1. Producer Price Differentials: The Good, The Bad and The Ugly Brian W. Gould Department of Agricultural and Applied Economics and Wisconsin Center for Dairy Research University of Wisconsin-Madison Wisconsin Dairy Field Representatives Conference February 9, 2005

2. Outline of Presentation Review Aspects of Federal Orders and Classified Milk Pricing Review Aspects of Federal Orders and Classified Milk Pricing – Most should be familiar with this material Definition of Producer Price Differentials (PPD) Definition of Producer Price Differentials (PPD) – Exists due to Classified Pricing/Pooling Overview of Recent PPD Experiences in UMW Overview of Recent PPD Experiences in UMW – Reasons for recent negative PPD’s Implications for the Future Implications for the Future

3. Federal Milk Marketing Orders April 2004 - Present MCP Markets

4. Federal Milk Marketing Orders Regulate Handlers not producers Regulate Handlers not producers Objectives of the program: Objectives of the program: – Assure dairy farmers reasonable minimum milk prices – Assure consumers an adequate milk supply – Guarantee orderly marketing of fluid milk Achieves purposes via the use of: Achieves purposes via the use of: – Classified pricing – Pooling where all producers share in the pool

5. Classes of Milk Class I: beverage milk Class I: beverage milk Class II: fluid cream, cottage cheese, ice cream and mixes, yogurt, infant formula, sour cream, etc. Class II: fluid cream, cottage cheese, ice cream and mixes, yogurt, infant formula, sour cream, etc. Class III: hard cheese, cream cheese Class III: hard cheese, cream cheese Class IV: butter, dried milk products (SMP), evaporated and Class IV: butter, dried milk products (SMP), evaporated and condensed milk

6. How Are Class Prices Determined? Based on commodity prices which are used in formulas to determine component values Based on commodity prices which are used in formulas to determine component values NASS surveys butter, cheese, dry whey and NFDM plants each Friday for sales data NASS surveys butter, cheese, dry whey and NFDM plants each Friday for sales data – Prices and weekly sales are reported the next Friday

7. How Are Class Prices Determined? Class I skim milk, Class I butterfat and Class II skim milk formula prices are advanced prices Class I skim milk, Class I butterfat and Class II skim milk formula prices are advanced prices – Reported on a Friday on or before the 23 rd of the month prior to production month – For example, Feb. 2005 Class I price Announced on Friday Jan. 21 st Announced on Friday Jan. 21 st Based on NASS survey prices for weeks beginning Based on NASS survey prices for weeks beginning Jan. 2 nd and Jan. 9 th. Jan. 2 nd and Jan. 9 th.

8. How Are Class Prices Determined? Class II BF price, Class IV and Class III skim and BF prices are announced on a Friday on or before the 5 th of the month following production Class II BF price, Class IV and Class III skim and BF prices are announced on a Friday on or before the 5 th of the month following production – Prices for Feb 2005 will be announced on Friday, Mar 4 th – NASS Survey Prices for weeks beginning Jan 27 th, Feb 6 th, Feb 13 th and Feb 20 th There is a 6 or 7 week difference in timing of prices used in advanced pricing of Class I and the remaining Class prices for the same month There is a 6 or 7 week difference in timing of prices used in advanced pricing of Class I and the remaining Class prices for the same month

9. How Are Class Prices Determined? Minimum class prices are calculated using Minimum class prices are calculated using – NASS weekly survey prices – Assumed make allowances (plant costs) for cheese, butter, dry whey, NFDM – Assumed cwt yields of cheese, butter, dry whey and NFDM – Assumed raw milk composition 3.5% butterfat 3.5% butterfat 2.99% true protein 2.99% true protein 5.69% other solids 5.69% other solids Class I and Class II prices typically higher than Class III and Class IV prices Class I and Class II prices typically higher than Class III and Class IV prices

10. Class III milk price= 3.5*Class III/IV butterfat value + 0.965 Class III skim milk price Class III milk price= 3.5*Class III/IV butterfat value + 0.965 Class III skim milk price – Butterfat value=f(butter price) – Class III skim milk price=f(protein value, other solids value) Protein value=f(cheese and butter price) Protein value=f(cheese and butter price) Other solids price=f(dry whey price) Other solids price=f(dry whey price) How Are Class Prices Determined?

