Why changing the Federal Orders won’t change much

The Milk Check

Industry discussion surrounds a docket’s worth of changes to the Federal Milk Marketing Orders (FMMO), and we feel like it’s high time that we weighed in.

The USDA hearing on pricing formulas reconvened November 27, and the Jacoby team can’t help but feel that much of the hearings will amount to wasted or misplaced effort.

On this episode of The Milk Check, recorded in mid-November, a group from throughout the company discusses the potential changes that might help dairies with ongoing profitability problems. Then, they share their thoughts on the contents of the hearing so far.

T3: Hello everybody, and welcome to The Milk Check podcast. Today, we are going to tackle the famous, or maybe rather infamous, subject of federal order reform. I think you’ll find listening to our discussion, that you’ll find us a little bit more ambivalent about the process than maybe you’d expect from a group that is experts in marketing milk and the federal order system. But I’ll let the conversation speak for itself, as we talk about the different things that the federal order hearing is trying to tackle and what we think should be done. And hopefully, it’ll be helpful to everybody. I look forward to discussing it further, when they finally come out with their recommendations for how the federal order needs to be changed.

Dad, obviously, the federal order hearing is going on. And my suggestion is the reality is the path we’re going down really isn’t going to change a lot, and maybe that’s what we should discuss is how some of these changes aren’t going to have a big effect because the market is going to change to that. Things like, okay, they’re going to change the make allowances. How much of an effect are changing the make allowances really going to have on the farmer’s milk price?

Ted Jr: Zero.

T3: That’s my point.

Ted Jr: The real issue is qualification and not the classified pricing system. Instead of having bottling plant A, for example, responsible for balancing, you now kick milk back to somebody else, usually a co-op who has a butter powder plant and you give them the responsibilities for balancing and then of course you pay for that with an overrated premium.

And the alternative would be, in my view at least, to weaken the minimum price requirements and do it in such a way, and I’m not sure you’re going to get out of the box with something like this, but do it in such a way that you can transfer some of the balancing requirements back to the bottling plant so that they can run sales on milk so we can get some of our customers back. Something that promotes marketing and allows at least a portion of the balancing to be transferred to the plant, I think would be beneficial. Is that going to happen? No, they’re not going to touch that With a 10-foot pole, the minimum price requirements are the key to qualification, and so that’s where the thing meets the wall. In the meantime, our Class I sales continue to decline.

Anna: I think the biggest issue for me is that Class I is completely hamstrung by how everything is based off of their sales, their qualification, their everything else. It means that we’ve talked about them not being able to be innovative before, just how much it really sticks them in a certain spot where they can’t do anything new. I don’t really have a major problem with qualification. I think when you change those provisions, you end up devaluing the whole pool, which is kind of against the point, right? But my biggest issue is that we’re basing all of this on Class I and quite frankly, they’re not the most difficult customer anymore. Class III is in many cases way more difficult.

Gus: How is Class III more difficult? And I look at this knowingly from the standpoint that cheese plants tend to take a more consistent volume of milk and therefore they’re an easier customer to serve. But why do you say that?

Anna: I don’t think they’re as easy as they used to be. You used to have your Class I sales were your primary, and then you’d go to III and IV to take the balance, and now, I mean at least we have many contract customers that are Class III that require more balancing than are Class I.

Ted Jr: Allow me to make a point that Anna is of course right that the cheese has picked up where Class I sales has dropped off. But the way I look at it, the price we pay for the classified pricing system is qualification. Qualification is a cost factor. You have to ship, you have to make deliveries, and they’re different in different orders, but that’s the price we pay for the classified pricing system.

I think we should stipulate we, Jacoby, but also from an industry standpoint that the classified pricing system is beneficial to us and beneficial to the dairy industry as a whole and beneficial to the dairy farmer. Can you imagine what would happen, what the market would be like with a $3 difference in gross return one way or the other between cheese and butter powder without the classified pricing system? Yeah, you can drag in issues like depooling and so on into that discussion, but that still relates to the classified pricing system, so I’m not suggesting to anyone that we ought to eliminate qualification, and by default, eliminate the classified pricing system. I don’t think that would be to anyone’s advantage, particularly the dairy farmer. The classified pricing system and preservation of it is in my view, the key and how to jimmy the qualification in order to preserve it is where we ought to be going instead of monkeying around with the so-called make allowance. You don’t even need a make allowance, you just need a price that everybody can work off of and do risk management from. That’s all you need.

