Geoff enlightens the group on localized production cost challenges and shares some anecdotes about farmers dealing with expensive feed. Sarina and Gus talk about regional challenges to expansion and the adverse economics limiting dairy in much of the eastern U.S.
T3 sees cause for Class IV prices to stay high, and, after a lively conversation, the group shares a healthy laugh at Ted Jr.’s expense.
T3: Welcome everybody to the Milk Check. This month we’ve got two guests. Welcome Sarina Sharp with the Daily Dairy Report in Ag business and also Geoff Vanden Heuvel. Geoff, why don’t you quickly introduce yourself?
Geoff Vanden Heuvel: Well, Ted, it’s great to be here. I’m a faithful listener of the Milk Check, so it’s fun to see you guys by the power of Zoom. I’m not sure if our listeners will see that. But I was a dairy farmer in Southern California for 39 years, and at 2018, urbanization took my dairy. I was very involved in water and milk pricing issues as part of the Milk Producer’s Council, which is Dairy Farmer Trade Association board. And when I sold my cows in 2018, I was going to move to the Central Valley because I had kids and grandkids here. Given my experience in water policy, the Sustainable Groundwater Management Act had just been passed in California and was being implemented throughout the Central Valley. And Milk Producers Board asked me to be the dairy industry’s guy on water supply, and the implementation of what we call SGMA, Sustainable Ground and Water Management Act.
So since 2018, mid-year, that’s what I’ve been focusing a lot of my time on. That particular Act is designed to be implemented at the local level. So what that meant was I needed to identify where we had dairies in the Central Valley that were in what the state had designated as critically overdrafted basins. That turns out that’s pretty much all of the Central Valley. It’s critically overdrafted. There were dozens of new groundwater sustainability agencies that had been formed as a result of that law. They were all in the early stages of organization, and then gathering data, with a goal of putting plans together for how they were going to bring their area into basically balance or sustainability. So in the course of that I cover, we have dairies from south of Bakersfield all the way up to Stockton that are in overdrafted basins. That’s about a little over 200 miles. So north to south, I spent a lot of time on the road. But that’s what I do, is focus on water supply for the California Dairy Industry.
T3: Well thanks Geoff and welcome. Dad, I know you’ve got a question that you’re burning to ask, so I’ll let you go ahead and start it off.
Ted Jr: I’ve bet every time you open the papers these days you’re seeing pictures, and hearing dissertations on how miserable the water supply is in California. Just yesterday I picked up the Sunday edition, and I had pictures of parched land, perfectly brown, not a bit of green on it, but the last number we have on milk production is up 2.5%. So how do we manage to have all these dire predictions of drought? And we’ve had predictions about drought for 50 years. And every time we hear it, the milk production in California goes up. Is this the year that all of a sudden we’re going to have a drought that really counts? Let me pose that question to you as a matter of getting the ball rolling.
Geoff: I hope not. We would hope that we can manage our way through it. But it’s real. If we don’t get some rain and snow, and we don’t have any surface water, I think we are going to begin to bite down on the water availability, particularly in the Southern San Joaquin. Because those water districts there now, the groundwater sustainability agencies that I’ve described to you, in areas where we have some fairly significant dairy presence, have put their guys on water allocations. They’re fairly generous to start and they’re ramped down over the next, until 2040. But those are real, and it’s essentially overdrafted water, and they’re paying fees to access it that they haven’t had to work into their budgets before.
And then probably the big thing, to respond, that might be different this time… And I remember when I first started my education on the California Water System, which was the early 1990s, I took a Central Valley water tour for a few days, three day tour, and got familiar with the problems in the Central Valley. And then a few months later I did the Colorado River tour. The biggest single lake in California is Shasta. Lake Shasta, that’s the source lake for the Central Valley Project. It’s four and a half million acre feet of water. That’s the biggest lake in California. Lake Mead and Lake Powell are the two supply lakes on the Colorado River system. Each one of those lakes, each one, is over 27 million acre feet. And they were full. They were full in 1999.
So in the last 23 years, we’ve taken well over 50 million acre feet and we’re down to about 15 million acre feet, and we’re hitting shortage provisions that we never thought we’d see. And I think for the Central Valley Dairy industry, I think we’ve been in competition for water for a long time with other things that are more profitable per acre, like growing pistachios and almonds, and those two in particular.