11. Class IV Price= 3.5* Class III/IV butterfat value + 0.965*Class IV skim milk price Class IV Price= 3.5* Class III/IV butterfat value + 0.965*Class IV skim milk price – Butterfat value=f(butter price) – Class IV Skim Milk Price=f(NFDM price) Class II Price=3.5 *Butterfat price+0.965 advanced Class II skim milk price Class II Price=3.5 *Butterfat price+0.965 advanced Class II skim milk price – Butterfat value=Class IV butterfat price + $0.007 – Advanced Class II skim milk price=advanced Class IV skim milk price+$0.70 How Are Class Prices Determined?

12. Class I Advance (higher of ) Pricing Class I Advance (higher of ) Pricing – Class I skim milk value is the higher of advanced Class III or Class IV skim milk price – Class I mover= (0.965 x Class I skim milk value) + 3.5 x advanced Class III/IV butterfat value Class I price = Class I mover plus a differential Class I price = Class I mover plus a differential – County specific Class I differential is added to Class I mover to determine min. Class I price – For Chicago area, differential is $1.80 How Are Class Prices Determined?

13. Uniform Price (Simplified Definition): Weighted average price calculated as sum across all classes of (min. class price) x (% of milk in class) Uniform Price (Simplified Definition): Weighted average price calculated as sum across all classes of (min. class price) x (% of milk in class) – % referred to as utilization Actual uniform price more complicated but weighted value relatively close Actual uniform price more complicated but weighted value relatively close With market-wide pooling all handlers share in pool and pay producers same min. uniform price (ignoring differences in milk composition, quality and plant location) With market-wide pooling all handlers share in pool and pay producers same min. uniform price (ignoring differences in milk composition, quality and plant location) Federal Order Uniform Prices

14. Concept of Pooling Pool Handlers Producers Handlers with milk value higher than uniform price pay into the pool Handlers with milk value lower than uniform price draw from the pool Handlers pay producers the same price regardless of how milk is used

15. Producers in 6 MCP orders (including the UMW) do not receive uniform price directlyProducers in 6 MCP orders (including the UMW) do not receive uniform price directly –Federal order payment based on value of butterfat, protein, other solids, a SCC adjustment and producer price differential (PPD). PPD accounts for difference between Class I, II, and IV prices and Class III pricePPD accounts for difference between Class I, II, and IV prices and Class III price –Except for some minor adjustments: PPD approx. = uniform price - Class III price Producer Price Differential

16. Producers are paid via the following: Producers are paid via the following: Producer Payment = Butterfat Lbs/Cwt x Class III Butterfat Value Butterfat Lbs/Cwt x Class III Butterfat Value + Protein Lbs/Cwt Class III Protein Value + Other Solids Lbs/Cwt x Class III Other Solids Value + PPD + SCC adjustment

17. Producer Price Differential Class III price reflects total value of protein, butterfat and other solids in producer’s total cwt of marketed milkClass III price reflects total value of protein, butterfat and other solids in producer’s total cwt of marketed milk PPD is the added value per cwt of that portion of an Order’s milk used for Class I, II and IV.PPD is the added value per cwt of that portion of an Order’s milk used for Class I, II and IV. In approximate terms, for each 6 MCP orders :In approximate terms, for each 6 MCP orders : PPD = % Class I x (Class I price – Class III price) + % Class II x (Class II price – Class III price) + % Class II x (Class II price – Class III price) + % Class IV x (Class IV price – Class III price) + % Class IV x (Class IV price – Class III price)

18. Producer Price Differential What has been recent experience of uniform prices and the PPD in the Upper Midwest (UMW) Order?What has been recent experience of uniform prices and the PPD in the Upper Midwest (UMW) Order?

