The Problem with Protein Pricing
January 3, 2022
The creation of component-based pricing in the late 1990s was a huge innovation to milk pricing in Federal Milk Marketing Orders (FMMO). New equipment and technology allowed the protein content in milk to be approximated by using a nitrogen test, a fixed parameter to convert nitrogen to protein, and a small correction for “True Protein” that eliminated “non-nitrogen protein” from the nitrogen-based test. In part, because of this innovation, the component content in milk in Federal Orders that pay on the basis of components steadily increased over time. Farmers responded logically to the new pricing incentives.
The market for protein has grown considerably since the late 1990s with increased domestic demand for cheese, and the rise of export markets. With size comes complexity. The economics of selling low moisture white cheddar to markets in Asia is completely different than meeting the demand for sliced and shredded cheddar in Wisconsin. Component pricing under Federal Orders needs a fresh reboot, and the many challenges in improving the current method of Class III protein pricing offers insights into Federal Order Reform for 2022-23.
Representative Survey
In Federal Order Reform, USDA basically reversed engineered component values based on standard commodity prices. The idea was to approximate true price discovery for components. But they needed to identify well traded commodity markets. For Class III protein, they used block and barrel cheddar cheeses. Mozzarella was avoided because it is priced off of cheddar, and most mozz is manufactured to customer specifications and is therefore technically not a “commodity.” In 2019 cheddar cheese accounted for 28% of all cheese produced, and mozzarella 34%. So, is cheddar cheese today truly representative of the market value of cheese when deriving protein pricing? Also, USDA’s strict definition of commodity blocks and barrels further limits the scope of the survey.
Van Slyke and the Protein Formula
The protein price formula used today in Federal Orders hails from a collaboration between government and university food scientists and economists. They started with the famous “Van Slyke” cheese yield formula that was created by the chemist Dr. Lucius Van Slyke in a 1918 treatise on cheese yields. Along with “tweaks” from “True Protein” pricing and USDA assumptions on shrink for butterfat and milk, they derived a complex mathematical formula that produced fixed parameters that entered the new protein pricing formula. All of the details used to create this new formula may be found in Chapter 7 of my new textbook, “Dairy Economics: Pricing, Policy, and Risk Management.” Taking a fresh look today, maybe a formula derived from a treatise from 1918 is no longer relevant to pricing cheese in 2022.
The Butter Offset
As stated earlier, component prices under FMMOs derive their value from narrowly defined commodity prices. In the case of Class III protein, it derives its value from both cheese and butter commodity prices. That’s because cheddar cheese contains 23.3% casein protein and 34% fat (see Table 2.3 of my new textbook). So if the price of cheese remains flat, but butter prices rise, the derived protein price has nowhere to go but down. Cheese processors will now pay less for protein even though the cheese market is flat. Farmers will respond by producing less milk. On the other hand, if demand for cheese is steady to weak, but domestic butter is long, the Class III protein price could increase. That means West coast producers of cheese will be less competitive in global cheese markets. Valuing butterfat in cheese prior to computing a protein price is tricky business.
Exports
Cheese exports are effectively excluded from FMMO pricing because a) exports are sold 2-4 months into the future, and b) the kind of cheese exported abroad to customers doesn’t always neatly fit into the commodity description for cheddar cheese used in the NDPSR survey. But exports are increasingly important. For the first 10 months of 2021, the U.S. exported 340,134 mt of cheese. That is approximately 6.6% of all U.S. produced cheese. Cheese is a high value export and includes both fat and protein from farm milk. The EU is aggressively signing trade deals with other countries in order to expand their trade in cheese. But the cost of manufacturing cheese under FMMO’s many not always line up with the market value of cheese overseas.
In order to have a vibrant and growing industry, the U.S. will need to aggressively export products like cheese. And FMMO’s will need to find a way to reflect exports in order to be able to pool Class III milk in all federal orders, including those on the west coast.
