Dairy can move past the CME spot markets
Is the headline controversial?
Absolutely, but it is time the dairy industry has a serious discussion about improving and modernizing the price discovery tools used to value milk and dairy products. This includes the Chicago Mercantile Exchange (CME) and USDA price reports such as the National Dairy Product Sales Report (NDPSR) and Dairy Market News.
Price volatility is a key concern for everyone along the dairy value chain. Dairy prices were especially volatile over the last few years with COVID-19-related disruptions. Dairy’s use of spot markets for price discovery adds unneeded volatility to an inherently volatile product given its perishability. A better price discovery process could reduce volatility to the benefit of farmers, processors, end-users, and consumers.
The CME spot markets trade the marginal load of product, essentially making it the market of last resort. Trading is very thin with only a small number of traders and a limited number of commercial firms participating in the price discovery process. In 2022, CME spot trading volume represented:
2.4% of annual butter production
0.2% of barrel cheese production
Under 0.1% of total cheese production in the form of blocks
At times, the market moves on no volume. And that price sets the price for practically all cheese and butter in the country, and by extension, most of the milk. Try to name another agricultural product, or any product, that values billions of dollars of production in the manner that dairy does at this current time.
There is a long history of allegations of manipulation and other sordid misdeeds in dairy spot markets. The National Cheese Exchange ceased to exist in 1997 and spot trading of cheese moved from Green Bay, Wis., to Chicago, Ill. When Federal Order reform was being debated in the late 1990s, USDA developed a new price reporting system to use in the product price formulas for milk starting in 2000. The option of using CME prices in the price formulas was rejected by USDA, given their concern over price manipulation. It is natural for buyers to complain when prices are going up, and for sellers to do the same when prices are going down, but when some market movements are hard to explain or understand, it does not build trust in the markets.
A better dairy future
Instead of using thinly traded spot markets, imagine getting daily reports from USDA with prices for many dairy products – cheese, butter, milk powders, and whey products, as well as milk and components. The report could also include milk volume and other important market factors.
If you are not familiar with USDA mandatory daily price reporting for pork and beef, check out the volume of data and information contained in those reports. A similar report for dairy would create a new price discovery mechanism that captures a much larger number of products and transactions. The interplay between cash and futures prices would continue, and over time, futures markets could be used for price discovery like they are for other ag commodities.
Alas, the elephant in the room is the Federal Milk Marketing Order (FMMO) system and the use of commodity products to value milk. As long as product price formulas are used, there is a need for a centralized spot market to discover prices. One option is to once again use reported prices for milk in unregulated areas to establish minimum prices.
Prior to 2000, this method included the Basic Formula Price (BFP), and prior to that, the Minnesota-Wisconsin (M-W) price series. Why not use Idaho milk prices for setting Federal Order prices? If the Upper Midwest voted out of the order to become unregulated, even more milk transactions could be used to set national minimum prices. More broadly, if minimum price provisions were removed for manufacturing milk (nonfluid/beverage milk) in the FMMO system, buyers and sellers of milk and dairy products would be free to negotiate prices on terms they feel reflect market dynamics including dairy price benchmarks, regional prices, cost-plus contracts, or other new and innovative pricing that benefit both parties.
A pain point for many in the cheese industry has been the volatile block-barrel spread. In the current FMMO milk pricing construct, block and barrel prices are used to calculate the Class III milk price. The volatility in the spread has created serious financial challenges at times, mostly for barrel plants. Some are advocating removing barrels from the milk price calculation. As noted above, less than 0.1% of all cheese production was traded on the CME block market last year. Instead of removing barrels from the formula, eliminate the CME barrel market, or better yet, develop a new way of valuing milk that moves away from rigid product formulas with outdated make allowances.
A new daily mandatory price report from USDA could replace the NDPSR and Dairy Market News reports. More products could be included in USDA reporting with better definition of products. The current issues with lactose and WPC 34 price reporting could be solved with additional tiers of price reporting to differentiate between specifications and including secondary transactions.
Do we need to change?
To be clear, the spot markets have generally benefitted the dairy industry over the years. Despite their shortcomings, the industry has validated their credibility by using the spot prices in commercial transactions. There will be some that will oppose any change to how dairy prices are discovered. Those include individuals and companies that financially benefit from the current system. Others simply are afraid of the uncertainty that would come with a new pricing system. There is no reason to fear – Idaho has shown how an unregulated dairy industry can prosper, and the beef and pork segments underwent a similar transition to a new pricing system with vocal opposition.
What needs to happen to make this a reality?
The 2023 Farm Bill is the primary vehicle that can be used to develop a new price reporting system for USDA to implement. If you agree, make your voice heard when the farm bill discussions begin. The industry also needs to move away from product price formulas to value milk. These changes will not be easy, but the industry can develop a price discovery system similar to other agricultural commodities that could result in less volatility, better price transparency, and improved ability to manage price risks.
February 6, 2023