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US Dairy Policy at a Crossroads

Christopher Wolf 
Dept. of Agricultural, Food & Resource Economics

Introduction
The dire financial consequences of low milk prices and high feed prices on dairy farms of the past couple of years has jump-started a national dairy policy debate that might be part of the next Farm Bill or possibly enacted at an earlier date. Several policy proposals are currently being discussed by industry and policy-makers. This article considers the current policies, the set of dairy alternative proposals, some of the economic consequences of these alternatives, and the dairy policy outlook. 

Current Dairy Policies
A review of the current policies—their origins, purposes, and current issues with their functioning—is a useful place to begin this discussion.  At the present time the major aspects of dairy policy include milk marketing orders, the dairy product price support program (DPPSP), the milk income loss contract (MILC) program, export subsidies and import tariffs. Milk marketing orders have been around since the 1930s. Federal Milk Marketing Orders set minimum prices of milk based on end use and blend the revenues to assure all farmers in the order receive a minimum average blend price. They were created to ensure an adequate supply of fluid milk and deal with equity issues across farms. A major Order restructuring occurred in 2000 with 32 Federal Orders consolidated to eleven (now 10 as the Western Order was voted out of existence a few years back). That Order reform also included setting minimum prices based on wholesale product prices.  Using wholesale prices necessitated determining how much of that price should be credited to processing the milk (called a make allowance). That process is unwieldy to say the least and has been a source of contention, calling for the need for better “price discovery” of farm milk price. Marketing Orders smooth out wholesale price changes to some degree as they blend product prices together and some prices enter with a time lag. The regional nature of milk marketing orders has fed disputes relative to dairy policy discussions in the past. Milk Marketing Orders are not intended to support milk prices but rather to pass a share of the value of milk on to the farmers based on end use and assure an average share to each qualifying producer.

The dairy price support program has existed since 1948 as an open offer by the government to purchase cheese, butter, and non-fat dry milk. Following several years of large government dairy product purchases to support those high prices, the support price was ratcheted down to a level that basically has not interfered with milk price since the early 1990s and volatility has increased greatly. In the most recent Farm Bill, the support program was changed from supporting milk price at the farm level to supporting dairy product prices which would then indirectly support farm milk prices. Besides the support being basically too low to matter much in today’s market, the program has been accused of squelching incentive to innovate in dairy products and supporting import prices when world prices are low. With the exception of non-fat dry milk purchases, the support program has not had a great deal of relevance in recent years and seems to be on the chopping block as far as most everyone in the industry is concerned. 

The MILC program came about in 2002 and provides deficiency payments for milk when the price falls below a target level (i.e., $13.69/cwt Class III milk). The payments were originally limited to the first 2.4 million pounds of annual milk production and later increased to 2.985 million pounds. A feed cost adjuster was later added to make the payments greater when grain price volatility increased. This program is much more important to small farms than large farms as a consequence of the payment limits. The MILC program has been accused of retarding the market signal to contract milk production by insulating farms from low milk prices.

Dairy trade regulations and the dairy export incentive program (DEIP) also have been important dairy policies. Historically, the US has exported about five percent of production in the form of bulk cheese, butter, non-fat dry milk, dry whey and whole milk powder.  Prior to the world-wide recession that occurred in late 2008 the US had several years of export growth and appeared poised to be a major dairy supplier to emerging markets in Asia. On the flip side, the US generally imports about the same amount of product (in milk equivalents) but the imports are composed of higher value specialty products (e.g., specialty cheeses).  While government export incentives were utilized heavily years ago, more recently competitive US prices and industry programs have made them less important.

Cooperatives Working Together (CWT) is an industry, rather than a government, program that has been very important since its creation in 2003. The program is funded voluntarily by cooperatives and independent farm members. The funding has been utilized for herd removals ten different times, representing more than 510,000 total cows and subsidizing dairy exports. While the longevity of the program is a testament to the ability of dairy farmers to cooperate, membership in the program has deteriorated somewhat especially as the economic conditions of 2009 made it difficult to afford the payments.

Many existing dairy policies, like many existing US agricultural policies, have their origins in the Great Depression era. While these policies have been updated periodically and changed through Farm Bills, massive technology changes (both on the farm and at the processing and retailing levels) population and income changes, and a host of other dynamics cannot possibly be reflected in slowly changing legislation and administrative rulings.

