Why you should care about the block-barrel spread

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Ted, T3 and Anna talk through the problems caused by chronically high milk supplies before diving into a discussion on why the widening block-barrel spread hurts dairy farmers.

Anna: Welcome to “The Milk Check,” a podcast from T.C. Jacoby & Company, where we share market insights and analysis with dairy farmers in mind. Today is November 1st. We’ve still got too much milk, Class III prices aren’t doing what we would generally expect for this time of year, even though demand seems okay. Ted, why don’t we start off with your impressions on what’s going on right now?

Ted: Well, we’re in a very unique situation where 75% or 80% of the time, in the second half of the year, the prices for milk and dairy products go up. I guess as late as three or four months ago, we thought that that cycle was gonna continue for 2018. Obviously, it hasn’t. And we find ourselves in actually a pretty desperate situation with the Class III price nudging the $14 range. The PPDs are at a lower level than we’ve seen in my memory. And Class I sales are bad. However, in spite of all that other sales, other than fluid milk sales are pretty good. Exports are still very good on an annualized basis, but the price of milk is low. The question is, how is this problem going to be solved anytime soon? We’re going to need to see a reduction in the amount of milk out there in order for these prices to go up.

We’ve heard a lot of conversation about it. Everybody talks about it. There’s sales. There’s talks about record number of dairymen in Wisconsin and New York, and so on going out of business, but the production goes up and not down. And our production numbers have reflected that for the last six months.

T3: The feeling that I get is that in the last month with the price of cheese dropping instead of going up as we get into the holiday buying season, if you’re a dairy farmer who’s been on the fence trying to decide whether to stay in this business, it’s almost like the last month has been that final nail in the coffin that’s made you decide maybe this isn’t worth it. And it takes three, four, five, six months for those decisions to play out. But I wonder if the latest price decrease was that final nail into the coffin that that maybe has changed the landscape a little bit. Maybe we’re finally going to see some of the negative production numbers that we need to see if we’re going to hope for a turnaround in dairy prices.

Ted: We all would like to see a little light at the end of the tunnel other than the train coming at us. I’m sure the dairymen even more than us would like to see that. However, we don’t want to paint a false picture. We got to see some production reductions.

T3: Our current situation reminds me a lot of the mid-1980s. The ’70s was a period of high volatility. Milk prices, corn prices, oil prices all significantly increased. There was a period of significant inflation, but more importantly, there was a period of significant increases in commodity prices and significant volatility. And then in the ’80s, inflation subsided. The economy as a whole started to grow strongly, but it didn’t really pull the agricultural commodity business with it. The ’80s was a great time to be an investment banker in the stock market. It was not a great time to be a dairy farmer. The mid to late ’80s was a period of relative stability in dairy prices at the low end of the spectrum.

Ted: Let me take a little bit of an issue with that just for the sake of the discussion, to point out what’s different. It wasn’t the ’80s necessarily, but in 1974, we had a huge price increase going on for two or three years in dairy prices. And the psychology at that time was that it would never end. It’s like every increase in pricing, anytime that market’s going up, whether stock market, dairy prices, milk prices, cheese prices, the people in the trade always think it’s going to go on forever. They never really gets through their head that these cycles, you go up and then they go down again. So, in 1974, the industry almost in total got caught with inventory as the market collapsed. And there were a lot of bankruptcies, not on the dairymen side necessarily, but on the processor side. Where people who had long storage cheese, Swiss cheese, for example, was a 90-day storage in those days. So, you got 90 days’ worth of inventory sitting out there and all of a sudden, the price dropped 50%. And that’s just one example.

You had a lot of other examples and I could tell you stories of how plants were liquidated and how debts were paid and so on. But in any case, the ’80s were, as you say, people recovered and prices went up and prices went down. But there’s a difference between that example and today. Today, virtually all of the inventory that people have is hedged. Okay. So, people don’t really…at least in my view, they want to see an upmarket because up-markets generally give you bigger margins. Okay. On the processing side of the industry, an improving market improves margins. Those margins are passed onto the dairyman. And so, everybody’s happy as the market’s going up, but the stakes of a change of direction are much reduced for the processor because any processor worth this salt, has got whatever inventory he’s got and his warehouse is fully hedged.

The dairyman is the one who bears the brunt these days. They have tools at their disposal to do risk management. But as we know from some experience, dairymen do risk management only when the prices are in the toilet. They don’t do risk management when the prices are at the high end of the spectrum because they always think it’s going to go another $3 or $4 higher. And so, a lot of them, not all of them, of course, but a lot of them tend to do their risk management haphazardly instead of doing it on an orderly program. So, your example is good, comparing it to the ’80s. But I would point out that there’s a big difference in the dynamics of the industry today than there was in those days when you didn’t have any risk management facilities at all.

