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Why dairymen absorb the CME's rough price ride

Ben Yale Published on 21 May 2010


The first automobiles were truly horseless carriages. They moved and bounced like horse-drawn ones but without the horse and faster. What was merely uncomfortable in a carriage at a trot was downright dangerous and life-threatening at the rapid speeds of 20 and 30 miles per hour.



As these early automobiles went over the uneven and rough landscape, many a driver lost control or the cars broke down. Out of necessity, car manufacturers developed and used springs, rubber blocks, pneumatic tubes, hydraulic systems and even computer-controlled shock absorbers to make the ride ever more comfortable.

Riding the volatility and velocity of dairy prices has been like a high- speed chase in an old carriage across newly furrowed ground. If unprepared, the bouncing along this path of bumps, dips, hills, ditches and even mountains and valleys has been painful. For some, their operation could not withstand the forces and they have folded. Many others are badly damaged.

The road is, of course, the market. Few dairy meetings today do not show a chart depicting the ups and downs of dairy markets. The illustration of this is often a chart of the CME spot prices for cheeses, the Class III price or the all-milk price. They all look the same. The CME price moves; the milk price follows. Volatile cheese prices mean volatile milk prices. Poor cheese prices mean poor milk prices.

That connection should surprise no one. The CME prices for butter and 40-pound block cheese are used by CDFA directly in its pricing for the California state milk order. While the USDA formulas call for a NASS survey of cheese and butter prices, research shows that those survey prices correlate to the CME very tightly, and for good reason. Virtually all buying and selling of butter, cheese and cream is indexed off of the CME prices. Only one component of CDFA’s formula is not based on CME prices – NFDM. Plants that contract outside of the pricing orders almost always use an end product pricing tied directly or indirectly to the CME. The FMMO also incorporates prices for NFDM and dry whey, neither of which correlate to the spot CME price. But with rare exceptions and depending on the order, these factor little into the ultimate price and volatility.

The connection of the CME to producer prices is quite simple. In short, the milk is worth no more to a plant than what the finished product yields, less the cost to make it. As the markets for its products go up and down, so does the value of that milk to the plant. The CME measures these market changes. The CME identifies the smoother road surfaces.


Commodity exchanges, such as the CME, provide an essential function for trading in agricultural commodities. Not just the cheese and Class III milk of our industry, but corn, bean, wheat, cocoa and pork bellies, and even flowers, use exchanges to facilitate the trading for those who trade them. They do this by providing transparent markets for the buying and selling of the commodity – providing price discovery through sales reporting, auctions and other means; establishing product and packaging standards; defining and enforcing terms of trade; providing dispute resolution systems; and many other services that ensure an efficient and transparent market for the commodity.

Of all of these, it is the price discovery that gets all of the focus. Exchanges provide discovery of prices in one or more types of transactions: cash or spot markets, forward contracts, futures and options.

The CME block and barrel market and block market are cash markets. The seller must have cheese to physically deliver, and the buyer must have the capacity to receive the product traded. Though anyone can participate in such a transaction, the requirement of physical trading limits the exchange to those who truly are in the business of trading cheese. This means that speculators, common in the futures and options exchanges, are absent. The bids come in contracts for a railcar load of cheese, which is approximately 40,000 to 44,000 pounds. The details for a CME cheese spot market are summarized at the CME website, . The standards for the cheese spot market are spelled out in Chapter 53S of the CME Rule Book. These include such things as moisture, color, age, variety and other specifications.

As a spot market, it is a market of last resort. Sellers unable to clear inventory at stated market prices can bring them to the CME and price them until they sell. Similarly, a buyer short of product can come to the market and bid until it receives what it wants. Markets of last resort are the first to sense, and thus measure, the changes in market prices.

Very little cheese is actually traded on the exchange, but almost every pound of cheese is initially sold referencing the CME price. Therein lies the complaint – CME cash market is “thinly” traded. Statistics would tend to support this: In March 2010, there were 118 trades for barrel cheese and 53 for blocks for approximately 7.25 million pounds of cheddar cheese, compared with over a quarter billion pounds of Cheddar cheese and three quarters of a billion pounds of all cheeses produced in the U.S. for the same month. For that month at least, for every pound on the CME, a hundred pounds were actually sold elsewhere. Some months it is more than 1 percent or less, but not by large numbers.

But not all of the prices are actual trades. If the last transaction before the closing bell is an unfilled bid higher than the previous transaction, that is the price. Similarly, if the last transaction is an unfilled offer lower than the previous transaction, then that is the closing price. Once it is clear that no one in the market is willing to even buy at the lower price, the last trade at a higher price can no longer claim to represent the market price. In both cases, within a few trading days, actual trades take place.


Some point to these few actual sales as the cause of volatility. The argument is that a few people can trade, or even offer to trade, at prices that are translated into all cheese being sold at those prices, which in turn sets milk prices. The implication is that these individuals, known, unknown or suspected, manipulate this spot market to distort the entire market in their favor. It follows, then, that by ending the CME trading or at least imposing regulations on its use, would end volatility or low prices.

The government responded to similar arguments about the now-defunct Green Bay Cheese Exchange with the National Agricultural Statistic Service (NASS) product price survey. Intending to avoid the exchange price of a few trades, this survey of cheddar cheese sales of blocks and barrels looked at actual sales at greater volumes than the exchange. This eliminates any argument that non sales of the CME affect producer prices. The USDA combines the block and barrel price surveys by assuming a $0.03 basis between the two. It adds $0.03 to the barrel price and then computes a weighted average cheese price for the week.

But in the end, this survey, now used to set component and class prices in the FMMOs, shows that virtually all cheese is sold at prices derived directly from CME price.

These prices were then incorporated into an end product pricing formula. These formulas took this average price for cheddar cheese, implied a yield and subtracted a cost for margin, sometimes called the “make allowance.” The result is the minimum price for milk used in cheese is directly tied to the CME price for cheese. If a plant ties its sales to the CME, then it knows what kind of margin to expect over its raw milk costs. Avoiding the CME markings of the road would be like driving off road.

This reduced risk program attracted the cheese sellers. Although the ups and downs of cheese pricing remained, the shock absorber of end product pricing protects its riders from being overly squeezed between the raw milk price and product price. This government regulation diverts the stress of raw milk volatility off the plants and intensifies it on the producers.

The plants, now freed from much of the risk of product to raw cost volatility, have less incentive to stop or reduce it. This is the same behavior as a smoother-riding car encourages faster speeds and riskier driving. At the same time, plants are unwilling to consider other pricing programs, potentially more profitable, for their cheese and buying programs for their milk, because such would add risk to their operations.

To reduce pain does not require elimination of the CME, which tells us the road. Eliminating it would move us to much more bumpy off-market or off-road pricing. With a rigid pricing program for end products as shock absorber, producers would be worse off.

The added volatility from a cash market, directly linked by government regulation to the raw milk price, makes the normal, natural and truly desirable movement of market prices too painful for producers. Removing producers from this shock absorber role would require the replacement of the spot market with a less volatile futures market program and pricing milk based upon competitive factors as opposed to the rigid end product pricing formulas used today. Then dairymen would no longer be the shock absorbers, and there would be less pain. PD

Ben Yale
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