You’d only need one look at recent history on the CME to see the rollercoaster that has been spot cheddar prices.
In this episode, T3 notes the collision of around a half-dozen contributing factors to explain why it’s happening. Ted discusses why the Federal Order system is hurting the situation more than it’s helping.
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Anna: Welcome to “The Milk Check,” a podcast from T.C. Jacoby & Company, where we share market insights and analysis with dairy farmers in mind.
Ted: What should we talk about? Markets have gone from the penthouse to the outhouse.
T3: Well, I would say the markets went from a fair price to the outhouse to the penthouse back to the outhouse, and I actually think we’re gonna probably end up back in the penthouse in about a month. It’s a roller coaster.
Ted: And it’s chaos on the milk side. I visited with our milk group today a little bit and depending on what you’re making and what you’re selling and what your orders are, you’ve got the Class III for August right now at $19-something, and I think probably around $19.50 or so. And you’ve got the Class III for September probably around $17 maybe?
T3: Yeah $16.80 or so right now, $17.
Ted: Something like that. So they could have as much as a $3 per hundredweight gap. So here we are trying to sell milk for delivery at this point in time and people are trying to figure out what price they’re gonna wind up having to absorb to put the milk into cheese and then what they’re gonna be able to sell the cheese for. So the futures market, at least in my view, is rather inadequate to solve that particular problem. And I think that accounts for a lot of the issues right now because, Teddy, and you correct me, you’re in cheese, but the inventories are not burdensome and the sales haven’t been that bad. In some cases, depending on the style and so on, they’ve been pretty darn good. And yet the milk, we wind up with some people unwilling to pay the going rate for milk because of the violence in the market at this point in time.
T3: Exactly. And I think the biggest problem that we have right now in the marketplace isn’t necessarily the price as much as it is the volatility of the price. Why don’t I start by explaining, kind of, what’s causing this volatility? What has the journey been since, let’s say, the end of March and what it’s doing farther down the food distribution channel and how people at the supermarket level and at the restaurant level are reacting to it, and then we can talk about how that feeds all the way back to the milk price and what’s causing this rollercoaster that is creating stress for everybody in the pipeline?
When the pandemic started and restaurants started closing and food distributors started canceling cheese orders, the price started to drop. And by the end of March, the price had almost gone all the way down to $1 a pound. But two things happened while we were that low. The first thing that happened was supermarkets started seeing huge increases in sales. And the first part to keep your head around is cheddar, which is how we price all of our cheese and ultimately our milk, is really a market that’s skewed to retail. We sell more cheddar marginally in retail and more mozzarella, for example, in food service. And all you have to do is think about it when you’re in a supermarket and you look at all the shredded cheeses on all the pegs in the dairy case, you’ll see a lot more cheddar packages than you will mozzarella packages. Whereas if you’re thinking about it from a foodservice perspective and you think about all the pizzas and lasagna and Italian food and everything you eat, they actually sell a lot more mozzarella in that direction.
And so what happened is once you hit the bottom, three things happened simultaneously. The supermarkets’ orders were very, very strong, and so they were ordering more cheddar than usual, a lot more. Second, we were low enough that we were far below the international market and we got a lot of international sales, a lot of export sales took place and were confirmed right around that first or second week in April.
Ted: And those were based on the futures price for the next three or four months.
T3: Exactly, which was, at the time, pricing cheese at $1.30 to $1.40. It still seemed really high compared to the $1.10 that the market itself was sitting at, but it was well below the international market and certainly, an opportunity for those cheese companies that did a lot of exporting to take advantage of that and those international buyers to take advantage of that and get some good pricing. A lot of cheese sales got done internationally while our prices were really low. As we got into the latter part of April and into May, the restaurant industry started figuring it out. Now, even today, they’re obviously not back to where they were before this all started. But the sales at the restaurant level have come back. Most of it is curbside pizza delivery, other kind of delivery, eating outside but not inside. I mean, we’ve all experienced what’s going on at the restaurant level. And their sales are not all the way back to where they were pre-COVID, but they’ve still come substantially back.
