The charge to the USC was to analyze alternative BFP pricing procedures for use in FMMOs. In doing so, we narrowed the options to those that meet the criteria considered to be consistent with the objectives of the AMAA and have the potential for being understood. However, we explicitly avoided the issue of political acceptance.
USC was not charged with coming up with a recommendation on which alternative performed best in terms of the criteria set forth by the Committee. The reality is that none of the options performed perfectly. There are tradeoffs that exist among the options. Some of the tradeoffs are inherent in the AMAA. For example, the AMAA asserts that order prices should both reflect current economic conditions and be stable. If an alternative is more responsive to supply-demand conditions, it is likely to be more unstable. These tradeoffs are not always explicit in our analyses in that they involve consideration of the degree of reliance to be placed on markets versus regulations.
In narrowing down the options, USC feels that it has learned much that USDA and industry interest groups should find useful in arriving at a decision and in drafting regulations for its application. The purpose of this chapter is to present its findings and conclusions regarding the procedures to be followed in applying whatever alternative is adopted.
The AMAA sets minimum prices. While enacted a half century ago, regulatory experience indicates that minimum pricing allows latitude for market forces to operate while providing stability, orderliness and a reflection of national supply and demand conditions. In other words, USC concludes that the framers of the AMAA acted with considerable wisdom and insight which should be taken seriously in designing a substitute for the M-W price series.
Minimum pricing means that the BFP should not be the price paid for milk used for manufacturing all the time nor, for that matter, on most of the product most of the time. This conclusion is particularly relevant in the current policy environment where, in the absence of an effective price support program, the market needs to be able to clear. Moreover, this BFP decision needs to look to the future where, in year 2000, under the 1996 Farm Bill, there is no milk price support program. It is also consistent with today's dominant political philosophy that less market regulation is preferable.
In the short run, if BFP is set too high under FMMOs, the market will not clear. More than likely, the excess stocks of manufactured products will end up in the hands of cooperatives that process the majority of the production. The producers who own these cooperatives would bear the immediate brunt of any decision that had the effect of setting the price of milk above the market clearing price. Over time, pressures would build for cooperatives to put the stocks on spot markets such as National Cheese Exchange or the Chicago Mercantile Exchange. If a product formula was used, the price to producers would fall and be reflected to producers in the price of milk within a month. If a competitive pay price is used, the producer price would likely decline more gradually as lower margins are reflected in less competition for the available milk supply.
Clearing the market is assured if product prices are free to fall to the point where supply and demand are equal. For the options that survived to Step 2, the market would most readily clear under the following conditions:
If classified pricing is to be sustainable, it must be uniformly applied to all manufactured products. The current Class IIIA pricing system is undermining the Class II and Class III price by allowing milk to be manufactured into NDM at a lower price which, in turn, appears to be utilized in increasingly large quantities to make soft products and cheese.
Data on the extent to which NDM is being utilized in Class II and Class III products is less than perfect. Figure 22 indicates the quantities of NDM used to make cheese (excluding cottage cheese) and soft products (including cottage cheese, sour cream, ice cream and yogurt). The quantity of NDM used to make soft products increases when milk supplies are tight as was the case in the late 1970s and the early 1990s. However, since the establishment of Class IIIA there has been a sharp increase in the utilization of NDM to make soft products. The quantity of NDM to make cheese likewise increased sharply after Class IIIA pricing began. Figure 23 indicates the proportion of Italian cheese production manufactured using NDM could have exceeded 15 percent in 1994. This assumes that all NDM used to manufacture cheese was made into Italian cheese -- clearly the largest use. Based on estimates of the nonfat solids composition estimates for soft products, figure 23 also provides an indication of the proportion of total nonfat solids that come from NDM. It suggests that as much as half of the nonfat solids contained in soft products came from NDM in 1994 and 1995.
FMMO surveys were conducted of regulated plants in March and September 1995 (AMS, March and September 1995). The results indicated that the utilization of NDM to produce Italian cheese is consistent with the findings of this report. The quantity of milk used to produce Class II products in FMMO regulated plants has been relatively stable since 1993. However, USDA/American Dairy Products Association data suggests that substantial quantities of NDM were used to produce soft products. These products apparently are produced in unregulated plants that were not accounted for in the 1995 reports. USC suggests that further study is needed to confirm the extent to which NDM is being used to produce soft products throughout the United States.
With technology for recomposing products from dairy ingredients continuously improving, it can be anticipated that the utilization of NDM to make cheese and soft products will continue to increase. The result is the utilization of valuable economic resources for largely nonproductive purposes. That is, it is inefficient to expend the resources for drying milk when fresh milk could be utilized to make the same product that would, perhaps, be of higher quality.
Moreover, if as a consequence of Class IIIA pricing, NDM demand continues to increase for use in manufacturing cheese and soft products, regional distortions in production patterns for these products can be anticipated. That is, the costs of producing cheese and soft products would tend to be the lowest in those regions that have direct access to NDM produced at the Class IIIA price. The result is a distorted, disrupted and disorderly circular effect that undermines the FMMO pricing system as well as the overall efficiency of the milk industry.
