About 80 percent of the milk in the United States is marketed and pooled on Federal Milk Marketing Orders. Federal Milk Marketing Orders ensure the orderly marketing of milk through end-product pricing formulas, minimum price enforcement and market-wide revenue-sharing pools.

Recent price volatility related to COVID-19, though not a new phenomenon, and a modification to milk-pricing rules in the 2018 farm bill are now likely to result in negative or very reduced returns from Federal Milk Marketing Orders revenue-sharing pools – negative producer price differentials. Those negative producer price differentials are expected to offset recent price increases in some dairy-farmer milk checks to the effect of $5 to $7 per hundredweight. Subsequently these negative PPDs are likely to lead to large volumes of manufacturing milk being de-pooled from Federal Milk Marketing Orders revenue sharing pools. Today’s article reviews negative PPDs and the current economic conditions that have resulted in low or negative producer price differentials and the de-pooling of milk.

What Causes Negative PPDs

A key component of Federal Milk Marketing Orders are the revenue sharing pools, which, at a high level are designed to redistribute the higher prices extracted from the beverage milk market to the manufacturing markets. This form of cross-subsidization is achieved by establishing a Class I milk value that is (generally) higher than the value of milk used to manufacture milk products such as cheese, butter, dry milk powders or dairy ingredients. In multiple component pricing orders, proceeds from the pool are based on the difference between the classified value of the milk and the component value of the milk – which is effectively the Class III price. When the component value of the milk exceeds the classified value of the milk, the proceeds from the pool are negative and result in a negative producer price differential.

Historically, and prior to farm bill price changes and COVID-19, the difference between the Class III milk price and the Class I mover ranged from -$4.96 per hundredweight to $6.02 per hundredweight. It averaged -47 cents. In general the greater the difference on the positive side between the Class I mover and the Class III price, the greater the producer price differential.

As evidenced in Figure 1, the producer price differential and the difference between the Class I mover and Class III prices are greatly and negatively correlated, with a correlation coefficient of -70 percent. The takeaway is that negative producer price differentials generally occur when the Class III price exceeds the Class I mover. Based on current futures prices for Class III milk, the difference between the Class III milk price and the Class I mover is likely to be record large in June at $9.51 per hundredweight and the third-most in July at $5.08 per hundredweight. Some dairy-industry analysts indicate the June producer price differential could be in the range of -$5 and -$7 per hundredweight in some portions of the country. The July producer price differential is also expected to be negative due to the wide difference between the Class III and the Class I milk price. August Class I milk prices have yet to be announced, but some also anticipate a negative producer price differential in August. As a result of those negative producer price differential, milk prices paid to dairy farmers are likely to be well less than the $20-per-hundredweight headlines.

Consider recent producer price differentials

There are two predominant factors that led to the current negative producer price differential situation.

The first factor is COVID-19-related price volatility resulted in a sharp decline in milk prices beginning in March, followed by a rapid increase in spot cheese prices in early May. Given the two-week lag from the Chicago Mercantile Exchange spot market prices to the U.S. Department of Agriculture’s National Dairy Products Sales Report prices and the nature of advanced pricing – Class I prices are announced one month in advance – the June Class I milk price was established using late-April and early-May spot market prices for cheese, butter, dry whey and nonfat-dry milk. That means the market depression experienced in late April – six weeks ago – is now being used to price fluid milk in June.

Consider that between mid-March, when social distancing and stay-at-home orders first went into place, and May 20, when the June Class I mover was announced, the Class III milk price declined by 21 percent or $3.30 per hundredweight. Similarly the Class IV milk price declined by 26 percent or $3.80 per hundredweight. That contributed to a Class I price decline of 34 percent or more than $6 per hundredweight from March to June. The June Class I mover was announced at $11.42 per hundredweight – the worst since the Great Recession.

While the June Class I milk price suffered a steep price decline, by mid-April the June Class III milk price began to rally on the back of anticipated demand spurred by restaurant re-openings and the USDA food-purchase and distribution program. Cheese prices more than doubled during that time. As a result, between mid-April and June 29, the June Class III milk price increased by 89 percent or almost $9 per hundredweight. The June and July Class III milk prices are better now than pre-COVID-19 levels.

The second reason producer price differentials are expected to be negative in June and July is the modification to the Class I milk-price formula in the 2018 farm bill. The 2018 farm bill changed the Class I milk price from the greater of the Class III or Class IV advanced price to the average of the Class III and IV advanced skim-milk price plus 74 cents per hundredweight. The June milk price under that newly implemented pricing formula is more than the greater-of pricing formula. The July Class I milk price, announced in June at $16.56 per hundredweight, is $2.57 per hundredweight less than what would have been the greater-of July Class I price of $19.13 per hundredweight.

