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Volatility in the new world of the California Federal Order

Geoff Vanden Heuvel

Director of Regulatory and Economic Affairs

It may seem obvious, but it bears repeating that the price of milk a dairyman receives is based on the value of the products that are made from that milk. California now operates under a Federal Milk Marketing Order (FMMO), which is very different from the old California State Order. Under the California State Order, the proceeds from nearly all the milk produced and sold in the state were rolled into one pot of money. That money was then distributed out to all the California producers based on their share of that pot and their quota holdings. If you were a Grade A milk buyer in California, the minimum price you had to pay for milk was dictated by the California Department of Food and Agriculture (CDFA). With a few exceptions, the proceeds from those purchases were not directly distributed to their producers, but were pooled with all the other milk in California. There were consequences to having the rules structured in this way. For one thing, because CDFA was using the power of the government to set and enforce the milk price processors were required to pay, it was extremely sensitive to setting that minimum price too high. The second consequence is that because the milk prices were lower and because nearly all the milk money was pooled, processors did not have to worry too much about being competitive with other processors.

The Federal Order program rules create a very different competitive environment. For one thing, in the FMMO, only Class I milk must pay a minimum price and pay its money into the common pool. For the other classes of milk, pooling is optional. This means that the handlers of non-Class I milk can decide every month whether they want that milk to be associated with the pool. The only reason to associate with the pool is to get a share of the Class I money that is in the pool. Because the government is not forcing anyone into the pool (since associating with the pool is voluntary), it is much less sensitive to setting minimum prices for cheese milk and butter/powder milk at levels that are favorable to processors.

You might wonder if paying minimum prices is not mandatory, what is their use in the market? Mostly, the Class III (cheese) and Class IV (butter/powder) prices serve as benchmarks in the contracts that producers and cooperatives have with processors. Secondly, because cheesemakers and butter/powder processors have the option to not pool and keep the money if their prices are higher, there is a built-in opportunity for competition between processors for who is in the best position to pay higher prices to producers. The other rule in the FMMO is that cooperatives can, and often do, act as the handler who decides whether to pool, rather than the actual cheesemaker or butter/powder maker.

In the FMMO, who you sell your milk to matters a great deal to the price you get paid for

that milk. California producers found this out right away when the FMMO started in November 2018. At that time, the Class IV price was quite a bit higher than the Class

III price, and consequently, handlers that were weighted more heavily to Class IV were able to out-pay handlers that were weighted more toward cheese.

Suddenly producers had a reason to start paying attention to where their milk was being sold. In the processing community, that competition forced everyone to sharpen their pencils and think about how to best position themselves for the new competitive environment.

Enter 2020 – the most bizarre year in any of our collective memories, not just in the dairy industry, but in life. Everything we thought about the world six months ago has been turned upside down. In the last 60 days we have seen cash cheese prices go from a low of $1 per pound to $2.81 per pound and then begin to fall. There have been price swings for the other classes of milk as well, but not near as great as what has happened to cheese prices. As these volatile prices work their way through the FMMO formulas, and as the impact of these prices filter through the competitive environment that is the California dairy industry, there will be those who will see much higher milk prices than others in the near term.

The three major cooperatives in California are all committed to paying their producers consistent with the FMMO published blend price, but that blend price will be highly impacted by the reality that almost no cheese milk will be associated with the pool. In addition, the Class I prices for June were set based on cheese, butter and powder prices from the first two weeks of May – before cheese prices took off. Therefore, the June Class I price is low. Because of this, the pay prices of the individual cooperatives will no doubt be quite variable for June depending on how they decide to distribute the money they will receive or earn from the milk they handled for their members.

All three cooperatives have some exposure to both Class III and Class IV buyers, but that exposure is not identical. California also has several processors who buy milk from independent producers. Most of those processors are either cheese companies or powder manufacturers and pay their producers accordingly. Obviously, the cheese plants are in a much better position to pay higher milk prices than the powder plants under current market conditions. But cheese and butter/powder prices do tend to converge over time. When cheese is this much higher in value compared to powder, cheese plants begin to purchase powder to add into their cheese vats to increase cheese production. This increases the cheese supply and tightens the powder supply which tends to bring the values of these two into closer balance.

So, what can you do about this? In the short term, not much. It is a good thing that cheese prices have rebounded. A rising tide lifts all boats. But unlike the tide, not all boats will rise at the same rate. This will create differences in producer pay prices. But these experiences will force producers and processors alike to evaluate vulnerabilities and threats as well as opportunities and strategies for how to protect and profit from the challenges we are facing today. Isn’t that what a free people do? We learn, we adjust, we adapt, and we get better. Yes, there will be some pain and collateral damage. But the FMMO structure provides an amazing amount of market freedom to incentivize improvement across the board.

Also, there are now some risk management tools that were not available in the past, like the Dairy Revenue Protection crop insurance program that is available to every producer. We know these remarkably high cheese prices are not likely to last forever. So, getting some protection from that future risk is certainly something producers should consider doing. One other thing to keep in mind is the rules that are in place in California now, are the same rules that apply to our competition in the rest of the country. How we respond to these challenges is really our test. While 2020 is certainly a crazy year, eventually all waves pass over and storms quiet down. What we learn from these experiences can make us better. Dairy farmers are an amazingly resilient group and I have no doubt we will survive this calamity and that better days are ahead.

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