Economic Status of the Dairy Industry: 1996

Each year following the development of the FAPRI/AFPC baseline, the AFPC dairy faculty develop a status report placed in the context of current industry issues and problems. This year's report emphasizes three significant developments:

• The short-run impact of high feed prices.

• The long-run impact of the provisions of the 1996 Farm Bill.

• The competitiveness of the Mexican dairy industry.

• We simultaneously analyze the impacts of changes in the feed and dairy sector.

• We make a year-by-year projection of price changes, assuming normal weather. This gives the reader a greater appreciation for the industry dynamics, as we see them.

• We analyze impacts at both the sector and the farm level.

• Iowa State University takes the lead in analyzing the international dairy economy from a crop, beef and milk perspective.

• University of Missouri takes the lead in analyzing the domestic dairy economy from a crop, cull cow/beef and milk perspective.

• Texas A&M University (AFPC) takes the lead in analyzing the farm level impacts utilizing its 22 representative U.S. dairy farms and its eleven Mexican farms.

The 1996 Farm Bill represents a watershed change in U.S. crop and dairy policy. Not since the Agricultural Adjustment Act and Agricultural Marketing Agreement Act was enacted in the 1930s has there been policy change of this magnitude. Many of the core crop programs were completely eliminated, with a resulting direct impact on dairy feed costs. In year 2000, the milk price support program is scheduled to be eliminated. The dairy industry is challenged to become a factor in the export market.

Crop Policy

Changes in crop policy are often overlooked as factors affecting the dairy industry. Sometimes crop policy changes are misunderstood or misinterpreted. The following represents a brief summary of crop policy changes that are likely to have the greatest impacts on dairy.

• Transition Payments Initiated. Target prices, resulting in direct payments to farmers when market prices fell below the target levels, were completely eliminated. Substituted in their place are 7-year decoupled transition payments. These payments are essentially fixed, are not dependent on market prices, and occur virtually regardless of what is produced.

• Virtual Full Flexibility. In the past, farmers had to plant within their acreage base to receive government subsidies. This is no longer the case. With the exception of fruits and vegetables, farmers can plant whatever they desire, including hay and pasture, and still get transition payments. Therefore, an eligible Wisconsin dairy producer can grow hay on corn base land or corn on hay land while obtaining transition payments on any base acreage regardless of what is grown. Virtual flexibility has meaning to all dairy farmers. It also means that crop producers can be more responsive to the prices of corn, cotton, soybeans and hay. This responsiveness, of course, influences the level and stability of input prices utilized in producing milk.

• No Set-Aside/Acreage Reduction Program. In the past, program benefits were contingent on farmers setting aside (not producing on) a specified percentage of their acreage base. These production control provisions reduced production, lowered government stocks, increased price instability and raised the level of market prices. Crop production will increase in the absence of these set-aside provisions.

• Conservation Reserve (CRP) Early Out. While the 1996 Farm Bill reauthorizes CRP at roughly its current level, it provides an early out for producers who have less than five years left on their contract. Moreover, land coming out of CRP is eligible for transition payments. Land enrolled in new or expiring CRP contracts will be paid the going cash rental rate for comparable land in the region. Preference could be given to land that is subject to water erosion or having shallow soils affecting water quality. Land coming out of CRP must have a conservation plan to control erosion. These requirements appear to favor hay, pasture or small grain production on lands coming out of CRP. Our baseline assumes that 17 percent of the 36.4 million acres of land currently in CRP will come out by year 2002.

Dairy Policy

Dairy, along with peanuts, cotton and rice, is generally classified as a loser in the 1996 Farm Bill. This may be unfair since all commodities, except sugar, lost subsidies. But, while crop subsidies, arguably, will not exist after year 2002, the dairy support program is eliminated in 2000. This Bill clearly represents the most change in dairy policy since 1949 when the milk price support program was authorized. The major changes in dairy provisions include:

• Price Support/Purchase Program Phaseout. The milk price support level is reduced by $0.15/cwt per year through 1999 as follows:

1996 $10.35/cwt.


