In dealing with complex relationships and numbers, it is common to employ “rules of thumb.” Rules of thumb are broadly applied descriptions used to approximate calculating or recalling a value. As a rule, rules of thumb are not strictly accurate, which means they probably are wrong to some degree or another. They survive because the differences are within a small range.

The origin of the measurement phrase is ancient and, as such, unknown. Not to be denied, a number of theories abound, the most common being it was used as a measurement by a carpenter or others. In some languages, such as French, the word for inch and thumb are the same. We have all seen the artist with his thumb upright at the end of an outstretched arm as he measures the scene he is painting in order to maintain perspective and size.

For the proper task, a thumb measure works, but when precision is required, it is less than desirable. While identifying the tip of the thumb (not the thumbnail) is easy, precisely identifying when the thumb ends is not. Is it to the fold of skin that connects to the hand, to the joint, center of joint? Then, of course, there is the variation in lengths of thumbs. All of which adds to its concept that such rules are approximations.

Dairy, complex in pricing and marketing, is no exception and has its rules of thumb. The most common one for commodity pricing is the difference between the closing price of the Chicago Mercantile Exchange (CME) 40-pound block and 500-pound barrel cheddar cheese price per pound. The rule of thumb for the spread is blocks over barrels by three cents. So common is the rule that virtually every Friday when the market newsletters discuss the cheddar market, almost always they phrase the pricing in terms of whether or not the block cheddar spread differs from the three cents.

The CME cheddar price is important to the industry. Since September 1, 1998, cheddar blocks and barrels have been traded daily. The CME cash cheese trading takes place between 10:45 to 10:50 a.m. The closing call can be delayed another 10 minutes if bidding is going on. It is a cash market, which means the seller must deliver and the buyer must accept delivery of the carload of cheese. A carload of cheese is between 40,000 and 44,000 pounds. The last trade sets the price. Uncovered bids higher than the last trade and uncovered offers lower than the last trade are the closing price. This last sentence is so because if someone bids to buy cheese at a higher price and no one accepts it, then the cash market for cheese is at least that high. If the bid is lower and no one accepts it, then the last complete trade sets the price. Similarly, when someone offers to sell lower than the last trade and no one accepts, it signals that the market is no higher than that price.

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Though these actual transactions cover very small amounts of cheese sold in the U.S., the announced prices are used to index virtually all cheese sold, even including some non-cheddar cheeses. The NASS survey of cheddar cheese prices reflecting actual sales closely correlates to the CME prices, just delayed about a week or so. (In this way, the NASS intended to be a “replacer of” but is in fact a “confirmer of” the CME pricing.) Because the prices are used to price product and become the driver of the pricing formulas for the FMMO system (California actually uses the CME block price in its formula), they are very important. Anomalies, violations of the rule of thumb, get attention.

In the over 2,800 daily reports of these prices since the commodities were first traded in September 1998, 324 or 11 percent of the time the spread was, in fact, 3 cents. The average is 3.5 cents, with a low spread for barrels over blocks of 15.5 cents and a 26-cent block over barrel spread reported the first week of December. It is not just that there has been a spike on one day, but for at least a month beginning early in November the spread has been consistently in the double digits, fueling much discussion in the dairy industry.

The concern is that such a spread continuing suggests something unseen in the dairy industry before. Though listed as two commodities, historically, blocks and barrels have been viewed as essentially the same product differing primarily in size of package. The difference in size is represented in different uses for the cheeses. This means that a customer for one could purchase the other and meet its needs. The result of this interchangeability is that the two should not get too far out of line, which is the difference in the packaging and handling costs. If one is priced out of the accepted range, then customers will move to the relatively lower-priced product. This is market “arbitrage” at work.

Arbitrage, pronounced so as to rhyme with “garage,” occurs when there is a disparity between two commodities or other assets of otherwise equal value. Arbitrage is possible when one of several conditions occur. The most common is when the same asset, such as cheddar cheese, is trading at different prices in different markets at the same time. If the difference exceeds the location difference, customers will move to the lower-priced one until the prices realign. This is commonly called the “law of one price,” which says that one asset or commodity, such as cheddar cheese, should have one price. For example, 40-pound block cheese and 500-pound barrel cheese should have the same price after adjusting for difference in handling and packaging costs.

