Federal Milk Marketing Orders and their Role in Dairy Pricing

Transcription

1 December 2014 Federal Milk Marketing Orders and their Role in Dairy Pricing By Leonard Sahling Division Manager, Knowledge Exchange Division Inside this Issue Introduction...2 Preview of FMMO system...2 Milk Components...2 Classified Milk Pricing...3 Pricing Formulas...4 Over-Order Price Premiums...4 FMMO Pooling...5 Producers Milk Checks...6 FMMO Settlement Pools...8 Qualifying to Participate in a Settlement Pool...9 De-pooling...11 Distant Pooling...12 Concluding Thoughts...13 Appendix Pricing Formulas...14 Key Points: Farmgate prices of nearly two-thirds of the nation s raw milk are regulated under an administrative system known as Federal Milk Marketing Orders (FMMO). There are ten individual orders, each defined for a specific geographic region. The FMMO system is designed to promote two key objectives: (a) to ensure that the supply of raw milk will be adequate to accommodate consumer demand for fluid milk, at a reasonable price; and (b) to facilitate orderly marketing within the marketplace. The system s overarching goal is to balance market power between farmers and milk handlers, while reducing the destructive competition between milk producers that can drive down prices, to their mutual detriment. Two key provisions underpin the FMMO system: classified pricing of milk, according to how it is used; and pooling of purchasers receipts across all classifications, with the pool proceeds used to pay farmers equitably, regardless of how their milk is used. Four broad uses of milk are recognized, each designated as a separate class (Classes I, II, III, and IV). Class I milk is used for dairy beverage products. The other three classes of milk each cover different groups of manufactured dairy products. Minimum prices are set for each class. Weekly surveys are conducted to determine the market-based prices of dairy products such as butter, cheese, whey, and nonfat dried milk. The FMMO s pricing system uses a series of formulas that link the prices of the four classes of milk to the market-based prices of the dairy products. All ten Federal Milk Market Orders use the same formulas and the same wholesale price surveys in setting their Class II, III, and IV milk prices, so these three prices of raw milk are exactly the same across all ten orders. Class I milk prices usually are set well above those for the other three classes of milk, to ensure that each order will have enough fluid milk to satisfy consumer demand for dairy beverages. These Class I prices, however, vary widely among the ten orders. 1

2 Introduction The farm prices of roughly two-thirds of the nation s Grade A raw milk are regulated under an elaborate administrative system known as Federal Milk Marketing Orders (FMMO). A classified milk order system has been in operation, in one form or another, since the 1930s. More than 20 years ago, two dairy economists at the University of Wisconsin began their authoritative report on the then newly reformed FMMO system with the observation that, Dairy pricing is complicated. 1 And it s no less complicated today. But anyone who wants to know how the dairy industry and markets operate today must have a basic understanding of the FMMO s pricing system. The main goal of this report is to provide an updated, comprehensive overview of how this administered pricing system works. Preview of FMMO system At present, the FMMO system encompasses ten individual orders, each one defined for a specific region and each with its own (or in two cases, shared) administrative apparatus. (See map.) These ten orders do not cover the entire country. Several states including all of California Federal Milk Marketing Order Areas and Montana and parts of New York, Pennsylvania, Maine, Nevada, North Dakota, and Virginia have their own milk marketing order or other systems for regulating milk prices. For each federal order, the geographic boundaries correspond roughly to the marketing region where fluid milk is sold to customers, and not necessarily to the milk shed or region where it is produced. Actually, with modern transportation and packaging, raw milk can be transported readily cross-country, so the geographic boundaries matter much less today. At the core of the FMMO system are two key provisions: (1) classified pricing of milk according to how it is used and (2) pooling of receipts across all classifications, with the pool proceeds used to pay farmers equitably, regardless of how their milk is used. This system is designed to promote two key objectives: (1) provide consumers with an adequate supply of beverage milk, at a reasonable price; and (2) promote orderly marketing within the marketplace. 2 Its overarching aim is to balance market power between farmers and milk handlers, while reducing the destructive competition between milk producers that can drive down prices, to their mutual detriment. 3 In an unfettered market, the perishability of fluid milk would likely give a competitive advantage to buyers. Sell it, or smell it, as industry insiders are fond of saying. At the same time, with its premium price for fluid milk beverages, the FMMO system functions as an institutionalized form of price discrimination designed to increase the total revenues received by dairy farmers. Milk Components Cow s milk is decidedly not a homogenous commodity, contrary to its appearance. Rather, it is a composite of various 2

