Financial volatility: Experts study supply management

Editor’s note: The following article includes a summary of economic analysis of several federal dairy policy proposals by Charles F. Nicholson, California Polytechnic State University, SLO, and Mark W. Stephenson, University of Wisconsin, as well as reaction from a California dairy organization leader.

Volatility of prices and incomes has been an issue of importance for the U.S. dairy industry since the early 1990s. Much of this volatility appears to arise in the dairy supply chain, particularly the production sector, consistent with observed patterns of behavior for other commodities (both agricultural and non-agricultural).

Volatility in prices and incomes has been brought to the fore by recent events, especially a prolonged period of inadequate income for many dairy farmers during 2008 to 2009. There are likely high costs associated with price and income volatility throughout the U.S. dairy supply chain, but accurate estimates of these costs do not currently exist.

Given the costs, a number of programs have been proposed in recent years with the objective of reducing variation in milk prices and farm income. Key questions related to these programs are: 1) can they be effective at reducing variation in prices and income? and 2) do they have other effects that industry organizations consider either positive or negative?

This report summaries are analysis of the three main programs currently proposed as mechanisms to reduce price and income variability:

• Legislation introduced by Costa (H.R. 5288) and Sanders (S. 3531) (also known as the Dairy Price Stabilization Program, hereafter CS);

• The Marginal Milk Pricing (MMP) program proposed by Agri-Mark (cooperative in the Northeast);

• Elements of the Foundation for the Future (FFTF) program proposed by the National Milk Producers Federation.

Our analyses employ a complex systems modeling approach previously used for many other commodities that represents the U.S. dairy supply chain in significant detail. Although the analysis is undertaken at a national level, the model incorporates many product categories (intermediate and final), all current national dairy policies, a trade sector that accounts for interactions with the rest of the world and detailed representation of the proposed programs.

We compare the outcomes of each of the programs to a baseline scenario (which assumes continuation of current policies and no new programs) for the period 2010 to 2018. We undertake this comparison assuming no shocks, a single large shock to feed costs and export demand, and a set of stochastic shocks for which the timing and magnitude of changes in feed cost and export demand are randomly chosen for 200 simulations. These shocks are not forecasts of the future, but represent the types and magnitude of shocks that may occur during the next nine years. We also explore the impact of selected alternative programs implementations and behavioral assumptions.

Our assessment focuses on the level and variation in the all milk pricde, the level of milk income less feed costs for dairy herds of a constant size, milk marketed, government expenditures, net exports of three key dairy products (American cheese, NDM and dry whey) and total sales of fluid milk and American cheese. This indicators provide a spectrum of outcomes of interest to dairy producers, processors, consumers and government policy makers.

Key results

• All three programs would reducd milk price volatility significantly compred to the baseline, both with and without shocks. Under the assumption of large shocks, the program would reduce the average absolute deviation from $1.75/cwt to $1.26/cwt, $1.25/cwt and $1.13/cwt, respectively;

• Cumulative milk production from 2010-18 would be reduced by 0.4% to 0.7% undr the MMP and FFTF (range with and without shocks). Milk production would be increased 0,6% to 0,8% under CS with assumed program parameters;

• All three programs would reduce government expenditures for dairy programs significantly. Under the assumption of large shocks, government expenditures would be reduced from about #3.2 billion over 2010-18 to $1.6 billion for MMP and FFTF and $1.1 billion for CS.

• The MMP and the FFTF programs would increase the average all-milk price by $0.23 and $0,17/cwt, respectively without shocks, and by $0.12/cwt and $0.06/cwt, respectively, with shocks. These price enhancement effects occur because MMP and FFTF spend collected monies on demand enhancing activities (modeled as food donations through non-commercial channels);

• The programs would have different effects on net exports of American cheese, NDM and dry whey. Under the scenarios assuming the large shock, the MMP and FFTF would reduce average monthly net exports of American cheese by 17% and 22% respectively, compared to the baseline. Net exports would continue to grow under the program, just a slower rate than under the baseline. Moreover, the lower exports under MMP and FFTF, respectively. Because CS produces somewhat more milk than the baseline, American cheese exports and dry whey exports would increase by 2.6% and 8.1% respectively, compared to the baseline.

• The impact of the programs on cumulative fluid sales during 2010-18 would be less than 0.4% (the reduction under FFTF). The impact on cumulative domestic and export sales of American and other varies with the program. MMP and FFTF would reduce cumulative American cheese sales by 1.7% and 0.7% respectively. Reductions in cumulative other cheese sales would be 0.2% and 0.3% for MMP and FFTF, respectively. CS would increase cumulative sales of fluid milk by 0.2%, but decreases American cheese and other cheese by 0.5%, 1.0%, respectively.