20. = Neg. PPD month

21. April 2004 PPD Milk Class Pricing Time Period Announced Date Price Class Price – Class III Class I 2/29 - 3/13 3/19/04$15.44-$4.22 Class II SkimFat2/29-3/133/28-4/244/30/04$15.21-$4.45 Class III 3/28-4/244/30/04$19.66----- Class IV 3/28-4/244/30/04$14.57-$5.09 Note: The Class I price is the Class I mover plus the differential for Cook County, IL

22. April 2004 PPD Negative $4.11 Upper Midwest PPD Negative $4.11 Upper Midwest PPD Over the Mar. 19-Apr 30 period there was a significant increase in cheese price Over the Mar. 19-Apr 30 period there was a significant increase in cheese price – Two-week avg. cheese price for advanced Class I calc.: $1.4582/lb – Monthly avg. cheese price for Class III calc.: $2.0520/lb, $0.5938 higher than advance value

23. April 2004 PPD Class Price Factor AdvancedAnnounced % Change Class III Skim Milk ($/cwt) $5.64$11.30100.4 Class IV Skim Milk ($/cwt) $5.96$6.031.2 Butterfat Price ($/lb) $2.2525$2.501311.0 Average Product Price Butter ($/lb) $1.99212.199410.4 NFDM ($/lb) $0.80900.81711.0 Cheese ($/lb) $1.45822.052040.7 Dry Whey ($/lb) $0.17060.260252.5

24. Why The Negative April 2004 PPD? Steep run-up in cheese prices between advance and Class III announcement periods Steep run-up in cheese prices between advance and Class III announcement periods – Created an inverse relationship between normally higher Class I and Class III price Price inversion occurs if: Price inversion occurs if: – The monthly Class III price is higher than the Class I Mover by more than the Class I differential

25. Why The Negative April 2004 PPD? Besides difference in Class III and Class I, April Class II and IV prices were well below Class III Besides difference in Class III and Class I, April Class II and IV prices were well below Class III – Value of milk used for butter and NFDM well below milk value used for cheese – Substantially reduced value of components for Class II and IV milk

26. Why The Negative April 2004 PPD? Changes in class utilization due to depooling added to size of negative PPD Changes in class utilization due to depooling added to size of negative PPD Manufacturing plants can depool from an order prior to release of monthly classified prices Manufacturing plants can depool from an order prior to release of monthly classified prices Bottling plants are not allowed to depool Bottling plants are not allowed to depool To understand why a plant depools or not: To understand why a plant depools or not: – Relationship among class prices and timing of Federal Order price announcements – Obligation of pooled handlers to producer settlement fund Lets compare April 2003 and April 2004 Lets compare April 2003 and April 2004

27. ClassPriceUtilizationValue % Mil lb. Class I $11.4418.2 338.1 338.1$2.08 Class II $10.442.8 52.8 52.8$0.29 Class III $9.4176.81,430.9$7.73 Class IV $9.732.241.0$0.21 Weighted Average Pool Value $9.81 Actual Uniform Price $9.87 PPD= $0.46 April 2003 Upper Midwest Order Why The Negative April 2004 PPD?

28. Class III and IV plants have economic incentive to pool Class III and IV plants have economic incentive to pool Class I handler pays into pool $1.63: $11.44 - $9.87 Class I handler pays into pool $1.63: $11.44 - $9.87 Class II handler pays into pool $0.63: $10.44 - $9.87 Class II handler pays into pool $0.63: $10.44 - $9.87 Class III handler draws out of pool $0.46: $9.87 - $9.41 Class III handler draws out of pool $0.46: $9.87 - $9.41 Class IV handler draws out of pool $0.14: $9.87 - $9.73 Class IV handler draws out of pool $0.14: $9.87 - $9.73 Class I price Uniform price Class II price Uniform price Class III price Uniform price Class IV price Why The Negative April 2004 PPD?

29. ClassPrice($/cwt)UtilizationValue($/cwt) % Mil lb. Class I $15.4462.8381.8$9.70 Class II $15.2115.896.3$2.40 Class III $19.661.811.0$0.35 Class IV $14.5719.6119.0$2.86 Weighted Average Pool Value $15.31 Actual Uniform Price $15.55 PPD = -$4.11 April 2004 Upper Midwest Order Why The Negative April 2004 PPD?

