Depooling Has Greatest Impact on Revenue Losses
July 20, 2020
The Producer Price Differential (PPD) is perhaps one of the most confounding and confusing aspects of Federal Order Milk Market (FMMO) pricing.
Dairy economists who understand it say PPDs are nothing more than basic arithmetic, accounting for different class values and the timing of when prices enter the formula. In the end and over time, it all works out to pretty much neutral.
Mark Stephenson, a dairy economist with the University of Wisconsin, and Andy Novakovic, a dairy economist with Cornell, recently released a 22-page explanation of why and how the PPD is calculated. (Actually, half of the report is tables on how the PPD affects the Statistical Uniform Price or blend price in each of the Federal Orders.)
Here’s their explanation:
“In 7 of the 11 Federal Orders, farms are paid on the basis of the Class III component values for protein, butterfat, and other solids (mostly lactose). When Class prices behave according to the usual expectations –Class I price is the highest value - there is money left over in the pool after withdrawing the Class III component values and that remainder is distributed to producers based on the volume of milk sold. Expressed in dollars per cwt., that remaining value is called the Producer Price Differential, or PPD.
“The PPD can be thought of as an accounting exercise, but there is a purpose to this approach as well. For the seven orders in which this system is used, there is a notable volume of cheese production, and it was believed to be a good idea to reward farmers for producing higher protein milk, which is not one-for-one the same as higher skim solids milk. Once it was decided to pay out to producers on the basis of the same components that are used in Class III, and only in Class III, then it made mathematical sense to begin the blend price calculation with the Class III price and add (or subtract) whatever moneys remained in the pool.”
So why do PPDs go negative. It’s mostly timing. “…we did not anticipate the possibility of a Class III price, calculated after the advance Class I price was already announced, rising so much in the span of a few weeks so as to result in a Class III price that was higher than the total average amount of money paid into the pool. Thus, we can have a month where the Class III price is higher than the blend price, and in this instance, the PPD calculation will be negative. All that means is that we paid out more money to producers in Class III component values than we collected from plants across all classes of milk. For farmers, it is really just a curiosity in the accounting method.”
Except for cheesemakers, who must pay into the pool when Class III is higher than the blend price. Cheesemakers have an out, however, in that they can depool and avoid these payments. The penalty they pay is that they must requalify in succeeding months to re-enter the pool. Those criteria vary by order. In the Upper Midwest and California, it’s fairly easy to re-qualify. In others, criteria are much stricter.
Stephenson calculated what PPDs would be without depooling and with 100 percent depooling, using futures prices to estimate future formula prices. In the Upper Midwest, he estimated the PPD in June would be -$1.30 without depooling and -$8.11 with 100 percent depooling.
When prices were announced, the Upper Midwest PPD came in at -$3.81. In other words, depooling dropped the PPD $2.50 more than the straight PPD mathematical calculation. Upper Midwest Class III utilization in June did not drop to zero, going from an average of 84 percent to 50 percent. Note: How much is depooled is up to cheese plant managers who much calculate current month pool payments versus against future pool draws.
There are a few points to all of this.
The PPD calculation itself is purely mathematics. Totaling Stephenson’s PPDs from October 2019 through December 2020, the Upper Midwest average monthly PPD comes out to -10.4₵. Seven of the 15 months had negative PPDs, with June 2020 coming in at -$1.30 and July coming in at -83₵. (Remember, too, that the Upper Midwest has a Class I utilization of just 8 percent and a Class III utilization of 84%.) In the Northeast, the calculated PPD over the same 15 months is +14₵. With depooling, it’s -11₵. In the Northeast, Class I utilization averages 31 percent and Class III is 27 percent.
Depooling has a major impact on PPD. In the Midwest, when Stephenson’s projection assumed 100 percent depooling, the PPD averaged -$1.18/month over 15 months—more than a dollar less than the calculated PPD without depooling. (When I adjusted for the actual PPD in in June, the depooled PPD was still -90₵/cwt per month for the 15 months.)
When depooling is large, there is money lost to the system. Stephenson explains it this way: “The product price formula would have said that plants received about $2.22 for their cheese [in June], and that implies that the Class III milk value was $21.04. But if a cheese plant only paid their farms the $17.23 blend price in the Upper Midwest because of depooling, their milk value was actually $3.81/cwt more than they paid.”