• The programs would have different effects on Class III and IV prices. Due to purchases of American cheese, the MMP and FFTF programs tend to enhance Class III prices compared to the baseline (an average over 2010-18 of $0.45/cwt, respectively) for the scenario assuming large shocks. Average Class IV prices are higher under MMP ($0.09/cwt for 2010-18) and lower under FFTF ($0.04/cwt) compared to the baseline for the scenario assuming large shocks, which implies a larger average price spread between Class III and IV. The CS tends to lower both Class III and IV prices ($0.14/cwt and $0.20/cwt) for 2010-18 assuming large shocks, but maintains a smaller price spread.

Conslusions and implications

Milk price volatility has clearly become a significant problem for the dairy industry since the 1990s, although the underlying causes of volatility continue to be debated. Some observers have hypothesized that without an active Dairy Product Price Support Program dairy manufacturers will simply not hold enough commercial stocks of product to buffer supply anbd demand imbalances.

Others have suggested that it is our emergence into world trade in dairyu products that has been a cause of the price swings. Still others have suggested that it is simply a faulty price discovery mechanism in the Federal Milk Marketing Order system. But some dairy producers have also suggested that volatility results from rational responses to profitability incentives in the absence of coordinated expansion decisions.

Recent research has shown that there are complex cycles in milk prices. Over these last two decades, a 36-month cycle has emerged and is becoming larger, and these cycles are probably related to dairy producer decisions. This endogenous variability is consistent with the experience for other commodities, as noted in Sterman (2000). As a result, a number of dairy industry organizations have proposed programs with supply management components to reduce this volatility.

Our analyses of three proposed programs indicate that all three would significantly reduce milk price volatility and would reduce government expenditures on dairy programs in the absence of shocks, for a set of specific large shocks, and for a set of 200 randomly selected shocks.

In general, MMP and the FFTF programs would marginally enhance the average milk price over the baseline, primarily because they are stimulating demand for dairy products through food purchases for domestic assistance programs. The CS program would somewhat diminish the average all-milk price from the baseline. This occurs because the allowable levels of growth are generous and without the deeper troughs in milk price, producers are willing and able to expand milk production.

The three programs have different impacts on exports. The CS program results in more cheese production (due to the additional milk marketed) and some of that additional cheese, dry whey and NDM are exported. The MMP and the FFTF programs reduce exports of cheese and whey compared to the baseline.

The ultimate objective of this research is to help the dairy industry better assess the trade-offs associated with these policy options. This analysis attempts to account for a variety of potential unintended consequences, but we have not assessed every possibility. Moreover, we do not directly address implementation issues. We assume for the purposes of our analyses that the programs can be implemented by appropriate government agencies in a reasonably effective manner. Although ewe have no reason to believe this would not be the case, it is worth noting as an underlying assumption. The industry should now use this information to facilitate thoughtful discussion about potential benefits and drawbacks of these programs.

Early industry reaction

Rob Vandenheuvel, general manager, Milk Producers Council, has been working with dairy producer groups and cooperatives across the country since the early days of this market volatility issue to fund a broad analysis of the major proposals being made to address the extreme boom/bust nature of the dairy industry.

“Both of these economists (Stephenson and Nicholson) are well-known in the industry for their work while they were at Cornell University,” Vandenheuvel said in a recent newsletter communication. “One of the most important comments in their ‘key results’ is the first bullet point, which starts out…‘all three programs would reduce milk price volatility significantly compared to the baseline…’ With multiple policy proposals on the table for the industry to discuss, it’s important that any proposal meet a basic threshold – that it would successfully accomplish its stated goals: most notably, providing dairy producers with a more stable and profitable future.”

“There is a sobering reality expressed in this report that must be heard loud and clear by the industry. Included in the analysis is a ‘baseline’ projection for the next 8-9 years.  This projection is what the economic model predicts our national all-milk average prices to be, if we do nothing. Vandenheuvel stressed, “waiting is not a luxury we have.”

“Conventional wisdom among some of our leaders is that no change will happen until the Farm Bill. Some have even suggested that there is no use in even trying to push something sooner,” Vandenheuvel wrote. “But National Milk Producers Federation had it right on this issue. When approving their ‘Foundation for the Future’ proposal, their board voted that it be part of ‘the next Farm Bill or other suitable Federal legislation.’ Let’s consider the Farm Bill a last option, and see what our industry can pull together in the early 2011.