So we’ve had a competition for water. In fact, a lot of dairymen have taken out some ground and put in those permanent crops. And I think, in the back of our mind, we always figured if push came to shove, we could go to the Colorado River area, the region there in Imperial Valley, Palo Verde Valley, and post in Arizona that had access to the Colorado and buy forage. And I think that all bets are off with regards to that because of the Colorado River issues. So Ted, I hope that you can, next year, rub this in our face and say, “See you guys. Chicken little, sky really isn’t falling.” But you know what, it just might be, and I don’t think we want to just sit on our hands.
Ted Jr: From what you say, it sort of sounds like we’re looking at maybe a crisis in 2023. I mean, this year is almost gone.
Geoff: Oh yeah, no, I think this year it’s baked in. I don’t think there’s going to be a whole lot of change in milk production in 2022 on water.
Sarina Sharp: This year it’s affecting dairy producers on the farm in their feed costs, but they’re weathering that storm for now, and super high milk prices are helping them to do that. But their cost of production is much higher than it’s ever been, even after you adjust for inflation. So when you add to that environmental restrictions unrelated to water, the high labor cost, high energy cost. The higher cost to move other crops, not just forages, out of areas that have a surplus like the Western corn belt and get that all the way over to California or canola from Canada down to California on rail. You add all that up, and their cost of milk production is simply too high. $25 milk was a bandaid on that. And it does take, I don’t know, six months probably of negative margins before we start to see a downturn in milk production. So I agree it’s a 2023 problem, but it’s a problem that is having an impact on dairy producers in California today.
Ted Jr: We’re in the Midwest, we’re not used to that kind of a scenario. But how close to the bottom are we?
Geoff: It’s very site specific. And a lot of it has to do with what type of surface water supply has historically come into that area. We can get into detail on where in California there’s trouble. Generally the southern San Joaquin, south of Fresno, is more vulnerable than north of Fresno. But there’s a lot of dairy south of Fresno. But then there are pockets south of Fresno that, there’s a pocket in Kern County, South Kern County, that has rights to the Kern River, which actually, in wet years, produces a lot of water. They’re in a very different position than their colleagues 20 miles north who don’t have rights to the Kern River. So it’s very, very location specific. There’s roads that delineate the boundary between a water district and an undistricted area. Dairy farmer that’s north of the street that’s in the water district is in a very different position than the dairy that’s south of that road and not in a water district. So it’s very, very site specific.
And I will say this too, there’s been a paradigm shift in the attitude of farmers, not just dairy farmers, all farmers. Typically when we’ve had wet winters, the guy wasn’t irrigating. He didn’t really necessarily want to take on surface water. Because the groundwater wasn’t regulated, it was free essentially. And so they let a lot of water go out to the ocean in wet years because they just didn’t think about capturing it. That has all completely changed. If we get a wet year… Well the last wet year was 2019 and we started some of it already then. But I would say that now, if we get a wet year, it will be remarkable to see what farmers will do to hang onto that water. And a lot of it’s going to be just flooding their fields and let the water percolate down into the ground in the wintertime. I mean that’s the one last remaining large supply of water that it hasn’t been spoken for, are those infrequent, but maybe two years out of a decade, large wet years.
And what we’ve got to do is get that water, capture it, spread it out, disperse it over the landscape, and get it down back into the groundwater table. I’d say at the local level, farmers are berming their fields and getting ready for it. We need some additional conveyance facilities to do it more long term, but that’s what we need to do.
I think one other thing, on feed, I think we’ve never really thought about our feed inventory as really being the water underneath us in groundwater. We had a dry year, we can always pump groundwater. That’s not going to be as easy of an option or maybe not even an option. And so I think in the California Dairy industry, we got to start budgeting for carrying much larger feed inventories than we’ve historically thought about.
T3: Geoff, I have a question for you, I’m operating under the assumption that this is really an issue about feed rather than an issue about not having the actual water for the cows to drink. Is that a fair assumption?
Geoff: Yeah, it is. Because that’s one of the things we found out as we’ve gotten into this. There was a perception that dairy was a big water user and it turns out that we pump a lot of water. We need access to good clean water 24 hours a day, seven days a week. As opposed to say a farming operation. They have an irrigation season. They’re growing a crop. They hit the ground hard, but then months they don’t ever run that well. But the amount of water we actually consume, that it actually disappears is relatively small. It’s much smaller per acre than farming. In fact, the number we’re using is about six inches of consumption on the dairy footprint. That is where the corrals, the barn, the feed area, that footprint needs about six inches of water.