3 Exhibit 1: Stylized Composition of the Average Cow s Milk components, each with distinct physical characteristics and with market values that reflect their uses in different kinds of processed dairy products. In general, cow s milk consists of water, butterfat, and nonfat solids where nonfat solids are comprised, in turn, of protein, lactose, and minerals or ash. (See Exhibit 1.) The actual proportions of these components will vary from cow to cow, day to day, farm to farm, and breed to breed (e.g., Holsteins versus Jerseys). Dairy processors turn these milk components into consumable dairy products. Fluid milk beverages, Source: CoBank. for example, consist of some combination of skim milk and butterfat. Skim milk is what s left after butterfat has been removed and consists of water and nonfat dairy solids. Butter is processed butterfat. Nonfat dried milk (NFDM) consists entirely of nonfat milk solids, which are used as ingredients in many other prepared foods, including infant formula. Cheese is made from butterfat and protein. Whey is a byproduct of cheese-making, a process that uses casein protein but not the whey protein. Classified Milk Pricing The current FMMO system recognizes four alternative, broad uses of milk, and each one is designated as a separate class: Class I milk is used for fluid milk products, including whole milk, low-fat milk, skim milk, chocolate and other flavored milk, buttermilk, and eggnog. Class II milk is used for soft manufactured products such as ice cream, cottage cheese, yogurt, whipping cream, and half-and-half. Class III milk is used to manufacture hard cheese, cream cheese, whey products, anhydrous milkfat, butteroil, and other similar products. 3.1% protein 87.7% water 3.7% butterfat 4.8% lactose 0.7% minerals or ash Class IV milk is used to make butter, NFDM, and other dried dairy products. As one pundit put it, Class I milk, we drink; Class II milk, we eat or stir with a spoon; Class III milk, we eat on crackers; and Class IV milk, we consume as butter or powders. 4 Once a month, the FMMO system sets minimum prices for all four classes of raw milk. Dairy handlers or processors must pay these minimum prices, or more, for the milk used in producing whatever products they make and sell; and the price paid will depend on what kinds of products they make. If a processing plant produces multiple products belonging to different classes, then it must specify how much raw milk was used as inputs to each of the products and pay the appropriate prices for each class. (By the way, the amounts paid will be audited by the order s administrator.) It Is the dairy processors, not the farmers, who are the ones regulated under the FMMO system. One of the foremost objectives of the FMMO system is to ensure that enough raw milk will be available to meet consumer demand for beverage milk products. (However, with fluid milk consumption per capita 3

4 trending downward, this objective is becoming less pressing over time.) Toward this end, the system is designed to set the price of Class I milk generally at a premium above the prices of the other three classes. Most analysts believe that the price elasticity of demand for fluid milk is less than the price elasticities of demand for other kinds of dairy products. Hence, charging a higher price for fluid milk will generate a greater revenue pool for milk producers than they would get otherwise. Using a fully transparent rulebook, FMMO administrators adjust the minimum prices once a month to reflect shifts in the underlying market fundamentals. Toward this end, the USDA s Agricultural Marketing Service (AMS) conducts weekly surveys of dairy processors to determine the nationwide, market-based prices of key dairy products such as butter, cheese, whey, and NFDM. 5 By the fifth day of every month, the FMMO administrators will have announced the prior month s minimum prices for each of the four classes of milk. These prices are derived in two steps. The first one uses a set of FMMO formulas to link estimated prices of specific milk components (i.e., butterfat, nonfat solids, protein, and other solids) to the AMS s wholesale prices of Grade AA butter, cheddar cheese, NFDM, and dry whey. The second step uses a complementary set of formulas to link the administered minimum prices of the four classes of skim milk and butterfat to the estimated prices of the milk components. Pricing Formulas The key formulas mandated by the FMMO system to calculate the estimated prices of the milk components all conform to the following general form: Component Price/lb = (Dairy Product Price/lb Make Allowance/lb) X Yield The so-called make allowance is the estimated cost per pound of manufacturing the finished product, excluding the cost of the raw milk; and the yield indicates how many pounds of final product can be produced from a pound of a particular milk component. (The actual formulas are listed in the appendix to this report.) These pricing formulas are critically important to the dairy industry. The USDA devotes considerable time, effort, expense, and careful thought into estimating what the make allowances and yields should be, with numerous inputs and suggestions from dairy processors and producers. These formulas are generally regarded as decent approximations, though there is widespread disagreement about just how good they are. In reality, the make allowances and yields are undergoing constant revision as processors adjust and fine tune their production processes and improve their productivities. Yet in practice, the FMMO s formulas seldom change. All ten Federal Milk Market Orders use the same formulas and the same wholesale price surveys, so the Class II, III, and IV milk prices are exactly the same for all ten orders. However, the FMMO rules set Class I milk prices to be usually well above the prices for the other three classes of milk, to ensure that each order will be able to attract enough fluid milk to satisfy its demand for dairy beverage products. At the same time, these FMMO rules also embed a substantial degree of variability in the Class I price among the ten orders. Over-Order Price Premiums The FMMO-pricing formulas are used to calculate minimum prices for the four classes of skim milk and butterfat. Dairy processors usually end up paying prices that exceed the minimums. The differences between actual and minimum prices are referred to as over-order premiums and have climbed as high as several dollars per hundredweight. They are neither regulated nor audited by the FMMO administrators. 6 Over-order premiums originate from many different sources. Dairy cooperatives often organize into marketing agencies-in-common to negotiate over-order premiums to compensate them for the costs incurred in transporting milk to bottling plants, market balancing, or other marketwide services. On occasion, individual dairy processors are willing to contract to pay over-order premiums to specific suppliers to guarantee a steady supply of milk with certain desired qualities. In a few cases, the overorder premiums may be mandated by state regulators. 4

