The dairy industry has been impacted by many factors during the COVID-19 pandemic, but perhaps the largest factor is the uncertainty in milk price. Its volatility over the last three months has been the most extreme in many years, which has prompted numerous milk price risk management discussions. Dairy farmers have more options at their disposal than ever before, but along with it comes the need to educate oneself about each program or product.
A key to risk management is understanding milk price basis, and one of the largest factors in basis is the Producer Price Differential (PPD) portion of your milk check. This article will explain this value for the Northeast milk order and how it will significantly impact your next few milk checks.
Milk Price Basics
All milk sold in a Federal Milk Marketing Order (FMMO) pool is measured every month, and the administrator reports how much milk was sold through four major channels:
- Class I: Fluid milk products
- Class II: Cream, cultured dairy products, ice cream, cottage cheese, ricotta cheese
- Class III: “Hard” Cheeses
- Class IV: Butter and dried milk powders
Prices are assigned to each class based on the value of the milk that went into each product, which is derived from the market prices of butter, non-fat dry milk, cheese and dry whey product. Under normal conditions the price will be highest for Class I and lowest for Class IV because Class I is priced based on the average of Class III and Class IV plus a national location differential. However, during times of volatility, this can be reversed because of timing differences of when the monthly Class III and IV prices are set and when the Class I price is established. While this is an over-simplification of the “pool,” the description will help provide a basis for the pool calculation discussion that follows.
If you take the total pool value divided by the total pounds of milk, the Federal Order system comes up with the Statistical Uniform Price (SUP), often referred to as the Blend Price. In effect, this results in the weighted average milk price of all four channels for milk at the “standard” component level of 3.5% fat and 2.99% protein.
PPD often appears on a milk check as ‘Producer Price Differential’ and sometimes includes a line for location adjustment. The location adjustment is a fixed reduction in price based on how far your milk market is from Boston. The net result of adding those two items together is technically your PPD, but for this next section we will focus on the PPD portion only.
The simplest way to describe PPD is that it is the calculated adjustment per hundred weight (cwt) to make sure every farmer in the federal milk order gets their “fair share” of the milk marketed in the region (the pool).
PPD is the difference between the value of the same pounds of components at Class III prices and the value assigned to the components by each channel the milk was sold through. To see this calculation for the Northeast order each month, visit FMMone.com and look for the Statistical Uniform Price report to see how your PPD was calculated each month.
As of the release of this article, June, July and August Class III prices are at or are expected to be at very high levels. One of the quirks of the system is that the Class I price is announced 35 to 40 days in advance of the other class prices. Example: Your milk check for June 2020 milk will be based on a Class I price announced on May 20 based on May 9 and May 16 product prices, and a Class III price announced on July 1 is based on the four days of June 6, 13, 20 and 27 product prices. Due to this time lag and other factors, the Class I milk will be priced lower than Class III for June. In addition, Class II and IV are also expected to be far lower than Class III. With approximately 75% of the milk in the FMMO 1 going through classes other than Class III, you may now understand why the PPD will be significantly negative in June to reflect what was sold through the milk order. In fact, we expect PPD to be historically low in June 2020 and it is expected to be lower than average for several months.
How your milk check calculates your share of the pool
The first step your milk handler takes in calculating your milk check’s share of the pool is to value your components at Class III prices per pound of fat, protein and other solids. If they left it at that, you would be receiving a pure “Class III” milk check! Instead, the Federal Order provides the PPD to correct the milk price from Class III to the pool average. Your milk handler applies the PPD including location adjustment to correct your milk price after giving you credit for your components under the Class III price per pound. In addition to your component differences, your milk handler applies quality and other premiums to your milk check, and these can contribute to the differences between your milk price and the average pool price.
Some other Federal Milk Marketing Orders that process predominantly Class III milk have a lower PPD value and lower volatility. In the Northeast, PPD has generally allowed dairy farmers to enjoy a better price than our Midwest or Western counterparts due to better fluid milk sales. However, as different dairy products become more popular and fluid sales fall, PPD has also decreased. Perhaps most disheartening is to see an excellent price for Class III and not have the immediate effect on your milk check.
Because of the Class I to Class III time lag noted above, the PPD calculation tends to “reward” you with a positive PPD during the decline of Class III and “punish” you during a recovery. This quirk in the FMMO calculations also makes milk price risk management more difficult for us in the Northeast since Class III is the most widely exchange traded of the two classes of milk that are the foundation of most dairy risk management alternatives (the other being Class IV). For now, I think we should take heart in the prospect of improving milk markets despite the reality of federal order pricing that can delay a significant improvement to cash flow.
If you would like more assistance in understanding your milk price relative to cost of production or break-even milk price, please contact your branch manager to see if now is the right time to add Farm Credit East’s business consulting service as a competitive advantage for your business.