Girl pouring milk into glass.
September 28, 2017

Industry Proposes Changing How Fluid Milk is Priced

 |  By: Jim Dickrell

The dairy industry is proposing changing how fluid milk is priced, moving away from the controversial “high of” calculation to one that is more straight forward. In turn, the proposal would make managing risk for both farmers and fluid milk users somewhat easier. The change will be proposed in the next farm bill.

In the current Class I mover formula, the “higher of” the Class III or Class IV price is used to determine Class I. This ensures that fluid milk is priced so that it is always the most attractive home for milk as processors of all stripes compete for it. Since 2001, this “higher of” provision has added 43¢/cwt to the Class I value.

But the “higher of” formula creates a number of problems for both farmers and fluid milk users in hedging risk because there is no direct hedge for fluid milk, says John Newton, Director, Market Intelligence for the American Farm Bureau Federation. To hedge risk, farmers and processors must either take out Class III or IV futures contracts, but if they pick wrong, they are subject to huge basis risk. Between 2001 and 2017, the basis risk to cross hedge Class I on the Class III market averaged 47¢/cwt, but ranged from a low of -78¢ to a high of $4.64.  The cross hedge to Class IV averaged 90¢ and ranged from -77¢ to $6.68.

So the dairy industry is now proposing that minimum Class I prices be set by a simple average of Class III and IV plus 74¢. “The 74¢ addition to the simple average is in lieu of the ‘higher of’ mechanism,” says Newton.

Using the 50/50 Class III/IV mechanism will allow farmers and fluid milk users to better hedge risk. “The average basis would drop to 2¢, and from 2001 to 2017 would have ranged from -77¢ to $1.03/cwt,” says Newton. “That leaves some risk in the market, but is a substantial improvement over the existing cross-hedging approach.”

That would allow major milk retailers such as McDonald’s and Starbucks to hedge their input costs and provide more price stability for customers. “This would [also] reduce the risk of servicing school milk contracts currently held by the milk processors,” says Newton.

Having less risk means processors might also be willing to innovate more and come up with unique milk- and milk-based products. “All of these benefits would ultimately help reverse the much longer trend plaguing the dairy industry: Declining per capita consumption of beverage milk products,” says Newton.

Read more on the proposed change here.