Meanwhile, the supermarket sales still are running well above last year, year over year, for obvious reasons. Net-net you ended up with a situation where you had severe drops in the cheese price and then severe increases in the cheese price as the combination of government programs like the Food Box Program, increases in exports, increases in retail sales, and better than expected foodservice sales, as you were getting into May, caused the price to start to go up and then keep going up as all these pipelines, especially the food service pipeline had to be refilled, the panic of not being able to get the cheese at the expected price for the Food Box Program, and the continued strong sales through the retail channels in addition to exports. You basically had everybody trying to go through the same door at once.
But at that point, many of the buyers of cheese in all the different levels, retail, food service, industrial started changing the way they were ordering in this way. This pandemic has pretty much caused everybody to take their original sales plans and forecasts and throw them out the window. Well, the way things work in a normal year is you have your sales forecast, therefore, you have your purchasing forecast. And as you go along week to week, you’re tweaking it a little bit here and tweaking it a little bit there and you’re managing your working inventory. But the best way to describe how that has changed in this COVID environment is a conversation that I had with the dairy case manager at my local supermarket a few weeks ago.
I went up to him and I asked him how much cheese he had in inventory in the back. And he said, “We usually keep about eight cases of shredded cheddar in the back and we get our truck about two days a week.” He goes, “But back when this whole thing started,” he goes, “They were telling me they had 3,000 cases at the distribution center, but they had none to give me. So I decided to start keeping 15 cases every time I reordered in the back so that I had the extra cheese. Because sales are so good, I wanna make sure we don’t run out of cheese.” He goes, “But the funny thing is just the other day, a whole pallet, 80 cases of shredded cheddar showed up in my warehouse at my supermarket.” He goes, “Now, the purchasing manager has the ability to do that and I don’t know why he did it. But for some reason, he felt I needed a whole case of shredded cheddar, and it’ll take me forever to get through that.”
But the moral of the story was this, everybody had gotten so discombobulated by these wild swings in prices that they had decided to keep larger inventory levels at all the different levels, whether it’s the retail distributor, whether it’s the supermarket themselves, the different supermarket chains, even at the food distribution centers for restaurants, the wild swings in price and the wild swings in volume and the very volatile order patterns, the way everybody started reacting to all of that was, “I need to manage a larger inventory of cheese to make sure I have cheese for my customers.”
And so the retail pipeline, distribution pipeline really, really became swollen with extra cheese. And the foodservice pipeline probably was swollen too, because everybody was kind of expecting restaurants to go back to normal. Well, they came back a lot, but they didn’t go all the way back to normal. So on a relative basis, there was probably too much cheese at the restaurant and foodservice distribution level as well. And then you still have the Food Box program and then you still have exports. Well, that all led to the cheese price going all the way to three bucks by the middle of July.
But what happened then? Well, just as everything tried to go through the door at the same time, everybody tried to exit at the same time, too. The export orders that were booked in April and were eating up manufacturing capacity in May and in June and into the beginning of July, they finally started getting all of those orders filled, and now they had open capacity to focus back on domestic. And at $3 a pound, there was nobody ordering internationally. The second thing is the Food Box program, you’d kind of hit a window between the first and second bids and then the third group of bids, which is coming in about a month, and so there’s a window there. And then as we just talked about, at the restaurant level…excuse me, at the supermarket level, all of the supermarkets had more than enough inventory, and so the price started weakening and the price started falling.
Well, what is the natural inclination of anybody who’s carrying more inventory than usual when they start to see the price fall? “Hey, I’ve got enough inventory right now. I’m just gonna sit on my hands. I’m not gonna order this week because I have the ability to wait because I have extra inventory. Well, they had so much extra inventory, they were able to wait two weeks, and then three weeks, and the price just kept falling. And from a price of $3 on, I believe it was around July 20, we finally bottomed out a few days ago at $1.58, $1.50 a pound drop in the price of cheese, basically cutting the wholesale price of cheese in half between the peak in the middle of July and what I think is probably the bottom here in August.
And just in the last few days, we’ve had discussions with export customers who say, “Oh, I’ll buy cheese here.” So now the export orders are starting to pick up again. We have supermarkets saying, “Oh, I like this price. I’ll start buying cheese here.” We have people who need to store parmesan and hard Italian, which is a cheese that needs to be aged for eight to nine months, and this can actually be made with the same equipment that makes cheddar decide, “I wasn’t buying anything at $3 a pound, but I’ll have my manufacturer make hard Italian for me at $1.58.” Everybody who wasn’t buying at $3 a pound and then wasn’t buying as the price was falling, just in the last few days, they’ve started showing up again.