“To do anything less would be a huge disservice to the dairy farmers across the country who have sustained a devastating 2009-10 and are craving the tools necessary to combat this boom/bust volatility,” he concluded.

Policy changes require cooperation

Editor’s Note: Jamie Bledsoe’s “President’s Outlook” communicates with Western United Dairymen membership.

Congress passed the last Farm Bill in 2008. Much has happened in the dairy industry since the bill’s passage. No one could have predicted the horrific global economic meltdown that occurred in late 2008 nor the lingering impacts that crisis would have on our businesses even today. Clearly, Congress didn’t envision what transpired.

Western United Dairymen aggressively and steadfastly pushed to utilize all of the tools the 2008 Farm Bill provided to our dairy families to turn back the calamity we saw occurring with our businesses and the businesses of our friends and neighbors. We encouraged our Congressional representatives to help us, and the groundwork that we have laid with the Congress over the years paid off. Food donations were made to the hungry, export subsidies were wrestled free, environmental regulations were deferred, the price support program was enhanced and WUD’s expertise was sought by the House and Senate Agriculture Committees. CWT was kicked into high gear and several hundred thousand dairy cows were retired. We effectively enlisted the media to join in our calls for help. Many long hours and sleepless nights interspersed with critical meetings were the rule for our staff and our Board.

It wasn’t enough. Dairy families hemorrhaged equity that had been built over generations. In some tragic cases, the family dairy legacy expired. Safety nets included in the 2008 Farm Bill were not adequate for a disaster of this magnitude and the net itself was full of holes.

Since the crisis began there have been many ideas proposed to rescue the industry. While these efforts are well intentioned, our board recognized the grim reality that no significant change in national dairy policy would be available to us until the next Farm Bill. That has been the inescapable political reality of our dilemma.

Our board was asked for and provided input on some of these proposals.

In good faith we worked hard and provided it. Of course, nothing anyone could do was going to convince the Congress to take apart and restructure a Farm Bill that was passed less than two years ago. Nothing was going to move in the Congress on dairy until the next Farm Bill; on that the chairs of both the House and Senate Ag Committees have been adamant.

The hard work continues. This summer we joined a national coalition to help fund a study attempting to model the effect of proposed policy changes. The results of that effort have been released and will be used as one of the analytical tools in our toolbox. We also surveyed our members this summer and one thing resonated within the survey: The status quo is not an option.

Our Board and staff have continued to plow ahead. We’ve held dozens of meetings and engaged national and international experts to provide us with advice. Their conclusions supports something our Board has recognized all along … the next shot at shaping future dairy policy will be within the next Farm Bill. We have continued to labor with that in mind. We have also been mindful that the processing side of the industry will oppose some of the policy ideas desired by producers. We also recognize that a divided house cannot long stand.

This past summer a dairy policy proposal for the next Farm Bill was developed by National Milk Producers Federation (NMPF). This proposal, called Foundation for the Future, enjoys overwhelming support among their member cooperatives. Our Board has reviewed this idea and had discussions with them about it. Of course, our interest lies in what might be best for our members. We’ve asked ourselves the questions about whether this might be part of a solution, and importantly, whether this proposal might work for California.

Our Board is interested in several aspects of this plan. We are also intrigued with the fact that substantial political and producer support already exists for this plan across all regions of the country. Further, our relationship with NMPF is a positive one and they have worked well with us and us with them as we’ve moved key federal legislation together in the past. Their support of a dairy policy initiative is important relative to its likelihood of success. Their opposition to policy proposals is problematic. We do have questions and concerns, however. NMPF has solicited our input and encouraged positive dialogue and also has an appreciation for WUD’s political influence and our expertise on dairy policy.

Our board realizes that substantial changes to U.S. dairy policy will not be an easy lift in the Congress. Our membership seems inclined towards change. With the recommendation of the Dairy Programs Committee that met on September 3, our Board memorialized this impetus at our meeting on September 10 and voted to work closely with NMPF as they refine Foundation for the Future. Our work started this week as our CEO traveled to Washington, DC, to begin collaborative discussion with their organization.

The scope of this proposed change is broad. The effort to move real change in US dairy policy will be significant. The importance of developing a secure safety net for California producers is critical. We have been deliberate and thoughtful because this issue is so important.

We hope that others will join us to find positive solutions. We encourage all California dairy families and their organizations to help us work collaboratively for change. We extend our hand and hope it is accepted. Our industry must be viable for our member families to succeed.

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