Milk Pricing: Part 2
By: Helen Labun
What follows is a primer on how dairy pricing works in the Northeast and the logical framework behind it. It assumes that everyone involved is working rationally, trying to get the greatest good for the greatest number of people. That is a common economics policy assumption. It's not great for a plotline - where's the story without at least a little human weakness? - but if you want a good faith starting point for discussing what may, or may not, need to be done differently in the future, it’s a perfectly suitable approach. That isn’t to say that there aren’t many points along the way where reasonable people can differ - and through the wonders of digital publication everyone has the chance to skip off down diverging paths via links in the text.
PART 2: Calculating Milk Prices
(Missed Part 1? It's linked here)
Armed with the preceding basic considerations for how we would set about finding a “fair” price for milk, we can start the long mathematical journey to that actual price. [What if we also considered costs of production in setting a price?]
The way that an FMMO prices milk is as transparent as painfully difficult arithmetic can be. The USDA publishes the underlying price formulas and interested readers can watch how these formulas play out by reading the Northeast FMMO monthly price pool announcements that show the numbers plugged into the calculations. Taking it a step farther, it’s also possible to see the wholesale pricing that feeds into these calculations and the timetable of price release dates and which averages to use in which part of the calculations. The FMMO publishes these numbers and additionally checks the numbers handlers report by managing testing of milk components on the farm, calibrating bulk tanks, and auditing the paper trail from farm to handler to buyer.
In some ways this system is like a rudimentary blockchain - keeping an open ledger book on the inner workings of the milk market. That being said, more information isn’t always more knowledge and we’re already 1,500 words into the design of milk prices without yet touching on a single price. We’ll leave the background math for individual exploration and hit highlights:
Everything starts with the component parts of milk: butterfat, protein, nonfat solids, other solids. These are valued based on the average wholesale market prices for Grade AA butter, 40 pound blocks and 500 pound barrels of cheddar cheese, nonfat dry milk, and dry whey, respectively. Those prices are then adjusted by “make” (national estimates of the cost of manufacturing) and “yield” (how much of the final product you get from a given quantity of each component). [Are these really the key indicators?]
From these component prices the FMMO builds up to the four class prices for milk, using the established formulas linked at the top. The minimum class prices in May 2018, for example, were Class I - $17.69, Class II - $14.47, Class III - $15.18, Class IV - $14.57. Prices are by 100 pounds of milk (cwt), which is roughly 11.63 gallons.
The handlers report, and the FMMO publishes, how much milk they sold at the established class prices in a given month.
None of these prices, however, is “the price of milk” that we hear reported. And, furthermore, that “price” isn’t what a farmer sees in a milk check. There’s more math to be calculated. . .
The “price” of milk - aka the Statistical Uniform Price - is equal to the Class III price of milk (calculated above) plus something called the Producer Price Differential (to be revealed in a moment). The price of milk changes throughout the year, although it does so on a very regular schedule - with each year's schedule of release dates published ahead of time by the FMMOs. [Can you plan ahead for changing prices?]
The Statistical Uniform Price (Class III + PPD) is a benchmark that farmers can use to measure their farm’s performance. Their individual check has several components:
First, and foremost, farmers are paid for the component parts in their milk using the component prices announced by USDA. This is the largest part of the check and it’s based on the farmers’ actual milk, not an average from the pooled milk.
The pool does matter for the next part - that Producer Price Differential. The whole of the milk is greater than the sum of its disassembled parts, and the Producer Price Differential reflects the value of the overall pool minus what farmers have already been paid for components. Roughly speaking: you add up the total value of the component parts in all of the milk sold, you remove the amount producers would have been paid for the total component parts at Class III component prices (the baseline prices for components), you add in a location adjustment, you divide the resulting dollar figure by the total amount of milk in the pool, and you get an initial Producer Price Differential, paid per hundredweight.
A farmer’s individual payment changes based on their county's location in relation to the price setting location, as discussed in Part 1, so one more adjustment gets made for location, then that number is multiplied by the hundredweight of milk sold.
Payments also include premiums - determined by each handler.
Minus allowed deductions - for example hauling fees, marketing campaign fees, an FMMO administrative charge.
Add it all up and . . . milk pricing.
But we can feel a sense of accomplishment, having just outlined a way to achieve our original goals. . . it gets complicated, and it introduces many elements that are up for debate, but the philosophical threads never disappear. It’s a system that uses a combination of minimum prices and open data to protect against milk handlers giving farmers a bad deal, that gets fluid milk to where it’s needed, and that pays farmers based on both the qualities of their own particular milk and the performance of the entire milk pool.
Dairy pricing is notoriously complicated, but if we took another national system and tried to quantify, equalize, and make public each step in the process to get to a price would it be much simpler? What would it look like? Like an agricultural economics thesis, probably. Or like the first step in designing something better.
Notes from the Text
What if we also considered costs of production?
