On this bite-sized episode of the Milk Check, Ted Jr. and Ted III take a look ahead to discuss one of the industry’s most pressing questions: how will deflating premiums and rising labor and manufacturing costs affect market inflation?
Ted Jr. begins by observing how decreases in Class III and IV premiums over the past five years have exacerbated the domestic industry’s reliance on exports, and Ted III follows by outlining the encroaching dangers of inflation to the domestic and international industries.
The hosts go on to predict the timeline of market inflation, the dangers imposed by international supply chain issues and the reformations needed to counter rising prices.
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Ted Jr.: What we were talking about this morning was the change in the hauling rates and how it affects the dairymen. Talking with our milk group, five or six years ago, the norm on hauling from picking up the milk on the farm and delivering it to the usual handler or a plant, let’s say. Call it 50 to 75 cents depending on location. Maybe less up in Wisconsin and maybe the handler, whether it’s a co-op proprietary, is picking up part of the tab on the hauling. But today that hauling cost is pretty much double. And you’re not going to have, even if the manufacturing plant is across the street, you’re not going to really have it for less than a buck, and a buck and a half we decided is probably the norm. Well, the issue is, and this relates also to Ted’s meeting on how to handle Class III and IV. Five and six years ago, the norm was to sell the milk to the manufacturing plant at a premium, and premium over the Class III or IV as allocated.
Ted Jr.: And today premiums are difficult. If we get any premium at all, they’re relatively small. Five and six years ago, maybe a buck in some cases, a buck and half over delivered. Today, 25 cents if you’re lucky to deliver it to a manufacturing plant. Then in addition to that, you have operating costs not only for the manufacturing plant, but also for the handler who happens to be handling the milk, whether it’s cooperative or proprietary, and those costs continue to go up. So, we’re asked from time to time, when are we going to get back to a premium? Well, I don’t see it coming. I do see the price possibly going up, the net return to the dairyman. But if you do the numbers right now, you’ve got Class III and IV at roughly $20, a hundred weight. Hauling costs in a buck and a half or so. The dairyman is lucky to wind up with $15.
Ted Jr.: It’s a rare dairyman who’s going to make money at $15. Yeah, there’s some very efficient, large dairyman who could probably do it, but the everyday dairyman is going to have a problem with that. I think this is a reality which needs to address, which of course is one of the reasons that…why you had the meeting. Obviously the people who call the meeting are feeling the same heat that I’m detecting with regard to how much money is actually being filtered back to the farm. And we’re becoming more and more reliant on exports. And what a mess that is when you look at the logistics for getting containers, whether it’s cheese or powder or whey or whatever. Getting it to the port and then there seems to be quite a bit of controversy on who’s the problem at the port, whether it’s the port facility or the trucker or the steamship line, it’s a mess.
Ted Jr.: You wind up losing business. You wind up with much, much higher costs and very little margin left when you’re done. So this is an issue that I think we need to deal with. I’m not sure how we’re going to deal with it. I think inflation will probably take care of it and the result of that would be that there would be continuing diminishing milk supply. We dropped to 1.1 last August. It’s still pretty high compared to two years ago, but if dairymen are going to continue to lose money with these costs, I wouldn’t be surprised to see that supply drop significantly for the next several months. And if that occurs, then the price for cheese and butter and powder are going to go up. So it’s got to run its course, the laws of supply and demand have not been repealed. And all this hassle is going to create, I think, much higher prices that’s significantly down the road.
T3: Well, I think you’re right. And I think when you have a conversation about inflation, a lot of times it’s a circular argument. I think you can make the case: the premiums have dropped for a number of different reasons. Most dairy farmers are going to be able to argue very clearly that all of their costs are going up. Their labor costs are going up. Their feed costs are going up. Their building costs are going up. They’re definitely feeling the pinch of higher costs across the board. Well, the cheese plants and powder plants are feeling the same thing. Their labor costs have gone up as well. The cost of building a cheese plant has probably tripled in the last 15 years. The cost of building just about any plant has at least doubled. And so those costs are a lot higher as well. And it’s interesting because if you bring up the subject of changing the make allowance and increasing the make allowance, your manufacturers are going to go, “We have to do that. Our costs are gone up.”
