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From The MPC Newsletter
Friday, August 30, 2013

A Look at California Pooling and the Upcoming CDFA Hearing
By Rob Vandenheuvel, General Manager

Regular readers of this newsletter will recall that we’ve written previous articles about how our pooling system works, the interaction of the five classes of milk, and how modifications to any or all of those class formulas/prices impact the overall system. With a hearing coming up at the California Department of Food and Agriculture (CDFA) to discuss proposed increases to the Class 4b price (milk sold to California’s cheese manufacturers), it’s worth a refresher on exactly why it is critically important that CDFA establish proper pricing formulas, both for producer income and the relationship between the classes.

For those of you who have attended any of the Class 4b formula hearings in the past several years, you undoubtedly remember hearing testimony opposing increases to the minimum prices. After all – those witnesses have said – it is merely a minimum price, with no limitation to premiums that are paid on top. Sounds pretty logical, doesn’t it? While this may seem like a rational argument, it completely ignores the fundamental reality of pooling, and the fact that the individual price formulas do not operate in a vacuum, but instead impact the entire California milk pooling system.

So today, I will be looking into the “big picture” impact of changes to the Class 4b price and why it’s so critical that the formula generate prices that are not only in a reasonable relationship with comparable milk sold around the country, but also in a reasonable relationship with the other classes of milk in California.

Before getting into the specifics, let’s take a quick look at the California pooling system. Most of you already know these things, but bear with me for the sake of those who want a refresher:

Manufacturers are obligated to pay for their milk based on the monthly State-established minimum price formulas. There are five individual formulas, with each representing a different utilization of the milk:

bulletClass 1 (fluid products)
bulletClass 2 (soft products like yogurt/sour cream)
bulletClass 3 (frozen products)
bulletClass 4a (butter/powder)
bulletClass 4b (cheese/whey products)

So a plant that uses their milk to make sour cream would pay a price based on the monthly Class 2 price. If that plant also makes cheese, they would pay the Class 2 price for the milk they used to make sour cream, and the Class 4b price for the milk they used to make cheese.

However, as all California dairymen know, under the pooling system, the processor you sell your milk to doesn’t pay you the Class 2 or Class 4b price, but rather the blended “Overbase” price (or the “Quota” price for those that own Quota, but that’s another topic for another day).

So how does the accounting work? Every month, CDFA calculates the monthly “Overbase” price, and reconciles each manufacturers’ account with the pool. Here’s a simplified example, using data from July 2013 (I say “simplified” because (1) this does not factor in the Quota payments, and (2) all the figures below are “per cwt,” while CDFA determines the financial obligations per pound of “fat” and “solids-not-fat.”):

bulletClass 1 price (plants in No. CA): $19.59/cwt
bulletClass 1 price (plants in So. CA): $19.86/cwt
bulletClass 2 price (plants in No. CA): $18.31/cwt
bulletClass 2 price (plants in So. CA): $18.54/cwt
bulletClass 3 price: $18.26/cwt
bulletClass 4a price: $18.61/cwt
bulletClass 4b price: $15.65/cwt
bulletOverbase price: $16.85/cwt

So using this information (and ignoring the Quota calculation), we know that California dairy farmers that participated in the pool in July (which is most of them) were entitled to the Overbase price of $16.85/cwt, regardless of what plant you shipped your milk to and what products that plant makes. On the other side of the equation, there is some reconciling to do:

bulletClass 1 plants in Northern California paid their dairy farmer suppliers or cooperatives the Overbase price of $16.85/cwt, but then paid an additional $2.74/cwt ($19.59 - $16.85) into the California pool, making their total obligation $19.59/cwt (the Class 1 price)
bulletThe same kind of calculation occurred for the Southern California Class 1 plants, as well as all Class 2, 3 and 4a plants.
bulletClass 4b plants, on the other hand, had to pay their dairy farmer suppliers or cooperatives the same Overbase price as everyone else ($16.85/cwt), but rather than make an addition payment to the pool, they actually got a payment from the pool amounting to $1.20/cwt ($16.85 - $15.65).

So this, in very simplistic terms, is how our system is structured. Plants pay for their milk based on how they use it, and producers are paid a blended average price. CDFA manages the differences by requiring pool contributions for some plants and making payments to other plants.

So at this point, some of our readers may be asking, “So what does this have to do with the upcoming hearing?” The answer is EVERYTHING. Each of the five class prices contributes to the ultimate blended Overbase price. In the case of the Class 4b price, it represented about 45% of the pool in July, making it the largest since class of milk in the pool.

