We’re no strangers to criticizing the Federal Order system. We find a way to do it almost every episode.

But this month, we’re devoting the entire conversation to the fact that the regulatory framework in the dairy industry has hurt producers’ bottom lines more than helped.

It’s a phenomenon we’ve noted in bits and pieces in previous episodes, including near the end of our conversation last month. But in this episode, we examine the lack of competition and innovation in the industry with an eye toward its earliest source—the Capper-Volstead Act of 1922.

Ted shares an idea for how to fix the problem. It might seem backward—but only at first.

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T3: What do we want to talk about?

Ted: Well, one thing as Anna can testify we’ve gotten some emails from mostly dairy farmers who express a lot of paranoia with regard to the federal order system and the regulatory system and where the money is going and so on. I think we had part of that discussion last time, didn’t we? Didn’t we shelf part of it?

Anna: I know we started that conversation.

Ted: Yeah. We beat it a lot. And we’ve also danced around it a lot. The tenor of the emails that we got was paranoid. You know, somebody’s going south with the money, the co-ops are no good, they’re stealing the cash, and that isn’t what’s happening and that’s not the problem.

Anna: You know, even some of our producers have had a little bit of paranoia, and not about the co-ops or us, but about the Federal Order system in general. Because when everybody has money taken out of their check, they don’t understand that somebody is getting it. It looks like, you know, the MA office is keeping it or something, when really it’s not that. It’s that it gets distributed to the co-ops and everything, especially the ones who are using, you know, lower price utilization.

Ted: You know, if we want to go back to square one and the Capper-Volstead Act, and then regulation that developed not at the same time but eight or ten years later, the Capper-Volstead Act gave the co-ops power to collective bargaining similar to a labor union. Well, let’s take a look at the results of that. In the ’30s, when the Capper-Volstead Act came in, we had basically fluid dairies, bottling plants, were 70% or 80% of the market in cheese, and it was a balancing item similar to what powder is today.

It was not a good retail product in the ’30s. And the collective bargaining was mostly targeted towards the fluid end of the industry. Look at the results. The fluid end of the industry has been destroyed. So, how do we solve that problem? The problem is not necessarily the fault of cooperatives. The problem basically goes back to the structure and the fact that we’ve eliminated competition for the milk. Now, that, of course, that gets back to, well, what’s competition? Is it collective bargaining or is it handlers bidding for the supply?

So that’s a discussion, I think, that probably needs to be had but it needs to be had in the vein of not being anti-cooperative because that’s not the right way to do it. There’s some very good cooperatives in the United States and in the world actually. But generally speaking, they don’t do a good job on the marketing side of the business. And that’s where 50% of the price on the retail shelf is. It’s in marketing. The dairyman winds up lucky, 20%, 25% of the retail price. So, obviously, to my mind, there’s something wrong. And I think it comes back to the fact that you don’t have the competition for the milk, and that’s a regulatory issue. I’m not sure how you solve it. Clipping the wings of the cooperative a little bit. I’m not sure that’s an answer but empowering the proprietary side of the industry might be a better answer.

T3: What is the best way to increase competition for milk in a certain region? It’s the more plants looking to buy milk, especially that capacity relative to supply, is what’s going to drive up the overage price for the milk. And so, you know, why did it take so long, for example, for a big cheese plant to be built in Michigan? I mean, Michigan had that problem of having an extreme amount of surplus milk, more milk than there was dairy plant capacity in the state, you know, for a good five years before an agreement was finally made to build a cheese plant in Michigan.

Furthermore, Michigan is closer to the population centers on the East Coast than where most cheese plants are in Wisconsin or, you know, Texas, New Mexico or Idaho or California. So why did it take so long, you know, to get that plant built? It would seem it would be a no-brainer. The irony is it was because it was going to be so expensive to build a cheese plant relative to the price that they could get for the cheese within the context of the Class III formula that it was very hard to find, you know, the investment capital to build the plant. And it took a long time for the price to come down to a point and for there to be cooperatives to agree to be part of it at a low enough price point to justify building that plant.