T3: The dairy farmer is going to yell and go, “Why are you reducing my milk price? We’ve got enough problems.” But the reality is I…and I don’t think it’s a hundred percent of what’s happened with the premiums going down, but I do think it plays a role. One of the reasons the milk premiums have gone down is because the cost of manufacturing at the plant level has gone up. And so the more it costs for people to turn milk into cheese or into powder or into butter or into whatever dairy product it is. You’re either going to raise the make allowance, which essentially lowers the class price, or you’re going to reduce the premiums. Either way, it’s a classic case of supply and demand moving the market price. And so when you ask, you wonder what it’s going to take to get the premiums to come up.
T3: The irony is, I think it’s going to take increasing the make allowances. Because what’ll happen is if you increase the make allowances, let’s say for Class III by 5 cents, and I’m making up numbers here. I have no idea what that number would be, but let’s say you raise it 5 cents. So from approximately 20 cents to 25 cents a pound for cheese, for example. There’s no reason that the premiums paid for milk don’t go up about 50 cents a hundredweight at about the same time as a change in the milk allowance would get instituted and passed into a Class III price, effectively lowering the Class III price by about 50 cents. But really because market forces really haven’t changed, they move constantly, you actually give the cheese companies an ability to pay a little bit more relative to that Class III price.
Ted Jr.: I’d like to weigh in a little bit on the make allowance. And I don’t know what the discussion was in your meeting this weekend, but over the years, I’ve seen the cooperatives wanting to squeeze the make allowance and make it as small as possible. And their theory was that the smaller that the make allowance was, the higher the money that goes to the dairyman. And I’ve always argued that that’s absolutely false. The reason that they wanted to squeeze is it locks the milk into the local market. And the smaller that the make allowance is the less subsidy you have to haul it. So as a result, you have less competition for the dairyman’s milk at his location. And this is particularly true in a place like Wisconsin, where you are in what’s now the I-29 corridor. Where you have groups of manufacturing plants competing for milk for dairymen. So my argument is that the larger the make allowance, the more competition is introduced for the milk. And it puts the dairyman in a position where he can negotiate with more people for his market. Now it’s going to take a heck of a lot of changes in the make allowance today, compared to what it used to be. I don’t think it’s been changed for five or six years, and there’s no doubt it’s completely out of date.
T3: I believe it’s over 15 years at this point.
Ted Jr.: But it’s completely out of date, and that would account for the reason that there’s no premiums as you pointed out. But getting the make allowance as large as possible, allows the dairyman to pursue more distant alternatives. And I think there’s a good case to be made for that, but I’m not sure who’s going to listen to the argument. The dairyman might listen to the argument, but it’s a little bit counterintuitive for him. And since they’re not in the market every day, they might have trouble understanding it.
T3: I think that’s a big part of the problem, trying to understand markets and market prices is often counterintuitive. You think a certain action will affect price one way when in reality it affects prices the other way and make allowances is a perfect example of that. I look at it this way. I think a lot of people in our industry fall into the trap of believing that if you change a formula somewhere, let’s say the formula for the Class III price, that that will adjust the actual supply and demand price for milk. It doesn’t. All you’re doing is moving around a number, market forces always tend to equilibrate the price. And it’s just like the basis price for corn, in different regions of the country, you have a different basis for what you buy corn at. And as market conditions change, that regionally, that basis will change.
T3: Well, it’s the same with your milk price. If you are going to move around the formulas by changing the make allowance in a Class III or a Class IV price, you’re also going to end up changing the basis by almost the exact same amount. It may take a few months for it all to reach that equilibrium point. But at the end of the day, market forces tend to work and they tend to balance that out. And right now what’s going on is, costs have changed enough downstream from the dairy farmer, that it has caused downward pressure on the market’s ability to pay for milk relative to what the Class III price is, or Class IV price. Right now, hauling costs domestically have probably doubled in the last few years. Internationally, they’ve probably tripled and quadrupled. Those costs alone are having significant effect on the basis price, if you will, that is being paid for cheese, milk powder, whey powder, lactose, butter.
T3: And it ultimately is causing, not only the end using customer to pay more for that product, it is also causing the farmer to receive less on a relative basis. And that’s the inefficiency that inflation adds to the system. And what’s kind of scary is, I’ve been in this industry for over 30 years and I’ve never experienced significant, serious inflation. Which means, well over 50% of the industry hasn’t experienced that in their career. There’s not a lot of people left who went through the seventies and eighties when inflation was a significant issue. And so I think there’s a lot of people out there that just don’t know how to deal with it, and don’t intuitively understand how it affects price. And not just the price of whatever product you’re responsible for selling, but completely up and down the supply chain. It affects the prices of everything. And so it makes it really difficult for markets to reach their equilibrium point in a fair and orderly manner.
