End product pricing: three views

By Dave Natzke

The National Dairy Leaders Conference, held April 20-21, near Denver, featured a panel discussion on “Milk for manufacturing: How should it be priced?” The discussion was a forum on end product pricing, featuring Dave Fuhrmann, Foremost Farms USA; Geoffrey Vanden Heuvel, California Milk Producers Council; and Jeff Williams, Glanbia USA. A summary of the discussion follows.

 

Fuhrmann: Unintended consequences 

“The current system of end product pricing has produced ‘unintended consequences,’” Fuhrmann said.

Those include:

• negative “other solids.” Under component pricing, the value of protein is primarily based off the cheese market; the butterfat value is primarily based off the butter market; the “other solids” value is based off the whey market.  “For the last six months, the value of the whey has been less than the ‘make allowance’ to process the whey into powder, so producers receive a ’negative‘ value or deduction from their milk check for other solids,” Fuhrmann said. “If you’re a dairy producer trying to maximize the value of your animals and your milk – using genetics and feeding – a negative value for other solids sends the wrong signal.”

• negative producer price differentials (PPDs). Typically a higher Class I price adds value to the blend price. There are times – happening more frequently – that that number has been negative. There’s a huge negative impact on producers who use forward contracting.

• the lag between market changes and producer payments. “When you are paying producers for a commodity – milk – processors and producers should be able to respond to market conditions. With the volatility we’ve had, the lag sends the wrong message to dairy producers,” Fuhrmann said.

For example, on Dec. 1, 2008, Chicago Mercantile Exchange (CME) cheddar blocks sold for $1.79/lb. By Dec. 31, the price had dropped to $1.1325/lb. The December CME price averaged $1.6123/lb., but the average price used by USDA to calculate federal milk marketing order Class III price – using a National Ag Statistics Service (NASS) survey – was $1.7544/lb. As a result, dairy farmers received a December Class III price of $15.28/cwt. on their milk checks received in the middle of January. In addition, many Midwest producers received quality and volume premiums of $1/cwt.

“You really don’t get a sense of how bad it is until you get the check in the mail,” Fuhrmann said. “We in the industry realized what was going on, and with a $15.28/cwt. Class III price, the signal we were sending to our dairy producers was that it wasn’t that bad.”

On Jan. 7, CME cheddar blocks sold for $1.0725/b., and on Jan. 31, the price was $1.15/lb., for a monthly CME average of $1.1358/lb. However, with the lag in reporting, the January 2009 NASS average was $1.2961/lb., and resulted in a Class III price of $10.78/cwt., plus premiums.

On Feb. 1 and Feb. 28, the CME cheddar block price was $1.15/lb. and $1.1750/lb., respectively, and the February CME average was $1.1785/lb. The NASS average for February was $1.1518/lb., yielding a February Class III price of $9.31/cwt., which was reflected in the milk check producers received in mid March.

“So the check producers received in March actually reflected the market conditions on Dec. 31, 2008,” Fuhrmann said. “That lag is too long. The reverse happens when prices are rising quickly. Producers aren’t receiving the economic signal as quickly as they should, and it’s a major flaw in our system.”

“We’re probably never going to find a system everyone will agree on,” Fuhrmann said. “I don’t think anyone likes the current pricing system, but it becomes the degree of how bad everybody dislikes it.”

Furthermore, the “make allowance” issue splits manufacturers across the country.  Every plant has different manufacturing costs. It’s a controversial issue that we’ll probably never get resolved, he said.

He recommended eliminating end product pricing formulas, and reverting back to  a system similar to the old Minnesota-Wisconsin (M-W) price series, which allows competitive pricing methods and establishes prices for two classes of milk: Class I, for all packaged fluid milk; and Class II, for all milk used in manufactured products. He admitted that system may not work in regions where there is limited competition for milk.

 

Vanden Heuvel: Tweak, don’t toss

While there are problems with end product pricing formulas, they have only been in use for 8-10 years, said Vanden Heuvel.

”With any system there will be bumps,” he said. “There’s nothing fundamentally wrong with the product pricing system. But, there are problems, and it requires care to get it right.” 

