April 26, 2021 at 6:00 p.m.
Six factors that drive PPDs
“Until last year, negative PPDs were always a short-term phenomenon,” Dr. Marin Bozic said. “The markets would have steep rallies but then with the intricacy of milk pricing, it would smooth out from one month to the next. Never did we have nine of the 10 consecutive months of negative PPDs. We’re here to have a frank discussion on what is driving this.”
Bozic is an assistant professor of applied economics at the University of Minnesota.
In an educational webinar co-hosted by Minnesota Milk Producers Association and Wisconsin Dairy Business Association April 13, Bozic explained six factors that create PPDs and why that value has been below zero for much of the last year.
PPDs were developed as a way to create pricing fairness for each dairy farmer in a FMMO despite what the milk was processed for.
“Revenue pooling is a noble concept,” Bozic said. “In theory, theory and practice are the same. In practice, they are not.”
Long-term trends in utilization rates
When FMMOs were first developed as a way to protect against abusive power with large milk buyers at the end of World War II, two-thirds of fluid milk pooled was processed for beverage. For this reason, the revenue from Class I was redistributed to milk pooled in other classes. In 1998, that value decreased to 45% and the last major FMMO reform took place.
Over the years, a larger portion of milk produced in the United States has been used for manufacturing and less for beverage consumption.
In 2019, fluid milk pooled for beverage was as low as 28%, Bozic said.
“Once we’re back to normal, post-pandemic and when Class III and IV converge, we believe we will find Class I to be 1% lower still,” Bozic said. “Simply put, at its core, there is not enough fluid milk to make FMMO work as it was designed.”
Rising protein test
Over the last decade, dairy farmers have increased the amount of solids they sell. In the Upper Midwest, FMMO 30, the average protein test was 3.04% in 2008-09; in 2020, that value rose to 3.14%.
While the tests have risen, accounting for that change in PPDs has not.
“When Class I processors pay to pool milk, that’s based on skim milk pounds per hundredweight, not protein or other solids. On the other hand, when those same processors take money from the pool, then protein tests are counted,” Bozic said. “The money out rises over time as protein tests grow but the money in doesn’t change.”
The same scenario is true when reviewing how Class II and Class IV are paid out, because in FMMOs, protein is paid for based on the value of cheese while not all protein is used for cheese. Processors pay in on non-fat solids prices, but they can take money out based on the protein price and test.
“How we price protein and draw prices to the pool all matters,” Bozic said.
Spreads between Class III, Class IV
Last year, the spread between Class III and Class IV reached unprecedented levels.
“This is really the same story told,” Bozic said. “Because the spread reflects the spread of protein and non-fat solids prices, and the wedge is growing.”
Last month, the spread was at $1.97, while the historical average spread is at $0.39.
In 2020, the spread was driven by government purchases. For corrective action, dairy organizations testified that the short-lived federal food box program should emphasize butter as a method to quickly address the spread.
“In FMMO 30, as Class III rises above Class IV, PPDs go negative and do so in a hurry,” Bozic said. “Long term, we need to look at incentives to move milk.”
Advanced pricing for fluid milk products
In the current pricing system, retailers may know the price of milk before the month begins to provide certainty. However, that introduces discrepancy between advanced prices and the full-month average prices.
A decade ago, negative PPDs were short-term instances and would rebound in a single month or two with advanced pricing.
“The idea is that you’ll have a rally but it will stabilize,” Bozic said. “The biggest question we need to be asking is, ‘Do we still need (advanced pricing)?’ Right now, it’s more of an annoyance than a concerning factor.”
Class I formula reform introduced in the 2018 farm bill
A Class I policy change was implemented in 2019 under the previous year’s farm bill.
Prior to the reform, Class I prices were always calculated as the higher of Class III and Class IV. The change now reflects Class I as the average of Class III and Class IV plus $0.74.
The new formula does not allow for a boost of PPDs but can depress it significantly.
In a narrow focus, the Class I formula has cost dairy farmers a little more than $1 per cwt, Bozic said. The dairy economist also mentioned that prices were driven in 2020 by the taxpayer-funded massive purchases of cheese.
“We cannot escape the possibility to mention that if markets were left to work on their own, the new system would have worked better,” Bozic said. “All prices would be in the basement and farmers would be losing equity, but the new system works better when prices are more closely aligned.”
The FMMOs were designed in a way that all classes except Class I could pool milk in the order. This was because, at the time, manufacturing classes were a significantly smaller share of milk.
“Historically, the FMMO system was for processors to specialize in what they’re good at and participate in Class I sales. It was easy to do because there was so much milk in fluid sales,” Bozic said. “We never intended that it would be Class III that would have to pour revenue into other classes.”
Classes are now depooling more frequently as Class III and Class IV are being used to subsidize the other class prices.
“Depooling doesn’t happen because people are selfish,” Bozic said. “It happens because the legal language of the (FMMO) system was based on the premise that most milk will always be in Class I.”
Considering these six factors, the actual PPD for January 2020 in FMMO 30 was -$8.69. Last month, the actual PPD was -$0.51, Bozic reported.
“The next 24 months will be consequential for milk pricing for the next decade,” Bozic said.
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