So let’s take a look at an alternate scenario for July where the Class 4b price is held in a closer relationship with the Federal Order Class III price (the benchmark price used for milk sold to cheese plants around the country). Over the course of the past ten years, the other major manufacturing class in California (Class 4a, butter/powder) has averaged about $0.28 per hundredweight below the comparable Federal Order Class IV. During that same period of time, the California Class 4b price has averaged about $1.71 per hundredweight below the Class III price. So what if the California Class 4b formula were modified to maintain a price that averaged $0.28 per hundredweight below the Federal Order Class III price, keeping it in the same relationship that CDFA keeps the Class 4a price? What would the July 2013 numbers have looked like in that scenario? (The red bolded numbers are what changes in this scenario.)

bulletClass 1 price (plants in No. CA): $19.59/cwt
bulletClass 1 price (plants in So. CA): $19.86/cwt
bulletClass 2 price (plants in No. CA): $18.31/cwt
bulletClass 2 price (plants in So. CA): $18.54/cwt
bulletClass 3 price: $18.26/cwt
bulletClass 4a price: $18.61/cwt
bulletClass 4b price: $17.10/cwt
bulletOverbase price: $17.50/cwt

For starters, the first thing you see is that the change would have increased the Overbase price by $0.65 per hundredweight. That’s the direct impact the change would have on producers – a significant (and much needed) increase in producer revenue. In fact, over the past 3 ½ years, this scenario of maintaining our Class 4b price within $0.28 per hundredweight of the Federal Order Class III price would have raised the Overbase prices to the tune of almost $930 Million. Stop and think about that for a second; all CDFA would have had to do is establish a Class 4b price that maintains the same relationship as the cooperative-owned butter/powder manufacturers are asked to maintain (still lower than the Federal Order prices), and producers would have received almost $930 Million in higher Overbase prices. How much of your dairy’s debt could have been retired for your share of that amount???

This change would also have an impact on the plants. As mentioned earlier, the manufacturers of Classes 1, 2, 3 and 4a all made pool contributions during the month of July. That contribution was above and beyond what the plant had to pay its producers in the Overbase price. In the case of Class 4a plants, which are owned and operated by producer-owned cooperatives and represents the 2nd largest volume of California milk (approximately 30-35% of the pool), those plants had to send $17.6 million to the pool in addition to the Overbase payments they made to their suppliers. At the same time, the State’s cheese manufacturers received $18.3 million from the pool in order to be able to pay their producers the Overbase price.

Under the revised scenario where the Class 4b price remains in a more reasonable relationship of $0.28 per hundredweight below the Federal Order Class III price (which still represents a significant discount for our State’s cheese plants relative to their Federal Order competition), those California cheese plants would have still received a payment from the pool, but it would have shrunk to $6.5 million. At the same time, our Class 4a plants would have still been required to make a pool payment, but it would have shrunk to $10.6 million.

So why are all these figures important? In a single month, it may seem like a modest difference. But over the past 3 ½ years, California’s cheese manufacturers have drawn $456 million out of the California pool in order to be able to pay their producers the Overbase price. At the same time, our cooperative-owned butter/powder plants have had to contribute nearly $375 million above and beyond their Overbase payments to their producers. Consider the inequity of a butter/powder plant competing for a milk supply with a cheese plant, with both plants having to pay the same Overbase price to their producers, but experiencing very different economics, courtesy of the State-run pooling system. Think about that the next time you hear our State’s cheese manufacturers tout “free markets” and brag about the generous premiums they pay.

Now some of you may be saying, “That’s just the way the pooling system works.” And you’d be right IF our Class 4b price were constantly lower than the other manufacturing classes for legitimate reasons – like the value of milk sold to cheese plants around the country was chronically lower than the value of milk sold to butter/powder plants. But that has NOT been the case. Our Class 4b price is chronically discounted because of an administrative decision by CDFA to maintain an artificially low price. How would the past 3 ½ years have looked for Class 4a/4b plants if the Class 4b price maintained a $0.28/cwt relationship with the FMMO Class III price?

2010 - Present Actual Pool Contributions/(Withdrawals) Pool Contributions/Withdrawals under a $0.28/cwt relationship Difference
Class 4a (butter/powder) $374.7M Contribution $66.2M Contribution ($308.5M)
Class 4b (cheese/whey) ($456.2M) Withdrawal $56.7M Contribution $512.9M

What a difference in balance between the two classes! In fact, what this demonstrates is that around the country, the Federal Order Class III and Class IV prices maintained a very close average relationship (less than $0.10 per hundredweight gap). If California had kept that same relationship, you can see the difference it would have made.

While nothing can be done about the past 3 ½ years, the CDFA hearing this month represents an opportunity for the Department to begin rectifying this obscene disparity. The modest proposal being discussed the hearing – based on a written offer by the Dairy Institute (http://www.milkproducerscouncil.org/070813dairyinstitute.pdf) – slightly shrinks this gap. But to be certain, we must continue efforts to close that gap in the long term. California dairy families cannot afford to leave another $930 Million on the table over the next 3 ½ years!

 

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