T3: But one of the things that is going on right now in the dairy industry, and it’s happening from the dairy farmer all the way through the processor and the converter, even to the supermarket level or restaurant level. And that’s what’s going on with inflation. Hauling is probably the best example today of where costs are going up while prices not. It’s not just happening in terms of logistics, it’s happening in terms of cost of money. The fact of the matter is, interest rates today mean the cost of money is roughly double what it was 12, 14 months ago. And so, you talk about inventory, well, it may be hedged, but the cost of holding that inventory today is almost…it makes a difference. It makes a significant difference. The dairy industry is not an industry where people are operating on 20% margins. The dairy industry is an industry where people operate on 2%, 3%, 4% margins.

Ted: If they’re lucky.

T3: If they’re lucky. That ends up making a material difference. And so, you take the cost of money increase. You know, dairy is not a cheap product. It is not a cheap food. And so, that cost of money increase combined with that logistics cost increase, combined with labor increase pressures that are happening throughout the supply chain, all of those costs are adding up. And they’re compounding the issue at the same time as price seems to be going down. You know, we have to see some kind of reduction in production. And I hope it’s one where there is enough dairy farmers or frankly, it’s really a cow issue. Because if the dairy farmer goes out of the business and the cows go down the street to the bigger farm, that doesn’t solve the problem. Enough decisions are made that cause us to reduce the number of cows in the system, then there’s hope. Or if it’s a demand side equation. But that’s part of the hard part of the problem right now, is as much as I’ve been frustrated with demand because I don’t think it’s as good as it needs to be, the numbers say that the demand isn’t that bad. On the cheese side, demand has actually been pretty good. So, why has demand for cheese been good and yet the cheese price going down?

I think it’s two things. One, you’ve had some increases in plant capacity that has caused more cheese to be made, especially cheddar cheese to be made. Both barrel capacity increases and block capacity increases. You combine the increased cheese being made with the decrease in Class I sales. You’ve seen a lot of milk move to cheese production from Class I, probably indirectly, but that’s the net effect. And I think you’ve even seen a small reduction in the amount of powder production and maybe even butter production. It makes me pessimistic about what the next 12 months for Class III prices is going to be. If anything, I’m a little bit more optimistic about Class IV prices than I am Class III prices, which isn’t going to help the PPDs very much, I don’t think either. So, that’s going to compound that situation at the same time.

So, you know, I think there’s challenges ahead. And as much as I want to be optimistic about prices because of demand, I don’t think demand is good enough to overcome the increases in production that we’re seeing combined with the losses in demand on some of the other parts of the industry, namely, Class I, a little bit of Class II, where we’re seeing decreases in usage and almost all of that milk going into Class III.

Ted: I think you should transition into the block-barrel spread and try to make some sense of why the spread occurs.

T3: Okay.

Ted: And also, the impact that it has on the dairyman’s price, considering that as PPD is added to the Class III price.

T3: So, another thing that’s been going on it’s a fact that’s just making this bad situation worse is, traditionally the spread between the block barrel price is about 3 cents, 3.5 cents. In 2017, it was at 7.7 cents. And so far in 2018, it’s almost 12 cents, 11.8 cents, I believe through September. That’s an issue that I think the dairymen need to understand because it’s affecting them in a very negative, and frankly, unfair way. The way the Class III price works, there are three things, three variable factors, market factors that go into the Class III price. The price of cheese, the price of whey, and then a very small amount, that’s the price of butter.

You know, people have made issues with the milk allowances over the years and that’s certainly a factor too, but those are relatively static, but get changed about every five years just because cost of production at the processor level does go up. The cheese price calculation has to do with the NDPSR, which is the government agency, a part of the U.S. Department of Agriculture that does the statistical surveys that result in the numbers that are ultimately used to create the Class III price. They take a survey of all of the cheddar plants in the country that are making 40-pound blocks of cheddar and making 500-pound barrels of cheddar. Five hundred-pound barrels go into processed cheese, 40-pound blocks are usually used for natural cheese. And so, when you’re buying a sliced natural cheddar or chunk of cheddar at the supermarket, that was a 40-pound block. And if you make processed cheese, that originated as a 500-pound barrel.