The framework for measuring U.S. milk minimum pricing is built around the pricing considerations of the milk handlers and processors. Another contender for consideration is a farmer’s costs of production - after all, it doesn’t matter if the price handlers pay for milk goes up if the costs of producing that milk goes up even faster. Farms’ costs vary widely and we would still have the need to agree on a framework for what constitutes a “fair” assumed cost of production. The current Dairy Margin Protection Program allows for some security by paying farmers when the difference between national feed prices (typically a dairy farmer’s largest cost to produce milk) and national milk prices falls below a certain threshold.
Are these really the key indicators?
The short answer is possibly not. Milk appears in a lot of stuff, and often not in forms we think about - the components get taken apart, isolated, shipped around the world, used in factories to create any number of things that do not resemble its original form. And the manufacturing specifications get. . . specific. For example, The Dairy Reporter reports that it’s not nonfat dry milk powder but skim milk powder that’s the international standard now, because (in spite of it being basically the same thing) skim milk powder has a protein standard while nonfat doesn’t. And maybe even the "no fat" element will become outdated, since powdered whole milk is in growing demand. And tomorrow something new may be invented and demanded. Even in the most familiar products there’s been change; mozzarella now beats out cheddar as America’s favorite cheese product. Shortcomings aside, the current indicators may be the key ones through the self-fulfilling destiny that they’re the ones folks have more or less agreed to accept and for which information is most widely shared, including historical trend data.
You could go further to question what the component pricing numbers used by USDA actually mean. The Chicago Mercantile Exchange trades futures on the components of milk prices (e.g. barrels of cheddar) and on the Class III and Class IV prices themselves. There is no futures option for fluid milk and because the formulas for fluid milk prices take the greater of Class III or Class IV prices (which regularly flips) you can’t derive one. Future contracts can be a useful tool for risk management and some people believe that this option should be more available. A criticism is that this also introduces the influence of people who are not involved in the food business at all, but rather are in the business of making money from financial markets. In theory the USDA wholesale numbers reflect actual prices paid for actual product . . . in practice, when large companies enter into contracts they use futures numbers as part of determining prices, pulling the speculative figures into an actual sale. Similarly people interested in futures will look at USDA’s numbers to make their prediction about where the market is headed. The two aren't wholly separate.
Can you plan ahead for changing prices?
Some businesses use the futures market (described above) as a form of risk management. Another financial instrument for risk management is forward contracts. Futures are traded on an open exchange and used to speculate on which way an asset’s price will move from day to day; forward contracts are privately negotiated and intended to result in delivery of that asset (ie. milk) at a previously agreed upon price on a previously agreed upon date (or over several dates). Sometimes these are used like any other contract with a buyer who's planning ahead, but they can also be intentionally established for risk management purposes. For example, a Co-op can offer its farmers a chance to lock in a certain price for their milk over a period of time (that price might be for different parts of the formula -- blend price, Class III price, etc). To make this contract something other than a bet on prices going up or down, a farm needs to have a pretty good handle on finances to calculate where they think the markets are going, what they need to get as a minimum price, the tradeoff for stability versus possible higher prices, and how much of their milk to put in under contract. If used well, these contracts can hedge against price swings. Forward contracts can become quite risky if there’s any question about the counterparty holding up their side of the contract; if they drop out, a farmer is left with actual milk that has no home and possibly excess milk production capacity. The USDA has been experimenting with allowing more forward contracts.
Thank you to Diane Bothfeld from the Vermont Agency of Agriculture (rumored to be one of only a half dozen people who truly understands milk pricing) for help answering questions and reviewing an early draft of this article. Thanks also go to Catherine de Ronde, an economist at Agri-Mark, for her help with follow up questions.
Dairy Pricing reports briefing from the USDA: https://www.ams.usda.gov/market-news/individual-dairy-market-news-commodity-reports
Map of the Marketing Orders: https://www.ams.usda.gov/sites/default/files/media/Federal%20Milk%20Marketing%20Orders%20Map.pdf
Northeast Federal Milk Marketing Order: http://www.fmmone.com/
Sample Announcement of Statistical Uniform Price: http://www.fmmone.com/Price_Announcements/Statistical_Uniform/UP201805.pdf
Price Formulas: https://www.ams.usda.gov/resources/price-formulas
USDA Explanation of FMMOs: https://www.ams.usda.gov/rules-regulations/moa/dairy
An FMMO Primer from the Congressional Research Service: http://nationalaglawcenter.org/wp-content/uploads/assets/crs/R45044.pdf
Explanation of how Farming Practices affect Milk Component Production: https://extension.psu.edu/milk-components-understanding-milk-fat-and-protein-variation-in-your-dairy-herd
The Capper-Volstead Act as explained by the University of Wisconsin in 1997 (why? because it's the underlying framework for dairy cooperatives and explain how they fit in antitrust regulations) http://www.uwcc.wisc.edu/info/capper.html
Northeast Interstate Dairy Compact: https://ilsr.org/northeast-dairy-compact/
Background Information for 2017 Vermont Milk Commission Hearings: http://agriculture.vermont.gov/milk_commission
Explaining a Milk Check: https://extension.psu.edu/dairy-risk-management-education-understanding-your-milk-check
Text of the Agricultural Marketing Act of 1937 https://www.ams.usda.gov/sites/default/files/media/Agricultural_Marketing_Act_of_1937%5B1%5D.pdf