Anna: I don’t have any beef with the classified pricing system, but I also don’t have an issue with qualification. I think that if you require people to qualify and it’s more expensive and more difficult, because in certain orders it is, that usually ties to a higher return, right? The bigger issue for me becomes why are we letting people come in and out when they want to? You address your ability to depool and pool when you want, like order one does, you’re in or out.

Gus: Well, and I would also add, Anna, that in some orders around the country it becomes very difficult for certain people to qualify the milk. We’ve seen that. And for me, it doesn’t seem right that it should be so hard, but it’s obvious that because —

Anna: You say you’re in or out, then you don’t have to keep doing the qualification, right? You’re part of that.

Gus: Yeah, exactly. And basically what we’re doing is if you’re anybody who doesn’t have a balancing mechanism in certain parts of the country, they can’t serve the Class I account. And if they can’t serve the Class I account, then it makes it that much more difficult to qualify, right? You get to a point where it’s just kind of haves and have-nots and how does that really help the industry? I’m not so sure it really does.

T3: Qualification isn’t even on the docket in terms of what the federal order reform hearing is discussing.

Let’s organize this conversation and talk about some of the things that are on the docket. Obviously updating the milk allowances is on the docket. I think it’s worth having a really good conversation about the fact that updating the make allowances, as much time and effort is going into trying to figure out how they should be updated, I think it’s worth us having a conversation about how it’s not going to change really anything.

Gus: I’ll mention something on the make allowance that I think is important, an interesting point to discuss, I would hope that you would agree. I agree, the market is what the market is, right? And the values will change accordingly relative to supply and demand, Economics 101, so to speak. But one thing I am concerned about when it comes to fiddling with the make allowance is I think it’s safe to say, considering the varying types of cheese plants out there, size and style and so on, so forth, that pigeonholing or making one make allowance for all Class III milk, which I’m not suggesting anything other, I’m just saying that you basically have one processing cost that we’re going to fix it at. And how is that necessarily healthy for the industry if we want more than just large, big cheddar cheese plants, right?

T3: You make a good point that we’ve got, I don’t know how many, 500 different cheese plants in this country, and each one has a different actual processing cost. They make different cheeses, they’re different sizes, there’s different things they do differently. They’re all different, and so no one has the same cost, especially if you’re making mozz in one plant and you’re making cheddar in another plant, Swiss in another plant, feta or Parm in another plant, but they will adjust… what we’re basically trying to determine is what is the fair price for the milk going into that plant? And then they’ll adjust the cost of the product coming out of that plant to the market. And the reality is if they’re super profitable, they’ll try to produce even more of that cheese and the supply and demand of that cheese will therefore start to come down decreasing that profitability.

So I think one of the most important things that needs to be pointed out to people is the laws of supply and demand, at the end of the day, really determine the profitability, not just of a dairy farmer, but also of every cheese plant that’s out there.

Gus: In my mind, I think it does bring the discussion back to the market is what the market is and we have to figure it out. Kind of the point that I think I’m getting to is it doesn’t really matter, and by us even honing in on this and having these surveys to me is a fruitless effort. At the end of the day, cheese plants have to run their business and producers have to run their business, and I think we need to put some type of understanding in place and get away from these formula-driven prices with make allowances and let the economics stand on their own, if that makes sense?

T3: It makes perfect sense, and I couldn’t agree with you more, but it almost sounds like what you’re advocating is get rid of the system altogether.

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Gus: I’ll go back and say that I agree with dad’s perspective that certain pool and blend mechanisms are important to make sure we have some sort of uniform pricing to a certain degree across the country so that we don’t ebb and flow relative to supply and demand specific product types. I think that could get out of hand. So I think something is necessary, but I do believe that it is a fruitless effort and not necessarily good for the industry as a whole to jump in these modifications on make allowances and analyzing production costs because at the end of the day, we need to accept that there’s a market from a standpoint of how much it costs to make milk and what’s needed for the producers to make money to grow their businesses just the same as it is for processors to make their products and grow their businesses.

T3: Let me ask you this question, do you think that the federal government should have a role in determining what that profitability is, or do you think they need to do their best to get out of the way?

Gus: As far as determine that level of profitability on a specific basis, meaning I, II, III and IV? The answer to that is no. But I think there is always going to be a need for some protection on the ebbs and flows of one dairy product to the other because I think you can get into a situation where the demand for cheese, for example, in one region gets extremely high, but if someone’s being paid off just cheese and another person’s being paid off just powder and those get out of whack and there’s no effort to blend the price, that can be an ugly situation. I think dad alluded to that earlier and we need to be careful there.