So, there’s a balance there. And I can see how many dairy farmers get extremely frustrated because they feel that other people are profiting from their hard work. But you’re not going to be able to get that competition for your milk if there isn’t an opportunity for those who are buying your milk to profit, too. And the federal order system has become something that’s actually squeezing both sides and nobody is winning from it at the moment.

Ted: Well, we don’t know—and Michigan is an excellent example—but we don’t know what the deal is on milk supply in Michigan. Probably we don’t even want to know. But…

T3: You’re talking about what that price was for that plant.

Ted: What the price of the plant was and what the deal was for the milk going into it. Obviously, the deal for the milk going into it guaranteed the company that built the plant the margin that they required to give them a return on investment. And the dairymen will benefit from that because it will increase competition for the milk. The blend price in the area will be more tilted towards Class III instead of Class IV. Class III is normally higher. The problem that you have is that a lot of dairymen, not all of them today, but a good portion of the dairymen don’t really understand the classified pricing and what they see are these negative numbers on their checks.

Well, where do those come from? One of the provisions in the Federal Order, and we’ve had this discussion before, is that Class I plants who basically are responsible for qualifying the milk under the regulatory system are required to pay what’s called the minimum price under the Order. In addition to that, they define these classes, Class III, Class IV, Class II, by formula. These formula include, are described as make allowances, which, to me, is silly. Basically there is no such thing as a make allowance. The manufacturing costs for a guy producing Swiss and a guy producing cheddar are two remarkably different things that even between two different cheddar plants, they’re much different.

The cost of production for dairymen in Michigan as opposed to Texas is very much different. So, the idea that you have these minimum prices and these defined make allowances and so on confuses everybody, I believe. Even to the point of customers who are buying the cheese and milk and cottage cheese and whips and dips and toppings, what do they know about how in the hell those prices are constructed? And the fact that you have the minimum price under the order for Class I means basically an actual practice that the rest of the industry bears the burden of balancing and Class I doesn’t.

So, to me, this is an issue that interferes with trade and it interferes with the realities of the give and take of the marketplace. Yes, the classified pricing does mean that a fellow who produces cheese has got a price that he can hedge and look at. And he can negotiate either plus or minus for his milk supply. And a plant that produces butter and powder can do the same, either plus or minus, but for the last four or five years, it’s been minus. And the reason is, is because the make allowances are going down. They’re basically squeezed. The hauling costs have gone up. The operating costs have gone up. And regardless of whether you have manufacturing facilities or not, those costs are higher, even just for running an office, it’s higher.

So those make allowances add a lot of confusion to the whole thing. And it would be better if the make allowances were much, much higher so that you had free exchange between handlers as to what they’re willing to pay for the milk. When you have minimum price provisions under the Order, it means that co-ops who are exempt from that under the Capper-Volstead Act aren’t required to pay those minimum prices where proprietaries who are not exempt are required. And if you look at the recent phenomena in the industry with regard to Class I plants, the consortium of plants that went out of business and were absorbed into Dean Foods and Borden’s, they all went bankrupt.

And now all those are in the hands of the co-op. Not only one co-op but others, good co-ops, bad co-ops, but regardless, that’s reduced competition for the milk. The make allowances will not provide for any margin for any outside entity to get into the bottling and to the industry. So the result is going to be less competition between the handlers and less competition for the milk at the farm level.

T3: It sounds like you’re actually advocating for a higher make allowance, which on the surface, you know, if I’m, you know, a dairy farmer, my initial reaction is going to be, “What do you mean a higher make allowance? A higher make allowance would make my milk price lower. It would give more money to the manufacturer and less money to me as a dairy farmer.” Why are you saying that that’s not the way it would play out?

Ted: The make allowance is an artificial number. It’s determined by…

T3: But it’s part of the formula that creates a milk price for the dairy farmer.

Ted: Didn’t use to be. It used to be that it was a statistical service that determined what dairymen were being paid for manufacturing milk. It used to be called the MW. They called it the MW up until…what? God knows. I don’t remember. Maybe until the ’90s.

T3: Late ’90s.