Ted Jr.: No question that that’s correct, but let me return to the issue of federal order changes to deal with the problem for a minute. You know, the make allowance is basically a two pronged affair. Since the make allowance is much lower relative to the costs than it used to be, what it does is it affects the premium going into the plant, as we’ve said before. A proprietary is trying to qualify as milk is obligated to pay the minimum price under the order. Cooperatives are not. So this really reduces competition for the milk. If a proprietary was to set up a cheese plant somewhere or a butter powder plant or a plant which makes a custom product of some sort, that little make allowance will require him to deal with the local co-op, but he won’t be able to go out and buy milk directly from the farm because the costs of doing so will far exceed the minimum price requirements under the order.
T3: So long as he pools that milk.
Ted Jr.: As long as he pools it, but in most areas of the country, pooling is a necessity. I agree that the cost of pooling in Minnesota and Wisconsin and certain areas of the upper Midwest are negligible, but they’re still real. 10 or 15, 20 cents is still real. In other areas of the country, the Southeast for example, those minimum price requirements have driven the manufacturers out of business, and they’ve all moved to other parts of the country. So, this is an issue which dairymen do not understand. When it comes time to talk about reforming the federal orders, this issue is the sticking point that they have. The last thing that the cooperative wants to do is see the proprietary handlers get their foot in the door on the farmer. Because increasing the competition for milk on the farm will require them to be more efficient in the way they handle things.
Ted Jr.: So, it’s a big issue and there’s two arguments. One, we can reform the federal order so we can accommodate everybody. Or number two, we can toss the whole thing out. And there’s a significant number of, particularly dairymen, who don’t understand the implications of throwing the whole thing out and the collateral damage if we go down that road, as opposed to a significant reform which allows for more players. So inflation is going to exacerbate this issue. If the price of milk with the scenario that we’ve described and $7 corn, and right now, unprofitable milk prices at the farm level, the result of that will mean that we’re going to look at significant increases in price. And it’s a question of timing. Is it going to occur in the next few months? Probably not. Cause it’ll take longer for it to bite. In the next year, year or two, we could be looking at a 50% or so increase in the milk price.
T3.: I think one of the hard things sometimes for anybody, not just dairy farmer, is to come to terms with when you’re dealing with market forces. The argument is, well, the price needs to go up because nobody’s making any money. Unfortunately, the price is probably not going to go up until a few more people go bankrupt and get out of the business, so that the supply goes down and then the price can go up. Well, even at 1.1%, that’s still growth. And the reality is, especially with some of the international shipping challenges we have, and in case there’s anybody out there who hasn’t seen any of the articles lately, about a month ago, there was an article that said there’s 23 ships waiting at the port to unload. And that’s the most ships that have been waiting to unload at the port of Long Beach in something like 40 years.
T3: Well, that was four weeks ago. Last I heard that number’s up to 83, and this international shipping issue is getting worse and worse and worse every day. It’s literally become a nightmare. And the scary thing to me is, it is preventing U.S. Dairy exporters from getting product to their customers overseas. Well, if it’s not going to leave the country, that means it’s going to stay in the country. And what happens when you have cheese or powder or butter or whey staying in the country? Ultimately, it drives down the domestic price. And so, ultimately, that will affect the milk price. So I agree with you, I think the next six to 12 months, we’re going to probably see some lower Class III prices, lower Class IV prices, lower, let’s just say lower milk prices, and that’s probably going to cause dairy farmers to have difficulty expanding in some cases, selling the farm and shrinking. And, ultimately, it will probably lead to higher prices, but things got to get worse before they can get better because you’re going to have to actually continue to see reductions in cows first.
Ted Jr.: There’s another issue too, that will have an effect on this. Our population is not increasing at the same rate it was 10, 20 years ago. We grew accustomed to the scenario where we have a population increase which sort of matches milk production increases. Now, that’s changed. Our population increases are relatively flat, if non-existent, actually. And yeah, people are consuming more dairy products, but the rate of increase is diminishing and will allow for a smaller increase in milk production to keep from driving the price down. So that also is going to have an effect on everything, demographics and so on. So trying to project how this is going to all play out and what the timing’s going to be is a difficult issue.
T3: I think it’s a really difficult issue. I think there’s a lot of different things that are going to affect it.
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 Peggy. The Milk Check is a production of T.C. Jacoby & Company.