So if you think of the Chino Southern California dairy model, we bought all our feed and exported all our manure. We basically ran a milk factory. We had very little water consumption on that operation. The water that you recycle eventually ends up on a crop and that’s where it gets charged then, it gets charged to that crop. So the dairy footprint is viable in a restricted water area. But here’s the big vulnerability the industry has and the one we’re going to, we’re spend a lot of time and effort trying to solve, is what do you do with all those manure nutrients? Because historically what we’ve done with manure is we’ve utilized it as fertilizer. And if we’re going to be restricted on water, and we’re not going to be able to grow crops in the volumes that we need to utilize all that manure, not only are we short on feed, we’ve got a very significant surplus nitrogen problem.
So the industry knows that. One of the things about the California industry, that I think is credibly admirable, is that we faced environmental challenges a lot earlier than the rest of the country did. We got ourselves organized. We fought like crazy on all the fun milk pricing stuff. But on the environmental stuff, the producers and processors and the co-ops, we were all on the same page and set up a separate organization, Dairy Cares, and got the universities involved and the government at all levels. So we’ve been working on air issues, and wherever we can try to monetize solutions, so that we can generate revenues. And you can see the digester program is one of those. And now we know we got a nitrogen problem and we’re working on it big time.
T3: Let’s switch to feed. Cause it sounds like the water issues that California have really manifest themselves from a market standpoint as a feed issue. Sarina, is it fair to say that the cost of feeding cows in California has doubled in two to three years?
Sarina: I’m not sure if we’re quite at double, but it is significantly higher. I would put the cost of milk production in California, not just feed, but all the other expenses as well, in the low to mid twenties range. Everybody is well over $20 a hundred weight. And that’s going to go up because as Geoff mentioned, their forages are extremely expensive. Corn silage, they have just wrapped up that harvest. They’re not feeding this year’s corn silage yet. They will be in a few months. And that’s 60% of your ration locked in for a year. What they’re paying for this year’s corn silage is sharply higher than it was a year ago, and that was higher than the year before that. So we’re starting to stairstep these ration costs sharply higher, and they’re paying very high prices now. And those costs are not going to go down, they’re going to go up.
T3: So it’s almost like it’s a perfect storm. You’ve got water issues in California, which mean they have to import even more food. The cost of freight has gone up. The corn price has gone up. Every cost in the feed cycle has gone up significantly. Creating, the cost of producing milk in California, it’s just made it much, much higher.
Sarina: And it’s not just California’s water issues that have raised this feed cost. So historically we have a major surplus of grain available in the corn belt, the Canadian canola crop, and we pull all those crops into the southwest, the Pacific Northwest, and into California. But because we had a drought throughout the west, we’re pulling harder on those feed supplies in New Mexico and Texas for example. We also had a very poor crop in the central and northern plains. So that’s usually where that grain came from, and they don’t have a surplus or as large of a surplus there due to their drought.
So we’re just moving farther and farther east into the corn belt to pull on these crops. So we’ve increased the freight expense, we’ve also increased the local basis. So these regions that were surplus areas, like South Dakota, Nebraska, Kansas, instead of selling corn at a discount locally, they’re selling it at a premium to make sure they have enough corn in the area. You start at that premium, and then you add freight, before you get that corn to California or Texas or Idaho, wherever your dairy cows are the most hungry I guess. So if you look at corn futures, which are extremely high, we’ve got December corn at almost $7 a bushel today. That understates the feed costs for almost every dairy producer in America, not just those on the west coast, but those on the west coast feel it most extremely.
T3: Because of the higher basis.
Sarina: Because of the higher basis.
T3: One of the things that we’ve been theorizing, or at least I’ve been theorizing lately, is that 2023 is going to be a year to find where we’re going to be much more short Class IV milk than Class III milk. So today we’re Class IV milk is running about $3 above Class III. Let’s assume for a moment that that’s going to continue, and what’s happening in California almost makes me feel like it has to continue, because if our break even in California is 22, $23 a hundred weight Class IV prices can’t get much lower than they are right now or you’re putting California dairy producers in a serious disadvantage. So if the additional cheese making capacity that’s coming online next year could continue to cause somewhat of a suppression of Class III prices, you’ve got the opposite thing going on in Class IV, where you’re walking a fine line between actually causing some significant pullback in production in California because it’s just not cost effective. Am I looking at that the right way?
Sarina: I think you’re correct. Pullbacks in production though always take a long time. So we need to see milk prices go sharply lower, or not even that much lower to put some guys underwater. But you need significant financial losses for several months in a row before we start to see restrained production. That often happens slower than you think, but I do think that Class III will have all the milk. That Class IV is going to balance. We will be tight milk in some places. Certainly we’re not expecting big growth, at the very least, and we are expanding cheese production capacity. So I think we’re going to have heavy Class III production, much lower Class IV production. But I want to be careful about suggesting that Class IV milk can’t go below producer’s break even because the market doesn’t owe anyone a living and dairy producers know that through experience.
