The Class IV milk price has been above Class III since November and the spread keeps getting wider. On top of that, the CME futures market is pointing toward the Class IV price staying above Class III at least through the end of 2019. There is a common industry perception that Class III should be above IV most of the time. For those who aren’t familiar with the Federal Milk Marketing Orders, the Class III milk price is the minimum price of milk that cheese plants are supposed to pay dairy farmers while the Class IV price is the minimum price that butter/nonfat dry milk plants are supposed to pay. The designation of “Class III” or “Class IV” milk applies only to the price and use of the milk; there is no difference in the quality or attributes of the physical milk going into these plants. So why do people think Class III (cheese milk) should usually be higher than Class IV (butter/powder milk)?
I would argue that if the Class III and Class IV price formulas accurately reflect the yields and costs of producing the different dairy products, and if there is sufficient excess processing capacity, and there is a competitive market for liquid milk, then Class III and IV prices should average very close to each other over time. If one price was consistent above the other, farmers (co-ops) would direct all surplus milk to the higher return products, which would quickly bring the prices back into alignment. But those conditions don’t match the real world and there is enough friction in the system that the prices do deviate from each other.
Class III has been above Class IV more often than not
Theoretically, we should be able to look at cheese and butter production data to determine if processors / co-ops are shifting milk from one class to the other to take advantage of the relative prices. I’m often asked to produce a graph showing this shift. I’ve tried to do it numerous times in the past by crunching the numbers in different ways, but I’ve always had a hard time showing that this shift happens. I tried to crunch the numbers again this month and the resulting graph may be the best I’ve ever been able to produce showing a shift does happen, at least sometimes.
What does it mean moving forward? The spread was inverted November through February and it looks very likely that it will be in March as well. That is 5 months in a row, which is just about long enough to start to cause a shift if one is going to happen. But with milk production growth running weak, it’s also possible we could we might get into a situation like 2013 where there isn’t enough surplus milk available to shift around. So, we might not see much supply side adjustment that would bring Class IV below III for at least a few more months, and if the futures are right, it might not even happen during 2019.
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Nate Donnay is the Director of Dairy Market Insight at INTL FCStone Financial Inc. and has been applying his interest in large complicated systems and statistical analysis to the international and U.S. dairy markets since 2005. As a consultant, he has worked with clients at all levels of the dairy marketing chain from the farm level up to processors and packaged foods companies, food distributors and restaurants as well as connected industries like banks, private equity groups, government agencies, and industry associations. Through ongoing reports or one-off client specific projects, he helps them understand the short and long-term trends and the underlying relationships driving the market and what that means to their businesses.