When traders take advantage of this arbitrage we have price convergence. That is, the prices for each of the assets are realigned so that the “normal” pricing relationship between the products is established. In the cheese markets, at the close of 2009, this expected price convergence has not occurred.

What is the impact of this widened divergence? This depends on where you are in the pricing of cheese. For California producers, it does not directly affect them because their price is based only on the average of the block prices reported by CME, not the barrel. For many sellers of cheese, including barrel cheese, the block price is still the benchmark. For producers and processors in the FMMO system, it is a little more complex.

Since 2000 the USDA has incorporated the three-cent rule of thumb in coming to a weighted average price of cheddar cheese. The National Agricultural Statistical Service (NASS) reports weekly the volumes and prices at which cheddar cheese is sold as block and as barrel. Dairy programs adjust the raw data for the barrel cheddar to match the same moisture as block cheddar and adds three cents to the barrel price before computing a weighted average price used to compute the Class III protein price. When the spread exceeds three cents, the relative price paid by producers goes down. For barrel cheese makers, the margin between what they pay for milk under the orders and the value of their cheese reduces. As the spread widens, the margins can disappear.

One of the important policy issues of end-product pricing is to discover a price for milk that correlates to the cheese product being sold. Long-term discrepancies between the actual block cheddar spread and the three-cent rule of thumb puts strain on this relationship for some producers of cheese. The same thing happened several years ago when the value of dry whey shot above the values of whey protein concentrates and resulted in substantially higher milk prices relative to the value of products plants were producing. If the market does not converge, then pressure will be on the pricing formulas to adjust.

Market forces should bring convergence. But why has the market allowed such a spread to exist and continue? The answer lays in the cheap milk available earlier this year. Those plants who could took in the extra milk and made barrel cheese for sale when cheese prices, and milk prices, recovered. It is a classic case of buy low and sell high. The result is that there has been a large inventory of barrel cheese waiting for the price recovery – more barrel cheese than there is a market. As a result, barrel prices have been low.

This inventory of cheese is also too old to sell on the CME, so none is offered. Buyers for barrel cheese have not needed to go to the cash market because they can purchase barrel cheese cheaper in the marketplace. Until the old cheddar barrel cheese is sold, the CME barrel price will be relatively quiet.

While it is understandable as to why the barrel prices are low, the question becomes: Why have the block prices remained so much higher? If cheese is cheese, buyers of blocks would buy cheaper barrels instead and makers of barrel cheese would switch over and make block cheese. These shifts in supply and demand would bring about the convergence the market expects.

Therein lies the real, longer- lasting story. The easy arbitrage between blocks and barrels of the past is disappearing. Over the years plants have become more and more efficient. The efficiencies are needed to stay in business. One of the efficiencies is to build production lines that make only barrel or block cheese without the flexibility to switch. With block lines full to capacity and barrel lines that cannot switch, plants cannot easily transfer production to blocks to get the higher price. At the same time the buyers of cheese, too, have become more efficient. Just-in-time inventory and just-as-we-need-it supplies mean that these plants are designed to accept ingredients in specified sizes and shapes. The plant that handles 640-pound block (16 40-pound blocks combined) is not as efficient if handling barrels. A plant designed for barrels will find handling 40-pound blocks more expensive. It is like a dairy that handles 1-ton bales of hay and has to use a three-string bale or round bale. Hay is the same, but the handling equipment is more cumbersome. As a result, cheese buyers are not moving to the cheaper barrels as they would have in the past.

The result is that these two cheese commodities are more divergent than they used to be. Their supply and demand do not overlap as completely as before. Spreads, in both directions, will continue and even be extreme. This is especially true when one of them takes advantage of cheap milk and stores cheese for future, higher-priced, sales.

Markets work. The market will find the appropriate level of price convergence with blocks and barrels. Whether it confirms to the old rule of thumb or creates a new one, only the future will tell. PD

Ben Yale