Anna: I agree with you theoretically.

Ted Jr: I weigh in on the side of Gus and Ted on this, Anna, that you’re not repealing the laws of supply and demand. You have a so-called premium on the producer pay price and what, 5, 6, 8 years ago, the premiums disappeared. Prior to that time, having a larger make allowance enabled the dairy farmer to reach out more for markets and increase competitive factors for his milk supply, but now with the increase in hauling costs and all the increase in manufacturing costs and so on, most dairy farmers are paid something under the blend price. So how does that make a difference now with regard to the make allowance, I would say that the make allowance is an arbitrary risk management number that allows dairy farmers and processors and co-ops to do risk management on whatever deals they’re inclined to make. So if you want to look at where the benefit of an adjustment might come, adding that kind of stability to the marketplace I think would be the biggest benefit.

Anna: You can take the make allowance out, you could bump it up, you can do whatever you want to it, everybody has the ability to change their premiums accordingly. They can bump them up because the make allowance is better for them or whatever it is. The only person who’s stuck, the only group that’s stuck is Class I, and we keep making them stuck, that’s the biggest problem.

Gus: You’re right there, Anna, but still, to make sure we convey it properly, the market provides opportunity to adjust, so premiums and so on and so forth. Now, obviously lately milk has been long in a lot of areas, it’s been a buyer’s market, so to speak. We’ve gotten used to that probably over the last decade, although you could make a case considering the adverse farm economics right now that perhaps that’s changing finally and shifting some leverage to the producer, I guess we’ll see. But whatever the case may be, I can’t agree with you more, that we have to put a system in place that doesn’t seem like everything falls to the bottom of the hill with the producers being at the bottom of the hill. If we just let the market do what it’s supposed to do, then at least we can say, “Well, dairymen, the market has too much milk and this is why the price has fallen to what it is. And you’re not missing out on any piece of the action because of some formula that the USDA has implored upon you. It’s just what the market is.”

T3: Let’s switch subjects for a second. So one of the other things that’s been coming up in the federal order hearing is a discussion about removing advanced pricing from the Class II in Class I markets. What are your thoughts about removing advanced pricing, specifically the advanced skim price? The skim price is an advanced price that’s published before the month starts versus in Class III and Class IV where it is announced after the month is over. Basically the idea is with Class I Milk, there is an advanced price so that bottlers know what their costs are so that they can price their milk to the supermarkets. The argument is, and it’s an interesting argument, is that dairy farmers don’t know their price ahead of time and they have to use the futures and options markets in order to achieve price stability. There’s no reason why Class I processors can’t do the same thing, and I think they’ve got a point.

Historically, the opposition to advanced pricing has been, well, if you don’t do advanced pricing, they don’t know their price beforehand, but there are risk management tools now to help them there. What used to be for me, something where I thought it was a no-brainer, of course you don’t remove advanced pricing because they need to know their costs so they can give the customers a price. Now, I sit there and I look at it and I go, they kind of got a point that they have access to the same risk management tools that producers do. Why don’t you put the onus on the Class I guys to do their own hedging?

Ted Jr: Well, one of the reasons that they’re talking about going back to the higher of-

T3: I agree, you can’t have one without the other. That’s a very good point.

Ted Jr: … that presents a big problem when it comes time to talk about hedging. So if we want to get out of the box a little here when they’re talking about advanced pricing and so on, you could have one number, one hedgable number, and then you could have Class I price based on that as well as III and IV to give that number hedgability, a milk number, so that it’s for all the different classes, I don’t think would be very complicated.

T3: There is a lot of conversation in the hearing right now from both sides, the side that wants the higher of, they’re just saying, “Hey, during the pandemic, Class III was way higher than Class IV, and we only got the average of the two rather than the higher of. We’d rather go back to the higher up so we can get that benefit.” And those who are opposed to it are saying, “Look, it’s a risk management issue. Is there a way we can resolve this issue you have because we’re not disagreeing with you, we just want to make sure it’s hedgable.” And my gut, knock on wood, saying it out loud may write it in stone that it won’t happen, but my gut is they’re going to come up with a resolution so that they end up with something hedgable at the Class I and Class II level.

Ted Jr: Well, I hope you’re right, but the devil will be in the details, as Gus alluded to, the zones, the qualification requirements and all that, no one’s talking about all that, but it’ll be there in the final decision as if it’s been talked about for the last year and a half. That’s something to be concerned about. And whether or not they’ll see the light to make everything more risk manageable, I guess remains to be seen. Frankly, I doubt it. I think a lot of people feel that that’s a liability rather than an asset

T3: At the producer level?