5 FMMO Pooling Under the FMMO system, pooling occurs in two different ways raw milk and money. 7 Dairy producers within a given order pool their milk (on paper) and are all paid a common equitable price regardless of whether it is used to produce Class I, II, III, or IV dairy products. This is the milk pool. In addition, each federal order also has its own money pool. This is the sum of dollar obligations owed by the dairy processors within a given federal order to producers for the raw milk used as inputs in the manufacture of dairy products. The dairy handlers or processors are the ones who fund each order s money pool. How much they are required to pay depends upon how much skim milk and butterfat were used to make Class I, II, III, or IV dairy products. In particular, dairy processors must generally pay higher prices for the raw milk used to produce Class I drinkable beverages. By the fifth day of every month, the FMMO market administrators will have announced the official Class I, II, III, and IV minimum prices for skim milk and butterfat effective for the preceding month; and each processor will then be able to calculate the dollar amount of its obligations to the order s milk producers. While two different processors may have used the same total volume of raw milk as inputs, their monetary obligations to the order s pool will differ insofar as their relative utilizations vary among the four different classes of milk and differ from each other. (See Exhibit 2.) Milk handlers are market intermediaries who buy milk from dairy producers and then supply it to dairy processors. It s the handlers who write the milk checks to producers in payment for their milk, and it is also they who must file reports with the FMMO market administrators detailing their receipts and utilizations. With this information, the market administrators can then Exhibit 2: Processors Settlement Fund Obligations This hypothetical example contrasts the settlement fund obligations of two Processors A and B, using the FMMO s actual component posted in December Both processors are assumed to have December milk receipts totaling 200,000,000 pounds of milk, with a composition of 3.88 percent butterfat, 3.26 percent protein, and 5.74 percent other (nonfat) solids. (These are the actual order-wide percentages recorded in December 2013 for Central Federal Order No. 32.) Processor A is primarily a bottling plant. It uses 50 percent Class I milk, 10 percent Class II milk, 30 percent Class III milk, and 10 percent Class IV milk. However, its utilizations of butterfat are not necessarily the same as those for whole milk, and we ve assumed the following utilizations for butterfat: 1.5 percent for Class I, 10.0 percent for Class II, 4.0 percent for Class III, and 9.3 percent for Class IV. When summed, these four utilizations add up to 7,760,000 pounds of butterfat, i.e., equal to 3.88 percent of Processor A s total receipts. For December 2013, Processor A s total obligations to producers amounted to $44.8 million, or $22.39 per cwt. Processor B is primarily a cheese manufacturer. It uses 20 percent Class I milk, 5 percent Class II milk, 50 percent Class III milk, and 25 percent Class IV milk. Its utilizations of butterfat are assumed to the same as for Processor A: 1.5 percent for Class I, 10.0 percent for Class II, 4.0 percent for Class III, and 4.3 percent for Class IV. For December 2013, Processor B s total obligations amounted to $41.6 million, or $20.80 per cwt. Both processors, however, will have paid the same amount to purchase the 200,000,000 pounds of milk (including 7,760,000 pounds of butterfat) from producers i.e., $43.3 million or $21.67 per cwt. The disparities between what the two processors were obligated to pay and what they actually paid to producers needs to be settled. Afterwards, both processors will have paid $21.67 per cwt to dairy farmers. This settlement is done through an FMMOadministered settlement fund, as discussed below in the text. (Exhibit 2 continued on page 6.) 5

6 Exhibit 2 Continued: Illustration of Processors Settlement Fund Obligations Price per Pound Processor A Utilization Shares Pounds Value Class I: 50.0% 20.0% Processor B Utilization Shares Pounds Value Skim Milk $ ,500,000 $17,050, ,400,000 $6,820, Butterfat $ ,500,000 $2,427, ,000 $971, Class II: 10.0% 5.0% Nonfat Solids $ ,685,393 $2,998, ,697 $1,499, Butterfat $ ,000,000 $3,548, ,000,000 $1,774, Class III: 30.0% 50.0% Protein $ ,953,558 $6,913, ,255,930 $11,522, Other Solids $ ,439,700 $1,316, ,453 $205, Butterfat $ ,400,000 $4,241, ,000,000 $7,068, Class IV: 10.0% 25.0% Nonfat Solids $ ,698,502 $3,002, ,479,401 $7,919, Butterfat $ ,860,000 $3,286, ,160,000 $3,817, Total Value for Handler $44,785, $41,598, Average Cost per Cwt $22.39 $20.80 Less: deduction from the pool PPD $ ,000,000 $2,160, ,000,000 $2,160, Protein Value $ ,520,000 $23,074, ,520,000 $23,074, Other Solids Value $ ,480,000 $4,392, ,480,000 $4,392, Butterfat Value $ ,760,000 $13,713, ,760,000 $13,713, Total Deductions $43,340, $43,340, Producers Price per Cwt $21.67 $21.67 Net Obligations to/from Pool $1,445, ($1,741,528.27) Source: CoBank. calculate the Uniform Blend Prices for the ten orders, where each one is equal to the total value of obligations divided by the volume of milk utilized as inputs. These uniform blend prices always vary to some extent across the ten federal orders reflecting differences (a) in utilizations across the four classes of milk and (b) in the Class I price differentials. (In every month, as you ll recall, the prices of Classes II, III, and IV milk are the same across all ten federal orders, and so is the Class I base price or the so-called mover price.) Producers Milk Checks By design, the FMMO system ensures that all milk producers who supply raw milk to the dairy processors within a given federal order will be paid at the same equitable rate regardless of what kinds of dairy products are made from their milk. But this doesn t necessarily mean that all producers receive the same price per hundredweight for their milk. In fact, two different methods are used by the ten federal orders to calculate how much the dairy farmers within a given order must be paid for the milk that they produced and sold to the order s processors. 6