30. Class III plants have economic incentive to depool as they would have to pay into the pool Class III plants have economic incentive to depool as they would have to pay into the pool – 1.4 Bil. lbs. Class III milk in April 2003, 11.0 Mil. in 2004 – Class III milk pays into pool $4.11 ($19.66-$15.55) Class I handlers have no choice but to pool Class I handlers have no choice but to pool – Draw from the pool $0.11 ($15.55-15.44) Class II and Class IV handlers have incentive to pool because they draw out of the pool. Class II and Class IV handlers have incentive to pool because they draw out of the pool. – Class II milk draw out of the pool, $0.34, Class IV milk subject to a draw of $0.98 Why The Negative April 2004 PPD?

31. Class2004Price($/cwt) 2003 Utilization (%) Simulated Value ($/cwt) Class I $15.4418.2 $2.81 $2.81 Class II $15.212.8 $0.43 $0.43 Class III $19.6676.8$15.10 Class IV $14.572.2 $0.32 $0.32 Simulated Average Pool Value $18.66 Actual Weighted Avg. Pool Value $15.31 → If had more typical pooling patterns in April 2004, the PPD would have been close to -$1.00 vs. -$4.11 the PPD would have been close to -$1.00 vs. -$4.11 Why The Negative April 2004 PPD?

32. Dec 2004 Pooling and Class Prices Class Price Factor AdvancedAnnounced % Change Class III Skim Milk ($/cwt) $8.12$9.3415.0 Class IV Skim Milk ($/cwt) $6.37$6.52 2.4 2.4 Butterfat Price ($/lb) $1.8834$2.0366 8.1 8.1 Average Product Price Butter ($/lb) $1.68451.8122 7.6 7.6 NFDM ($/lb) $0.85530.8713 1.8 1.8 Cheese ($/lb) $1.54811.714610.8 Dry Whey ($/lb) $0.23380.2423 4.1 4.1 PPD = -$0.95

33. Class Dec 2004 Price($/cwt) Dec 2004 Util. (%) Dec 2003 Util. (%) 2004 Value ($/cwt) 2003 Simulated Value ($/cwt) Class I $16.2359.318.1 $9.62 $9.62 $2.94 $2.94 Class II $13.9815.2 5.2 5.2 $2.12 $2.12 $0.73 $0.73 Class III $16.14 5.3 5.368.5 $0.80 $0.80$11.06 Class IV $13.42 20.2 20.2 8.2 8.2 $2.71 $2.71 $1.10 $1.10 Simulated Average Pool Value $15.25$15.83 Uniform Price $15.19----- → If more typical pooling patterns in Dec 2004, PPD would have been close to -$.35 vs. -$0.95 PPD would have been close to -$.35 vs. -$0.95 Dec 2004 Pooling and Class Prices

34. 2003 % Class Utilization PPD 2004 % Class Utilization PPD IIIIIIIVIIIIIIIV Jan19.72.376.02.00.58Jan17.85.568.97.80.37 Feb18.52.474.24.90.47Feb18.34.374.43.00.47 Mar17.52.777.32.50.54Mar58.711.212.317.80.21 Apr18.22.876.82.20.46Apr62.815.81.819.6(4.11) May17.92.577.91.70.40May 53.217.54.624.7(1.97) Jun15.62.777.44.30.38Jun 15.96.369.88.10.30 Jul49.715.911.622.8(0.41)Jul 16.15.870.87.30.72 Aug50.618.48.422.6(1.58)Aug 18.06.668.27.30.22 Sep54.017.65.722.7(1.07)Sep 29.18.951.910.10.13 Oct55.217.04.823.0(0.88)Oct 18.95.768.66.70.31 Nov35.611.036.217.2(0.07)Nov 40.611.735.712.0 0.13 Dec18.15.268.58.20.54Dec 59.315.2 5.3 5.320.2 (0.95) UMW Utilization Patterns: 2003-2004

35. Summary Why the negative PPD’s? Why the negative PPD’s? – Advanced pricing system for Class I milk 6-7 week delay until Class III price set 6-7 week delay until Class III price set – Easy for Class III plants to depool one month and pool the next What does it mean for 2005? What does it mean for 2005? – What is happening in the cheese markets? – Any changes in pooling policy?

36. Summary If you want more detail If you want more detail – access the publications section of the University of Wisconsin Dairy Marketing Website www.aae.wisc.edu/future www.aae.wisc.edu/future – Feel free to contact me anytime: gould@aae.wisc.edu gould@aae.wisc.edu

37. Thank You!!