I think the first thing that you need to know is, one of the places where we’re seeing increasing declines in consumption is in processed cheese. Fortunately, for the cheese industry, what’s happening is whether it’s, you know, changes in fast food consumption from burger joints, like McDonald’s to what they call “fast casual,” like Panera. You’re seeing the consumer switch away from processed cheese consumption to natural cheese consumption. So, the overall industry continues to grow, but processed cheese consumption has continued to drop. And in 2018, the number so far, basically saying that you’ve seen processed cheese consumption drop at a rate of about 4% percent annually, which is not slow. At the same time last year, we added barrel capacity in this country. We’re making more barrels today than we were 18 months ago. The result has been that the barrel market, we have a significant overproduction of barrels. We’re producing a lot more barrels than blocks.

Ted: Wouldn’t you say that that overproduction is due to the fact that the milk supply is so long? That it’s cost effective to put it into barrels instead of blocks?

T3: That’s part of the issue. I think the way I really look at it is, over the last 30 years, whey has probably been a more profitable part of a cheese manufacturer’s business than cheese. There’s a lot of cheese plants out there that really make their money on the whey side and the cheese is actually the byproduct. That whey or whey proteins and whey isolates, they’re going into, you know, protein drinks, bodybuilding formulas with high protein and amino acid levels. And it’s been a driver of the whey business. And so, there’s a lot of value added there and there’s profits there to be had. Well, one place where a lot of that whey is used, most of those end users in the formulations they want to make using the whey protein, is they want white whey. They don’t want colored whey.

So, if you’re buying a 40-pound block of colored cheddar, it was made with annatto. And some of that annatto ends up in the whey. That’s a less desirable whey than whey made from either mozzarella or from barrel cheese, which is a white cheese. And for a couple of different reasons, whey from barrel cheddar is probably a little bit more desirable than whey from mozz. And so that whey that comes from barrel cheddar plants is very desirable. The result has been, I want more white whey therefore, I’m going to build a barrel plant. Whereas the demand for barrels has been dropping due to the decrease in processed cheese demand.

Now we have a situation where we have way too many barrels. In relative to the ratio of supply and demand in blocks, the ratio of supply and demand in barrels is much worse. Here’s where this is an issue for the dairy farmer. When you include all of the cheese, all cheese, not just cheddar, but mozzarella, Swiss, Pepper Jack, Monterey Jack, Parmesan, all milk that is made into cheese is the milk is classed as Class III. But the Class III formula is only calculated using 40-pound block cheddar and 500-pound barrel cheddar. Just some rough numbers, Italian cheese production these days is about 45% of all cheese manufacturing. Cheddar cheese or American style natural cheeses is about 40%. And then the other Swiss and the others is the remaining 10%. I probably have my numbers off a little bit. I think there’s, 10% to 15% is not American style or Italian.

So, not only is cheddar no longer the largest, most…you know, the largest produced cheese in this country anymore, it’s actually mozzarella. But at the same time, the ratio of blocks and barrels or the ratio of American style cheeses that is not barrel cheese is a lot greater than that which is barrel cheese. Well, here’s the reality in our industry, almost all mozz is priced off the block market. Parmesan, I think is mostly priced off of Class III price. Monterey Jack is priced off of block market. You can go through almost all of the cheeses in our industry except for barrel cheese. And most of it is priced off a derivative of the block market.

And so, the reality is, when you want to talk about the pricing of cheese, I would say about 75% of all cheese sold in this country is priced off the block market. And maybe 15% is priced off the barrel market, with another 10% that’s priced uniquely. Yet in the NDPSR that feeds into the Class III formula, the ratio was about 50% block to 50% barrel. Which means 15% of our cheese production is being used to price 50% of the milk that goes into cheese. And that 15% is suppressed because of overproduction of the barrel market, due to factors that are not supply and demand of cheese. Basically, there is an incentive to produce barrel cheddar because they want the whey. And in many of these plants, these very large cheese plants, they may be producing 20%, 25% of their production maybe barrels and 75% of that production maybe is sold under the block market. You know, and there’s four, five different companies that have that kind of ratio. And then, of course, you have all the mozzarella companies that are also pricing off the block market.

I don’t think anybody in our industry is doing this intentionally. I want to make that clear. But there is opportunistic incentive to overproduce the barrels in order to suppress the barrel market because it drives down their Class III price, relative to what they’re charging or their cost of production and what they’re charging when they’re selling block cheese. And they sell a lot more cheese priced off the block market than they do off the barrel market. As a result, relative to where the cheesemakers supply and demand is and where their profit lies, the dairy farmer is actually taking the brunt of the hit for the fact that we are overproducing barrels and the market is not incentivizing away from the overproduction of barrels because there’s actually this incentive to continue to overproduce barrels in the marketplace because of the way the Class III formula is set up.

