Milk for Manufacturing: Number of classes; Number of components; Advanced Pricing

1. Milk for Manufacturing:Number of classes; Number of components;Advanced Pricing Bob Cropp Emeritus Professor Department of Agricultural and Applied Economics University of Wisconsin-Madison June , 2007

2. Opinions on these issues range from: • Those who want to expand FMMO pricing regulation to • Those who want to simplify FMMO pricing regulation I won’t claim to have the correct answers. But, I hope to stimulate discussion.

3. Answers to these topics are found in the stated objectives of the AMA Act of 1937, as amended. • To ensure consumers of an adequate supply of wholesome milk at a reasonable price. • To provide adequate producer prices that ensure an adequate current and future Grade A milk supply. • To promote greater producer price stability. • And orderly marketing.

4. These objectives are to be fulfilled via: • Classified pricing, and • Pooling

5. Some light as to FMMO objectives and achieving these objectives are contained in the Nourse Report. • A 1962 report to the Secretary of Agriculture by the Federal Milk Order Study Committee, Edwin G. Nourse, et al. • Considerable discussion on FMMOs and orderly marketing. • But, have FMMOs been amended on a timely basis in response to ongoing chances in the dairy industry?

6. I think a major question to the topic I have been assigned is: Are existing classified pricing and pooling provisions interfering with or not allowing for the adoption of innovative technology, new product development or the proper allocation of raw milk and its components to the highest and best use?

7. The objective to ensure an adequate supply of Grade A milk for Class I use has been more than met. • 97% of milk is Grade A • In 2006, Class I utilization averaged just 37.6% With the majority of Grade A milk being utilized for manufactured dairy products we need to evaluate whether or not classified pricing and pooling provisions allocates milk and components to the highest use and allows for technology and product innovation not only for beverage use of milk but for milk used in a variety of manufactured dairy products and dairy ingredients

8. Are both consumers and dairy producers receiving the full potential benefits from FMMOs as was intended by the 1937 Act? I think with existing classification and pooling provisions, the answer is NO.

9. Number of Classes of Milk: • In the 1930s life was much simpler—either we drank the milk or made basic manufactured dairy products; two classes of milk was all that was needed—one for beverage and one for manufactured products. • No practical technology existed for testing raw milk other than for butterfat.

10. A while later another class was established. • A class for soft manufactured products—ice cream, cream products, cottage cheese, condensed milk products. • Argued that these products processed and marketed together by handlers in common distribution channels with that of beverage milk products. • Three classes: Class I: beverage milk; Class II: soft manufactured products; Class III: butter, nonfat dry milk, cheese.

11. 1973 study,Milk Pricing Policy and Procedures, Part II, Alternative Pricing Procedures, report of the Milk Pricing Advisory Committee, USDA • Suggested one class for butter, nonfat dry milk and cheese still appropriate. “If a separate classes were created for butter-powder and cheese incentives for switching between the two products would be substantially reduced”. • “On the other hand, substantial evidence indicates differences in demand and price relationships between butter-powder and cheese and further consideration of separate classes appear appropriate”.

12. A fourth class came into being in 1993—Class III-A • Class III-A for butter-powder • Argued butter-powder plants couldn’t afford to pay same minimum price for milk as cheese plants. • Further, dairy co-ops provided market-wide service of balancing—co-op members bore the cost of doing so—other producers were ‘Free-riders” • Opponents argued Class III-A would inhibit milk being allocated to its highest use; FMMO market-wide service payments and over-order premiums should compensate co-ops for balancing costs.

13. Did Class III-A result in miss-allocation of raw milk? From 1993 to 1995: • Milk production grew 3.1% • Nonfat dry milk production grew 29% • Government stocks of nonfat dry milk grew 419%. • Nonfat dry milk made and later reconstituted to make Class II products.

14. 2000 FMMO reform implemented: • FMMOs reduced from 33 to 11; replaced BFP as the base price and Class I mover with component pricing using product price formulas with fixed make allowances and yields. • Four classes: Class I: beverage milk; Class II: soft manufactured products; Class III: cheese; and Class IV: butter and nonfat dry milk. • Need I remind you of the number of proposals, hearings and amendments since 2000? A full-employment act for lawyers and economists.

15. Since 1993 we have had the opportunity to observe what happens with Class I and three manufacturing classes—II, III and IV. • If we expanded classes, what? • Some argue for a separate MPC class. • Others argue that if it was not for CCC support price on nonfat dry milk, we would be making MPC.