One problem Vanden Heuvel identified is that “end product pricing formulas require good data … something that has been lacking.”

USDA should have established a “cost auditing unit” when end product pricing was implemented, including measuring manufacturing costs and yields at plants, he said. “If those factors are going to be used to price milk, then we have to know what it costs to manufacture butter, powder and cheese. It must also reflect improvements in manufacturing efficiencies.”

Second, dairy product price discovery methods must be valid. While NASS butter and cheese price discovering methods have worked fairly well, milk powder price discovery has not, he said.

“The only reason it has worked as well as it has for cheese and butter is because California manufacturers have to pay for milk based on CME cheddar 40-lb. blocks and CME butter,” Vanden Heuvel said. “To protect their markets, California manufacturers must pay for milk based on those prices. That forces the rest of the industry to follow.”

There have been tremendous problems in reporting nonfat dry milk prices to NASS in recent years, Vanden Heuvel noted. California’s weighted-average nonfat dry milk price formula is troublesome because one large firm controls 90% of the powder sales. There’s no competition, and that influences NASS. He recommended using the CME spot nonfat dry milk price.

CME has come under criticism as being subject to market manipulation.

”There are plusses to CME, and it’s a mistake for producers to criticize it,” Vanden Heuvel said. “We should try to improve CME transparency. But all the buyers try to manipulate the price down; all the sellers try to manipulate the price up. To the extent each of them is successful each day is based on supply and demand, and that’s what you want to know. CME reflects real-time market discovery. It’s the best tool we have. It reflects the supply and value.”

With the advent of whey as an increasingly important food ingredient, Vanden Heuvel said establishing a value for whey in the milk price needs work.

“The whey industry has become mature enough so that producers are entitled to some share of the value of the whey stream,” he said. ”But, we need to recognize the cost relationship between whey and its conversion to a marketable product, compared to other products.”

With cheese, butter and powder, the end product is worth 6X-8X the cost to make the product, he explained. But with whey, the end product value/cost ratio is less than 1.5:1, and, in the past six months, the cost to make the product exceeds the value of the end product. Producers are subsidizing the manufacture of whey, and that’s not the purpose of milk pricing formula.

“Most cheese varieties price off the CME cheddar price,” Vanden Heuvel said. “Even if you’re making mozzarella, if the cheddar price is moving up, the mozzarella price moves up.  There’s much less tracking on various dry whey products. That requires that we treat whey differently.”

He recommended establishing a base value for whey, with some sharing of upward movement when the value of whey moves higher. It should never be a “negative” to the producer. But, it’s an evolving industry that requires a lot of capital to be invested in whey processing. 

“While the minimum price formula ought to capture most of the value of commodity-size butter, powder and cheese, the regulated system should leave some value of whey on the table for those who invest in whey processing, and as a buffer to deal with price inversions,” Vanden Heuvel said. “We have to encourage innovation in this area, so we can’t grab every dime out of that portion.” 

 

Williams: It works well

Operating plants in areas not regulated by federal/state milk marketing orders, end product pricing has worked well for Glanbia and its predecessors for a quarter century, Williams said.

“We have a model that works in Idaho, and a modified system that’s working at Southwest Cheese in Clovis, New Mexico,” he explained. The practice has helped lead to rapid growth in Idaho’s cheese production.

Using a variation of systems used in California and federal orders, Glanbia establishes values for milk based on the product yields for cheese, whey, dry milk and butterfat products. It pays for components (protein/fat) produced at the farm. Each formulas is slightly different, but is usually based on published commodity prices from CME, NASS and USDA’s weekly Dairy Market News.

Citing Idaho’s growth in milk production, Williams said end product pricing helps determine the fair value of milk and encourages innovation in the dairy industry, especially for export markets. That leads to plant expansion and industry growth.

Williams said Glanbia was considering future changes to its end product pricing formulas, including testing and paying for casein, and considering whey pricing changes to more accurately reflect product mix.

For copies of presentations at the 2009 National Dairy Leaders Conference, visit http://www.nmpf.org/NDLC/presentations.

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