The ins and outs of producer price differentials

Edge asked Mark Stephenson, director of dairy policy analysis at the University of Wisconsin-Madison, to explain producer price differentials (PPDs) and the negative values that farmers have been seeing on their milk checks.

Q: What causes negative PPDs?

A: It is important to know the basic reason that we get negative PPDs in the first place. We collect money into a Federal Order pool by charging dairy plants different amounts depending on the products that were made from the milk. We have four classes of milk: Class I for fluid dairy products, Class II for “soft” dairy products, Class III for hard cheeses and Class IV for butter and milk powders.

Generally, these prices descend in value from Class I as the highest value. It is important to understand that the ranking of value is a historic observation and that occasionally the values are different. All of the class values are “pooled” and the weighted average value of the pool is what is called the “statistical uniform” price or sometimes called the blend.

The blend price gets paid out to producers on the basis of component values — butterfat, protein and other solids — which are calculated from the Class III price formulas. There is usually a bit of money left over in a pool after the component values are paid. This money is distributed by dividing up the remainder by the hundredweights of milk in the pool and it is called the producer price differential or PPDs.

PPDs are usually a positive value, but if the calculated value of the components in the pool is greater than the total pool, the PPD is negative. Look at any market administrator’s monthly bulletin and you will see that the PPD is exactly equal to the uniform price minus the Class III price.

The cause of any negative PPD is that the Class III price is greater than the average value of the blend price. Historically, this has most often happened when prices are rapidly rising and the advanced price of Class I becomes lower than the Class III manufacturing price. The Class I price used to be determined as the “higher of Class III or Class IV” plus the local Class I differential. The 2019 farm bill changed the “higher of” to be the “average of Class III or Class IV plus 74¢.” This was primarily done to make hedging easier and the basis more predictable. But it has had other consequences as well. When there is a big spread between Class III and Class IV, the Class I contribution to the pool (the average of CIII and CIV + 74¢ + the Class I differential) can become less than the Class III value.

Q: What caused the return of negative PPDs and when will it end?

A: In the table, I have collected class price values and estimate the uniform price based on class utilization and other factors. You can see the column with the estimated PPD that the values are exactly equal to the uniform price minus the Class III price. The actual PPD differs from the estimated PPD because class utilization and other minor factors will differ from my assumptions.

You can see that from December 2020 to January 2021 that the Class III price was rapidly rising (+$4.05) and that can often contribute to a negative PPD in January. You can also see that there was a $7.24 difference between Class III and Class IV, which can also cause a negative PPD. It’s no surprise that January had a return of a negative PPD. The February 2021 was actually a falling Class III price and the Class III-IV gap had narrowed to $2.56, but the inertia of prices still caused a negative PPD.

Q: Does the depooling of milk by processors cause negative PPDs?

A: Depooling does not cause negative PPDs. The negative values would exist even if all plants remained in the pool. What depooling does do is make the PPD more negative than it would otherwise have been.

It’s important to remember that only Class I plants must be pooled in a Federal Order. All other plants may choose to pool because it is of value to them. Pooled plants have the opportunity to take a draw from the pool when their class price is below the uniform price. This is called an equalization payment and it allows them to pay the class price plus their draw to their farmers, and all farmers in the Order will receive the uniform price.

However, if the Class III price is greater than the blend value, it means that a pooled cheese plant would have to contribute the difference as an equalization payment to the pool for other class plants to pay their dairy producers. If they choose to depool, then they avoid that payment and are free to pay whatever it takes to get milk into the door of their plant.

I have a column in the table labeled “With no depooling” and “With complete depooling.” If you depool, you are essentially pulling out the highest value milk from the pool calculations and the PPD will become more negative. A negative PPD indicates that there is an incentive to depool, but not all plants will take their milk out of regulation for various reasons, so the actual PPD is usually between the “With no depooling” and “With complete depooling” values.

Q: Why have some producers’ milk checks been affected by negative PPDs and not others?

A: When a plant depools, it is not obligated to pay any minimum price for the milk because the plant is no longer regulated. However, plants must pay a competitive price or they soon wouldn’t have any milk in their plants. The real question is what do they choose to pay?

At the high end, plants could pay the Class III price, which they would be obligated for if they stayed in the pool (blend plus the PPD to the pool). But they might realize that they could estimate what blend price is going to be and pay their producers something like that. This means that their producers are getting the same as producers whose plant is still in the pool. But from what I have seen, most milk checks during these volatile times show that plants are paying their producers somewhat less than the Class III price but more than the uniform price.

In some areas of Wisconsin, like in the southwest corner, we also have neighboring farms shipping milk into different Federal Order plants. One farm’s milk goes into an Upper Midwest Order plant and another to a Central Order plant. Because of the quite different utilization in those two Orders, the PPD can be very different. For instance, in June 2020, Order 33 had a negative $3.81 PPD while the Central Order had a negative $7.51. That is another reason why producers may have different PPD values on their checks.

Q: Where does the PPD money go?

A: If your cheese plant stays in the pool, then the PPD is the equalization payment that will get distributed to other producers who do not ship to another cheese plant but whose plant gets to take a draw from the pool.

If your cheese plant depools some or all of its milk, then the PPD is in your plant’s hands and the plant gets to decide what to do with the funds. As mentioned, most plants’ checks that I’ve seen have paid their producers more than the Federal Order blend price. This is usually shown on a milk check as a less negative PPD than the Federal Order’s calculated value. In other words, your plant has chosen to share that value with you and keep some of it.

Before anyone gets judgmental about a plant keeping some of the negative PPD, I would point out that plants have experienced significant additional costs during the pandemic which have not been reflected as a change in the make allowance. (A make allowance is part of the calculation that the Federal Order uses to determine milk values. It is supposed to reflect a cost of making the product like cheese.) And, many cheese plants continued to purchase milk and make products that they didn’t have a customer for early in the pandemic. You can see this in the increased cheese stocks of last April and May, but those actions kept a lot of milk from being dumped.

Q: Why is milk priced the way it is and not based on supply and demand?

A: In the past, Federal Orders were used to determine the M-W (Minnesota-Wisconsin) monthly price. This was a survey of prices paid by mostly small Grade B cheese, butter and powder plants in this region and it was a competitive pay price based on supply and demand. The M-W price determined the Class III and IV prices.

However, USDA determined that there was too little remaining Grade B milk to make this a viable means of determining prices, and in January 2000 we started using the current product price formulas. These formulas begin from a survey of a few products: 40 pound block and 500 barrel cheese, butter, nonfat dry milk and dry whey. Effectively, these prices are determined by supply and demand, but they are one step further up the supply chain than the old M-W. From the product prices, the formulas back-calculate what the value of the milk that went into the products must have been.

Q: What needs to be done to return PPDs to a positive price?

A: The chart also shows values for March 2021 through the end of the year based on the current Class III and IV futures market prices. The Class I and II prices are estimated from those. So, I am also estimating the blend and PPDs for the rest of the year. If the futures market prices are any indication, we can expect the negative PPDs to diminish and go away by the end of the year.

There are several regulatory options that could make a negative PPD disappear from a producer’s milk check. All of those would require a change to the Federal Orders, which can only happen through a hearing process or if Congress passes a law stipulating the change. Either of these would take some time to implement. The most likely return to positive PPDs will be when markets become less volatile and Class III and IV prices return to closer alignment. COVID markets have been anything but normal.