Is it time to simplify milk pricing?
August 21, 2020
The unprecedented volatility in dairy markets over the last several months has raised questions about how milk is priced. The epicenter for those concerns center on the Federal Milk Marketing Order (FMMO) system that was created in the 1930s. Federal orders were introduced in that era for several purposes: to provide for orderly marketing of milk, to assure reasonable prices to both dairy farmers and consumers, and to assure an adequate supply of wholesome beverage milk to consumers.
In the late 1990s, federal order reform brought about a number of changes, most notably the introduction of end-product pricing and make allowances to establish minimum prices for milk. Twenty years later, it seems a majority of farmers, milk processors, and customers are not happy with the current system.
Unfortunately, changes to dairy policy have been elusive at best. That’s partially due to the complexities of milk pricing, which is an indictment of the system itself, and lack of consensus. However, the time may be right to develop dairy policy and a milk pricing system that reflects the marketplace of the 2020s and beyond, not the 1930s or 1990s.
Negative numbers brought to light
While the current concerns involve negative producer price differentials (PPDs) and depooling, these are symptoms of a larger problem . . . an outdated, regulated milk pricing system. Milk used for beverage purposes, or Class I, historically represented the largest volume of milk and was classified as the highest valued milk. Today, only about 20% of farm milk is destined for beverage purposes, with twice that amount used for cheese and whey production.
In addition, the FMMO system was established to regulate local markets for fluid milk, not national or global markets for manufactured dairy products. The amount of milk used in products for the export market is approaching the amount used in Class I. The U.S. competes with other countries around the world that have more market-based milk pricing systems, which can put the U.S. at a competitive disadvantage.
Future growth in U.S. dairy demand will be driven by exports as developing market populations expand while the U.S. population stagnates. The U.S. needs to have a milk pricing system that reflects these realities in order to remain globally competitive.
Negative PPDs are generally a good thing for dairy farmers as they result in higher prices for Class III milk. The record negative PPDs in June, with more likely to follow in July and August, are hard for most people to understand. And when you can’t understand something, you don’t trust it.
This is an unwanted side effect of the FMMO system. As cheese prices fall back to average levels, the PPDs will likely flip to large positive numbers, so the positives and negatives should balance out over time. One of the primary causes of negative PPDs is when the Class III price moves up rapidly and exceeds the Class I price, which reflects cheese prices from over a month earlier.
This advance pricing mechanism for Class I milk has been in place for decades, but maybe it’s time to ask if this is still needed. Fluid milk plants will probably insist that they need to know their milk costs in advance. However, manufacturers of other dairy products have never had that luxury and seem to have figured out how to deal with it. Risk management tools are available to hedge the forward sales, or companies can adjust how they price their products.
Pooling and depooling
There is also a lot of misunderstanding about pooling and depooling. When plants depool milk, they have decided they don’t need the money from the pool to be competitive when paying for milk. Depooling is an important relief valve to clear milk when the market is in surplus.
When California had their state system, most milk was required to be pooled. In years of surplus milk, this resulted in milk either being shipped out of the state at a discount or dumped on the ground. The FMMO system creates lots of unintended consequences, so proposals to ban depooling or make pooling mandatory are shortsighted and not in the best interest of the industry.
More broadly, the concept of pooling should be examined, identifying both pros and cons. A hidden problem with pooling is the incentive it creates to overproduce and drive prices down. As an example, if one farm decides to expand production, the marginal gain in supply can push prices lower. Instead of the impact of that decision being felt solely by that farm, the pooling concept spreads the market impact, in this case lower prices, across all farms in the marketing order. This is one reason why some farm groups have advocated for supply management. Without pooling, milk buyers and sellers could coordinate needs and more effectively balance supply and demand. This private solution to managing supplies would be more preferable to a government run program. Developing clear signals Laying out a proposal to modernize the FMMO system and milk pricing is far too complicated for a short paper. First, it needs to be made clear the goal is not the elimination of the FMMO system. The FMMOs provide a number of valuable services including milk testing, payment enforcement, and data collection . . . these services should be continued. Instead, the regulations on milk pricing need to be modernized along with breaking the link to volatile spot prices at the Chicago Mercantile Exchange. Product price formulas have resulted in a low-risk, low-reward system that encourages production of large volumes of commodity products with commodity milk prices as a result. Dairy companies in Europe, New Zealand, and other countries are not bound by regulated milk prices, and they are free to invest and add value to milk and pay farmers higher prices. This can happen in the U.S. However, milk needs to be able to move to its highest value use through market signals, not a rigid regulatory system.
Another question is whether regulated minimum prices are needed. Cooperatives market over 80% of the milk produced in the U.S. and own roughly half of the milk bottling plants. An effective cooperative marketing system should be able to maintain reasonable price levels and prevent significantly lower milk prices feared by some in our dairy industry.
In a market-driven pricing system, plants would compete for milk, thereby ensuring milk goes to the highest value use. In some regions of the country, this could be fluid milk. In others, it could be cheese, yogurt, or milk powder.
In addition, the milk classification system is arbitrary and outdated. Treat milk as one product and let the market determine values for fat, protein, and other components. A new daily or weekly USDA reporting system can be established to provide real-time information on milk production, prices paid by plants, as well as prices received for a variety of dairy products, not just the basic commodity products that’s in place today. More information will be important to both buyers and sellers, and USDA can fill this role as it does in other agricultural products like cattle, hogs, and grains.
More than once, I’ve heard the comment, “Why would dairy farmers give up a system they know for one they don’t?” But how is the current system working for them?
Let’s think broader about supporting dairy farmers and the dairy industry. Dairy farmers have multiple risk management tools at their disposal to better manage volatile milk prices. More education is needed so all farmers understand how they work, and a simplified milk pricing system would help. A number of complex matters Milk pricing complexity is not the only issue facing today’s dairy farmers. Tools to transition dairy farms to the next generation, be it family members or others, need to be developed. Consideration of tax policy that smooths the impact of good years and bad years should also be considered.
Change in general can be difficult, and the ideas presented here will make some people uncomfortable or even upset. The goal is to present concepts on what a modern milk pricing system can look like and start getting dairy farmers and processors, as well as customers of dairy products, working on developing details around it. The FMMO pricing system fosters an environment where supply is pushed forward, whereas a modern system would be more consumer-oriented, pulling milk forward. Without a focused effort by all stakeholders, the current system will continue to become less relevant over time. Instead, stakeholders need to develop a milk pricing system that positions the industry for success in the future.