16. Recognizing modern technology allows for separation and refinement of milk and its components for the best use in different dairy products and food ingredients, and these potential uses could be the basis for expanding the number of manufacturing classes, The experience with Class III-A and the existing Class III and Class IV, points to the return of one manufacturing class for butter-powder and cheese. In fact, maybe we don’t even need Class II, but just a two class system—Class I beverage and Class II all manufactured products.

17. Classified pricing is to enhance producer revenue via price discrimination. • Do we have a good handle on price elasticities to do this????? • Even if we did, more is lost than gained in enhanced producer revenue in the long-run. • More classes would dampen new product development, new uses of milk components, may price out milk components to substitutes. • Considering the difficulty we are having on agreement with product formulas for Class III and Class IV, how do you think we would fair with more manufacturing classes?

19. With two classes--Class III and Class IV--there is little incentive to move milk to its highest use. • Economic logic for one manufacturing class is that raw milk and/or its components would be allocated among uses until the finished product market prices adjusted to bring about equilibrium. • But, with Class III and Class IV and fixed make-allowances manufacturers are enticed to maximize capacity use regardless of commodity market prices. • There is little incentive to “give-up” milk to the higher valued use.

20. Class III and Class IV leads to greater dairy product and producer price volatility and longer periods of time before appropriate raw milk and milk component allocation and price adjustments come about. • Manufacturer of low value product maintains or expands production which lowers fixed unit costs, further lowers product price, but increases profitability. • Manufacture of high value product has no greater margin to pay for and to attract more milk because higher product prices don’t result in greater margins, just increased milk cost. • Both manufactures share in market-wide pooling.

21. With Class III and Class IV there are problems with pooling and de-pooling—consider the 2000 -2004 experience. • 2000: High butter prices but depressed cheese prices pushed Class IV above Class III—less incentive for Class IV plants to pool than Class III plants. • April 2004: High cheese prices pushed Class III well above Class IV, and in fact, above Class I; Class IV plants stayed pooled, Class III plants de-pooled. • If there had been one manufacturing class, both butter-powder and cheese plants would pay the same minimum pay price for milk and components—milk and milk components would have allocated to the highest use much quicker, there would have been more price stability and probably less de-pooling.

22. Class III and Class IV interferes with the support program being an effective support price. • Consider the 2000 -2003 period—Class III was below $9.80 support price for 7 months in 2000, 3 in 2002 and 6 in 2003—being as low as $8.57 November 2000. • Yet, Class IV was above $9.80 • Why didn’t cheese plants sell to the CCC? • There are several reasons, BUT, fixed make allowances guaranteed cheese plants a margin and provided an incentive to maintain or increase cheese production to lower fixed per unit cost of cheese. • This situation would have been different with one manufacturing class.

23. A related issue is the Secretary of Agriculture’s authority to implement a Butter/Powder Tilt. • The mover of Class I is the higher of an advanced Class III or Class IV price. • In 2000, due to high butter prices, increasing CCC purchases of surplus nonfat dry milk, but depressed cheese prices the advanced Class IV was the mover of Class I. • A butter/powder tilt was delayed due to political pressure. • While a butter/powder tilt was justified in the proper operation of the support program, by doing so would have lowered the advanced Class IV price and the Class I price.

24. Conclusion: Evidence supports one manufacturing class for butter, nonfat dry milk and cheese. • Milk and its components are more likely to move quicker to the highest use value thereby enhance producer revenue and reduce dairy product and producer price volatility—an important of objective of FMMOs under the 1937 Act. • In order for two manufacturing classes to enhance producer revenue there needs to be different price elasticities and the possibility of substitution of lower cost components foreclosed.

25. The argument that a separate class for nonfat dry milk is needed for “balancing” the milk supply???? • Dairy co-ops do provide an important market-wide balancing service and at a cost. • While it may be easier to balance with a butter/powder plant, balancing is also done with cheese plants. • FMMOs ought to provide adequate market-wide service payments, and/or • Dairy co-op negotiate adequate over-order premiums to cover associated costs.

26. Do we need a separate Class II???? • Class II pricing has been controversial • Class II should be prices higher than other manufacturing classes, but how much higher???? • In 1980s, Class II $0.20 to $0.25 higher than MW series • In 1990s, Class II $0.30 higher. • Under 2000 FMMOs reform Class II skim milk $0.70 higher than advanced Class IV; butterfat $0.007 higher than Class III/IV butterfat.

