There have been a lot of discussions this year about possible changes to the milk pricing system with dairy cooperatives within the National Milk Producers Federation (NMPF) aligning on a set of proposals. With the potential for a Federal Milk Marketing Order hearing in 2023, having the cooperatives’ position defined is a good first step. But dairy farmer groups, processors, and other parties also will get involved in the hearing process with different ideas and proposals. In baseball vernacular, we are still in the early innings of the game.

Consensus is a word that typically does not apply to dairy policy reforms, so little change actually takes place over the long haul. Congress mandated USDA reform the Federal Milk Marketing Order (FMMO) system in the 1995 Farm Bill. The outcome of that effort was the pricing system we have had since January 2000 when the dairy sector and milk and consumer markets looked very different than today. This should be a call to have a broader review of long-term dairy policy in the next farm bill and starts with defining the goals for federal dairy policy. Think of these as long-term improvements in addition to the short-term fixes to the current system proposed by NMPF.

Let’s start with beverage milk

While dairy farmers and fluid milk bottlers do not like to hear it, fluid milk consumption continues to decline with no sign the trend will stop. This is a fundamental problem for the current milk pricing system – there simply is not enough money generated from Class I sales to make federal order pools work as designed 25 years ago. Elevating Class I prices by changing the Class I mover formula, component levels, and Class I differentials only make the problem worse. Basic economic theory would show that lower Class I milk sales push more milk into manufactured products, which results in lower milk prices for farmers. There are also important regional differences as farmers in the Upper Midwest, California, and other areas with low Class I utilization see a larger negative hit to their milk check.

Negative PPDs (producer price differentials), depooling, make allowances from 2007, and the “higher of” are all symptoms of a larger issue, which is an outdated regulated milk pricing system. Less than 20% of milk is used for Class I purposes, nearly half of what it was in the mid-1990s when federal order reform was debated. In addition, the FMMO system was established in the 1930s 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 has exceeded the amount used in Class I in some months in 2022. The U.S. competes with other countries around the world that have more market-based milk pricing systems, which puts 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.

Still top value?

Even with a diminished role in today’s dairy market, the federal orders still treat Class I milk as the most valuable use of milk. The debate around how to price Class I milk involves a change from the 2017 Farm Bill to use the average of Class III and Class IV milk prices plus a fixed differential that would allow for better risk management for processors and farmers. Unfortunately, some are advocating for a return to the “higher of” formula of pricing Class I milk, which would effectively eliminate the ability of processors to manage price risk for value-added milk products, an area of growth in the category. It would also greatly increase the basis risk for farmers in higher Class I utilization markets, something that has not been discussed much, if at all. Why not just update the differential each year?

For reference, the debate around Class I pricing from the late 1990s and how the “higher of” came to be should be reviewed to understand the assumptions made at that time and how the market has evolved since then. Seasoned industry professionals will likely remember an initial proposal to use a six-month rolling average of Class III and Class IV prices as the Class I mover. Imagine what that would have looked like in 2020!

There are also proposed changes to other elements of the current pricing system. Eliminating barrels from the Class III price formula is problematic, as barrel volume in the National Dairy Products Sales Report (NDPSR) series has been higher than blocks the last three years. If one market should be eliminated, take out blocks. Or better yet, eliminate the CME barrel market and price barrels off the block market. The volatility of the block-barrel spread has been a source of pain for cheese plants, but there are better ways to solve the problem.

Costs must be relevant

Make allowances also are a problem for plants, as the manufacturing costs used in the milk price formulas are from 2007 to 2008. It is understandable some cooperatives did not like using the most recent cost data submitted to USDA given the impact on milk prices. However, if the industry is going to use product price formulas to value milk, then the make allowances need to be current. A better option is to remove regulated minimum prices for manufacturing milk and let plants compete. Product price formulas have resulted in a low-risk, low-reward system that encourages the 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 are investing to produce value-added dairy products and paying farmers higher prices. This can happen in the U.S., but milk needs to be able to move to its highest value use through market signals, not a rigid regulatory system.

Look at the success Idaho has had since deregulating in 2004. The state became the No. 3 milk producer in the U.S. and has seen billions of dollars in investment in new plants. In Idaho, milk pricing is easy to understand, and dairy farmers can effectively manage their margin risk from volatile milk prices, another goal of future dairy policy.

The goal of federal order reform should not be the elimination of the FMMO system. FMMOs provide several valuable services including milk testing, payment enforcement, and data collection, and these should be continued. Some say let the current system slowly become irrelevant and have companies opt out of the system.

If the Upper Midwest federal order is voted out, would the Central order be next? Would that bring down the entire system? It seems there is a better path forward that maintains the positive aspects of the current system but makes it reflective of the dairy marketplace of today and tomorrow.

If given a blank sheet of paper to draw a future-oriented milk pricing system for the U.S., it is hard to imagine anyone designing a system like we have today. The dairy industry has a unique opportunity over the next few years to rethink and redesign federal dairy policy. Inertia will lead to little or no change to a system that is fundamentally broken. Removing outdated regulations could let the U.S. dairy industry prosper, bringing more money and profits to dairy farmers and processors.

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(c) Hoard's Dairyman Intel 2022
December 8, 2022
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