7 The first method is the Component Pricing System and is used by six of the ten FMMO orders (i.e., Orders 1, 30, 32, 33, 124, and 126). In this case, dairy farmers are paid not for their milk per se, but for the constituent components that comprise their milk i.e., the butterfat, nonfat solids, protein, and other solids. Hence, when a producer delivers raw milk to a processor, the milk is tested to determine how much butterfat, protein, and other solids it contains; and the producer is then owed (on paper) an initial amount for the value of those milk components, each valued at the appropriate Class III price set by the FMMO administrator. In effect, these initial estimates of how much producers are owed for their milk are based on the assumption that all of their raw milk is used for Class III products an assumption which, when revised later to reflect actual utilizations, leads to the actual amounts which they are paid. In fact, the sum of these initial estimates of what producers are owed for the components of their milk will generally be unequal to and usually less than the pool of processors obligations. This inequality occurs because the prices of Class I, II, and IV milk are not equal to the price of Class III milk. Consequently, to correct the imbalance, handlers must adjust the amounts paid to producers, and this adjustment is known as the producer price differential (PPD). (See Exhibit 3.) It is equal to (a) the difference between what processors are obligated to pay for raw milk based on how they have used it and the total value of raw milk when priced at the Class III prices, (b) plus or minus any additional adjustments for producer location or somatic cell counts (as described in the text box on page 11), and (c) with the grand total then divided by the total volume of milk sold to the order s processors during a given month. In the six federal orders where the component pricing system is used, all producers will be paid the same prices for those components e.g., butterfat, nonfat solids, proteins, and other solids. However, even if two dairy farmers produce the same volume of milk, the total amounts that they receive for their milk will vary insofar as the compositions of their milk vary. Those Exhibit 3: Computation of Producer Price Differential This illustration of how the Producer Price Differential is calculated is based on actual statistics for the Central Federal Order No. 32 posted in December Given the actual utilizations of skim milk and butterfat across the four classes as well as the actual prices for the various milk components, the total obligations of all processors in this federal order amounted to $284.1 million for the 1.3 billion pounds of raw milk delivered to the order in December 2013, or $21.88 per cwt. In contrast, the value of the protein, other solids, and butterfat contained in those 1.3 billion pounds of milk (including an adjustment for the somatic cell count) amounted to $268.9 million. a This total corresponds to what s referred to in the text as the sum of the initial estimates of what producers are owed for the components contained in their milk. Hence, to this point, the difference between the sum of processors total obligations and the sum of what producers are owed for the components contained in their milk, when valued at the Class III component prices, amounts to $15.2 million. Taking into account a few more FMMO adjustments, another $1.1 million is then subtracted from the subtotal, and the difference between those two sums gets whittled down to $14.0 million. This is the amount of the Producer Price Differential and is equal to $1.08 per cwt. The FMMO administrator also calculates the so-called statistical uniform price. It is computed as the sum of the FMMO s price for Class III milk plus the producer price differential, and assuming that the butterfat content is 3.5 percent. In this example, the standard uniform price for milk was equal to $20.03 per cwt for the Central Federal Order No. 32 in December The statistical uniform price is calculated in this fashion for comparability across the federal orders. (Exhibit 3 continued on page 8.) a The adjustment for somatic cell count is explained in the text box appearing on page 11. 7

8 producers who deliver higherquality milk will get biggerthan-average checks. The second method is the Skim Milk/Butterfat Pricing System and is used by the other four FMMO orders (i.e., orders 5, 6, 7, and 131). In this case, two order-wide blended prices are calculated, one for skim milk and the other for butterfat. Within all ten federal orders, the prices for Classes I, II, III, and IV skim milk and butterfat are calculated using the same FMMO formulas and AMS wholesale prices. What s different for these four orders, however, is that two orderwide blended prices one for skim milk and the other for butterfat are determined essentially as the order-wide weighted averages of all skim milk or of all butterfat produced within the district, where the relative weights for each are based on the relative usages of the four FMMO classes of skim milk and butterfat. (See Exhibit 4.) As a result, all the producers within each of these four orders will receive the same skim milk price per hundredweight and the same butterfat price per pound for the milk and butterfat that they have sold to processors within the order. FMMO Settlement Pools The market administrators of the ten FMMO districts maintain separate settlement pools used to settle the mismatches between individual processors obligations and actual payments to producers. In principle, the dairy processors or buyers pay into the FMMO settlement Exhibit 3 Continued: Computation of Producer Price Differential Central Federal Order No. 32, December 2013 Utilization Product Pounds Prices Value Class I Product 32.26% 418,891,844 $ $84,207, Skim Milk 411,167,414 $ $71,173, Butterfat 7,724,430 $1.619 $12,502, Location Adj. $531, Class II Product 7.63% 99,064,603 $32,654, Nonfat Solids 8,333,466 $1.779 $14,824, Butterfat 10,049,548 $1.774 $17,829, Class III Product 53.57% 695,554,603 $142,167, Protein 22,683,659 $3.539 $80,277, Other Solids 39,951,772 $0.383 $15,285, Butterfat 26,371,687 $1.767 $46,604, Class IV Product 6.53% 84,790,957 $23,924, Nonfat Solids 7,362,038 $1.768 $13,016, Butterfat 6,172,611 $1.767 $10,908, SCC Adjustment (Class II, III, and IV) $1,154, Total Producer Milk 1,298,302,007 $284,107, Producer Cwt $21.88 Minus: Value of Protein 42,336,194 $3.539 $149,827, Value of Other Solids 74,478,836 $0.383 $28,495, Butterfat 50,318,276 $1.767 $88,922, SCC Adjustment $1,701, Subtotal: Negative Adjustments $268,947, Difference: Obligations less Payments $15,160, Net FMMO Adjustments ($1,138,631.16) Producer Price Differential $14,021, cwt $1.08 Statistical Uniform Price (Class III + PPD)@3.5% Butterfat) $20.03 Sources: USDA and Federal Order No. 32 Administrator. pool at the classified milk prices and withdraw funds from the pool at the blended prices. Invariably, some processors pay more into the pool than they withdraw while others pay less than they withdraw. In general, Class I buyers are net contributors to the settlement pool while dairy manufacturers are net takers from the pool. For example, as illustrated in Exhibit 2, Processor A owed $44.8 million for the milk used as an input, but paid producers only $43.3 million and thus underpaid by $1.5 million. In contrast, Processor B owed $41.6 8