Ted Jr: Yeah.

T3: Yeah, unfortunately, I think you’re right.

Gus: Hey, Dad, I’d like to ask a question. An out of the box thought that your perspective might help either throw shade on or explode, one or the other, but considering the strong trend of Class I as well as the advancements in packaging and the ability for basically the Class I producers to put bottled milk into a package that provides some shelf life, in addition to the fact that now we have certain products replacing typical Class I bottled milk that are considered Class II because of the way their solids levels have been concentrated, are we getting to a point where maybe it’s fruitless to have Class I and Class II two different classes and maybe that we should combine the two anyway?

Ted Jr: No, just as a matter of my opinion. Class II is probably more appropriate in Class III as far as definition is concerned. You’re talking whips, dips, toppings and so on, and there are manufacturing costs involved in that. They’re not exactly the same as cheese, but on the other hand, there’s a lot of different manufacturing costs in cheese too. But I think you hit on a point that needs to be considered carefully. We’re suffering from a continuing decline in Class I sales, and from what I hear so far, the hearing that I read doesn’t really address that. They’re talking how to jimmy the price as if it makes a difference.

One of the issues that you talked about is UHT processing-

Gus: Packaging.

Ted Jr: … which allows milk to have six months shelf life and package and so on. To acknowledge that fact and allow for pricing, which is risk manageable to promote that kind of the inventory would go a long way towards eliminating the cost of balancing and would put money in the pockets of everybody, including particularly the dairy farmer. I mean, if you’re out of milk to Timbuktu for balancing purposes, that money comes out of the dairy farmer’s pocket. Let’s face it, it does. One way or the other, one time or another, it’s going to come out of the dairy farmer’s pocket. So if you got UHT milk that you can store for six months, or even longer, then you need to allow for risk management of that supply so that people like Walmart and Publix and Kroger and others can take advantage of that and eliminate these humongous balancing obligations.

T3: So let me ask one last topic that’s come up in the federal order hearings is they’ve discussed getting rid of the barrel price in the NDPSR survey, they’ve discussed adding a 640 cheddar NDPSR survey, they’ve even discussed adding mozzarella. It sounds like adding a mozzarella survey’s unlikely to happen, it sounds like adding a 640 survey is unlikely to happen, but there’s still a lot of discussion about getting rid of the barrel survey. What is everybody’s thoughts on that? Generally speaking, barrels tend to have a lower survey price, even with the 3 cents that’s added going into the Class III formula, it still tends to be a lower average price for the year than the block survey and barrels are a decreasing percent of the overall cheddar market. Does it make sense to get rid of the barrels or do you guys think they should stay in? Or does it matter?

Ted Jr: Let me give a quick opinion on that. I think it’s BS. There is a large contingent of people in the industry who think that if you want to raise the price to the dairy farmer, all you have to do is raise the regulatory price and that’ll wind up as money in the dairy farmer’s pocket. That’s false. It does not. They don’t like the fact that the barrel price is lower. “Well, let’s get rid of the barrel price and that’ll raise the Class III price.” Well, guess what? The market will adjust to that. It might take them a few months, but they will, and it won’t make a bit of difference as far as the money in the pocket of the dairy farmers is concerned

T3: I’ll even take it a step further and say it’ll actually have the opposite effect that they intend and it’ll lower their price. And you know why? Is because one of the things that happens is barrels become overproduced when the mozzarella market gets long. There’s a few processors out there have the ability to make barrels instead, and the reason they make barrels is because they want their whey to be white, they don’t want the colored whey from colored cheddar. Guess though, what will happen if they no longer have the ability to make barrels and sell barrels on the exchange, thereby lowering the barrel survey price? They’re going to go ahead and bite the bullet and make blocks, which means they’re going to lower the block price, which will be 100% of the cheese survey price rather than just 50% of the cheese survey price, and that will lower a dairy farmer’s milk price.

Ted Jr: Yeah, the road to hell is paved with good intentions, but particularly when it comes to the classified pricing system as far as setting these prices are concerned.

T3: Thank you for listening today, everybody. As we all know, the federal order hearing is not over yet, and so we’re looking forward to it as much as you are to find out what their suggested changes are. When that does happen, we look forward to having another discussion about federal order reform and our beliefs about what we think will happen once the changes are enacted. Thank you.