Commodity Formula
The “cheese price” used in the Federal Order formula for protein is based on a weekly weighted average of the NDPSR survey for 40-pound block and 500-pound barrel cheese (barrels adjusted to 38% moisture). It does not reflect 640-pound cheddar blocks, which are increasingly used in sliced cheese. And, the monthly average cheese price, which uses all 4 weeks of data, includes a 3-cent per pound markup for barrel cheese. Why the 3-cent markup? Well, the reason may be buried in testimony from the 1990s, but I believe it was used to reflect the added cost of washing and returning steel barrels. But no one uses steel barrels anymore, and there is no way a West coast cheese processor can recover that cost when exporting cheese to Mexico or Asia. Exports, particularly high value cheese exports, are crucial to the future of the U.S. dairy industry.
Basis to Market
Commodities have two basic factors that affect their price: a) the base market price, and b) the local basis to the market. Basis is a commercial reality. The price of corn harvested off your farm won’t be the same as that quoted in Chicago. Everyone accepts that. But when it comes to dairy, FMMO’s say it doesn’t exist. The Federal Order system quotes one price of protein each month, whether your plant is in Michigan or Oregon. The system does allow for location adjustments, which are based on Class I differentials created by Cornell and approved by Congress in the 1990s. In the grains markets, local basis adjusts every day. It reflects not only transportation costs, but also local supply/demand factors. Again, under the Federal Order system, a cheese plant in the Central Valley of California has to pay exactly the same price of protein that a similar plant would pay in the Midwest, even if the California plant is exporting their product abroad. This defies commercial reality and may partially explain why Class III pooling in the new California order has only averaged just 17.3% since inception. In the commercial world, each FMMO pool should have a different “basis” to the central market (i.e. Chicago or Oceania) when computing component prices and calculating the farm value of milk.
Valuing Byproducts
The “True Protein” price in FMMO’s values both the casein and whey protein in raw milk. Typically, cow’s milk is 80% casein and 20% whey protein. When cheese is produced, the water soluble whey protein, and a small part of the casein structure, is washed out of the cheese curds along with lactose and minerals. This liquid cheese whey can then be dried into “dry whey,” or the whey can be modified to make whey protein concentrate, reduced lactose, or reduced mineral whey with lactose as another byproduct. But while the lactose and minerals have a component formula (called “Other Solids” and is based on the dry whey price), the value of the whey protein is undetermined. Most plant accountants charge the Class III value for True Protein and Other Solids, then assign a separate lower value for the byproducts such as whey protein. That ensures that any byproducts, which are expensive to make, can be booked as profitable.
FMMO’s value byproducts merely as credits in the calculation of component prices. But wouldn’t it be better to set separate protein prices for casein and whey if classified pricing and pooling is maintained? They are two very different markets and often diverge in value. Casein is largely driven by domestic cheese supply/demand, whereas whey protein is impacted by global factors.
Any Conclusions Here?
We’ve listed seven issues that need to be addressed in order to modernize the protein price reported under FMMO’s. And I did not mention “make allowances,” the most controversial issue of all. Making changes won’t be easy as these issues tend to be regional. Also, in order to grow the dairy market, it may be necessary to lower some prices down to commercial values. USDA acts as the referee here and convincing them to adopt commercially viable practices, such as multiple basing points, may be difficult given they haven’t experienced these issues in the market place.
By its nature, Federal Order reform will require a) a “YES” vote for changes by dairy farmers that supply the order, and b) a comparison back to “how things used to be.” Both of these facts present challenges to any change. Dairy farmers need to focus on building a stronger market for their milk over the next 10-20 years. And, any “scoring” of proposed policy changes to current formulas should be avoided since the market today, and in the future, isn’t the same as it was back in the 1990s. Focus instead on what changes are necessary to improve the market and expand production and exports. Otherwise, we’ll simply leave the growing world market to the Europeans.
One idea may be to go the Canadian route and break down Class III into subclasses for blocks, barrels, 640’s, mozzarella, etc. There could be separate protein prices for each. Classified pricing on steroids! But that means more rigid formulas that will need to be adjusted via an expensive hearing process. Or, we could simply ditch the idea of a commodity reference point altogether and simply have each order report actual sales of cheese and actual processing costs each month. Component prices would be derived separately in each order. A final idea, one I would favor, would be to simply deregulate the Class III market altogether and allow the wisdom of the commercial market, not the book smarts of economists (this one including!), to determine the market value of protein.
So, keep your eyes on protein pricing as it represents all of the challenges to modernizing and improving Federal Milk Marketing Orders.
Dr. Ken