1997 $10.20/cwt.


1998 $10.05/cwt.


1999 $9.90/cwt.

In year 2000, the purchase program is to be converted to a $9.90/cwt recourse loan available to processors who have butter, NDM or cheese in storage. A recourse loan, is, in essence, an inventory loan from the government. It will be taken out by processors who cannot receive lower cost credit from other sources. The effect of converting from the purchase program to a recourse loan is to remove the floor on the market price for manufactured products that has been provided by the support program. The butter and NDM price will likely fall to the world market price. However, strong domestic cheese demand, combined with import quotas, are projected to maintain cheese prices above world market levels.
• Maximum Make Allowance. While the price support program is in effect, the 1996 Farm Bill sets a maximum $1.65/cwt allowance for processing milk into butter and NDM and for cheese. This compares with current levels of 1.22 and 1.37, respectively.

• Assessment Eliminated. Since the 1990 Farm Bill, dairy farmers have been forced to pay for part of the costs of operating the price support program by an assessment on producers that increased production. This assessment, which has typically been about $0.11/cwt, was often referred to as a tax and eliminating it, perhaps, was the highest single item on the dairy farmers' policy agenda.

• Milk Marketing Order Reform. The Agricultural Marketing Service (AMS/USDA) is given three years to implement reform of the milk marketing order system. Mandated is a reduction from 33 orders to 10-14 orders. In doing so, the geographic structure of milk prices will need to be adapted to the new order configuration. In addition, Secretary Glickman has mandated that AMS come up with a new basic formula price to replace the recently reconstituted Minnesota-Wisconsin (M-W) Price Series. The M-W price reflects the prices paid for Grade B milk, which is no longer produced in sufficient quantities to make the series statistically reliable.

• California Order Authorization. The largest dairy state, California, is regulated by a state milk marketing order. State regulation has become the subject of increasing challenge from a regional competition perspective. In the 1990 Farm Bill, the controversy centered on lowering the California make allowances to the Federal levels. On another state regulatory issue, the U.S. Supreme Court has continued to chip away at states' ability to regulate where it interferes with interstate milk movements. For example, California has mandated higher standards for nonfat solids than exist in other states. Recent court decisions raise questions regarding the constitutional legality of such regulations. This has the effect of undermining the California state regulatory system. Congress provided support for California in the 1996 Farm Bill by authorizing it to maintain its standards. Yet, the California system could still be subject to Constitutional challenge. The 1996 Bill also authorized a separate Federal Milk Marketing order for California if it desires to enter the system. California producers may opt for a Federal order if the ability of states to regulate milk markets continues to erode or if the California dairy industry concludes that it could increase profitability and stability with Federal orders.

• New England Dairy Compact Authorization. Recognizing the difficulty states have in enhancing returns to milk producers, New England dairy interests sought and obtained authorization to establish a compact/agreement among the New England states to raise producer returns. The Farm Bill provides that the Secretary must find that there exists a compelling public interest before implementing a New England dairy compact. Compacts among states are provided for in the Constitution. They have been used mostly to allocate limited water supplies among the western states. Whether compacts can be utilized by a group of states to raise milk prices is problematic. A conflict with the interstate commerce clause of the Constitution may still be found to exist.

• Exports Encouraged. Because the support program typically has maintained market prices for manufactured dairy products above world market prices, U.S. butter, NDM and cheese have not been competitive in the world market. Once the price support program is eliminated in year 2000, this barrier to exports is removed. However, the Farm Bill takes several additional steps to encourage and expand dairy exports:

The National Dairy Promotion and Research Board is authorized to spend checkoff monies on international market development activities -- a function that it did not previously pursue.

The Dairy Export Incentive Program (DEIP) is authorized to be fully funded at the GATT legal maximum levels.

The Secretary is mandated to see that a dairy export trading company is established.

These actions should assure that the U.S. dairy industry is a factor in the world market, particularly after the price support program is dropped in year 2000.