I’m a trader, which means at the end of the day what I want is I want an efficient marketplace and a marketplace that works. The block barrel…excuse me, the barrel price at the CME Spot Market is a true market. That price is suppressed because we’re producing too many barrels and as a result, supply and demand works. There’s too much supply. There’s not enough demand. That market is low. It’s working. But because of the way the Class III price formula is calculated, those producers are incentivized to overproduce barrels. And on that level, the market is not working properly. And the dairy farmer is getting hurt by that. And so that needs to change.

Now, unfortunately, I don’t have a role. My voice in determining federal order rules is not a relevant voice. The dairy farmer’s voice is a relevant voice. And so, I think it’s important that more dairy farmers start to understand this dynamic and how this dynamic is negatively affecting them, especially in times like this when they’re already having trouble making ends meet. They’re the ones who can make a change like this happen because it needs to happen at the federal order level and it needs to happen at the Class III formula level.

Ted: So, it needs to be an issue with National Milk Producers Federation.

T3: Absolutely. Markets get out of sync for a while, but eventually, the forces of supply and demand snap them back if they’re working properly. As a result, you know, you have a block-barrel spread that’s abnormal for a year. Most people are going to say, “It’ll fix itself on its own.” But after a while, people start to realize maybe that’s not the case.

Ted: Well, three or four years is long enough.

T3: Well, we’re at year two, we’re getting to the end of year two. And it’s been long enough now that people are starting to realize this is an issue. And I would say my sense is in the last month, two months, there’s finally a voice that’s starting to say, “We maybe need to think about this.” And so, you know, changes to the federal order don’t happen overnight. In fact, it may take a couple of years.

Anna: At least.

Ted: If you’re lucky.

T3: Yeah. But I think there’s a voice. The voice is starting. That momentum is starting. And the more dairy farmers would get on that bandwagon and start saying, “Hey, we got to fix this,” the quicker it’s going to happen.

Ted: Well, I think you make some very good points. And, hopefully, this will wind up in the right ears. I also would observe that it’s got to present big problems with regard to risk management for the industry.

T3: Yes. Actually, it does present big problems.

Ted: Yeah. And those big problems wind up in the…coming out of the pocket of the dairy farmer too.

T3: They do ultimately. Let me…

Ted: Ultimately, they do.

T3: Let me just…

Anna: Every cost eventually is going to trickle down to them because it’s not going forward to any retail consumer.

Ted: It does, but it’s nicer if they can understand where the costs are coming from.

Anna: Absolutely.

T3: Let me quickly kind of just describe a little bit of why it’s affecting the risk management industry as well. Because when you look at futures prices on the CME, you have a cheddar cheese future. You don’t have a block future versus a barrel future. You just have a cheddar cheese future. And so, there’s a lot of people out there who are trying to hedge, you know, let’s say, they buy mozzarella…say you’re a large pizza chain and you buy mozzarella and you say, “Hey, I’d like to lock up my Mozzarella parties for the year and at a flat price so that I don’t have to worry about changing the menu prices for my pizzas if the cheese price changes.” Well, if you use cheddar cheese prices futures to do that, you’re not using block prices. You’re using cheddar prices, which means that same 50/50 ratio means that at 20% block-barrel spread, those futures get pulled down much more so than the actual price of the cheese.

And so, it’s become very difficult for a hedger to get that hedge correct because they don’t know what…they can’t predict what that block-barrel spread’s going to be. So, they can’t predict what that actual cheese cost is going to be relative to where the futures will end up. And so, it’s causing those of us who do a lot of hedging for our customers, we’re having to add a risk factor to our pricing to cover that risk that’s on the table because we don’t know how that’s gonna play out month to month.

Ted: Would the solution be to take the barrel market out of the formula entirely and just let the barrel people do their own hedging based on block markets?

T3: I think there’s two paths kind of going opposite directions, but they both ended up, I think, in a relatively good place. The first option would be to add some kind of an NDPSR survey for mozzarella. And maybe add an NDPSR survey for what they call “640 cheddar.” Frankly, I think, mozzarella is probably enough because it’s a dominant cheese in the marketplace. The argument on the processor side is each plant produces a uniquely different mozzarella and prices it a little bit differently than the other, so it’s hard to figure out where that spot is. But I do think it’s such a large part of Class III utilization at this point that they need to somehow figure out how to do it. And so, I actually think that alone, adding mozz to the survey would solve the problem. Now you’re looking at, you know, a mozz number, a cheddar block number, a cheddar barrel number, and if you assume that the, that you’re going to get the same ratio of mozz to cheddar, then mozz probably becomes about 50% of the influence of the Class III price. Cheddar block maybe is 25%, barrel is 25%. And that significantly moves the dial in the right direction.

