Breaking down negative PPDs, depooling, transparency

From Edge Dairy Farmer Cooperative

With the intense focus on the Federal Milk Marketing Orders and producer price differentials during the past year, Edge connected with Dr. Marin Bozic, one of the nation’s top dairy economists, who dove into the issue of negative PPDs, the mechanics and impact of depooling, and calls for new pricing formulas. Bozic is an assistant professor at the University of Minnesota.

Q: Why do we need FMMOs, and what is their usefulness today?

A: Federal Orders have traditionally been thought of as collective bargaining tool that would even the playing field between dairy producers and privately owned dairy processors, particularly beverage milk bottlers. Those same reasons are still valid. If it weren’t for minimum price regulations, one could easily imagine large retail chains exercising their enormous market power to reduce the price they pay for fluid milk. Beyond that, Federal Milk Marketing Orders can contribute to transparency in milk markets, and set meaningful benchmark milk and commodity prices that are useful for risk management.

Q: Can you explain the negative PPD issue?

A: In orders where most milk is used for manufactured dairy products, we promise to pay producers based on the value of their butterfat and skim solids. We derive the value of skim solids from cheese and dry whey. That’s called component value of milk. When all money in the pool is allocated based on components, we either have some money left over or realize that we have promised more than we have in the bucket. If we have money left over, that’s positive PPD. When we have promised to pay for components more than we have in the pool, that’s manifested as negative PPD.

Q: What can cause component value of milk to be higher than total pooled revenue?

A: Three factors tend to dominate. First, and not the one that usually comes to mind, is that skim solids are paid for based on their value in cheese and whey, but only a fraction of skim solids are actually used in cheese and whey. They are also used in nonfat dry milk powder, in yogurts and fluid milk. When we have a positive spread between market value of skim solids in skim milk powder and in cheese/whey, then we pay for components beyond the value they create in the market, and must dip into PPD dollars to do that. That’s why PPDs are lower when the spread between Class III and Class IV milk prices are larger. 2020 proved that point in the extreme.

The second factor relates to Class I dollars flowing to the pool. Before 2019, value of skim solids in Class I was almost always at least as high as the value of skim solids in cheese; and most of the time it was much higher. This is due to the higher-of pricing we had until 2019. With the switch to average-of pricing, due to depressed prices for skim solids in powders, Class I dollars flowing to the pool are not as generous, and that is making it more difficult to meet the obligations for component value of milk.

The third factor is, of course, depooling. I want to be careful how I say this, because depooling does not make the dollars vanish into thin air; processors who depooled in 2020 are precisely those who are able to pay the top dollar for protein and other solids, because they sell cheese. But once they depool, they depress the PPD for everyone who remains in the pool; and they are also not obliged by any federal regulation to pay a fair price to producers. At that point it’s between them and the producer, and how they contracted for milk.

Q: Where does the money from the negative PPDs go?

Cheese processors who have depooled have the ability to pay their producers at least “zero PPD,” i.e. full Federal Order value of protein, butterfat and other solids, the component value of milk. Some processors chose to pay the full Class III price, and others did not, or perhaps were not able to due to COVID-19 impact on costs or demand for cheese. But it is important to emphasize that even if all processors pooled that would normally pool, PPD would still be negative. And in such a scenario, PPD is the measure of value not created – we have to pay producers for component value of milk beyond what those components have delivered on the market. That creates a deficit. Unlike central U.S. Treasury, FMMOs cannot carry a deficit from month to month; so negative PPD is a deduction on milk check needed to reflect the fact that milk components just are not as valuable as protein and other component prices would suggest.

Q: How or to what extent did COVID-19 and the related government food purchasing programs impact PPDs?

A: Food box programs led to record high spread between Class III and Class IV milk prices. That, more than anything else, caused negative PPDs in 2020. When spread between III and IV is large, what that means is that value of protein is much higher when that protein is used in a cheese vat, than in a milk dryer plant. So in Federal Orders where we have a substantial share of skim solids used in Class IV (powders), Class II (yogurts) or Class I (which is 50 percent based on Class IV value of skim solids since 2019), poolwide value of skim solids was much lower than the value of skim solids used for cheese and whey. Processors had to pay to the pool much less than what the pool obligations to producers were for components, particularly for protein. That deficit was manifested as negative PPDs.

Q: What is depooling and how does it affect prices?

A: Under the Federal Orders, only class I handlers must pool. Nobody else is forced to pool, and it would be considered illegal, maybe even unconstitutional to force them to pool. So why do other processors pool? Because they are better off, usually, than if they stay out of the pool. In return for providing balancing capacity to Class I plants, they get to participate in sharing revenue from Class I sales, and they are thus able to pay their patrons a higher milk check. This worked well in the past because historically most of the milk in Federal Orders was milk for fluid consumption. But over decades the share of pooled milk used for fluid products has dropped, and that decline is making depooling more and more rational.

When processors depool some percent of their milk, they are not allowed to come back fully into the pool next month if PPD is positive. Instead, they can only come back gradually. That’s why processors do not tend to depool 100 percent even when PPD is very strongly negative. When processors depool, they do not have obligations to the pool nor can they draw money from the pool. They are essentially unregulated, and what they pay dairy farmers depends on the nature of the contract between them and the farmer.