T3: I can’t agree with that statement more than I do. I agree.
Ted Jr: I would observe that the dynamics have changed significantly from what we’re used to and I’m not sure I have the correct vision going forward. It would appear to me that we’re looking at a market now based almost entirely on cheese pricing. And we’re going to see Class I sales and Class IV as progressively smaller categories going forward. So how do we look at that to try to figure out where we’re going to be three or four years from now? It’s a little hard to get your head around it. We grew up thinking that when the end of August came, we were going to wind up with a mushrooming demand for Class I milk. We still have some demand, but it’s not nearly as frantic as it was in years past. So it’s hard to see how that’s going to play as things go down the road.
T3: Dad, I agree with what you’re saying, and I wouldn’t even say slowly. We are becoming a dairy industry that is Class III dominant. But I think there are regions of the country, with California and Arizona being at the top of the list, that are still strongly skewed towards Class IV. So I think whereas definitely the upper Midwest Wisconsin, but even Texas and the Mid-East, either have been for a long time or are becoming very Class III dominant. California is really a Class IV dominant location. And I would put it this way. For 20 years, 25 years, which is more or less my career, the assumption that Class III milk prices are usually about a dollar above Class IV milk prices, you could pretty much count on that. Not perfectly, but that was the average.
I’m willing to argue at least for the next three or four years. That’s not the way it’s going to be. That we’re actually going to see Class IV milk including 2022, 2023, 2024, I’d be willing to say I bet Class IV milk averages a higher price than Class III milk, and maybe significantly higher. Because nobody’s adding any Class IV capacity in areas where milk production is growing. And the dominant Class IV region has always been the Central Valley of California. And with some of these issues that Geoff and Sarina are talking about… I mean, I’ll ask the question this way. Is there any dairy farmer in California who’s interested in building more dairy farms in California?
Ted Jr: Let me add to that quickly. You’re right there isn’t anybody building Class IV facilities, however, it wouldn’t take a hell of a lot for the Class IV price to drop down. All it’ll take is an increase in production. Like Sarina says you got three or four months of pricing, which is not conducive to milk production, in order part to decline. We also had three or four months for milk production to go through the roof.
Geoff: Yeah, Ted, I think you’re right about we’re in a different place. It’s interesting to hear Ted number three there say what you did about III and IV. Because I had a robust debate with a well known dairy economist, who’s a friend of all of ours, eight, nine months ago, who told me we were arguing about this higher of Class III or IV for the Class I formula. And I was arguing that we needed to go back to higher up. And he goes, “Well there IV’s never going to be higher than III.” I said, “Yeah, it will. And not only that, you can’t bet on it.”
We don’t know what’s going to happen. One thing I would just say, dairyman react, we say they react to high milk prices. I’d say they react to high margins. $23 milk sounds like a great price. That’s break even for a lot of guys right now. Uncertainty leads to a reluctance to make big capital investments. And I think there’s just massive uncertainty throughout the west. But hey, when feed gets really expensive, proteins get really expensive, do you spend that last dollar to go get that last couple of pounds of milk? I don’t know, but I doubt it.
Gus: I will add that at the end of the day, the cheese plants will get the milk because they’re contracted for it or the producers or the owners or however you want to look at it. So I think that, in and of itself, is the reason why we’re going to have a higher trending Class IV relative to Class III for the foreseeable future. And so I would strongly agree with that just because of that alone. Because at the end of the day, butter powder plants are built to balance and there’s going to be less milk relative to available capacity elsewhere in these areas. And we speak a lot about California, remember that California has grown recently only into Class IV capacity that’s already there from more volume in the past. You don’t need to grow the capacity in California and you can still grow into the Class IV opportunity exists with the higher price.
So there’s limitations there that I think we’re not recognizing. But nonetheless, I do believe there’s going to be opportunity to move solids into Class IV as we move forward, especially on the west coast. I also think no matter what, we’re going to have growth into the cheese plants that are being added in the Southwest and the central part of our country. So no matter what those voids are going to get filled.
Having said that, I do believe your adverse farm economics that are going on in the Mid East and the Northeast have yet to play themselves out fully. And I do wonder if any added capacity will change that right now. Because the ability for the dairymen, and Sarina, I hope you would agree with me, to grow in that southwest or western Kansas, all the way up to South Dakota, they’re much more motivated to grow in those areas than they are in the mid-East or the Northeast. Your farm acreage is much cheaper. Your access to land, access to water, your lack of regulation, all those things play into that. So it’s my feeling that we will have some haves and have nots as we move forward. And I think that’s important to recognize as we have this discussion.