As indicated previously, one of the virtues of the FAPRI consortium is that it allows for integration of the crop sector development into the dairy analysis. This is particularly important when both crop and dairy policy change simultaneously and when weather adversities result in major crop price adjustments.

Crop Indicators

Table 1 provides a year-by-year summary of major input prices affecting dairy through 2002. Because feed costs are approximately half of the cost of producing milk, the emphasis here is upon the outlook for concentrate prices.

In 1996, crop prices approached and, in some cases, set new records. High crop prices reflect low commodity stocks at the end of the 1995/96 crop year (Figure 1) combined with weather uncertainty heading into the 1996 growing season. Commodity stocks at the end of the 1995/96 crop year will be lower than those experienced in the 1973 world food crisis. Dairy farmers who buy concentrates could be literally caught in a supply availability crunch until the Fall of 1996 when the new crop is harvested. Unfavorable weather in the 1996 growing season would transition these high input prices and potential shortages through and beyond the 1996/97 crop year.

Rationing feed supplies with high prices is relatively foreign to the U.S. dairy economy. However, in the absence of government programs to manage stocks and in the presence of periodically strong export demand, tight input supply conditions could become more common.

Given favorable weather, the expectation is that as stocks build, corn and soybean prices will return to the more normal levels that characterized the early part of this decade (Figure 2). Yet, because of the potential for unfavorable growing conditions and in the presence of more volatile import and product prices, dairy farmers (like crop producers) are well advised to sharpen their risk management tools -- futures, option, storage programs, and cooperatives.

Dairy Indicators

Table 2 summarizes some of FAPRI's major price and performance indicators for the dairy sector. The projected drop in the price of butter and NDM to world market levels is the most important single factor influencing the price outlook. Cheese prices, on the other hand, are projected to hold above world market levels based on their strong domestic demand and the continued presence of import quotas as authorized under GATT.

Milk production increases by 14 percent to 179 billion pounds in 2002 as output per cow rises 18 percent to an average of 19,344 pounds and cow numbers decline 3 percent to 9.1 million head.

The lowering of the price support level by $0.15/cwt through 1999 leads to a reduction in the average all-milk price, but by a smaller magnitude (Figure 3). This reflects the moderating impact of the cheese price relative to that of butter and NDM. In the absence of the price support program, the all-milk price drops abruptly in year 2000 by $0.42/cwt to about $12.30. Subsequently, by year 2005, the milk price rebounds to $12.55/cwt, about $0.50 below the level of a decade earlier prior to the policy change.

Through the assistance of producer panels located in each of the milk production areas indicated in Figure 4, AFPC maintains 22 representative dairy farms. In most of the locations, there is a moderate size farm and a large farm. The moderate size farm is designed to represent a full-time family-type farm whose enterprise mix is typical of the area. That is, most of the moderate size farms grow a substantial proportion of the feeds used in producing milk.

The large farms are typically at least twice the size of the moderate size farms. By virtue of their size, they are likely to purchase a larger share of the feed utilized in milk production. Some of the larger dairies buy all or nearly all of their feed.

Dairy Farm Description

Table 3 and Table 4 describe each of the farms. The abbreviations in the second line of the tables indicate the state where the dairy is located (first two letters), that it is a dairy farm (third letter), and the size of the farm in terms of cows milked (the numbers). For example, the first entry in Table 3, CAD1710, is a 1,710-cow dairy located in Tulare County California.

Farm size ranges from the 55-cow Wisconsin dairy to the 2,000-cow Florida and New Mexico dairies. Large size is not restricted to either the South or West -- a large dairy in Western New York milks 1,000 cows. Asset values range from $442,000 for the 77-cow Missouri dairy to nearly $9.7 million for the large Florida dairy.

Once constituted and described, the data agreed to by the panel is entered into a computer simulation model that generates a balance sheet and an income statement. The data underlying these financial statements are adjusted until the results are approved by the panel as accurately reflecting the farm they have described. Panel approval must take place before the farm is utilized in our studies and reports. In the absence of the ability to achieve such approval, the farm is dropped from the set.