And so now everybody ran out of the room. And now what are we getting? Well, we’ve hit the bottom and my belief is that we’re gonna start running up again, hopefully not all the way back to $3. I don’t think that’ll happen. I wouldn’t be surprised if we get over $2. Everybody is trying to run back through the door again. And it’s become…the volatility, kind of, becomes a self-fulfilling prophecy. The larger the swings in the price, the more people hold back orders and then jump into the market and then jump out of the market, which just exacerbates the volatility even more. It’s become a problem not only in the way we are pricing our milk. It’s become a problem in our ability to, for example, stay in the export market on a 12 months a year, 52 weeks a year regular basis. It’s become a problem for the cheese manufacturers trying to figure out what they should make and when they should make it so that they can give all of their customers a consistent cheese and they can be running their plants consistently. It’s become a real mess.
Part of the problem, quite frankly, not the whole problem, but one element of the problem is the way the Federal Order system is set up and the way that the futures markets are set up. One of the places it is very difficult to do is be a consistent exporter 12 months a year because of the way that we price milk, and therefore, we price cheese relative to the way that our competitors do. And you’re starting to see how everything’s getting frayed because of the volatility. And I think everybody in the industry, from the dairy farmer to the cheese manufacturer to the restaurant owner to the supermarket owner, would all agree that if we could figure out a way to minimize the volatility so we can be a consistent supplier to whatever market we wanna sell to, it’s gonna make our lives a lot easier.
Ted: So you got any good ideas?
T3: Well, I think the start is to have enough people in the industry willing to have some honest and serious discussions about how we can take a look at the Federal Order system in how we price cheese and figure out if there’s a way to add stability to the marketplace. We’ve become a global player in the dairy industry, and the Federal Order system works against us as a global player. And if we can figure out ways to create more stable pricing, that would be a big help to the industry as a whole.
Ted: I agree with that and I agree that the Federal Order in this kind of volatility is a liability. What everybody has running through the back of their mind is production controls. Now, during this fiasco over the last four months, we had some of the larger organizations and cooperatives putting in programs. And the best one, for example, is like, “Oh, we’re only gonna pay for 90% of your milk during the base period.” And the base grade was probably, I think, January or February or something like that. And that did make a big difference down in Texas and New Mexico and in certain areas. But you can’t do that in a market which is divided up into a multitude of different factors. Some are gonna participate and others won’t if it’s on a voluntary basis.
We’ve had production controls in the forms of base excess programs in the Federal Order system before ostensibly to address the same problem you’ve just described. And those fell into disfavor and were discontinued over the years. And one of the reasons is, is that producers wanna be more efficient and efficiencies come with growth and economies of scale. And when producer A wants to add another free stall, or a few beds at the back of the one he’s got now, he’s not going to want somebody telling him no, he can’t do it. And, of course, probably the same line of thought, the cost of production has actually gone down if you look at it in terms of real dollars over the last 50 years. So production controls built into the Federal Order system have been tried and failed.
Now, I’ve been thinking about this too as to how we might come up with something that works. I haven’t come up with anything at this point that guarantees the dairyman an income and minimizes the volatility at the same time. It really is a knotty problem. And I think the industry needs to sit down together and try to work it out. One of the things that’s a problem with the Federal Orders right now is you have the negative PPDs, which the dairyman don’t understand. But what’s worse is they’re affecting our bottled milk end of the industry, which have no ability to de-pool milk. You know the rest of the industry, if they de-pool milk and the dairyman doesn’t get the money on June, he’ll get the money in August or September. For the bottling plant which has his own producer, he’s stuck. There’s a lot of room for revision within the Federal Order system. Maybe a consortium of some of the better minds on how this thing work is in order.