How did Class IIIA pricing get started in the first place? Its origin lies in the costs of performing the balancing function in markets having relatively high fluid utilization. These plants, primarily located in the Northeast and Southeast, maintained butter/powder plants to process supplies in excess of fluid (Class I) needs in the flush Spring months. As a result of the high costs of maintaining these facilities, there were petitions for either setting lower prices for milk used to produce butter and NDM or for service charges on milk used in Class I to pay for the higher costs incurred by balancing plants. USDA opted for a lower Class IIIA price during at least part of the year in selected markets. The other source of Class IIIA pricing in FMMOs was a desire to be competitive with California's NDM production. In the early 1980s California adopted generous make allowances to manufacturers as a means of manufacturing rapidly expanding supplies in California plants.
If the dairy industry is to maintain the classified pricing system, including FMMOs, it has to find a way to come to grips with the Class IIIA issue in the reform deliberations mandated under the 1996 Farm Bill. This can be done either by eliminating Class IIIA or by establishing a system of up-class charges of the difference between the Class IIIA and the Class III price for any NDM used to make cheese or soft products.
The former, eliminating Class IIIA, can be most easily and effectively pursued if the BFP is set at a minimum level or eliminated completely. These options allow the forces of competition, rather than administrative edict, to play a greater role in allocating supplies. The latter, establishing up-class payments, implies a considerably higher level of regulation. Moreover, any up-class pricing system for NDM would need to be applied on a national basis, including California. Without such a national application, there would be incentives for increased soft product and cheese production to be located in California. That is, if FMMOs imposed an up-class charge and California did not, it would be more profitable to manufacture products from NDM in California.
USC opts for no Class IIIA and a lower level of regulation with a minimum Class III price that applies to all manufactured products in all regions. In drawing this conclusion USC recognizes that in the long run the Class III price will need to be competitive with NDM traded at world market prices. Creating equity in the pricing of Class II products could require the elimination of Class III with a consequence of placing both soft and hard products in a single price class. The less desirable alternative involves a nationally applied up-class payment for NDM used in making cheese and soft products. Without one of these options, the Federal order system is not sustainable. If needed, a system of service payments to cover the costs of balancing is considered preferable to mandatory up-charges on NDM used to make cheese and soft products. The reason for this preference is that service payments force butter/NDM utilization to compete with cheese for the highest use value of raw milk.
Coming to grips with the Class IIIA issue requires that federal order and California state dairy policies be coordinated. It may not only require the elimination of Class IIIA and its California counterpart but also that all soft and hard products be part of the same Class. The movement back to a two-Class system will be a particularly relevant consideration as barriers to trade in dairy products are reduced. At that point, U.S. soft and hard product manufacturers will need to be in a position to compete with NDM traded at the world market price and with products made therefrom.
Throughout this report, the BFP options have been analyzed in terms of their ability to move the price of milk consistent with the requirements of the AMAA. Consistent price signals at the right time and in the right direction are more important than the absolute level of price in terms of reflecting national supply and demand conditions, stability and orderliness. In the short run this may be difficult for producers, who are trying to make a profit and survive, to accept.
USC concludes that from an operational perspective, it makes more sense to utilize the BFP as both a mover and a setter of the price. If the BFP is used as a mover but not a setter of the price, industry interests will always be second-guessing what the "right price" really is. That is, is it the price generated by the BFP or is it the price that the BFP is moving? This confusion itself will be a source of disorderliness.
If, however, it is decided that the BFP should only be a mover of Class III prices, it is desirable to pick a period of relative supply-demand balance and stability as a starting point for implementation. At that point in time, there is a decision on the appropriate starting price. The USC believes that the starting price should be relatively low, although not so low as to be destabilizing. This is a judgmental decision that requires economic input at the time of implementation.
A flurry of controversy surrounds wholesale markets for dairy products. The basic concern relates to what economists refer to as "thin" markets. In these markets, price is based on a relatively small number of transactions. Such markets are suspect simply because of the small volume of trade and the potential for manipulation. Mueller et al. have asserted that price manipulation of the cheese market has occurred. Gardner has contested this finding. USC draws no conclusion with respect to these issues except to recognize that thinness does exist and that the perception of a problem can be as important as the existence of a problem.
For the futures markets to be used as the source of prices for the BFP requires that the futures price be based on a large volume of trading. This does not yet exist for all products, with futures prices being as suspect as spot market prices. Perhaps this suspicion is even greater for futures markets because of the lack of broad-based understanding of how they function.
Therefore, USC feels that the USDA should take steps to see that the manufactured product prices it reports are based on substantial volumes of market transactions. It, therefore, suggests that plant surveys of transaction prices for products need to be expanded. This is the case regardless of the BFP option chosen. That is, regardless of whether the BFP is to be set by a competitive pay price, a product formula, or there is to be no BFP, the USDA has a stake in providing the industry with transaction prices that represent a substantial share of the industry's volume of production. To protect the integrity of reporting, periodic audits will be needed.