9 million, paid producers $43.3 million, and thus overpaid by $1.7 million. All the disparities between what processors owe and what they have paid need to be settled, and the FMMO s settlement pools are used for that purpose. Those processors who paid dairy farmers less than their obligation to the FMMO must pay the difference into the order s settlement fund. In turn, those processors who paid more than their obligation are allowed to withdraw what they are owed from the fund. Afterwards, the balance of the settlement fund falls to a statutory minimum balance. As a rule, Class I and Class II milk prices exceed Class III and Class IV prices, and the cheese makers who use Class III milk along with the processors who use Class IV milk normally receive pool draws from the settlement fund. Qualifying to Participate in a Settlement Pool Dairy farmers or operators who wish to share in a FMMO money pool must qualify to do so. The rules for qualifying vary among the ten federal orders. To qualify in the Upper Midwest order No. 32, for example, a dairy farmer must deliver one day s milk output to a pool plant located within the order (i.e., a plant subject to FMMO regulation), and such a delivery is referred to as touching base. After touching base, the producer would remain eligible to share in the order s money pool even if the rest of its month s supply were shipped to a non-pool plant. Several different types of players are active on the demand-side of the market. Some of them participate in an order s money pool, and others do not. 8 Handlers: these are market intermediaries who buy milk from producers and then re-sell it to processors. They are regulated under the FMMO system and are required to file (audited) reports with the FMMO market administrators detailing their receipts and disposition of milk within the four classes. Distributing plants: these are bottling plants that process, package, and sell beverage milk products to consumers. Virtually all bottlers, with a few minor exceptions, are regulated under the FMMO system. Dairy processors: these are manufacturers of nonbeverage dairy products. They purchase their raw milk from handlers, dairy farmers, or cooperatives. Exhibit 4: Computation of Average Producer Price The Florida Market Order No. 6 is one of the four federal market orders that computes the average producer price using the fat/skim pricing method. (The other three federal orders that use it are the Appalachia, Southeast and Arizona orders.) To illustrate the calculations, we re using the Florida order s actual statistics for April Dairy processors in Florida Market Order No. 6 utilized a total of million pounds of raw milk in April 2014, and the vast majority of it 84.3 percent, in all was used to produce Class I beverage milk products. The Class I, II, III, and IV prices for skim milk and butterfat were all determined using the FMMO s formulas along with wholesale prices compiled by NASS. Each dairy processor will compute its obligation by multiplying the amounts of Class I, II, III, and IV skim milk and butterfat that were used in manufacturing, each times the appropriate FMMO price. For the month of April 2014, processors total obligations amounted to $67.7 million. Based on the order-wide statistics for April 2014, the uniform or average price paid for butterfat was $ per pound and the uniform or average price paid for all skim milk was $21.87 per cwt. Some processors paid higher prices for the skim milk and butterfat that they used, while others paid lower prices. However, all milk producers who supplied raw milk to the Florida Order No. 6 received the same averages prices for however much skim milk and butterfat that they supplied. (Exhibit 4 continued on page 10.) 9

10 Supply plants: these plants serve as suppliers of bulk milk to the fluid segment of the dairy market, and their role is to help balance the supply and demand for fluid milk. Supply plants are free to choose whether to participate in an order s money pool, or not. Those that elect to participate and abide by the FMMO rules are called pool plants, and those that elect not to participate are called non-pool plants. Dairy cooperatives: these entities collect raw milk from their member-owners and then deliver it either (a) to supply plants or distributing plants or (b) to the coops Net FMMO Adjustments own manufacturing plants. Coops are obligated to pay into the federal order money pool for however much raw milk they processed at the order s minimum prices, or above. However, coops often collect milk from more than one federal order, and they essentially re-blend the milk and pay their ownermember-farmers a blended average producer price, based on the producer prices of the federal orders from which the milk is drawn. These categories are not mutually exclusive. Some dairy processors, for example, function not just as manufacturers, but also as handlers and supply plants. Similarly, many dairy coops, especially the larger ones, function as handlers, supply plants, and processors. To qualify as a pool plant, supply plants must meet the FMMO s performance requirements. In particular, they must be ready and willing, when called upon, to sell and Exhibit 4 Continued: Computation of Average Producer Price Florida Federal Order No. 6, April 2014 Utilization Product Pounds Prices Value Product 84.29% 198,984,102 $23.65 $52,529, Class I Skim Milk 195,106,327 $17.22 $33,597, Butterfat 3,877,775 $2.009 $7,792, Class I Location $11,139, Product 9.85% 23,248,650 $24.74 $10,351, Class II Skim Milk 20,073,986 $17.92 $3,597, Butterfat 3,174,664 $2.128 $6,754, Product 0.53% 1,256,472 $24.31 $523, Class III Skim Milk 1,100,500 $17.50 $192, Butterfat 155,972 $2.121 $330, Product 5.33% 12,584,339 $23.34 $4,267, Class IV Skim Milk 11,463,780 $16.50 $1,891, Butterfat 1,120,559 $2.121 $2,376, ,073,563 $67,672, Total Classified /value 8,328,970 $2.098 ($17,471,680.37) Uniform Butterfat Price ($392,542.69) Location Adjustments $105, ,744,593 $49,914, Total Skim Milk and Aggregate Value $21.92 Price of Skim cwt $0.047 $106, Producer Settlement Fund Reserve $21.87 Uniform Skim Milk cwt $2.098 Sources: USDA and Federal Order No. 6 Administrator. $28.49 ship a specified volume of milk from their own inventories to a local bottling company so that it will be able to satisfy the intra-order demand for beverage milk. Toward this end, the FMMO market administrators set the performance requirement for supply plants in conformity with the volume of milk required by the bottling plants to meet that demand. But there are costs involved in qualifying as a pool plant. For example, considering that most dairy manufacturing plants exhibit substantial economies of scale, it behooves them to operate at full capacity. Hence, calls from the local bottling company for additional milk could interrupt their operations and prevent them from operating at peak 10

