Record-High Farm Milk Prices Create Challenges for Understanding Input Costs

Numerous news stories this year have discussed the record-high prices in the dairy industry, from the farm to the consumer and both domestically and internationally. The U.S. Department of Agriculture (USDA) forecasts in its most recent Livestock, Dairy and Poultry Outlook that the average farm milk price in 2007 will exceed the previous record, set in 2004, by more than 19%.

The dairy industry this year has also experienced relative values for the primary components of milk that have never been seen before. This is due to the highly complex system the government uses to regulate the prices that processors must pay for farm milk.

Most farm milk bought by processors in the United States is regulated by the federal government under the Federal Milk Marketing Order system (FMMO). Nearly all the rest is regulated by various state milk price regulations. The FMMO sets the minimum prices that processors must pay for farm milk. Minimum prices are different based on what dairy products are made from that milk. There are four classes of milk use, each with a different minimum farm milk price. One common feature is that the primary components of farm milk — the milkfat portion and the rest of the milk, known as the skim fraction — are separately priced.

The FMMO minimum farm milk prices are based on the national wholesale price of four products: butter, nonfat dry milk, cheddar cheese and dry whey. The minimum price for the milkfat in farm milk, regardless of what dairy product is made from that farm milk, is based on the wholesale price of butter.

The skim fraction minimum price, however, is not the same for all dairy product uses. For farm milk made into most cheeses, the skim fraction minimum price is based on the wholesale prices of cheddar cheese and dry whey. For farm milk used to make nonfat dry milk and products like ice cream, yogurt, and cream products, the skim fraction has a minimum price based on the wholesale price of nonfat dry milk. Finally, the skim fraction's minimum price for milk used in fluid milk products like whole, reduced fat, lowfat and nonfat milks is based in some months on the wholesale price of nonfat dry milk, and in other months it's based on the wholesales prices of cheddar cheese and dry whey.

It is the relative wholesale prices for these dairy products that are so different this year, leading to never-before-seen regulated minimum price relationships between the milkfat and skim fractions. This has implications for all dairy processors, because the actual cost of farm milk at the minimum regulated milk prices to each processor depends on the relative composition of the finished dairy product in terms of milkfat and skim. Let's look at some examples.

About 30% of farm milk produced in the United States ends up as fluid milk products. Milk processors regulated by the FMMO must pay at least the minimum price for farm milk that is used to make a fluid product, known as Class I, like reduced-fat milk with 2% milkfat. USDA reports that the fluid milk product with the largest volume sales is reduced-fat milk.

Prior to this year, the skim fraction of that reduced-fat milk came with an FMMO minimum cost that represented, on average, 72% of the total cost, as seen in Chart 1. So far in 2007, that portion of the minimum price represented by the skim fraction has increased to 81%, and for September it was 83%. Not only is this true for farm milk, which actually ends up being sold to a customer, but the FMMO regulations even require that processors pay a minimum value on milk components lost in the processing plant.

According to USDA, farm milk has an average milkfat content of 3.67%. USDA also reports that the weighted average milkfat content of all fluid milk products sold under the FMMO is less than 2%. This means that most fluid milk processors have surplus milkfat. Many sell this surplus to ice cream, butter and other dairy product manufacturers in the form of bulk cream, which has 40% milkfat and 60% skim.

Under FMMO minimum price regulations, the fluid milk processor selling bulk cream to an ice cream manufacturer is still obligated to pay for the farm milk at the FMMO Class II minimum price. Chart 2 shows how the relative values of the milkfat and skim fractions in bulk cream used to make ice cream have changed this year relative to previous years.

Prior to 2007, the skim fraction value averaged about 7% of the total FMMO minimum price for 40% bulk cream used to make ice cream. So far this year, the skim fraction has averaged over 11%, and averaged nearly 15% in September. In this example, fluid milk processors must pay a minimum price for farm milk based on this higher government-mandated minimum price, an important consideration when negotiating a price at which to sell cream.

For cheese manufacturers, the FMMO minimum, or Class III, price for the skim fraction of farm milk used to make cheese has two components: one based on the price of cheddar cheese and another based on the price of dry whey. Prior to 2006, the portion of the Class III price that was attributed to dry whey never eclipsed 6%, as shown in Chart 3. This is because over that period the monthly average price of dry whey never exceeded $0.325 per pound. The 2007 average monthly dry whey price is more than double that previous record high, and through September it has been $0.6557, which has increased the portion represented in the Class III price to 15.5%. Prices have fallen back from a peak in April, but remain high enough that the portion of the September price is still 8.2%.

In the Livestock, Dairy and Poultry Outlook, USDA predicts that, while record high prices will abate somewhat during the next 12-15 months, the market will continue to experience higher than traditional prices for these component products. This means that these challenges affecting dairy product input costs are likely to continue.

Posted October 15, 2007