To generate a minimum price, the specific prices that are utilized should represent the most efficient production areas that have a large volume of trading. For example, if a product formula is used, price surface maps developed by Novakovic et al suggest that the NDM, butter and buttermilk price might logically be established on the basis of West Coast sales. Cheese-whey and whey-butter prices might be established on West Coast sales or by a combination of West Coast and Wisconsin sales. Product specification should be uniform commercial sales of products without significant value added components.
The dairy industry should be receptive to expanded reporting of transaction prices. It is essential to allowing the Federal order system to operate in a competitive, trustworthy and orderly environment. If it is found that industry participants are unwilling to provide such information voluntarily, USDA should explore and test its authority to require reporting and to audit company price records.
Transaction price data may not be available on a timely basis for setting Federal order prices. This is definitely the case when competitive pay prices are utilized. In these instances, the choice for USDA is to either rely on spot market quotations or on reporting of transaction prices by a small number of large plants. Market quotes that are relied on make them a tempting target for possible manipulation of sales and prices by firms having an interest in the outcome.
Futures prices having a large volume of trading hold greater future potential because of participation by interests other than those within the dairy industry. Yet, futures markets may not yet be sufficiently developed. Therefore, USC concludes that there is need for greater emphasis on transaction prices even if it means obtaining a representative sample on a timely basis for bridging to generate the BFP price.
The importance of product yields other than butterfat is now widely recognized by the dairy industry. This reality is seen in our research results which indicate explicit consideration of yields leads to greater explanatory power in the BFP options analyzed.
USC concludes that USDA and the various industry components need to give even greater attention to yield issues in its pricing decisions. The industry would be well served by a pricing system that recognized and utilized product yields at all levels and on all products. In today's markets, our analysis clearly indicates that pricing incentives/rewards for nonfat solids/protein are at least as important as for butterfat. It also suggests the need for uniform component pricing provisions cutting across all FMMOs.
Make allowance issues are critically important if the BFP is to be determined by a product formula. Under the price support program, USDA did not give the make allowance the deserved level of attention. Certainly, this inattention will need to be remedied if a product formula is adopted.
USC analyses indicate that product formulas with cost-based make allowances tend to more accurately reflect the value of milk for manufacturing and generate a more stable milk price. It, therefore, concludes that if a product formula is adopted as the BFP, a formal system will need to be developed for determining manufacturing costs by product.
The California regulatory system has placed substantial emphasis on auditing plant costs to determine the appropriate make allowance. But, even in California, with audits that tend to run on an annual basis, changes in cost can be missed by several months. This suggests the need for a rather major auditing function by USDA. Rather than employing a large group of financial auditors operating continuously, consideration could be given to modeling and regularly updating a set of representative plants.
The issue of what, if any, relationship there ought to be between the BFP and the Class I and Class II prices was not a focal point for the USC. However, there are implications from this study for Class I and II prices.
First and foremost, the utilization of the Class III price as a mover of the Class I and Class II prices provides direct coordination among prices of the different Classes. This direct coordination is important because it sends an unambiguous market signal to producers when there is a change in overall industry supply and/or demand. For example, a surge in demand for cheese is expressed through a product price formula in a higher BFP which, if used as a mover of the Class I and Class II prices, results in a higher producer price and signals the need for increased milk production. Without such a direct tie, the need for increased production gets diluted by a flat Class I price or, worse yet, a declining Class I price.
Fluid processors who object to a direct tie between Class III and Class I do so on the basis of the impacts of incremental changes in the price of milk on their profits. This concern could be taken into consideration by moving the Class I price in increments and/or multiples of $0.11 per cwt -- there are 11.6 gallons in a cwt. While direct Class III price transmission would be muffled, the impact of a substantial supply or demand shock would be reflected in the Class I price, therefore, directly in the producer price. Presumably because of the potential for using NDM in Class II products, Class II prices would remain directly tied to the Class III price.
USC considered the alternative of utilizing a moving average linkage between the BFP and higher Class prices. With moving averages, short-term Class I or Class II price movements could be in the opposite direction. However, the magnitude of the movement would be substantially reduced even if the BFP price movement was substantial. Moreover, the result would be relatively small changes in the higher Class prices leading to even greater potential impacts on processor margins.
As indicated previously, even under the option of component pricing with no BFP, a mover for the Class I and Class II prices can be computed. This mover can be used to obtain coordination between manufactured product values and higher Class prices.
A second issue in the relationship between Class prices involves not getting the Class II price out of line with the NDM price. When this happens, NDM is used in making Class II products on an increasing basis. Either an up-charge or a small Class II differential (assuming no Class IIIA) can deal with this problem within FMMOs. However, the up-charge can lead to distortions in processing locations when all geographic regions are not covered by orders.
The most progressive markets are those where there is continuous pressure for adjustment to the highest level of efficiency. Absent government, progressiveness is engendered by competition. If regulation stifles competition, market performance declines.
These relationships underlie the minimum price philosophy espoused at the beginning of this chapter and within the AMAA. Given a choice, it is better that the order price be lower rather than higher. Such a strategy allows the market to operate in a manner that was intended by the framers of the AMAA which, in the view of USC, reflects substantial vision of the role of government in market regulation.