11 Producer Milk Price Adjustments Somatic Cell Counts: this adjustment to the milk price received by producers reflects differences in milk quality, as gauged by the somatic cell count. In particular, the lower the somatic cell count, the greater the cheese yielded from a given amount of milk. Quality is measured relative to a base level of 350,000 cells per milliliter. The actual somatic cell count (SCC), e.g., 210,000 per ml, is subtracted from the base level, and a value is then calculated by multiplying NASS s cheese price for a given month by For example, in December 2013, NASS s cheese price was $ per pound, so the corresponding SCC value was equal to $ per thousand. Hence, raw milk with a SCC of 210,000 would command a premium equal to ( ) X $ = $0.13 per cwt, rounded to the nearest full penny. Producer Location Adjustment: this adjustment to the milk price received by producers is necessitated by the intra-order variability of the Class I Price Differential. For example, in the Appalachian Federal Order No. 5, the Class I Price Differential varies from a high of $3.40 per cwt in the order s principal pricing point of Charlotte to a low of $2.30 per cwt in Louisville. When the Appalachian federal order s administrator announces class prices for a given month, the stated price for Class I milk will include the Class I Price Differential of $3.40 per cwt appropriate for the order s principal pricing point of Charlotte. However, all those dairy processors located at points within the Appalachian order other than Charlotte will pay Class I prices that incorporate slightly lower Class I Price Differentials, e.g., $2.30 per cwt for processors located in Louisville. The Producer Location Adjustment reflects the sum of these negative adjustments in Class I prices for processors located outside of the various federal orders principal pricing points. efficiency, thus raising their unit operating costs above what they would otherwise be. Moreover, the reporting requirements under the FMMO system also impose additional costs on the supply plants. Given these costs, one might well ask why so many supply plants choose to become pool plants. Their main incentive derives from the potential savings on the cost of milk used as inputs in their production processes. Insofar as the prices of Class II, III, or IV milk are below the price of Class I milk, they will often also be below the order s uniform blend price, i.e., the weighted average price of milk across the four classes of milk. Cheese processors, for example, will have to pay producers at the uniform blend price for the milk used in making cheese. Insofar as the price of Class III milk is below the blend price, cheese makers will be eligible for draws, i.e., checks, from the order s settlement fund and these draws effectively lower the cheese makers cost of milk used as inputs. One of the two key objectives of the FMMO system is to ensure that the supply of Grade A milk within each order will be sufficient to meet consumer demand for beverage milk at a reasonable price. Thus, the FMMO administrator of each order will vary the order requirements to ensure that supply plants will meet this objective, which they must in order to qualify as pool plants. Consequently, insofar as consumers demand for milk beverages varies from one month to the next, so will the FMMO s pooling requirements. De-pooling The FMMO system is designed to maintain the price of Class I milk above the prices of the other three classes of milk. Normally, the monthly price of Class III milk, which is used to make cheese, remains below the weighted average blended price, so that when the bottlers and dairy processors within a given federal order settle up with one another, cheese makers and other processors typically receive draws from the settlement fund, thus incentivizing them to maintain their status as pool plants. Occasionally, however, this normal situation gets upended, and the Class III milk price ends up above the weighted average blended price for all four classes of milk. 11