27. Two major concerns of Class II handlers: • Class II products compete with similar products made from unregulated milk. • If Class II priced too high, this may encourage the substitution of nonfat dry milk for fresh raw milk in the making of Class II products.

28. Conclusion: Class II could be rolled into one manufacturing class. • Class II may not enhance producer revenue, at least very much. • Price elasticity of Class II products, may in fact be more elastic than Class IV products. • The $0.70 differential above Class IV adds relatively little to producer price—in 2006, Class II utilization ranged from 20% in NE order to less than 6% in UMW order and averaged 12%

29. An big issue with one manufacturing class: • Designing an appropriate formula for the minimum class price. • This is a minimum class price allowing for market forces to allocate raw milk and milk components to the highest value.

30. What milk components to test for and pay for? • FMMOs assume the following standardized whole milk composition for the purpose of calculating class prices: • 87.82 % water • 3.50% butterfat • 2.99% protein • 5.69% other solids (lactose—salts or ash) • 7 of the 10 FMMOs test and pay for multiple milk components and 3 pay on a fat-skim milk basis.

31. For the 7 order on multiple component pricing, milk is tested for and paid for on a one pound basis: • Butterfat • Protein • Other solids AND on a hundredweight basis a: • PPD and • SCC adjustment

32. Butterfat, protein and other solids are the correct milk components. • The big issue is the proper product price formulas for calculating the component values—these should be minimum values. • Pricing the correct components can be closely related to the proper number of manufacturing classes. • Technology allows for greater separation and refinement of components that can be used for specialized dairy products and food ingredients and these different uses could be a basis for determining milk classes.

33. Appropriate formula for component values? • Not big issue with butterfat value—based off of the price of butter. • But, protein and other solids prices are more of an issue. • Protein price per pound primarily driven by cheese price, but also butter price to recognize the value of casein retaining butterfat in cheese. • Some argue, such as National All-Jersey Assoc. that protein value ought to also recognize protein value in whey.

34. A big issue with cheese makers and the price of other solids and the Class III price is dry whey. • March 2006: Dry whey = $0.3409, resulting “other solids price” = $0.1874 Cheese price = $1.1612 Class III = $11.11 • March 2007: Dry whey= $$0.7060, resulting “other solids price” = $0.5257 Cheese price = $1.3732 Class III = $15.09 • From March 2006 to March 2007 the increase price of dry whey increased the Class III price by more than $2.20 per hundredweight while the increase value from cheese increased just about $2.00 per hundredweight. • A major short-run issue for cheese makers not processing whey. • But, in time cheese makers will invest in technology to capture whey value.

35. Protein can be separated into casein and whey protein. • The nutritional value is the same. • But, functionality differs—casein has the binding capability for cheese making and whey protein does not. • Casein could technically be separated for cheese making and whey protein put back into Class I products. • Should FMMOs be amended to pay one price for casein and another for whey protein? • Remember initially the FMMO reform had a different butterfat price of Class I than other classes—it was soon amended.

36. The real issue is should FMMOs regulate the paying of different prices for more refined set of milk components??? • Allergists are interested in protein beta lactoglobulin, the culprit behind allergies. • Casein macropeptide is found in sport drinks. • For cheese, casein is the major protein. • Rather than one “other solids” price should FMMOs pay a price for whey protein and another price for lactose? • Should FMMOs pay one price for dry why, another for WPC having 25 to 49.9% protein, another for 50 to 89.9% protein and another for whey protein isolates? • Should we have a separate prices for MPC?

37. Casein can be refined into: • Acid casein: A major product of world markets—used for glazing high quality paper, in production of paints, cosmetics. • Lactic acid casein: A favored for food uses by New Zealand and Australia. • Rennet casein: Serve as nutritious ingredient in process cheese products or modified to produce products that function like plastic. • Caseinates: 91% protein and used in the food industry in cured meats and to make milk and cream substitutes.

38. Considering all of these possibilities, where does it end??? • Buttermilk may be a good example. • Dry buttermilk impacts the value of Class IV, but it is not recognized in the formula. • In June 1995, when BFP replaced the M-W series as the base price and mover of Class I, the BFP was adjusted by recognizing the value of .42 pounds of dry whey in Western States in deriving the butter/nonfat milk portion of the BFP formula.

