August 2, 2021
Producers in many federal orders are continuing to open milk checks to find Producer Price Differentials (PPDs) of negative $1 to $2, where they would have typically expected positive values. While not the nearly $10 negative values seen at times last year, the negative PPDs may still be causing some head-scratching. What’s happening with PPDs is due partially to the market still recovering from the 2020 shockwaves. But the reality is that PPDs are on a long-term gradual decline.
In a practical sense, PPDs can be viewed as the basis between the Class III milk price and the blend price that a producer receives. A negative PPD on its own isn’t the cause of but rather a symptom of a challenging milk market.
In 2020 rampant de-pooling, massive class III/IV milk price spreads and other pandemic-centric market forces such as massive government cheese purchases created the perfect storm for extremely negative PPDs. Most of those factors have now subsided to more normal levels, but others remain. One factor that has persisted is the shift from a Class I price calculation based on the “higher of” to the “average of” Class III and IV.
Prior to 2019, the Class I milk price was a function of the “higher of” either Class III or Class IV advanced skim milk price. Now it is calculated as the “average of” those prices plus 74 cents. That 74-cent adder was intended to make the two pricing systems roughly equivalent in the long run. However, in January through June of 2021 the new “average-of” calculation of the Class I base price resulted in a Class I price that was $0.38 /cwt lower on average than what it would have been under the previous pricing formula.
Since Class I is typically the most valuable milk in the pool, any factor that brings Class I price down will also lower the entire pool value. Bringing the blended price and Class III milk price closer together means lower PPD.
Another factor pulling value out of the milk pool – and blend price – is the gradual decline in demand for fluid milk among consumers. The slowing demand for fluid milk over time is nothing new to the dairy industry, and it is important to remember that the lost fluid demand is more than made up for in demand for other dairy products. But for milk pricing purposes, the decline in fluid milk results in less Class I milk in the pool.
In the first half of 2021 there was 16% less Class I milk in federal order pools than there was a decade ago in the first half of 2011. Because the blend price is a weighted average of each class, giving a smaller percentage to the typically highest-priced Class I will again pull the blended price down, closer to the Class III milk price in the long-term. Again, lower PPD.
In addition to federal order pricing factors, cooperatives in some cases will “re-blend” their milk and incorporate other price factors into the PPD. This can happen for a variety of reasons including, but not limited to, blending of values across federal orders when a cooperative operates in multiple orders, blending in the value of surplus milk sold at a discount, and offsetting higher manufacturing costs than those established in USDA class pricing formulas.
These changes have risk management implications. When a producer’s PPD is relatively stable over time, class III futures (or their equivalent) are an effective hedge. Increasing variability in the PPD affects how well Class III prices reflects your milk price and therefore means increased risk. I believe PPDs will continue their trend down closer to zero but with more variability than what we saw pre-pandemic. When developing risk management plans, it will be important to assess what and how much you’re hedging given the potential for PPD variability.