12 When such a price inversion occurs, cheese makers are obligated to pay into the federal order s settlement fund, instead of receiving draws as they usually do. When faced with such an obligation, all cheese makers will reconsider whether to continue to be pool plants. Such inversions of milk prices seldom occur; but when they do, they re the result of a run-up or spike in the AMS wholesale price of cheese. It s strictly a timing issue. That is, Class I and Class II skim milk prices and the Class I butterfat price are calculated using so-called advanced AMS prices, i.e., they re based on the AMS s price surveys for the first two weeks of a given month and are announced on or before the 23rd day of that same month. In contrast, the Class II butterfat price and the Class III and IV skim milk and butterfat prices for a given month are all based on the AMS s price surveys for the four or five weeks of that month but are not announced usually until the first day of the following month. Hence, there is a five or six-week lag between the time when the advanced prices are set and the time when all the other prices are set. Occasionally, during this five or six-week hiatus, cheese prices (or the prices of butter or NFDM) can surge ahead, pushing the price of Class III (or the price of Class IV) milk above the Class I price and the resulting blended price. When such milk price inversions do occur, two other events invariably follow. First, the producer price differentials for those federal orders that rely on the Component Pricing system turn negative, which is symptomatic of the fact that the Class III or Class IV milk price is above the milk prices for the other classes. Second, cheese makers (or makers of butter or NFDM) begin to de-pool, because, by exiting the settlement pool, they re no longer obligated to pay into the federal order s settlement fund. Not all will de-pool, however, due to restrictions on their ability to rejoin a pool after having de-pooled. Distant Pooling Under FMMO rules, milk producers located outside the geographic boundaries of a given federal order are allowed to sell their milk to dairy processors within the order at (or above) the order s minimum prices, provided that the producers meet the order s touch base requirement. Such sales are called distant pooling, and they occur for various reasons. In some cases, these sales may involve organic milk when the demand for it exceeds the supply from within the order. But more often, distant producers find it worthwhile to sell their milk to a given federal order if the disparity between the milk price that the distant producers will receive from the order s dairy processors and the price of milk sold in the distant producers home territory is large enough to cover the transportation costs. Distant pooling provides direct benefits to the out-of-order milk producers, insofar as they receive a higher price for the milk sold to the federal order s processors than they would have gotten from selling instead to their own nearby processors. However, those benefits come at the expense of within-pool milk producers, because distant pooling reduces the order s producer price differential. The reduction occurs because distant pooling expands the milk pool by more than the money pool. For any given month, and within any given federal order, consumers demands for Class I and II dairy products are fairly well fixed in the sense that they will follow fairly predictable seasonal and structural paths that vary little from one year to the next. Consequently, when out-of-district milk producers transport and pool their milk in a distant federal order, all of it will be purchased by the in-district processors who produce Class III and IV products. As a result, the utilizations of the normally lower-priced Class III and IV milk will increase, the utilizations of the usually higher-priced Class I and II milk will likewise fall, and the federal order s PPD will necessarily shrink. The extent of the problem caused by distant pooling varies across federal orders and also over time. All things considered, it does not appear to be a very serious problem. For , for example, only 7.4 percent of the milk processed in the Upper Midwest federal order was produced by dairy farmers located outside of the federal order. 9 12

13 Concluding Thoughts At this point, after having reviewed the current FMMO system, surely all readers would agree that the current system is complicated, convoluted, and, at times, confusing. Advocates often mention that the current system has been in place for nearly 25 years, albeit with a few minor tweaks. Clunky as it is, the FMMO system evidently gets the job done assuring consumers of an adequate supply of fluid milk, at a reasonable price. Today, however, the dairy marketplace is in flux. Exports account for a large and growing share of domestic U.S. milk production. Global competitiveness is intensifying, with the EU scheduled to end its dairy quotas on March 31, Dairy manufacturers, here and abroad, continue to invent new kinds of dairy products, as well as new dairybased ingredients used in the preparation of new kinds of nondairy foods and beverages. With the passage of the Farm Bill of 2014, U.S. dairy policy has scrapped virtually all of the older support programs and replaced them with the new Milk Margin Protection Program, a promising new risk management tool for dairy farmers. Amidst these sweeping structural changes, the FMMO pricing system is at risk of becoming an encumbrance impairing the U.S. industry s flexibility and adaptability. Endnotes 1 Ed Jesse and Bob Cropp, Basic Milk Pricing Concepts for Dairy Farmers, Bulletin No. A3379, Cooperative Extension, University of Wisconsin Extension, September 2008, p Bob Cropp, Milk for Manufacturing: Number of Classes, Number of Components, Advanced Pricing, Undated manuscript, p Dennis A. Shields, Dairy Farm Support: Legislative Proposals in the 112th Congress, Congressional Research Service, Report No. R42065, October 28, 2011, p Testimony of Mary Keough Ledman on behalf of The Dean Foods Company, Hearing to consider amendments to the Upper Midwest Federal Milk Marketing Order, Docket No. AO-361-A39; DA-14-01; August 16 et seq, See, for example, the USDA, Agricultural Marketing Service s publication entitled, Announcement of Class and Component Prices. 6 See Geoffrey A. Benson, Milk Check Money: What Determines the Price Farmers Receive for Grade A Milk, undated manuscript, North Carolina Cooperative Extension Service. 7 For details, see Ed Jesse and Bob Cropp, Federal Milk Marketing Order Pooling, Depooling, and Distant Pooling: Issues and Impacts, Marketing and Policy Briefing Paper, Department of Agricultural and Applied Economics, University of Wisconsin-Madison, Paper No. 85, June The list of players and their definitions have been adapted from a power point presentation entitled, Pooling Basics: An Introduction, Blimling and Associates, July The statistic reported in this sentence was supplied by Mr. Corey Freije, Agricultural Economist for F.O. 30, in an dated June 11,

