Whether it is the newest version of the iPhone, a slight tweak to an existing medication just to extend the patent, or the newest version of the Teddy Ruxpin doll, sometimes minor improvements in products get marketed as a big leap forward. The 2018 Farm Bill changed the way the price of milk going into bottles (Class I) is priced. The change in the pricing formula was designed to result in roughly the same overall price level for Class I milk, but it reduces the basis risk around hedging the price. Some have played this up as a big improvement, and it is an improvement, but it may not make much of an impact on how the industry does business.
One of the original reasons the Federal Milk Marketing Orders (FMMO) were created was to make sure cities had a safe and consistent supply of bottled milk. To make sure that bottling plants had access to the milk they needed, the system was designed so that the Class I milk price would be the highest price in the market. Farmers and Co-operatives would naturally want to sell to the Class I plants first to capture that higher price and that would (hopefully) keep a safe and consistent supply of bottled milk available to consumers. So how do you make sure the Class I price is the highest?
- Class IV Price = f(butter price, nonfat dry milk price)
- Class III Price = f(cheese price, dry whey price)
- Class II Price = Class IV + $0.70
- Class I Price (old) = f(Higher of Class III or Class IV)
- Class I Price (new) = f(Average(Class III, Class IV) + $0.74)
To make sure that Class I would provide the highest price, the Class I formula used the “higher of” Class III or Class IV to set the price for Class I milk. Smart, right? Well, when the system was setup price risk management was not widely used in dairy. But for the past 15 years we’ve had active milk futures trading at the CME for Class III and Class IV milk and the dairy industry has increasingly been moving toward more use of risk management tools. Most of the time the Class III price is above Class IV, so Class III would set the price for Class I. If you were a milk bottling plant and you wanted to lock in your milk procurement cost you could buy Class III milk futures as a hedge. However, if butter or nonfat dry milk prices rallied and Class IV went above Class III, then Class IV would end up setting the Class I price and the effectiveness of your hedge would suffer.
In the 2018 farm bill, the Class I formula was changed to address this problem. The Class I price formula was changed to incorporate the average of the Class III and Class IV prices instead of the “higher of” the two. Historically, the average of the two had averaged 74 cents below the previous Class I price, so to keep things fair and keep Class I priced at a premium to III and IV, an additional 74 cents is added to the average Class III/Class IV prices in the new formula. This shift from “higher of” to “average of” has been touted as a big step forward that finally makes Class I milk hedgeable.
I would argue that it is a small improvement in the hedgeability of Class I that won’t change market activity much. Hedging Class I milk against either Class III or Class IV alone always exposed the hedger to the “higher of” problem and it has always been the least effective way to hedge Class I exposure. Even before the “average of” change went into place I was advising clients to spread their futures volume over Class III and Class IV contracts. This would reduce the basis risk from 6.6-8.3 cents down to 4 cents per gallon. That means that 66% of the time, the price you ended up paying for the milk (after netting the cash price against the profit or loss from the futures) would be +/- 4 cents from the price you thought you were locking in. The change to the “average of” formula brings that basis risk down to 1.8 cents. Undoubtedly that is an improvement in hedgeability, but is there anyone in the industry who is going to start hedging Class I milk now that the basis risk is closer to 2 cents/gallon instead of 4 cents?
The new Class I milk price formula does reduce the basis risk around hedging Class I milk compared to the old formula. If reducing the volatility of your input prices or locking up a fixed margin between input costs and selling price for Class I is something that will benefit your company, we would love to help you do that! There still seems to be reluctance on the part of bottlers and retailers to hedge Class I milk despite the change in the pricing formula. There are ways to protect against milk prices going higher, while still leaving the downside open to keep shelf prices competitive that might work well for retailers. But so far, the interest has been tepid.
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Nate Donnay provides a quarterly column for DairyBusiness.com He 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.