The four primary effects of the reforms were to: 1) consolidate 32 orders into 11, 2) utilize product price formulas to determine class and component prices, 3) implement multiple component pricing in seven of the 11 orders and 4) price fluid milk on county-level price differentials.
In the 20-plus years since order reform, there have been six primary changes to the system.
- The Western order (primarily Idaho and Utah) was terminated in 2004.
- During 2004 and 2005 the Central, Mideast and Upper Midwest orders amended rules to tighten pooling provisions.
- In 2007 the three orders in the southeast (Appalachian, Florida and Southeast) modified their Class I differentials.
- Also in 2007, a national hearing convened to update the make allowances and yield factors used in product price formulas.
- Following a hearing in 2015, California joined the federal order system as its own order.
- The 2018 Farm Bill changed the Class I price to be the average of the advanced Class III and Class IV prices, plus 74 cents per hundredweight (cwt).
However, since 2000, structural changes in the U.S. dairy industry have been greater than the modifications made to the federal orders. Class I sales have declined from 35% of national production to approximately 20% and seem destined to fall further. Commodity price volatility increased following the reduction, and then removal, of government price supports. Exports grew from being virtually nonexistent to now utilizing more than 20% of milk solids produced. In fact, estimates are that more milk solids were exported during 2021 than were consumed domestically in fluid milk. The make allowances implemented in 2008 need to be revisited given today’s higher processing costs. The distinction between co-ops and processors has become less discernable as more co-ops enter the processing business, including fluid milk processing.
In advance of potential proposals to overhaul milk pricing via order hearings and/or the 2023 Farm Bill, the International Dairy Foods Association (IDFA) commissioned an analysis of current market realities, competitive issues and global pricing practices. The resulting working paper, “Modernizing U.S. Milk Pricing: An Exploration,” was published on the IDFA website in late January. In addition, the authors, Dr. Marin Bozic, professor at the University of Minnesota, and Phil Plourd, president of Blimling and Associates, discussed their findings during IDFA’s annual Dairy Forum. Their yearlong project included interviews with dozens of industry stakeholders, both in the U.S. and abroad, data analysis and an extensive review of milk pricing systems used by other leading dairy countries. After sifting through a myriad of issues, the report focuses on three areas: Class I issues, exports and pricing structures in eight other countries.
Class I Issues – The federal order system requires regulated minimum prices be paid for Class I milk and for the revenues from Class I sales to be shared (pooled) with all qualified producers of a particular order. Furthermore, the classified pricing system was designed with the concept that the Class I price would be the highest-priced milk in the pool and, thereby, incentivize manufacturing milk to be pooled to share in Class I revenues. However, fluid sales have been declining for several years, and the trend doesn’t show signs of reversing. At the same time overall production has been increasing. The combination of less Class I revenue and greater production affects milk pricing in several ways.
First, having fewer Class I dollars to be shared among more total production lessens the incentive for manufacturing milk to participate in federal order pools. The report shows that from 2016 through 2019, the five federal orders with the lowest Class I utilization averaged only a 15-cent-per-cwt draw from the pool for Class III milk. If Class I utilization continues to decline, so will the associated pool draws leading to more de-pooled and deregulated milk.
Second, declining fluid milk sales have left the industry with excess fluid processing capacity. The result is that processors can’t command premiums from retailers and producers can’t negotiate premiums from processors. The excess capacity has driven processing margins to be razor thin, leaving little incentive to innovate or modernize.
Exports – 2021 marked a record year for U.S. dairy exports in both volume (5.9 billion pounds of product) and value ($7.75 billion). The potential for exports looks to be bright given the constraints being experienced by two of the U.S.’s main competitors. New Zealand’s pasture-based production system may have reached its land capacity. The European Union (EU) is converting its agricultural policy to direct payments to producers and away from subsidizing exports. However, increasing exports will also be a necessity for the U.S. if it wants to continue to grow its production. Growth in domestic consumption will not keep pace with historical production gains.
The IDFA report explains that most export buyers prefer long-term, fixed-price contracts. Meeting that requirement is difficult for U.S. processors given that federal order component values change monthly. While hedging and derivatives are available to manage processor price risk, often futures contracts are priced at a premium to current spot prices. Furthermore, liquidity in dairy commodity futures is often too low to provide a robust market for price risk management. As a result, the U.S. enters the export market when U.S. prices are below prevailing world prices. The analysis showed that when CME cheese futures were 10 cents per pound below Global Dairy Trade prices, U.S. cheese exports increased 15% two months later. In the case of nonfat dry milk, a 10-cent discount to world prices led to a 29% uptick in exports two months later. The net result is that the value of U.S. exports trails the EU by a significant amount. From 2012 through 2020, the EU weighted average unit price was $1.64 per pound compared to the U.S. export value of $1.14 per pound.
Another impact of being the low-cost provider is that U.S. firms are not regular suppliers to the world market. Therefore, the industry misses out on selling regular monthly volumes and forgoes value-added business that requires consistent monthly deliveries at fixed prices.
Where does the process go from here? The report does not venture into making policy recommendations. Its purpose is to provide a frank analysis of the current situation to spur discussion. Its primary two points are irrefutable. Fluid milk sales have declined and are very likely to continue to decline, and exports are becoming more important for the industry. Several organizations are crafting policy recommendations, including IDFA, the National Milk Producers Federation, American Farm Bureau Federation and regional dairy organizations. Then discussions will need to take place among industry stakeholders to see if a consensus can be reached. USDA Secretary Tom Vilsack has stated that the department will not notice a federal order hearing until the industry comes to a consensus on needed modifications. Such consensus has been extremely rare previously. However, the working paper makes clear that to do nothing will lead to gradual, disorganized deregulation. The industry needs to either make the hard choices and compromises to manage the evolution of milk pricing or live with the disintegration of the current system.
Erick Metzger is the general manager of National All-Jersey Inc.