directed to promote the development of the dairy industry. Both have met those challenges.

But these two dynamic marketing systems have benefitted each other. For example, the FMMOs have four classes of milk because Class IIIa, now Class IV, was created in response to California’s Class 4a for NFDM. When the FMMO was reformed in the 1990s, it adopted California’s milk price discovery system of end-product pricing.

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The “higher of” manufacturing class prices used in Class I pricing mimicked California’s earlier use of the same concept in pricing its comparable Class 1.

Both marketing systems face one of the underlying difficulties in minimum pricing for milk – there is a wide diversity in how the milk is used and what in the milk is valuable. This goes beyond the simple four classes of milk.

Cows produce a mixture of water, fat, protein, lactose and minerals called milk. Milk a cow – any quarter – and you get all of those components and in proportions that vary in a limited way.

When it comes to making dairy products, not every processor needs all of those components. For bottlers, they need all of the solids, but not all the fat. For ice cream they need all of the sugar, protein and fat, but not the water.

For cheese, they generally do not need the lactose or the minerals. Non-fat dry milk is everything but the fat and water.

In making the products, these different components separate. Whey is a natural byproduct of making cheese. In the formation of cheese, the casein proteins act as nets that capture and hold the fat and some of the water and some of the minerals.

The rest, mostly water, separates from the curds, leaving a mixture of whey proteins, minerals and some of the fat. Though separated, Miss Muffet ate all of them. The liquid whey remained with the curds, providing a sweet taste to the chewy curds.

But in modern cheese-making, the whey is removed from the cheese curds. For many years whey was a waste product – animal feed or fertilizer at best. But what was a waste has created new products.

The demands for whey protein and lactose have become major dairy products particularly in exports, and valuable ones at that. It has been said that some people built cheese plants to make cheese so they could get whey to make money. Not a completely true statement, but somewhat so.

The problem is that, while all cheese plants make cheese and the fat and protein have value, not all have the ability to capture whey. Even among those who do, some dry the whey (dry whey or DW), others actually concentrate the whey (whey protein concentrate or WPC) and others separate the whey protein from lactose to make whey protein isolates (WPI).

All of these have different market values, production costs, investment requirements and end consumers.

All of these issues challenge marketing orders: How do you establish minimum prices for producers based on end-product pricing and incorporate whey value with all of these differences? Butter has remained butter. NFDM has remained NFDM.

But cheese-making is different; its end products aren’t just cheese. In a free market with balance between supply and demand, a milk buyer should pay for the value of its end products, and its byproducts, to the producers; but in minimum pricing, the system forces the plants to pay minimum prices for the milk.

If their end product is consistent with the formula (cheddar cheese and dry whey), then pricing is simple. But if they make Italian-style cheeses, often the whey is acidic and not as valuable.

In Idaho, a non-regulated region, there is virtually no payment for whey to producers. Supply of milk exceeds demand. Lower milk prices result with no payment for whey, and even a lower value for milk made into cheese.

The nursery rhyme continues:

Along came a spider,
Who sat down beside her
And frightened Miss Muffet away.

In modern times, it is not the spider that is causing the story’s havoc, but the whey. To be relevant to producers, the orders have to value the whey as part of the minimum prices. Both the FMMO and CDFA have done that, but differently and in this difference, a serious market separation is occurring.

The FMMO takes the NASS average dry whey price, subtracts and multiplies the result by 5.9 to arrive at an addition (sometimes a subtraction) from the Class III price. Multiplied by 5.9, the impact of rising whey prices can be significant for Class III.

Since its introduction into the pricing formula in 2000, the other solids component derived from dry whey price has ranged from minus 4.37 cents to as much as a positive 60 cents, impacting the Class III price from a deduction of about a quarter to adding about $3.50 per hundredweight (cwt).

In 2011 the dry whey price has again climbed. The “other solids” component for December was about 48 cents, adding as much as $2.75 to the Class III price.

California also incorporates whey in its pricing but uses a table that can generate a range of 25 cents to 65 cents per cwt. When whey prices are low, California producers receive more than FMMO, but when dry whey climbs, like it does now, California producers come up short.

For 2011, the average difference between Class III and 4b was $2.00. In December it was $3.63.

The policy challenge is not about paying producers more or helping plants. Growing and diverse value for whey in milk defies the simple formulas minimum pricing requires. Different approaches used between California, FMMO and Idaho disrupt milk markets rather than order them.

California producers who hedge their milk price using Class III face an unlimited basis risk. For example, if a California producer had sold December 2012 milk futures at $18, he would have had to settle by paying 77 cents. At the same time, the Class 4b portion of his milk check would only pay him $15.14.

Subtract what he had to pay to settle from what he really got: $15.14 less .77¢. Rather than the $18 he thought he sold the milk for, he really got $14.37, or a $3.63-cent difference. If dry whey reaches historic levels, the negative impact could be dollars more. That is not a hedge but risk enhancement.

For producers in California, they do not have a market they can hedge their milk against because as the example shows, Class III and Class 4b are different. It’s like hedging the 2012 corn crop price with a May 2011 futures contract; they are essentially two different commodities.

For other dairy producers who are market participants, it means there are fewer players in the futures markets and less liquidity.

It is disruptive to cheese plants in the FMMO and producers who sell to them. California cheese plants, who make up a sizable portion of the NASS cheese price survey, are paying significantly less for their milk than those in the FMMO system.

They, in turn, can sell cheese at lower prices due to lower whey price factors in the CDFA formula. These lower prices are matched by plants in the FMMO system, slowly ratcheting prices down.

Even for whey, it can be argued that plants in California have a significant advantage in selling whey if their cost for the raw product is a fraction of its value. That forces all whey prices down, lowering FMMO prices in the end.

While using the same formula in California as the FMMO calculation appears to be the answer, there is another fundamental difference between California and the FMMO. Under CDFA rules, all cheese plants must pay the minimum prices, even for Class 4b.

That is not the case in the FMMO. FMMO producers and plants can forward contract, giving them the opportunity to adjust the whey pricing to what the plant makes, rather than what the formula expects. If that does not work, cheese plants can choose not to be in the FMMO and pay less than the minimum price.

California plants and producers do not have either of those options. To keep from overpricing milk to those plants without added whey value, California is compelled to have a lower value for whey.

The current CDFA formula has only been in effect since the fall of 2011. As a result, CDFA has rejected any efforts to hold hearings until more time passes under the current formula to see how they play out over time.

In the meantime, the differences will continue to hurt producer bottom lines, remove the value of hedging Class III from California producers’ toolboxes and create disorderly pricing between California and the FMMO. Unlike Miss Muffet, we cannot run away.

These market forces, not courts, are now forcing a number of producer organizations to reconsider the role of FMMOs in California, and even in historically independent Idaho. If they move, and it will not be immediately, it will still take time for the change to new orders.

It is not a question of whether one is better than the other – both have been good to the industry – but today, there is no longer any room for two separate systems. Leaving it to the market without minimum prices would be faster.

Either way, market forces will eventually prevail and Miss Muffet and the California producers can return to having their curds and whey. PD

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Ben Yale
Yale Law Office

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