Q: What are the prospects for negative PPDs in 2021?

A: I follow weekly forecasts from several FMMO economists. They don’t typically share these publicly, but they are very kind to allow me to receive those updates. They see negative PPDs for the rest of 2021. As of March 11, the average spread between Class III and Class IV futures for the rest of 2021 is about $2.00/cwt. If you look at the average spread between III and IV over five years prior to the pandemic, it was 92 cents. Whether the worst is behind us will depend on what happens to cheese prices over the next few months. On one side we have a very promising demand situation – more food box purchases by USDA and reopening of the economy as more folks get vaccinated. On the other side, as a few new cheese plant expansions get completed, we may have more cheese than market for it, so that may be the dominating effect. It’s hard to know at this point which force will dominate. On the powders side, we are seeing strong demand overseas. PPDs will be driven by the relative value of skim solids in cheese vs. powders.

Q: Some national groups are working on new pricing formulas. Have you seen any promising proposals?

A: It is encouraging to see various groups calling for an inclusive, open process toward finding a better policy framework. I think there are what we can call “maintenance issues” that need to be resolved soon, and then also long-term “strategic reform issues.” Maintenance issues deal primarily with Class I pricing rules and make allowances. Strategic reform issues are much less defined and can range from how many classes of milk should we have, to how revenue should be pooled, etc.

I would personally like to see more emphasis on milk check transparency, whether it’s through FMMOs or otherwise. It is really frustrating to talk to dairy producers and realize that they feel they don’t understand what is driving their milk check and if their cooperative or privately owned processor is treating them fairly or not. The glue that was holding the Federal Orders together all these decades were fluid milk sales and Class I dollars. Fluid milk sales are declining, and what we are seeing now is the system coming unglued. We can play with the rules until the cows come home, but there just aren’t enough Class I dollars in the system anymore.

The pandemic and these extraordinarily large spreads between Class III and IV milk prices only fast-forwarded us to a situation that would happen anyway sometime later in this decade. We will have to substantially redefine the “social contract” in dairy, and it will have to be based on transparency between processors and producers; between cooperatives and their members. Negative PPDs cannot be this cesspool that aggregates depooling loopholes, subsidization of high component dairy herds, long overdue reforms in make allowances, politically motivated interventions in cheese markets, and excuses for not paying producers their fair share. Producers should be able to look at their milk check and understand immediately how the value they received for their milk relates to the value that milk created for the processor, whether it’s a private processor or a cooperative.

Q: Understandably, producers and processors want to raise the issue at the highest level. Hosting an FMMO hearing through USDA has been floated. What would happen at a hearing? 

A: At an FMMO hearing, we could have the following two scenarios. First, the industry comes united, or nearly united, and presents to the USDA what they believe is the best solution for burning issues. USDA will likely go along with that solution. Alternatively, the industry may come to the hearing with many different voices, advocating for different solutions. USDA does not like to be seen as picking winners and losers, so in that scenario it is more likely that the status quo would prevail, i.e. USDA may not propose any changes.

Q: What is the risk and reward of an FMMO hearing?

A: When USDA puts its reform proposal to a referendum, the alternative to passing the referendum is not the status quo. A failed referendum leads to a dissolution of Federal Orders. The risk in any FMMO hearing is that the referendum would fail and that the order would dissolve. Folks more senior than me tell me that the Upper Midwest order came very close to being dissolved about 15 years ago when a major dairy cooperative, dissatisfied with the proposed change, came close to voting no on the proposed change. In a broader sense, inclusiveness is always a messy business. Consensus building is an exhausting endeavor.

Q: Why do we have a complex formula to determine milk price – why not a set price like corn or beans? Do we need to go beyond just the formulas?

A: Complex formulas would exist even if we did not have FMMOs. In unregulated areas, such as Idaho or South Dakota, or some private cheese processors in California that do not pool – they have all developed their own milk price formula that is tied to a price of the product they are selling, and the yield, that is how much product they can make per hundredweight of milk. We see similar patterns overseas. The formulas may be more or less complex, but what needs to be seen as simple is a social contract between the dairy farmers and processing community. That social contract, in my opinion, should have five elements:

1. Price of milk and milk solids paid to producers should reflect the value of commodity dairy products made with that milk. That relationship should be understandable, and without byzantine and arcane elements that breed mistrust.
2. Producers should be able to hedge price risk with low basis risk.
3. Processors should keep all the risk, and therefore get all the upside for differentiated dairy products, such as specialty cheese or branded yogurts or, for example, customized fluid milk products.
4. If producers want to participate in the upside from differentiated dairy products, they can do so either by directing their cooperative to play in those markets or by joining forces with a few other producers and starting their own dairy processing company.
5. Processors and producers should work together to win new markets and serve new customers, and the role of the government is to ensure fairness and promote intense competition at all levels – competition for foreign and domestic consumers, and just as important, competition among processors for raw milk.