Sarina: Yes, I’d agree with that, on the southeast and the Northeast, the economics there are just adverse and the climate is adverse in the southeast. And then in the Northeast you have to deal with a much denser population and different regulations. In the mid east, I think there’s some opportunity for growth. It’s one of the few places in the country that I can think of where there is excess processing capacity and not the type of feed costs that you see in the west. So I think we could see some growth there, but I don’t think there’s very much wide open space for the type of dairies, the cross fence, that require a big land footprint. There’s just not as much opportunity for that. But if a dairy producer can find that, I think that he’d be happy to locate there. In the past few years, the expansion has been in that I-29 corridor, that corner of Minnesota, South Dakota, Iowa. Land prices are going up significantly in that area, especially in Iowa, but also in those neighboring states where the corn yield isn’t quite as high, but still very attractive.
But they’ve got some real weather issues and we’ve seen that in South Dakota, several years of tough farming out there. And the dairies that have moved in there recently have filled up the existing processing capacity. So it’s going to take additional investment in that area, on the processing side of the industry, before we can see significant growth in milk production in that area. It’s on the drawing board. There are dairies or dairy producers who are ready to go out there. I’m not saying there will be no expansion, but it’s going to be a lot slower than it was in the past. And then you mentioned the Southwest, but there’s a really stringent base program on in the Southwest, so supply management I think is going to hold things pretty steady in that part of the world.
Gus: That makes sense.
T3: Geoff, let me ask the question. How big a cost to difference do you think exists right now between dairy farmers in the Central Valley, and dairy farmers, let’s say in…
T3: In Idaho or South Dakota or Texas?
Geoff: Well, milk producers is part of the Western states Dairy Producer Trade Association, so we got milk producers from California, then Oregon, Washington, Idaho, Utah, Arizona, New Mexico, and Texas. Twice a month we get together on calls. So the guy from Idaho, actually it’s a dairy farmer, he’s not a board member. He gets on a call, and he always leaves his camera on, and he’s working on the dairy. And he’s got this beautiful stack of hay and I said, “Willie, what’d that hay cost you?” “Ah, you guys, that’s $300.” I said “$300? We can’t buy grass for $300.”
It’s corn silages, 80, which he thought was outrageous. But we paid 120 this year. And the winter forage was 90. That used to be 40. Almond hulls, 300 bucks. Wheat straw, the other day I was with guys and they were getting wheat straw out of Oregon. The guy brought it down in vans, regular truck vans, and put the big bales in long ways. They couldn’t figure out how to get them out of the van. So they paid $225 a ton for wheat straw. I said, “For wheat straw?” They said, “Yeah, because the local guys around here want 260 for the wheat straw.” Add a hundred dollars a ton. Cow eats 50 pounds of feed a day. That’s another 5 cents a pound times $2.50 cents a cow a day, higher fee cost, by 80 pounds of milk or three bucks a hundred weight.
Sarina: I was going to say that it varies widely, but it’s between 2 and $6, I think, depending on business model, location and what your feed costs are.
Geoff: Now there are guys that got a lot of farm ground, and got good water yet. And they’re going to be fine, right? Corn silage would be $120, but they’re growing up for a lot less than that.
T3: I’ll say this, the big thing I learned today that I didn’t realize was the difference in the issues in the northern part of the Central Valley versus the southern part of the Central Valley. Just listening to what you were saying, it almost sounds like you can make, this may be a bit of a leap, but sounds like cost of production is almost $2 less up around Turlock than it is maybe down around Visalia. Is that probably about right?
Geoff: It could be. It wasn’t historically, but it could be right now.
T3: Well, Geoff, Sarina, thank you so much. I really appreciate your time, guys.
Geoff: It’s been fun.
T3: Really, really appreciate it.
Sarina: You’re very welcome. I’m glad that we were able to get Geoff on so I didn’t have to answer all those water questions in detail. Because I could have made some educated guesses, but this was way better.
Geoff: I’m glad you had Sarina because you needed somebody who knew what they were talking about when it comes to feed. Great seeing you guys, and keep up your great work. I love the work that you do. Even though once in a while Ted Sr gets me a little irritated.
T3: That goes for all of us.
Geoff: Especially when he starts talking about make allowances.
T3: You have no idea.
Ted Jr: We’ll save that for another day.