Currently the July Class III milk price is $5.08 per hundredweight more than the July Class I price. Had the greater-of formula still been in place, the Class III price would have been only $2.51 per hundredweight more. That would have reduced the magnitude of the negative producer price differential expected in July. And the Class I mover price would have been almost $20 per hundredweight – and as much as $25.13 per hundredweight in portions of Florida.

De-pooling likely

For the most part the only milk that’s required to participate in the Federal Milk Marketing Orders pool is milk delivered to a regulated Class I milk processor. All other milk such as milk in manufacturing classes has the option to participate in the pool. Given the current price relationships there’s an economic incentive to keep Class III milk out of the pool – in other words de-pool the milk. By de-pooling the milk handlers don’t need to “share” the increased Class III proceeds with other producers in the pool. De-pooled milk is not subject to Federal Milk Marketing Orders minimum-price enforcement. As a direct result, for June and July – and potentially August -- the Federal Milk Marketing Orders minimum prices and the mailbox milk price paid to farmers may not fully reflect the increased Class III values currently in the market.

If the Class III handler is a dairy cooperative, the increased proceeds from the Class III market would belong to its producer-owners. Dairy cooperatives are not required to pay Federal Milk Marketing Orders minimum prices so the additional Class III revenue could be used to offset anticipated or previously incurred operating, marketing or balancing costs – as well as COVID-19-related revenue declines. It can be used as retained equity or used to pay increased milk prices to its members.

Although de-pooling is likely, Federal Milk Marketing Orders do have provisions to discourage de-pooling. That’s done by limiting the amount of milk that can be re-pooled in subsequent months – such as at 125 percent of the previous month’s pooled volume. But there’s a provision that suggests those re-pooling limitations can be waived administratively by the Federal Milk Marketing Orders market administrator for “an existing handler with significantly changed milk supply conditions due to unusual circumstances.” That means the disincentive to de-pool milk could be reduced administratively by relaxing those re-pooling rules. That would allow any milk that was de-pooled due to the current price relationships to quickly regain access to the pool when the price relationship is more favorable to the pooling handler – such as a positive producer price differential. Further clarification on that provision is being sought by American Farm Bureau Federation staff from the USDA.

Summary

COVID-19-related milk-price volatility combined with recent modifications to the Class I milk-price formula are contributing to a record-large spread between the Class III milk price and the Class I base price. The expectation is for large negative producer price differentials in both June and July alongside wide de-pooling of milk from Federal Milk Marketing Orders revenue-sharing pools. The combination of large negative producer price differentials, de-pooling of milk and the lack of minimum price enforcement on de-pooled milk could prevent many dairy farmers from realizing the price increases experienced in recent months.

Moreover the price risk associated with the producer price differentials can only be managed through the terms of a forward contract. Commercial exchanges cannot entirely cover producer price differential-related price risk. In addition Dairy Revenue Protection and Livestock Gross Margin federal crop-insurance policies are based on the announced USDA prices. They don’t include the producer price differential because it’s not a publicly traded instrument. It’s unclear at this point what the impact of large negative producer price differential will be on the U.S. all-milk price and the Dairy Margin Coverage payments that will be based on that price. As a result the large negative producer price differentials are unlikely to be fully offset by federal risk-management programs. But payments from the Coronavirus Food Assistance Program to dairy producers will help to offset a portion of that negative producer price differential – but it’s based on first-quarter-2020 production only.

Currently there’s no mechanism to prevent negative producer price differential. Federal Milk Marketing Orders price reform 20 years ago established end-product pricing formulas. With multiple component pricing comes the possibility of negative producer price differentials. Historically negative producer price differentials occur less than 15 percent of the time. Methods to prevent or mitigate negative producer price differentials could be explored – such as eliminating the advanced pricing component, reconsidering the greater-of pricing formula but with forward contracting of Class I milk, requiring mandatory pooling of milk in all classes or consideration of decoupling the Class I milk from the price of manufactured milk products. Those considerations would require Federal Milk Marketing Orders reform, which traditionally occurs through a formal hearing process. But as evidenced in the 2018 farm bill it could also be done through congressional action.

John Newton is the chief economist with American Farm Bureau Federation’s Market Intel. Visit www.fb.org/market-intel for more information.