14 Appendix Pricing Formulas a Minimum prices are set for each of the four classes of skim milk and butterfat. Weekly surveys are conducted by the AMS to determine the market-based wholesale prices of dairy products such as butter, cheese, whey, and NFDM. The FMMO s pricing system uses a series of formulas that link the prices of the four classes of milk to the market-based prices of the dairy products. It s a two-step procedure. First, the market administrators use one set of FMMO-mandated formulas to link estimated prices of specific milk components (i.e., butterfat, nonfat solids, protein, and other solids) to the AMS s wholesale prices of Grade AA butter, cheddar cheese, NFDM, and dry whey. Second, the administrators use a complementary set of formulas to link the administered minimum prices of the four classes of skim milk and butterfat to the estimated prices of the milk components. The FMMO formulas used to calculate the estimated prices of the milk components all conform to the same general format: Component Price/lb = (Dairy Product Price/lb Make Allowance/lb) X Yield The so-called make allowance is the estimated cost per pound of manufacturing the finished product, excluding the cost of the raw milk; and the yield indicates how many pounds of final product can be produced from a pound of a particular milk component. Thus calculated, the monthly minimum prices of skim milk and butterfat are converted into minimum prices of whole milk for all four classes, based on a standardized milk profile consisting of 96.5 percent skim milk and 3.5 percent butter. Class IV Milk Price Class IV milk is used to produce butter and dried milk products. Butter is made from butterfat. Dried milk products consist essentially of nonfat solids. Hence, the price of Class IV milk is linked to the prices of butter and nonfat dry milk. Class IV Butterfat Price/lb = (AAA Butter Price/lb ) X The USDA s estimated cost of producing butter the make allowance is $ per pound, and the estimated yield is pounds of butter per pound of butterfat. Class IV Nonfat Solids Price/lb = (Nonfat Dry Milk Price/ lb ) X 0.99 In this case, the make allowance is estimated at $ per pound, and the estimated yield is 0.99 pound of nonfat dry milk per pound of nonfat solids. In turn, the USDA s procedure assumes that nonfat solids constitute 9.0 percent of skim milk (or 8.7 percent of whole milk, with 3.5 percent butterfat): Class IV Skim Milk Price/cwt = Nonfat Solids Price/lb X 0.09 X 100 For this calculation, the price of Class IV skim milk has been re-scaled to a hundredweight basis (cwt) from a per-pound basis. In turn, the price of Class IV whole milk is calculated as a weighted sum of the prices of Class IV skim milk and of butterfat: Class IV Milk Price/cwt = X Class IV Skim Milk Price/cwt X 100 X (Price of Butterfat/lb) The price of Class IV milk is quoted on a standardized hundredweight basis under the assumption that it contains 96.5 percent skim milk and 3.5 percent butterfat, much the same as the price of gold is quoted on a troy-ounce basis. (The prices of milk for the other three classes are similarly quoted.) Class III Milk Price Class III milk is used to produce cheese and whey products. Together, butterfat and proteins produce cheese. Whey is a liquid byproduct of cheese-making, and it is comprised of nonfat, non-protein solids. So the Class III milk price is linked to the prices of butterfat, protein, and whey. The so-called other solids milk component consists of whey, which, once the water has been evaporated from it, leaves dry whey. 14

15 Class III Other Solids Price/lb = (Dry Whey Price/lb ) X 1.03 The USDA estimates that the make allowance for dry whey is $ per pound and the yield is 1.03 pounds of dry whey for each pound of other solids. Cheese is produced from a combination of protein and butterfat. Class III Protein Price/lb = (Cheese Price/lb ) X {[[Cheese Price/lb ] X 1.572] 0.9 X Butterfat Price/lb} X 1.17 The USDA s formula assumes that the make allowance for cheese in $0.2003/lb while the yield is pounds of cheese per pound of protein. Additionally, the butter price plays a small role [in cheese making] as well by recognizing the added value from casein retaining butterfat in cheese. b The second term in the above equation reflects this interaction which adds to the output of cheese per pound for each pound of protein. Class III skim milk is assumed to consist of 3.1 percent protein and 5.9 percent other (i.e., nonfat, non-protein) solids, and is re-scaled to a hundredweight basis. Class III Skim Milk Price/cwt = (100 X X Protein Price/lb) + (100 X X Other Solids Price/lb) The Class III butterfat price is exactly the same as the Class IV butterfat price. Class III Butterfat Price/lb = Class IV Butterfat Price/lb Like Class IV milk, the price for Class III milk is also calculated on a standardized hundredweight basis under the assumption that it contains 96.5 percent skim milk and 3.5 percent butterfat. Class III Milk Price/cwt = X Class III Skim Milk/ cwt X 100 X Butterfat Price/lb By implication, Class III whole milk is presumed to be composed of 3.5 percent butterfat, 2.99 percent protein (i.e., X 0.965), and 5.69 percent other solids (i.e., X 0.965). In practice, the actual proportions will vary somewhat from this idealized composition. Exhibit A1: FMMO Class I Price Differentials for Principal Pricing Points and Other Major Cities within the Ten Orders Federal Milk Order Order Number Principal Pricing Point Major City in Principal Pricing Point Principal Pricing Point Northeast 1 Suffolk Co., MA Boston $3.25 Class I Price Differential for: Other Major Cities in the Order New York City, $3.15; Philadelphia, $3.05; Baltimore, $3.00; and Washington DC, $3.00. Appalachian 5 Mecklenburg Co., NC Charlotte $3.40 Knoxville, $3.20 and Louisville, $2.30. Florida 6 Hillsborough Co., FL Tampa $5.40 Orlando, $5.40, Miami, $6.00; and Jacksonville, $5.00. Southeast 7 Fulton County, GA Atlanta $3.80 New Orleans, $3.80; Memphis, $2.90; Nashville, $2.90; and Springfield MO, $2.40. Upper Midwest 30 Cook County, IL Chicago $1.80 Milwaukee, $1,75 and Minneapolis, $1.70. Central 32 Jackson Co., MO Kansas City $2.00 Mideast 33 Cuyahoga CO., OH Cleveland $2.00 Des Moines, $1.80; Omaha, $1.85; Oklahoma City, $2.60; St. Louis, $2.00; and Denver, $2.55. Indianapolis, $2.00; Cincinnati, $2.20; Pittsburgh, $2.10; and Detroit, $2.55. Pacific Northwest 124 King Co., WA Seattle $1.90 Portland, $1.90; and Spokane, $1.90. Southwest 126 Dallas Co., TX Dallas $3.00 Arizona 131 Maricopa Co., AZ Phoenix $2.35 Source: USDA/AMS. Houston, $3.60; San Antonio, $3.45; Albuquerque, $2.35; and El Paso, $