Current Economic Policies
With that as background, consider the current dairy economic climate.  The major issues from a dairy farm perspective are price volatility and frequent negative profit margin. The price volatility that has occurred in recent years in both farm milk and feed price is unprecedented.  Unpredictable, large changes in milk price make it difficult for both producers and processors of milk to make appropriate managerial decisions. While the current set of dairy policies may not have been directly responsible for causing milk and feed price volatility the fact of the matter is that these policies did little to prevent or off-set the extended periods of very low prices in 2002-03 and again in 2009-10. The inelastic supply and demand associated with milk and dairy products means that small changes in quantity (either supplied or demanded) can have large impacts on milk price. 

The biofuels policy as currently incarnated has in effect shoved the price volatility of the oil market into feed grains so that income over feed cost is an important metric of dairy profitability. Table 1 (page 22) uses nominal Michigan prices from 1985 through 2009 to illustrate the change in price level volatility. The time series was split at 1994 because of the increase in milk price variation that took place at that time. While average milk price—not adjusted for inflation—increased slightly in the 1995-2009 period relative to 1985-1994, milk price variation, as measured by the standard deviation, quadrupled. Coefficient of variation (CV) in Table 1 is the standard deviation divided by the mean. CV is a way to put the variation in perspective. All the price series saw a substantial increase in variation in recent years. For many years, milk price has driven variation in the MF (milk-fo-feed price) while feed prices—especially corn prices—have been low and stable.  However, in the past three years volatility in corn and soybean prices became major factors in driving MF variation.

The periods that have not been volatile in milk price have occurred when the milk price was very low. That is to say, when the milk price is near support price it is not volatile but it is unprofitable. Other problems with the current dairy market relate to farm milk price discovery as the current milk marketing order pricing derived from wholesale product prices does not reflect the dynamic market (and cannot possibly be reflected in an administratively set pricing rule). This issue manifests itself in the divergence between farm and retail milk prices.

Current Dairy Policy Proposals
Historically, there have been many dairy industry factors that shape the policy debate. Among these factors are regionalism; changing farm,

Click Table to Enlarge

milktable

1 All Milk price $/cwt (source: USDA). 
2 Corn ($/bu), soybeans ($/bu) and hay ($/ton) refer to prices received by farmers (source: USDA).  
3  Milk-to-feed price ratio (MF) = (All Milk price)/(Feed price per cwt feed) where
Feed cost ($/cwt feed) =[(Price of corn($/bu)/56) x 51] + [(Price of soybeans($/bu)/60) x 8] + [(Price of alfalfa hay($/ton)/2000 x 41)].
4 “St. Dev.” is the standard deviation—a measure of variation and “CV” is the coefficient of variation calculated as: standard deviation/mean.

cooperative, processor, and retailer structure; and the trade situation and trade agreements. Even with all the size and regional issues, there seems to be greater consensus now than perhaps at any time in recent memory that dairy policy changes must be made. There is not, however, agreement on what those changes should be. There are three major types of proposals widely discussed—or even introduced as formal legislation at this point in time. The current proposals can be categorized broadly as: 1) managing milk supply through fees and rebates; 2) risk management programs to support the margin between milk and feed prices rather than the current price support programs; and, 3) reform to marketing order price discovery mechanisms. The “Foundation for the Future” plan of National Milk Producers Federation is a comprehensive plan that includes all three of the policy changes discussed above. Each is discussed and contrasted to alternatives below.

Supply Management
Propping up the farm milk price through some form of supply management is one theme of several plans currently discussed including the “Dairy Price Stabilization Plan” from the Holstein Association USA (in the Senate it was introduced as Dairy Market Stabilization Act by Sanders (VT), Murray (WA), and Leahy (VT)). This plan includes a market access fee payment for all dairy farms which is later divided up and paid out to farms that did not grow milk production. The fee would increase if a farm increased production over historic base level or if dairy economic conditions suggest a needed cut in milk supplied (e.g., the milk-feed price ratio or margin is below a trigger level). This program is essentially a form of supply control.

Economists generally are not proponents of supply control as it tends to protect inefficient production and lower economic welfare of some market participants. If a dairy producer is not planning to grow production—as would likely be the case where, for instance, bringing a future generation into the operation— then they might find it appealing to get paid by new entrants and growing dairy farms. In past years, we might have expected states with recent rapid milk production growth, like California, to oppose a supply control program but that is not the case this time around as there appears to be support for this program in California. Analyses by researchers from Cornell University and the Food and Agricultural Policy Research Institute (FAPRI) at the University of Missouri suggest that this program would indeed lower the milk price volatility but the potential negative effects also must be considered.

