Market Implications of Federal Order Reform

By Ben Laine, Senior Dairy Analyst Federal Milk Marketing Orders (FMMOs) are set to change the way milk is priced. After receiving proposals, hearing testimony, making a recommended decision and taking public comments into consideration, the USDA will soon release its final rule for FMMO reform. Pooled producers (or their cooperatives on their behalf) will then vote to either adopt the new final rule or eliminate the FMMO completely. Either way, there is no returning to the status quo. And whether or not your milk is pooled within a federal order, there will be market impacts throughout the industry. Make Allowance and Cheese Pricing Changes The most consequential change in the recommended decision is increasing make allowances. The need to increase make allowances was central to the current federal order modernization process. There is general agreement that make allowances needed to be increased (with some debate over the magnitude) to reflect the higher cost of manufacturing since they were last adjusted in 2008. But, increasing make allowances directly reduces component values for protein, fat and other solids. As a result, milk prices decrease. There are other changes, however, that should counteract the decreased component values. The recommendation to remove barrels from the cheese pricing formula should generally increase the cheese average, since barrels drag that average lower more often than not. The return to the “higher of” as opposed to the “average of” Class I skim milk pricing factors will increase Class I and pool values whenever Class III and Class IV milk prices diverge widely, as they did in 2020. Increased Class I differentials will increase pool values and should help disincentivize de-pooling. The three factors combined should result in a mostly neutral price impact, and ideally will lead to more efficient milk marketing. Still, uncertainties and risk management implications could shake things up along the way. How Risk Management Factors In Risk management has become more commonplace in the dairy markets than when FMMOs were last changed. CME futures contracts for Class III and Class IV milk settle to the USDA announced price for each respective class of milk. It hasn’t historically been a concern that the way the USDA calculates those class prices would change between the time a contract is bought or sold and when it settles. But that risk has now gone from a negligible one buried in the settlement procedures to a likely scenario. Similarly, cheese futures will change in less clear ways. The cash-settled cheese futures contract settles to the monthly weighted average price for cheese using both 40-pound cheddar blocks and 500-pound barrels. If barrel prices are dropped from the protein price calculation, it’s unclear if the cheese average would still be published monthly, or for how long. It is feasible that the contract could eventually settle to the block-only cheese price, which would mean a change to the contract specification, or for the time that it continues to settle to the average of blocks and barrels, its effectiveness for cross-hedging purposes between cheese and Class III would be reduced. Even for producers who are not actively participating in trading futures and options contracts, these markets drive Dairy Revenue Protection prices as well. And the historically predictable relationships between prices contribute to liquidity from speculative traders, which could temporarily take a hit. Markets Will Adjust, Ultimately When the changes are implemented, other unintended consequences could emerge as markets adjust. Risk management plans, futures markets and insurance products will be jostled for a time, but ultimately markets will work and a new equilibrium will be found. One thing that is clear is that this is not the last change FMMOs will see. While these various pricing factors are being updated in an attempt to reflect the current reality more closely, they are all fixed, with no mechanism to update over time as manufacturing costs, product demand and component levels inevitably change. Milk pricing will change soon, but this won’t be the last time.