Class III and Class IV Milk Prices in Federal Orders: What’s Up?

Nate Donnay INTL FCStone

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

In the past 19 years, Class III has been above Class IV 59% of the time. The past 10 years have been similar with Class III above 58% of the time. But in the past five years Class III has been higher nearly 72% of the time. One explanation might be that co-ops own most of the butter/NFDM capacity in the country. If they can’t sell the raw milk to a commercial processor, then the co-op has to run it through their own plants. We’ve generally had a surplus of milk in recent years, which is likely leaving extra milk for the co-ops to process and that has kept Class IV low relative to Class III. But US dairy prices are highly correlated to the world market, so I have a hard time arguing this theory too strongly.

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.

In the graph, if you look at 2007 and 2010/11 when Class IV prices were above III (shaded grey), the share of milk solids going into Class III fell while the share going to Class IV increased as you would expect, but it looks like it took at least a couple months of the inverted spread to make the shift happen. That pattern fell apart in 2013/14. Class IV went above III but the share of milk solids going to Class III continued to increase. Milk production growth was weak during 2013, so it might have been a case where cheese plants had forward sales in place or contracts to buy fixed quantities of milk, so Class IV production fell because there just wasn’t much left-over milk after the cheese plants got what they needed. Since 2014, cheese has been taking a larger share of the milk and the short periods of inverted spread haven’t been enough to really change the allocation between III and IV.

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 INTL FCStone

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.

 

1 Comment

  1. FMMO minimum prices? The minimum prices plants are supposed to pay? Welcome to the real world of that last 8+ years. Most milk goes through Co-ops and they definately do not pay FMMO minimums on PPD, they pay whatever they want with what’s left over after they pay themselves handsomely and do all their pet projects. Proprietary plants don’t all pay FMMO mins either. There are loop holes. If they do not pool all their milk (and they don’t have to) they pay FMMO min on what they pool, whatever they want on the rest. How about report on that?

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