Ted: Yeah. And by that time, rightfully so, the milk basically was all converted to grade A. We still have a little bit of B milk out there but it would be very inaccurate to use that as the basis for pricing today. So what they did is they came up with formulas and make allowances that determined the class price. And the higher the make allowance, the more transportation allowance you have between plants. Just taking numbers out of the air and use them only as an example. If you have a plant located in Michigan and that plant can pay whatever, $2 over for milk and the make allowance is $3, well, then he could afford to pay his farmers maybe $2 over the Class III price. That’s what we used to do, basically, years ago when it was MW-based.

Alternatively, if a plant in Wisconsin who makes a specialty cheese, if they want to pay $4 over for milk, they could reach over for Michigan and take a $2 haul and then pay the dairyman a couple of bucks over FOB of the farm. So the higher the make allowance, the more hauling you can pay and the farther out that you could reach to compete for the milk supply. And that’s what’s disappeared. When you squeeze the make allowance down to a number as low as you can get away with, you lock the dairymen into their local markets.

They haven’t got the ability or the options to reach out and pursue markets that are a little bit distance away. There are other cheese plants in Michigan, for example, that someone located in the Thumb could access if you had higher make allowances as opposed to what you have right now. So, those make allowances are artificial numbers and the more you squeeze them under a situation which has a minimum price under the order provisions, the more you drive the milk into the arms of the local market. And the local market is usually the local cooperative. Not always, but it usually is. And that doesn’t mean that the local cooperative is bad. That’s what the rules are. But you’ve eliminated the competition for the milk from the proprietary and investment-oriented entities coming into the marketplace with new ideas and new provisions that would increase competition at the farm level. I don’t know whether I’ve made my point very well, but…

T3: I think it’s going to be difficult for people to understand your point. And one of the reasons is, is because you keep calling the make allowance an artificial number, which is going to really come across confusing to the audience. Because, you know, in the formula, it’s not an artificial number. It’s a very specific number that’s taken from a survey that, you know, tends to happen every ten years or so. I think that’s gonna create more confusion than it’s going to be helpful.

Ted: No. I agree, it’s going to be confusing but it should be. The make allowance is an artificial number. It’s artificially contrived by a formula to squeeze the milk into the most local market. That’s what it’s artificial about. You don’t really need a make allowance as such. What you need is competition to go out and get your milk supply.

T3: And that I agree with, and I would even take it a step further. You know, while I don’t think I would call the make allowance an artificial number, what I would say is this. It is a very misunderstood number in a couple of different ways. And to me, the biggest way it’s misunderstood is when people make the argument that the make allowance takes the risk out of being a cheesemaker and locks in a profit for the cheese manufacturer. The reality is this, if you want to take the make allowance and double it, well, the shallow thinking way of looking at that would mean, “Oh, my God, you’ve just given all the money to the cheese plants. They’re all going to be so much more profitable now.” Well, that may be true for a year or two.

Ted: Not even true at all. What it would mean is that if a dairyman who’s getting paid, an example, $1 under, now, all of a sudden he’s going to get paid $1 over but the bottom line on his check isn’t going to change. The dollar number on the dairyman’s check has nothing to do with the make allowance. It has to do with what he’s going to get paid. It sounds a little strange. It’s true.

T3: Well, and I follow what you’re saying and I would describe it this way. If you take a make allowance, let’s say you’re going to use round numbers here but the make allowance, let’s say, is 20 cents a pound of cheese and you double it to 40 cents. Well, what would happen is the Class III price may drop from $14 a hundredweight to $12 a hundredweight. But the overage that the dairy farmer would get would have gone from $1 under to $1 over because the reality is market forces are still working. It’s just the way that they’re working through the system is a little bit different.

And so, the dairy farmer, if he was getting paid $1 under $14, he’d get $13. Well, $1 over $12 is still $13. He’d still get $13 a hundredweight, but the numbers would just move around a little bit in terms of the overages. You and I are basically arguing, you know, the same thing that the make allowances…

Ted: That’s right, we are.

T3: …don’t really matter. Even though everybody wants to say they matter, they don’t because there are still more market forces in play but the local dairy plant is going to pay what they need to pay to fill up their plant.

