Third Quarter 2000
Volume 3, Number 2

by Roger Cryan

It has become clear, after seven months of operation, that the new Federal orders have made butter the pivotal price for the whole dairy sector. Three Classes of milk (representing three fifths of milk use) have been priced according to a formula that uses butter and nonfat dry milk prices; and since the government is setting the nonfat dry milk price, butter is moving the milk markets. What makes this especially significant is that the new pricing system tends to limit the incentives to move milk from cheese uses to butter and powder use, even when the butter-powder value is much higher.

In the past, the prices for most Federal order milk were based on cheese prices, and well under 10% of Federal order milk was priced on the Class III-A butter-powder formula. In the new system, Classes IV and II use such a formula. These Classes include milk used for butter, powder, cream and other perishable dairy products and make up nearly 20% of Federal order milk use. More importantly, Class I now uses "higher of" pricing, so that when the butter-powder value of milk is higher than the cheese value, it sets the Class I price as well. As a result, about 60% of Federal order milk is now turning on the butter price.

No Butter/Cheese Arbitrage. Before Class III-A was introduced in 1992, milk used for cheese or butter-powder had the same Federal order minimum price. With the same raw milk cost, processors would naturally move milk to whichever product had a higher value; so the cheese-price value of milk stayed even with, or seasonally above, the butter-powder value of milk. These prices were linked by processors' ability to capture the benefits of moving milk to the higher valued product. This kept the different use values of milk in line.

Under the new orders, Class prices are tied to the product prices, and when milk is moved from cheese-making to butter-powder, the raw material cost changes. Processors respond to the margin between the product price and the raw milk price; and for butter, powder and cheddar cheese makers, this margin is narrowly defined by the product price formulas for Class III and IV. To a limited extent, cheese-makers can get around this when the Class IV price is low, by using Class IV powder in their Class III manufacturing; and this can help bring Class IV prices back up toward Class III.

However, when Class III prices are low, milk can only move from cheese plants to butter-powder as milk; this milk gets re-priced at Class IV. Even when Class IV is far above Class III, butter and powder makers don't benefit from their re-allocation of milk to a higher valued product.

The practical conclusion is that, as things stand today, milk will not move into butter and powder just because they are worth more than cheese. The allocation of milk between butter-powder and cheese uses will respond to the need to dispose of surplus milk, to the relative processing margins provided for in the Class price formulas, to the value attached to upstream and downstream relationships, to the debt service on manufacturing capacity, and to almost anything else, except the relative prices of butter, powder, and cheese. As a consequence, cheese and butter-powder values may converge only randomly.

U.S. butter production during January through July of 2000 was 800,591,000 pounds, 2.9% above the first 7 months of 1999. After substantial year-over-year increases in January and February, monthly production in 2000 has followed 1999's seasonal pattern closely. March through July butter production is up less than one half percent, despite milk production that was up nearly 4% in the first half over last year and up nearly 5% in July, and despite high prices relative to other dairy products.

NASS reported July 31 butter stocks at 136 million pounds, down 6 percent from the end of June, but up 10 percent from July 31, 1999. Commercial utilization of butter during the second quarter was 279.9 million pounds, 11.5% less than during 1999's second quarter.

The Federal order butterfat price for August was $1.2659, only a shade below July's $1.2691. The Grade AA butter price on the CME averaged $1.193 per pound during August 2000, about 20¢ a pound lower than during August 1999; it stayed close to $1.20 throughout August.

The average retail butter price for U.S. cities was $2.52 per pound in June and $2.72 in July, as reported by the U.S. Department of Labor; the latter was about $0.05 per pound higher than July 1999. The Consumer Price Index (CPI-U, U.S. city average) for butter in July 2000 was down 6.7 percent from 1999. The butter CPI was down 4.4 percent over a year earlier in June 2000 and down 4.8 percent in May.

Milk production continues to grow, but behind the apparent glut of milk is a relatively short supply of butterfat. The cheese market continues to absorb milk at lower and lower prices, leaving butter makers to take what's left, regardless of the higher butter values. At some point increased milk production may push enough butterfat into the churn (and enough powder into government warehouses) to push the butter price down. Whether that happens in the fall or the spring will depend on the effects of this year's summer heat on the farm.

The USDA raised the make allowance in the support price formula for butter by 1.8¢. This had the effect of raising the butter support price by the same amount, to 66.8¢ per pound. The cheddar cheese support prices were also raised by 2.2¢. This action partially responds to industry concerns about discrepancies between the make allowances in the CCC formulas and in the Federal order price formulas.

Briefly: Senate Bill 2773 would require makers and warehousers of butter, cheddar cheese, nonfat dry milk, and whey to report inventories and prices of these products to the USDA; it was introduced by Senators Feingold, Craig, and Kohl on June 22…. No result is expected from USDA on revisions to the Class III and IV price calculations until after Election Day.

The new CME Class IV milk futures contract got off to a much faster start than its Class III counterpart did 3 years ago. Open interest on the Class IV contract went over 1,000 contracts (representing 200,000,000 pounds of milk) on August 28, just 7 weeks after it began trading.

One aspect of the new contract that may be contributing to its success is its use as a forward pricing vehicle for Federal order butterfat. The Class IV price is equal to 3.5 pounds times the Federal order butterfat price plus 96.5 pounds times the Class IV skim milk price. The following formula calculates a Federal order butterfat price from a Class IV price and Class IV skim milk price:

When the powder price is expected to settle at the $1.01 support price, as it has (effectively) for the first seven months of 2000, the Class IV skim price can be taken as $7.70, which simplifies the above to:

To date, anyone using the Class IV contract to forward price butterfat has presumably been doing so on the basis of this formula.

The Class IV futures contract is a cash-settled contract for 200,000 lbs. of milk with 3.5% butterfat or, to put it another way, 7,000 lbs. of butterfat and 193,000 lbs. of Class IV skim milk. On August 31, the December Class IV futures contract settled at $11.50 per hundredweight. A trader who bought one of these contracts would be, in effect, buying 193,000 lbs. of December Class IV skim milk at $7.70 per hundredweight and 7,000 lbs. of Class IV December butterfat at about $1.1627 per pound:

The Class IV skim milk price is a straight calculation from the nonfat dry milk price. Whenever nonfat dry milk rises above the government support price, the nonfat dry milk futures contract can be used to perfect the hedge on butterfat.

The CME powder contract has had no volume since its introduction; when it does it will be cash-settled against the price that USDA announces each month for calculating the Class IV skim milk price. USDA's rounding of the nonfat solids price to four decimal places and of the skim milk price to two decimal places will produce the only difference between the derivative settlement price for butterfat and the USDA announced price.