Now, I will say this, I think, if you do that, mozz prices can actually be a little bit more volatile than cheddar prices because mozz is not as easily storable as cheddar. And so, I think you also will get a number that moves around a lot if you do that. There’s a lot of dynamics to putting the mozz number in the survey that make it a very debatable thing to do.

The other choice is to go the other direction. And that’s to just take the barrel out of the survey. And then basically what you’re saying is, the commodity of the industry, cheese industry is 40-pound block cheddar. If you’re figuring out how to price your processed cheese on a 40-pound block cheddar, figuring out how to price everything else off 40-pound block cheddar and just do it that way. To me, that is a simpler solution. It is not a bad solution because, for many cheese manufacturers, 40-pound block cheddar is the default product. And what I mean by that is, let’s say, you’re a specialty cheese plant in Wisconsin that specializes in Gouda or in Pepper Jack or in Monterey Jack, what happens if you don’t have the orders for those cheeses? Usually, what you do is you make a commodity block cheddar. And so, because it’s the default product, it’s a pretty good indicator of supply and demand for the cheese industry as a whole. There’s even cheddar…or excuse me, mozzarella plants out there, I can think of three off the top of my head, who have the ability to produce 40-pound block cheddar just in case the mozz orders are too low.

And so, because it’s kind of a default production product, it probably is…you could do block cheddar alone and it’s probably going to be a relatively efficient measurement of supply and demand. The issue is too obvious, and the supply and demand implications are too important for people to aggressively argue against that change, even if it’s a change that affects their profitability because it’s too transparent an issue.

Ted: It’s a transparent issue right now when milk is long, but basically, one of the reasons that the block market…pardon me, the barrel market is what it is, is that milk is long. And so, you wind up with the barrels being profitable to make. If you wind up with a cheddar market, the first place that you’re going to see cuts in production are in the barrel market. It’s a declining market.

T3: I disagree.

Ted: Well, you may see it in 640s, but you won’t see it…

T3: You’ll see it in powder first.

Ted: You’ll see it in powder. Well.

T3: And most, think about it. It costs so much these days to build a cheddar plant.

Ted: I don’t necessarily agree with that. We may beg to differ on that because powder also includes butter. So, basically, you’re going to talk Class IV instead of Class III and the butter market is a big market. So, in a long market, you’re not going to see a big reduction in butter production and powder production. Pardon me, in a short market. I’m getting confused here. In a short market, you won’t see necessarily a reduction in Class IV. It depends on what the dynamics of the market are at that time. But in my view, the first place you’re going to see a reduction is in barrel production. So, if we do see a market that heads in that direction here sometime next year, for example, we’ll have to see if butter prices that are charged $3 and powder prices are a dollar 10, then you’re going to see a production drop in barrels, not in Class IV products.

T3: So, your argument is if Class IV demand is stronger than Class III demand, you’ll see a reduction in barrels?

Ted: Yes.

T3: That I agree with. But if cheese demand is the driver of higher prices, let’s say, it’s mozz and 40-pound block demand, not barrel demand, I think you actually lose powder production.

Ted: You’re right. Of course, it depends on what the dynamics are at the time.

T3: I agree.

Ted: But, you know, I think one thing that’s changed over the last ten years is the butter dynamic and how it influences this whole thing. And a tight butter market… I agree it hadn’t been that tight the last year, year and a half, but a tight butter market will cause milk to move towards Class IV. And that would be at the expense of barrels.

T3: Yes. Mm, yes. I think we’ve had a good discussion.

Ted: I think it’s been very good.

Anna: We know lots of people have lots of ideas for how to make producers pay prices better, but there are pros and cons, risks and benefits to all of them. In order to further this discussion industrywide, we’re looking to discuss these ideas in future episodes. If there’s one, in particular, you want to hear us take on, we’d love to hear from you.

We welcome your participation in “The Milk Check.” If you have comments to share or questions you want answered, send an email to podcast@jacoby.com. Our theme music is composed and performed by Phil Keaggy. “The Milk Check” is a production of T.C. Jacoby & Company.

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Dairy cooperative support

We can put our insights to work for your operation. Learn more about dairy cooperative support services from T.C. Jacoby & Co.

Listen to The Milk Check—the most compreshensive podcast in the dairy industry.

Listen to the Milk Check

Read our weekly market reports for the sharpest analysis on industry topics and trends.

Read Recent Reports