Ted: Let me tell you why it matters. It matters not to the cooperative what the make allowance is. He can pay whatever he wants. Under the regulatory system, the proprietary handler cannot. The proprietary handler is required to qualify the milk, which obligates him to pay the minimum price under the order. That’s the difference. So the dairyman has to make choices. Does he want to sell to the local who happens to be a cooperative, or does he want to reach out to a proprietary which might be located another 100 miles down the road who would pay him a higher price?

That’s the difference and that’s the argument that I’m trying to make is that we have eliminated competition for the milk by using minimum price under the Order provisions and make allowances and formula. And we’ve channeled all the milk into the cooperatives and we put the proprietaries out of business. They don’t compete for the milk the way they used to compete for it under the so-called Minnesota-Wisconsin series-based Orders. So that’s a big difference when you don’t have that competition out there. And it makes a difference as far as what the dairyman’s options are for selling his milk.

T3: At its core, the best way that you’re going to be able to increase competition for a local dairy farmer’s milk is to have an increase in plant capacity in that area because that means there’s, the local proprietary plants or co-op manufacturing plants, there’s more milk that they’re going to need to buy. And so they’re going to need to compete more aggressively for the local milk supply. So, what changes do you think we can make to the Federal Order that would increase the propensity for investors to build new dairy plants in various regions throughout the country and therefore increase the competition for the milk? Is the Federal Order system what’s keeping them from building more plants?

Ted: As it’s structured now, yes. Why do you think the plant in Michigan doesn’t have their own milk supply? Instead, they went out and they contracted with the cooperative side of the industry for their milk supply. There’s nothing wrong with that necessarily. The cooperatives are good cooperatives and the handler himself is a good cooperative or a good company, good corporation, but you haven’t got competition for the milk under that scenario. Basically you have cooperatives who purportedly are collective bargaining to get a price for the milk but what the hell kind of collective bargaining is that if you don’t have any other options?

You had to go low enough to convince the handler to come up and build this plant. And you had to guarantee him a return on his investment. Yeah, that’s fine. And that’s the way it should work. But by the same token, how does that benefit translate back to the dairyman? That’s the point I’m trying to make. If the handler came in and said, “Look, I could build my own milk supply and I can go buy milk directly from the dairyman,” well, now all of a sudden you’ve got the dairyman being able to sell the plant directly or the dairyman could go directly to the co-op, who may be able to negotiate and have a better situation, better hauling, and so on to get into the plant. You’ve got a much more competitive situation at the farm level under that kind of a scenario.

T3: In other words, your argument is that would add more buyers into the mix at the farm level. I mean, you could say that the plant in Michigan is going to help the dairy farmer because it’s going to swallow up a whole bunch of milk, which means there’s less milk now in the area to go around to all the remaining plants. And that may be helpful but there are no more or fewer buyers. It’s still the same people calling on the dairyman asking to be the ones who buy their milk on a daily basis.

Ted: Exactly. So you haven’t introduced any new markets for the milk. You’re still going through the same cooperatives you went through before. You have increased the utilization from Class IV to Class III, and that’s certainly something. You’re not hauling 100 loads of milk a day out of Michigan anymore. That certainly is going to be very helpful. So, I’m not trying to paint a scenario where this is a bad situation, it’s going to be an improvement over what we had before. But by the same token, it demonstrates, in my mind at least, the weakness of the overall marketing system that we have right now. And it goes back farther back than just the regulatory system, it has to do with the Capper-Volstead Act and the fact that co-ops basically have become exempt from some of the risks of the marketplace.

We have to put this thing back where we have an equal footing, where proprietary and investors who come in and make investments in manufacturing facilities and buy directly from dairy farmers have risks that are reduced from where they are right now. And that involves, as we’ve discussed here for the last half hour, that involves weakening the minimum price provisions under the order and the make allowances so that farmers can reach out further as to where they market their milk. Right now, a dairyman up in Cass City or in The Thumb couldn’t very well market his milk down in Benton Harbor or vice versa. And if you had a make allowance, which was much bigger in that particular federal order, at least he would be able to consider those options when it comes time to determine where he wants to go with it.

