Nepveux is an economist and Newton is chief economist, both with American Farm Bureau Federation.
While the ink on the recently signed farm bill is still drying, some in the industry are ready for a new policy challenge: Federal Milk Marketing Order (FMMO) reform. Particularly, there is interest in revisiting milk pricing regulations in light of the growing proportion of milk moving out of the fluid milk consumption category and into manufacturing channels and export.
Given California’s recent entry into the federal order system, it’s been projected that 80 percent of U.S. milk production is now covered by FMMOs. At a high level, FMMOs facilitate the orderly marketing of milk by using end-product pricing formulas and revenue pooling to determine the regulated minimum farm-level price of milk and milk components.
Those leading the call for reform are looking deep in the system at make allowances, which are included in FMMO end-product pricing formulas. Make allowances are processing credits designed to reflect the average processing costs associated with producing cheeses, butter, nonfat dry milk, or dry whey. Make allowances were last modified in 2007.
Make allowances impact plant investment decisions by processors due to the magnitude of the credit and can reduce the farm-level milk price by several dollars per hundredweight. For Class III milk used to make cheese, the current make allowance is $3.17 per hundredweight. The Class IV make allowance for butter and powder products is $2.17 per hundredweight. During 2017, 55.9 billion and 20.8 billion pounds of milk were utilized in Class III and IV, respectively, representing total make allowances of nearly $2.3 billion dollars.
Over the past 10 years, make allowances as a percentage of Class III and Class IV prices have ranged from 11 percent to 25 percent and 8 percent to 19 percent, respectively. In times of low milk prices, make allowances represent a larger share of the farmer’s milk check — putting more of the onus of plant profitability on the farmer.
STIMULATE NEW PLANTS
While make allowances at times represent more than 20 percent of the farm-value of milk, for some, the goal in revamping FMMO pricing formulas is to increase make allowances. The thought is that higher make allowances will stimulate plant investment across the U.S. by domestic milk processors – making them more competitive with foreign investments. A rising tide, however, would lift all boats.
There’s no debate that more processing capacity . . . as much as 30 billion additional pounds of milk . . . is needed to come online over the next decade. The way we get there, however, is open for discussion because higher make allowances reduce dairy farm profitability by pushing milk prices down. With farm gate milk prices at or below the cost of production for many, this is a difficult proposition even if the outcome provides more milk processing capacity.
Historically, make allowances have been justified based on the price circularity that occurs through USDA’s wholesale dairy product price survey. Under this circularity, the same prices at which manufacturers sell certain dairy products are used to determine FMMO milk and component prices, and thus impact any profit opportunities along the supply chain. Without these make allowances, some have claimed, there would be limited profit opportunities when manufacturing raw milk into finished dairy products.
Based on data over the last decade, approximately 35 percent of the cheese produced in the U.S. shows up in USDA’s national dairy product sales report. Meanwhile, the percentage of butter captured by USDA’s price survey is 12 percent, nonfat dry milk is 62 percent, and dry whey is 46 percent. The remaining dairy products are sold in a manner that makes them difficult to capture in FMMO pricing surveys, sold in export markets or sold under terms of a forward contract for example.
When converting these products into a milk-solids-equivalent, less than 10 percent of U.S. milk solids produced in a given year are represented in USDA’s price survey and determine USDA-regulated minimum milk prices. The remaining milk solids are sold in ways that may provide an opportunity to profit through speculative activity.
For most farm-produced commodities there are opportunities to profit along the supply chain by processing or marketing agricultural products at or into value-added products. Custom-fed cattle, corn into ethanol, soybeans into soybean meal, or products purchased for export markets are classic examples. Grain elevators storing commodities in the hope of selling at a higher price later is another. Adam Smith, who is considered by many to be the father of modern economics, described these self-interest actions as an invisible hand of the economy that helps to clear markets without government intervention.
A potential option for milk price discovery moves in a laissez-faire direction toward a competitive pricing environment — a place we almost went in the 2014 farm bill and a policy supported by millions of Farm Bureau members.
Under this approach, processors would pay farmers a market-clearing price based on the supply and demand for milk and finished dairy products. More efficient processors, or those with higher-value products, could potentially pay dairy farmers more for their milk. In the long-run, a competitive pay price environment would reallocate dairy processing and farm assets and drive plant investments and innovation in ways that maximize profits and productivity.
In the short-run, and without some sort of market-wide revenue sharing pool, competitive pay prices could be disruptive as resources are reallocated, and farmers compete against each other to service the higher-valued markets.
There are other options, too.
Consider phasing out make allowances and smoothing prices paid to farmers over a quarterly or biannual period that allows for processor profits to be equitably distributed back to farmers based on the financial performance of the business. Perhaps there’s a bright economist out there with a solution none of us are considering at this point.
THE PATHWAY FORWARD
Whatever the solution, it needs to recognize the current state of the U.S. dairy industry with low dairy farm income, accelerating dairy farm closures, and strained processing capacity. But we now have greater diversity in the products we produce and the markets we service. Can our pricing system be modified to accelerate our capacity for innovation and growth?
A mentor recently said, “These issues deserve thoughtful consideration, and perhaps we ought to figure out how to carve out the time to do just that.” The future of the dairy industry and the milk check outlook depend on it.