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Perspective:
Industry Issues

‘Averaging’ formula for Class I disrupts milk flow for III and IV

Harry Stugart

Harry Stugart is owner of Ration All Decisions, which provides independent dairy nutrition and consulting. He has been following milk pricing formulas and statistics for decades and provided this op-ed to the American Dairy Coalition, which has granted permission for it to be published in Cheese Market News®.

Current milk futures show Class IV exceeding Class III by more than $1.48 through year-end. When it exceeds twice the 74-cent adjuster, the Class I price is reduced compared with the previous “higher of” formula. This sets the stage for processors to not pool the milk used in whichever of the two manufacturing classes is higher.

Since the “higher of” formula was abandoned in May 2019, the Class III advance has exceeded Class IV by more than the $1.48 for 16 of 58 months; 12 of them in 2020-21 can be related to pandemic effects. In 19 of 58 months, Class IV exceeded Class III by more than $1.48 and is unrelated to such an external market event.

When dairy economists are asked what is causing Class IV to exceed Class III by such a large amount, they give a variety of reasons, which don’t fully explain what is going on.

Some reference reduced exports in 2023 compared with 2022. But then, why did the Class III price based on cheese drop by more than Class IV based on nonfat dry milk (NDM)? A larger percentage of total NDM gets exported as compared to the percentage of all cheese. In its Jan. 11, 2024, Market Intel report, the American Farm Bureau Federation (AFBF) calculated overall exports down 7% for the first 10 months of 2023, while NDM exports were down 3%.

It’s understandable for supply and demand of different products to get out of balance in the short term.

However, processors testified in the federal milk marketing order (FMMO) hearing they make decisions based on pennies. If so, processors should pull milk from cheese to NDM. But we hear that cheese plants “must run at capacity to be profitable.” While that’s probably true of any plant, it doesn’t make sense to oversupply a market and see storage costs increase.

Based on the AFBF Market Intel, cheese production increased from 690 million pounds in October 2021 to 709 million in October 2022, and to 720 million in October 2023. Cheese stocks increased from 605 million pounds in October 2021 to 617 million in October 2022, and to 626 million pounds in October 2023.

Conversely, NDM production for November 2021 and 2022 was 160 million pounds, but in November 2023, it was only 116 million pounds. Stocks show 245 and 252 million pounds, respectively, which dropped to 209 million pounds in November 2023.

These data suggest milk is not moving from cheese to NDM and has gone the opposite direction of the market signals.

The current “averaging” formula for Class I limits the upside to the $0.74 adjuster, while downside risk is unlimited compared with the previous “higher of” formula.

During the 20 years when Class I was based on the “higher of,” the spread between Classes III and IV exceeded $1.48 nearly 37% of the time (85 months), and this did not promote depooling.

During the 58 months since May 2019 while the Class I is based on the “averaging” formula, the spread exceeded $1.48 nearly 64% of the time, and this does promote depooling.

Is the “averaging” formula incentivizing production of products that can avoid paying into the FMMO pools?

Dairy farmers should ask their processors why milk isn’t moving in response to market signals, which would narrow the spread and improve orderly marketing. Historically, small changes in supply and demand generate large changes in milk price. This known fact can be used to generate larger spreads.

Farmers did not ask for the Class I formula change. A very small group of processors gave the reason that Class I processors want to use Class III and IV milk futures to contract with customers.

As an attendee of the AFBF forum in Kansas City in October 2022, I was able to ask USDA Agricultural Marketing Service Dairy Programs Deputy Administrator Dana Coale if the change was being used for its stated purpose. My own inquiries revealed very little, if any, Class I milk being hedged. Her response agreed.

Testimony at the recently concluded FMMO hearing revealed the only real interest in forward pricing of Class I milk comes from extended-shelf-life processors, a small percentage of the fluid milk market.

The change in formula never went through the normal hearing process to allow all affected parties to have input. Nearly five years of this has cost dairy farmers more than a billion dollars in Class I premiums and further uncalculated losses from disorderly marketing.

Dairy farmers need to let their members of Congress know they support the AFBF request to the secretary of agriculture for an emergency return to the “higher of” formula for Class I.

CMN

The views expressed by CMN’s guest columnists are their own opinions and do not necessarily reflect those of Cheese Market News®.

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