One important consideration in any supply control program is the potential for imports to increase market share. This plan may mean that the US will not be a significant player in the export market, either. Servicing contracts in the export market requires some degree of reliability which would likely be undermined by constrained supply with this program. On the flip side, the potential for maintaining high milk prices will almost certainly attract imports. Unless sufficient restrictions are in place, the US market might experience an increase in dairy product imports which pressure milk prices and prohibit domestic supply growth. The US has for the past few decades moved towards more free-trade agreements so these import restrictions might be a tough sell on Capitol Hill.

Risk Management
Recent volatility in grains means that margin over feed is a superior indication of dairy farm profitability rather than simply milk price. The dairy producer margin protection program supports the margin between milk and feed prices rather than milk price alone. The intention is to have a minimum margin protected at government expense with the option to increase the margin at a farmer’s expense. Past experience indicates that it is difficult to design and implement government insurance programs that do not entail large subsidies and potential production distortions. At the current time, producers could purchase margin insurance through dairy livestock gross margin (LGM) programs or put together their own margin protection using futures and options. Neither of these alternatives has been widely adopted to date. One pitfall of a margin protected at the government’s expense is a dulled market signal when supply is too large. To alleviate this concern NMPF’s Foundation for the Future plan also proposes a market access fee scheme to control supply. 

The NMPF plan includes eliminating the DPPSP and MILC programs with the farm safety net instead held by a combination of margin protection and market access fees. As was discussed above, there are many issues with the current support program including being irrelevant to today’s milk market prices. The willingness of NMPF to “trade” this long-lived program away indicates the seriousness with which dairy policy reform is considered in this proposal.

Reform Price Discovery
A third type of policy solution is to change milk pricing under the Federal Milk Marketing Orders. This is the approach taken by the “Federal Milk Marketing Improvement Act” (sponsored by Senators Specter (PA) and Casey (PA)). This Act would define two classes of milk-fluid and manufacturing—rather than the four that currently exist in federal milk marketing orders. The new Class II milk price would be based on the average cost of producing all milk in the 48 contiguous states. Basing farm milk price on cost of production might alleviate one area of concern for many industry participants which is the use of the Chicago Mercantile Exchange (CME) prices to set farm milk prices.

The CME spot cheese market is thinly traded—which is to say that there are few trades representing a very small portion of production—but most cheese buyers and sellers look to the CME prices as a reference. The concern is that a thin market might be easily moved by large buyers or sellers to favor their position. A University of Wisconsin study in 1996 found some evidence of market manipulation at the National Cheese Exchange in Green Bay (which subsequently moved to the CME). A thin market is not evidence, per se, of anti-competitive behavior but a higher degree of participation in the market would provide more assurance that an accurate, competitive milk price is reached. However, this plan may be a challenge to effectively implement as cost of production is a difficult-to- define term (operating and ownership costs, fixed and variable costs, accrual and allocation issues) and defining the pay cost at an inappropriate level (too high or too low) can have adverse consequences in the milk market.

The NMPF plan takes a different approach to reforming price discovery by basing Class III (milk for cheese) price on competitive pay price rather than wholesale prices. This is in many respects a “back to the future” move as the old Minnesota-Wisconsin (M-W) price series was the base for milk pricing for many years. It was a competitive price based on surveys of cheese plants purchasing Grade B milk. One concern with this approach is finding a significant enough unregulated milk market in 2011 to reflect a real competitive price. This concern was what drove policy makers away from the M-W in 1995.

What Happens Next?
Many of the aspects discussed above are in some form of legislation at the current time. For example, the Federal Milk Marketing Improvement Act and Dairy Market Stabilization Act are in the Senate Agriculture Committee. Keep in mind that there are three major underlying influences that shape agricultural policy in the US. First, people need to eat and US consumers are accustomed to safe, reliable and relatively inexpensive food. US consumers spend about ten percent of their income on food purchases which is one of the lowest levels in the world. Second, farmers must make a living. If we are to have a reliable supply of food, then sufficient income must be available in farming to maintain the management, labor and capital to produce it.

Finally, politicians desire to get re-elected and thus are quite interested in public opinion. These three influences will all play a role in any dairy policy changes which are likely to be contentious and unlikely to happen quickly.

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