T3: If we can figure out a way to do a better job of forward-pricing milk and dairy products, to me that would be the key, ironically, to take the volatility out of the market. And the reason I say that is because at the international level, what’s happening is our competitors in Europe are able to say, “Okay, I will price you cheese delivered over the next three months at this price.” And then once they commit to that price, that price will feed back into what the farmer gets paid. And they don’t have as good a futures market as we do, but they have a better ability to forward-price and more less-volatility price product as they’re selling into various different markets. And so the volatility happens on the edges rather than the whole market. And that’s part of, I think, the issue that we have is when our market gets out of sync, the whole market shifts rather than just parts of the market. I don’t have a specific, well-detailed answer. But to me, the answer would lie within figuring out how to address that issue.
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Ted: One thread to pull in this knotty problem might be the fact that our pricing right now is on a monthly basis. You know, noodling on this thing, if we had some sort of a basis for rolling prices over a longer period of time instead of monthly, maybe quarterly or a rolling quarterly or something like that, so that we could react to price stimuli that maybe not…we might give up being able to react as quickly, but you could keep the futures market in there. Now, who’s gonna bankroll that kind of a system? I have no idea who could do that. Maybe the Federal Order might be in a position to bankroll it. In the longer run, it would be revenue-neutral. In the shorter run, it would provide for less volatility if the prices were averaged over, say, a three-month period. It certainly would have made a lot less volatility in the system that we have that we’ve just been through.
T3: That’s an interesting way to look at it. I’ve never thought of it that way. So in other words, let’s say we had a monthly price for cheese for the month of August, but then that price of cheese would be applied one-third to August, one-third to September, one-third to October. And then in September, it would be applied one-third forward so that on the milk price level, there’s a smoothing effect. Even though on the cheese level, maybe there’s not. And one of the reasons I kind of like that disconnect is it will make things a lot easier for the dairy farmer on a month-to-month basis. It’ll have a smoothing effect.
And I can actually even imagine how some domestic cheese customers could back into the same type of system. Let’s say you’ve got a big pizzeria delivery company, one of the big ones, who wanna see much more stable pricing as well could take advantage of the same thing. But then you’d still have a market that would move for those who are buying week to week, or in an inconsistent basis, even in an export basis. That’s not a bad idea.
Ted: Well, it would take a lot more thought than just this phone call. But I think there’s some meat there to get our teeth into. We need to eliminate the volatility and perhaps most of all at the farm level. The reality is today, the dairy farmers don’t trust it. They don’t know where the hell all the money is going. And I don’t blame them for not understanding. It takes a trio of guys who have been in the Federal Order system their whole lives to figure out what’s going on in the kind of circumstances that we’re going through. So something that smooths it out without sacrificing the risk management opportunities that we need. People need those risk management facilities.
And, actually, as you say, they’re better here than anywhere else in the world right now. But when it comes time to pay dairy farmers, we don’t have a way to really smooth it out over a period of time so that he knows what’s coming and he gets a little bit better idea what his milk check’s gonna be. I think there might be a way to do that, but it’s gonna take some pockets, some deep pockets to do it. And that, I think, is where the Federal Order system might be able to come in.
And I don’t think it would really take government action. It would probably take…if somebody would come up with a viable methodology, it would probably take a hearing to adopt some sort of a program like that where there might be assessment on the frontend at the appropriate time out of a particularly high-price PPD or high-price level and where money is put aside and accumulated for smoothing purposes. I can see a lot of discussion about that where people right now have their tongue hanging out and then somebody wants to take money and put it in the bank to hold it for the next time the roof comes down. So it would be a big problem that needs to be solved, but there may be some way to do it if you get the right people at the table.
T3: I agree. Another thing that I think ultimately could be helpful is one of the things that happens when you have a huge disparity between Class III and Class IV prices, outside of a negative PPD or excessive positive PPD, if you will, is that you get milk not moving to the best value to the farmer. And what I mean by that is if you’re pricing Class III milk at $24 a hundredweight, which July was up there higher, and Class IV was at $14 a hundredweight, but the cheese price was weakening or at least you did not know where you were gonna able to sell cheese. Because of everything nets back to a blend price, I think we’re actually gonna be able to get a better value relative to the blend price going into a Class IV plant than a Class III plant.