I don’t pretend to know that I have an exact idea of what the solution is but what we have right now are people like Farm Bureau and people like the major cooperatives in the country trying to get together and determine how to solve this problem that we have at the marketing level. Well, good luck with that because basically the structure that they’re involved in is part of the problem. And I think that’s been clearly demonstrated in the talks that have failed here over the last couple years. They haven’t got anywhere because they haven’t really acknowledged that structurally we have reached a point where we’ve limited new money and new people and new ideas and innovation to come into the industry. We’ve made it much more difficult.

T3: It sounds like what you’re saying is that a lot of the best answers are very counter-intuitive. When you first say them, it sounds like they would have the exact opposite effect of the effect that they would ultimately have. You know, by increasing the make allowance, the initial reaction would be, “What a horrible idea, all that does is make the Class III price lower.” But it actually has a different effect when you really take economic forces into account in terms of how everybody would ultimately react to that. The same probably goes true for depooling and understanding, you know, how that money plays through the system. Because initially, depooling lowers the blend price in a region.

And that would seem like a bad thing for the dairy farmer but it’s not like that money disappears. That money, the handlers and the cooperatives who depooled still actually collect that money. And so they’re able to use that money to pay the dairy farmers more. There’s a lot of those kind of counterintuitive things that the federal order system tends to cause.

Ted: Yeah, you’re right. And the emails that we’ve got, as we’ve discussed, you know, demonstrate a paranoia that somebody is stealing the money and that there’s some mysterious force out there that’s winding up with his pockets getting lined. You know, my answer to that is, is that where we are right now, 50% of the value of the price on the retail shelf is on the marketing end. And only around maybe 20% to 25% is at the farmer’s end. So, whatever it is, it ain’t working. I do think that the dairyman should be able to participate at a higher level into the price on the grocery store shelf. I don’t think there’s any question of that, but I also don’t think that there’s anyone running off and pocketing all this cash. I think it has more to do with the mechanics of the marketing environment that we’re in today.

Anna: One of the things that strikes me a lot in the conversations that I have with people, when we talk about, you know, you have a new plant come in and increases competition, it’s sucking up this amount of milk and it should make things better in that area. The one thing that I kept thinking in my head when you were talking about that is that that is very, very temporary. To me, it seems like now, the way we work. Even if we have fewer farms, you know, if we get a cue, if any producers get a cue that the price is low, they up their production to make sure they’re getting as much of it as they can. If the price is higher and they get that signal that the market needs more, they’re just going to grow.

So, no matter what, producers now get the signal that they should grow no matter what the market conditions are. And I feel like that, you know, you’ve taken a bunch of milk out of the area, which should be an improvement but I don’t know how lasting it can be anymore. I don’t think we react in a way that’s slow. I think we very quickly just make more milk.

Ted: I think you’ve identified one of the major problems and that cash flow issue for a dairyman is everything, he can’t just turn the cows on and off. Although it’s interesting to note the phenomenon here. This spring when we had our supply chain disruption, Texas and New Mexico basically put a 90% rule in and got away with it. I think even some remnants of it are still there. And that was very successful in reducing production. Where the larger dairymen and, of course, all the dairymen in that part of the country are large, all truckload shippers, basically. They can change their rations rather quickly to draw down production. They may not make a 10% change just like that but they can do it pretty fast and that enables them to make some bigger changes.

And, of course, they can also do the reverse. When all of a sudden the price, like it is right now, looks like it’s going to take off and be a big number for what? October? Now, all of a sudden they can turn on the burners and add or put a few cows down at the end of the barn, and make the rich a lot richer and the milk supply suddenly increases. So how do we deal with that? Okay? Well, I’m not sure it’s our job to deal with it. And supply management programs have been tried and tested and failed over the last 50, 80 years ever since Federal Orders came in. So, the dairyman does have to accept that risk. And the ability to be more economical and be more efficient at the farm level is something that you can’t really stand in the way of. You can’t do that. You got to realize that the efficiencies are there just like in a cheddar cheese plant that’s running 10 million pounds of milk a day. So, it is a conundrum.

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