39. Conclusion: we are paying for the correct milk components. • But, we need to evaluate the product price formulas for calculating minimumvalues. • Another issue is appropriate price discovery for butter, cheese, nonfat dry milk and dry whey used in the formulas---NASS prices versus CME prices, some other alternative?? • An attempt to further refine milk components and to regulate the pricing of their minimum values would hamper the potential use of milk components in dairy products and as food ingredients. • Over regulation invites other sources of protein—vegetable proteins—in these potential uses.

40. Advanced Pricing: • For most of FMMO history Class I price has been established and moved by adding a differential to a manufacturing milk value, but advanced priced. • Manufacturing classes of milk have been priced after the fact. • From 1960s up until 2000 FMMO reform the base price and Class I mover was the MW and later the BFP—two months previous to when it applied.

41. Advanced pricing under 2000 FMMO reform: • Class I mover the higher of an advanced Class III or Class IV price announced on a Friday on or before the 23rd of the previous month to which it applies. • Class II skim milk price is advanced priced by adding $0.70 to the advanced Class IV price. • Class II butterfat and Class III and Class IV prices are announced on a Friday on or before the 5th of the following month to which its applies.

42. Major problems with advance pricing Class I and Class II skim milk and not Class III and Class IV. • Advanced prices are announced about six weeks ahead of the other announced prices. • With the volatility of dairy product prices, especially cheese, the relationship between Class I price and Class III and Class IV prices can become distorted. • For example, April 2004: - Class I announced on March 19th and Class III & IV on April 30th. - Average cheese price for advanced Class I = $1.4582 - Average cheese price for Class III = $2.520, $0.5938 higher. - Result: In UMW order Class III higher than Class I, $4.11 negative PPD - De-pooling by cheese plants—Class I utilization =63% and Class III = 2%. - FMMO objective of orderly marketing failed.

43. FMMOs have been amended to deal with de-pooling and later re-pooling, but major issues remain with advanced pricing. • With volatile dairy product prices disorderly marketing and class prices continue with a six week gap between announced prices. • Perhaps the gap can be shortened a week or two at most—could use CME rather than NASS prices. • Conclusion: Either advanced pricing of Class I and Class II skim milk should be dropped or all classes should be advanced priced and announced on the same date.

44. Question: Can Class I and II handlers live without advanced pricing? Answer: Yes • Manufacturing plants pay dairy producers or co-op milk supplier for raw milk around the 16th of the month for milk delivered the first half of the month—follow what is going on with dairy product prices in making the payment. • After the final Class III/IV price is announced for the month a final milk pay is made and adjustment is made if the 16th payment was too higher or too low. • Manufacturing plants can experience unfavorable margins at times because announced Class III/IV price still lags product prices. • FMMOs could be amended for Class I and II handlers to do the same. • Class I handlers may need to announce prices to retail outlets more frequent and they can learn how to manage greater margin risk.

45. Conclusions: • Current milk classification, pooling and pricing provisions of FMMOs are not allowing orders to fulfill the objectives as spelled out by the AMA of 1937. • Classified pricing and pooling provisions are interfering with allocation of raw milk and milk components to their highest use and hampering the use of modern technology in new dairy product development and new uses of milk components in dairy products and as ingredients in food and beverage products. • The potential growth in domestic and international markets for milk and milk components is hampered.

46. Recommendations: • Two classes of milk: Class I for beverage use and Class II for all manufacturing uses. • Continue to price the same milk components—butterfat, protein and other solids. • But, evaluate the appropriates of the product price formulas in reflecting minimum component values—and procedures for making amendments when changes occur. • Consider using CME rather than NASS prices for formulas and explore means of improving the appropriate price discovery. • Either advance price all classes or eliminate advance pricing of Class I and Class II skim milk.

47. In summary: • We need to move to a two class system (Class I and Class II) and a simplified rather than more complex component pricing. • But, much thinking and analysis is required to come up with the appropriate formula(s) to establish the minimum Class II price. • Market forces must be allowed to work so raw milk and milk components are allocated to the highest use. • When BFP was the base price and mover of Class I, product price formula for cheese and one for butter/nonfat dry milk were used to calculate the weighted average change in milk value for the month. A similar procedure could be used for the minimum value of one manufacturing class.