Waiting will be its undoing: Federal Orders
November 1, 2021
Back in the late 1990’s the USDA, along with academics and strong support from the commercial dairy industry, operated at warp speed to dramatically transform how milk was priced. The Class IV price was created, multiple component pricing introduced, and the number of orders was consolidated. Since then, the industry has witnessed strong growth in both milk production and domestic/global demand. But the current system of pricing milk is a bit dated, with make allowances unchanged for over a decade. Today, instead of operating at warp speed, USDA is taking a wait, let’s not rush, approach. But waiting another year, than another year, however, will have unintended consequences.
Federal Order Reform was launched back in 2000 and dramatically changed milk pricing in the US. Prior to this reform, milk pricing was based on the M-W, which was a survey of unregulated markets for Grade B milk in Minnesota and Wisconsin. Hey, remember Grade B milk? Today, about 98-99% of all milk is produced under Grade A regulations. The M-W represented a competitive price for surplus milk in the Upper Midwest and was quoted both “at test” and standardized to 3.5% butterfat. It was all pretty simple. Just conduct a regional survey, test the individual farm milk for butterfat, and that determined the farm price of milk.
As the supply of unregulated milk shrunk in the Upper Midwest, it no longer represented a statistically valid sample for milk pricing in the rest of the U.S. So, USDA needed a replacement, and fast. On June 1, 1995, USDA replaced the old M-W with the “Basic Formula Price,” or BFP. It represented a minor change, a formula-based update, but still relied on the M-W survey. When Federal Order Reform came about in the late 1990s, USDA worked with economists and industry representatives and came up with “End-Product Pricing,” whereby the farm value of milk components, not just butterfat, could be derived from wholesale commodity prices (cheese, butter, etc.). They basically reverse engineered the price. There was no longer a need for a survey of a dwindling Grade B milk supply. The new system, with suggestions from California milk pricing, would rely on math.
To calculate monthly farm level component prices, all you needed was a yield factor (how to convert milk components into finished dairy products) and a “make allowance.” The latter represented the average manufacturing cost of converting milk into finished dairy products. To come up with these yield factors and make allowances, essential elements into the math wizardry, multiple Federal Milk Marketing Order (FMMO) hearings were conducted. In fact, by my review, there were four FMMO hearings between 1999 and 2008 that were called to study these make allowances. The last change in the make allowances that are used to derive farm level component prices today was back in October 2008. Wait, what? Thirteen years ago?
These make allowances represent the cost of manufacturing, and most of these costs go up each year. So why have they not changed in thirteen years? The answer is three-fold. First, any change in FMMO make allowances requires a Federal Order hearing. Someone from industry, likely a cooperative, must call the hearing. Second, the make allowances are linearly related to farm-level milk prices. So, a rise in the make allowance, all else the same, results in lower farm prices. Third, and this is important, farmers, who own these cooperatives, have argued effectively that their costs of production have also gone up. So, as a result, no one has to date called a hearing to adjust these make allowances. The system is clearly broken.
The ramifications of relying on a hearing-based formulaic pricing system is obvious. Processing plants, which dairy farmers rely on for a local haul and for processing their milk, can no longer recoup their out-of-pocket expenses. Not even variable costs are fully recovered (e.g labor, packaging, energy). That results in thin or negative processing margins, minimal budgets for repairs and maintenance, and reduced plans for expansions.
Looking ahead, the industry has basically three options. Option 1 is to revert back to an unregulated survey method. Instead of a survey of Grade B milk in the Upper Midwest, today it would be Grade A milk in Idaho. Call it the “ID-Grade A survey.” Option 2, hold a hearing and link parameters of the make allowances to an annual survey of manufacturing costs. So if in Year X energy costs go down, but labor and packaging costs go up, the “adjustments” would be automatic. No need for a new hearing. Option 3, is to WAIT. Wait for a USDA-sponsored University study that documents plant make costs (now over 2 years old). Wait for someone brave enough to call for a hearing. Wait for USDA to approve the call for a new hearing. Just wait!
If I was to pick which option will ultimately prevail, it would be Option 3. It describes our current scenario, and it also is the least controversial option. No one will be upset waiting another year. But Option 3 has a big draw back – time. Waiting gives market participants time to really think what benefits exist to maintaining Federal Orders for milk. It doesn’t do a good job of pricing Class III and IV milk, particularly in the West, which must compete globally with the EU and New Zealand. The West also faces increasingly high transportation costs to move product to US customers in the Midwest and East; something not reflected in FMMO pricing. Those are two reasons why there is very little actual Class III pooling in Western orders. Time also gives witness to the continued crushing decline in Class I fluid milk sales. By 2023 there will be more exports of milk solids than Class I sales. Without offsetting Class I sales, not all supply plants in a given order will be eligible to participate in pooling. And with little Class I differentials to pool, why participate?
My conclusion is that waiting is what will create the conditions for the eventual unraveling of Federal Milk Marketing Orders in most of the U.S. It will start in the West, where cooperatives and dairy processors face strong global opportunities for exports, with only limited Class I milk sales. But it will quickly spread to the Midwest which has declining Class I sales and a strong and growing domestic cheese business. The need to first consider pooling and pricing restrictions on milk before sketching out a business case for a new product is mind boggling. Farmers will simply move on.
In the end, Federal Orders will have nothing to do with pricing casein/whey protein fractions or export-bound products, and will instead be reduced to what it was originally created to do – price Class I milk. That need will likely persist along the east coast where the majority of milk sales are Class I. But pricing milk elsewhere will eventually be done by the marketplace.
Dr. Ken