Milk sales constitute 85-95 percent of the receipts for these dairy farms. The remainder of the receipts come largely from cull cow sales. At the time of publication, 9 of the 22 dairies had been updated in 1996, including the farms in California, Texas, Georgia, and Florida. During the update process, only three (TXCD825, GAD650, CAD1710) of the nine farms indicated that they were using BST. The other six of nine farms were run not using BST. Farms not updated were run using BST as had been assumed in previous years.

Farm Financial Experience Under 1996 Farm Bill

Tables 5 and 6 report the financial experience of the 22 representative dairy farms under the economic conditions projected by FAPRI as summarized in Tables 1 and 2. Figures 5-10 present the expense, receipt and net cash income experience for each of the farms over the period 1996-2002. In comparison with past years, several farms experience lower net cash income and growth in net worth less than in past years due primarily to high feed costs early in the period and the change in price support policy. The sharpest reduction in equity growth compared with past baselines occurred in California and New Mexico.

Six of the 22 dairy farms experience a negative net cash income in one or more of the years 1996-2002, the period covered by the 1996 Farm Bill. Four of these had a negative average net cash income. All but one of the six farms with a negative net cash income were located in the Southeast and Southwest. It is important to note that, despite criticism of Federal orders for its geographic pricing structure leading to higher prices more distant from the Upper Midwest, all six of these farms are located a long way from the Eau Clair basing point. For these farms, mail box prices are not sufficiently high to maintain a positive cash flow -- although they probably were at one time.

Farms consistently exceeding $100,000 in net cash income were all large. Yet, size alone does not guarantee a favorable net cash income. The large Vermont (186 cows), large Central New York (225 cows), large Florida (2,000 cow) and large East Texas dairies were unable to consistently generate $100,000 in net cash income.

Figures 11 and 12 indicate the average change in net worth accruing to each farm over the period 1996 through 2002. Seven of 22 farms decreased their net worth while 15 increased. Only three farms increased their net worth by more than 50 percent (TXCD825, NYWD600, and NYWD1000) -- all were classified as being large. All of the dairies projected to lose equity over the period could maintain equity by reducing expenses or increasing receipts by 7 percent or less.

In summary, from a U.S. perspective, the high feed costs at the beginning of the period put a decided damper on earnings to dairies that buy most of their feed. While lower feed costs in the remainder of the period help, the price support reduction offsets this gain. In reality, the outcome could be worse than projected. We are unable to adequately anticipate/model the level of input and output (milk) price instability that might be associated with this new policy regime. Most economists anticipate more unstable grain and hay prices as farmers shift production to the most profitable crops. This may be reflected in more unstable milk prices as well. Well-managed dairies will be able to deal with this instability through hedging and contracting. Our expectation is that larger dairies will be in a better position to cope with instability than moderate size dairies. However, this expectation could be offset by aggressive cooperative input and marketing programs. More will be said about these issues in the concluding section of this working paper.

We are, likewise, unable to predict the consequences of mandated Federal order reform which must be implemented in 1999. If the price surface becomes more level in this process, dairies in market areas more distant from the Upper Midwest could be further disadvantaged. However, several of these proposals were voted down in the process of enacting the 1996 Farm Bill.

Over the past three years, AFPC has been supported by AMS/USDA to study the Mexican dairy economy. AMS's interest evolved from the realization that marketing order provisions would be affected by Mexican border issues. Our analysis has focused on two central concerns:

• Are there circumstances under which milk might flow north from Mexico, with the effect of disrupting the operation of Federal orders?

• What are the long-run prospects for increased Mexican milk production and the overall competitiveness of its dairy economy?