But the reality is you still would have achieved better value for the milk if you actually went into a Class III price at a lower value than, let’s say, the $24 for Class III milk. And that was causing milk to move away from a cheese plant into a Class IV plant when cheese was priced high and very tight and actually exacerbated the problem. It’s one of the inefficiencies of the Federal Order system. And I’m not 100% sure how you solve that problem, but there has to be a way to always encourage milk to go to its highest value and the blend price can work against you. It does do a good job of making sure we properly allocate capacity investment so that we don’t over invest in one or the other, but it doesn’t necessarily do a good job of allocating the milk properly when markets are stressed.
Ted: No question about it. That’s been a problem forever. But on the other hand, the government signs contracts, most of them on an annual basis. They sign it with someone who is producing a certain product, who probably is gonna qualify the milk that’s used to produce that product. If he had to put in a dryer and if he’s making cheese to protect himself against a change in market conditions, it certainly changes the whole dynamics of the dairy industry. The financing to put in facilities like that would put him out of business.
So that also is a problem on how you do it. You direct milk to the highest return, yeah, that’s what you wanna do. And the Federal Order system doesn’t necessarily do that, but it does…when cheese is strong, generally the cheesemakers are paying a premium against future sales to make sure they’ve got enough to cover their needs. So to that extent, milk is directed towards the higher return. And there have been times, not as frequent perhaps, but times when butter and powder were Class II products were premium products that paid premium prices, also. They, too, pay premiums to do it. So the current system doesn’t necessarily not direct. It just doesn’t direct it as much as we would like to see.
I guess, we have to be careful if we get into some of these creative ideas that we don’t wind up throwing out the baby with the bathwater. A lot of people who don’t really see the dynamics of this whole thing, they wanna throw the whole system out. Well, 50 years ago or 30 years ago, I used to sort of feel the same way, but I don’t today. I see that it would be chaotic to do that. And a much better solution would be to have the right people at the table to figure out how to have what we’ve got put back on the rails, and this is a good time to do it.
T3: Anna, I’m gonna ask you a question. Now that the cheese price has dropped down into the cellar, what happens to the PPD? How are things gonna play out for the dairy farmer in the next couple of months?
Anna: I think that’s a really hard question to answer right now, at least for me, because there’s more than just the change in prices to take into consideration. It isn’t just what the Class III price does, what butter does. It’s also what everyone did in terms of de-pooling and how they bring it back and the impact that that has. I still don’t think we’re looking at good PPDs for any amount of time here really. We’re looking at, minimum, three to six months of still probably negative. Well, will they be what they were this month, $8.69, $8.02, $4.86? I mean, those were huge negatives. I don’t think they’ll be that bad. But then also, I mean, without knowing what the prices are actually gonna do, where it’s gonna settle, I don’t know. I mean, it’s not a good answer.
Ted: I was gonna chastise you, Anna, but unfortunately, I do understand the problem, part of it. Well, maybe I understand the problem, but it’s gonna be pretty hard for the dairymen to understand it. You know, how could things get so catawampus and where does the money go?
Anna: I think one of the things that is the hardest is that when that PPD is negative and it gets pulled off of your check, you feel like that is your money that is going to somewhere and it has to end up somewhere. The reality is that that number is just a plus or minus to get back to the blended price, and that is just the value of everything in that pool. There are some orders that just do…they do a blend price. Like order five gives you a blend price and that’s what the producers get paid on. To me, that is a lot less confusing from a producer’s perspective. This is the value of the butterfat at the blended price. This is the value of the skim at the blended price. That makes a lot of sense. It’s a lot less confusing than, “This is the amount we had to add or take off to get you to the average.” I kind of wish they all did that. I never used to feel that way. But especially over the last few months, I feel like that would make a lot of things clearer for a couple of people.
Ted: Yeah, it’s true. And I think we’ve probably addressed the problem of the outhouse to the penthouse to the outhouse again, so we’ll just have to see where it’s gonna from here. I think Teddy is probably right. We’re probably headed back to maybe not the penthouse, but somewhere around the 15th floor.
Anna: We welcome your participation in “The Milk Check.” If you have comments to share or questions you want answered, send an email to podcast@jacoby.com. Our theme music is composed and performed by Phil Keaggy. “The Milk Check” is a production of T.C. Jacoby & Company.
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