The Mexican study was initiated at a time when exports of milk to Mexico were booming (Figure 13). The interest was in how much and how long exports would continue to expand, although joint venture Maquiladora-type operations along the border were being quietly studied -- or, perhaps, not so quietly. Then came the devaluation of the peso in December 1994. Fluid milk exports to Mexico plummeted from a high of 28 million pounds in November 1994 to a low of 3.5 million pounds in May 1995 (an 88 percent decrease). Whereas before devaluation, U.S. and Mexican whole milk sold for approximately the same price in Juarez supermarkets (about $2.45/gal.), after devaluation, Mexican milk sold for $1.55 but U.S. milk sold for about $2.16. Since the devaluation, there has been a seasonal recovery of exports as Mexican milk production drops cyclically in the Fall. However, U.S. milk is still at a substantial price disadvantage.

It was found that Mexican products often are produced with ingredients that are bought at the world market price. For example, fluid milk may be processed from reconstituted whole milk powder or from a combination of NDM and vegetable fat. Such occurrences can create incentives for Mexican products to move across the border, in the absence of adequate inspection.

From a demand perspective, there is an important constraint on the average Mexican family's ability to buy milk. In 1993, only three percent of the Mexican population had an income of over $5,000. One can readily draw the conclusion that future Mexican consumption is dependent on income growth while production depends on economic policies that foster investment and lower interest rates.

Despite the fact that Mexico is substantially deficit in milk production, there are incentives for Mexican producers to want to sell milk in the United States. That is, whereas the Mexican producer price was higher than the U.S. price before the devaluation, afterward a Mexican producer could potentially have received a higher price in the United States -- if there was a willing buyer and a U.S.-certified inspection system for Mexican farms. The incentive to sell in the United States is particularly strong for Mexican producers who are not "founder/shareholders" members of Mexican cooperatives. Founders/shareholders get a higher price for milk under their quota share.

To analyze the long-run competitiveness of the Mexican dairy economy, we developed eleven representative farms with the assistance of producer panels located in the tropics (Chiapas and Veracruz), in the traditional production area of Central Mexico (Queretaro), and in two of the northern production areas (Delicias and Torreon).

Tables 7 and 8 indicate the Northern and Central Mexico commercial dairy farm characteristics in the same format as was previously done for the representative U.S. farms. These farms vary in size from 300 to 2,000 Holstein cows. Tables 9 and 10 indicate the characteristics for the farms in the tropical areas. These farms range in size from 25 to 100 cows and are normally crossbreeds of Holstein and the more heat-tolerant Zebu cattle, or just Zebu cattle being milked during the rainy season as a way of increasing the farm's cash flow. The level of management is very rudimentary and it can be characterized as a low input/output system.

The combination of Table 7 and 8 shows the greater variability of Mexican dairying than in the United States. However, our analysis indicates that the large Northern Mexico dairies have the potential for being fully competitive with comparable well-managed dairies in the United States.

Figure 14 presents the net cash income achieved by the Northern and Central Mexican dairies in 1996 compared with their California and New Mexico counterparts. Because of the absence of baseline milk and feed prices, we are unable to reliably project these earnings out into the future, as was done previously for the U.S. farms. However, these results clearly indicate that Mexican dairies are able to generate substantial net cash income. Yet, the lack of access to debt capital and a limited availability of forages and feedgrains constitute important constraints to Mexico being able to rapidly expand milk production.

Figure 15 indicates the net cash income levels achieved in 1996 by the four tropical dairies. All incomes were below the level that would be considered to be economically viable in the United States with the 60-cow Palenque farm experiencing a loss.

Dairy did not enjoy many allies in the 1996 Farm Bill debate. Moreover, it had problems getting agreement within the dairy sector on the appropriate policy direction. As a result, there are some significant dark clouds on the horizon for dairy resulting from:

• Comparatively high near-term feed costs exist which, if extended by adverse weather, could prolong low returns in areas that purchase their feed.

• Anticipated increased price instability will put more pressure on dairy farms who have problems managing the risk of variable input costs and milk prices.

• Lower milk prices can be anticipated through year 2000 when the price support program is eliminated.

• The potential integration of California into the Federal milk pricing regime.

• The development and implementation of a rational alternative to the Minnesota-Wisconsin milk pricing series.

• A testing of the ability of U.S. dairy farmers to compete internationally, including serving the needs of a growing Mexican market.