Will the average Class IV price finish 2021 higher than Class III?


Slipping milk production and residual COVID-related volatility could cause something truly rare in dairy: An average Class IV price for 2021 that’s higher than the average for Class III.

This last happened in 2013, when the market was powered by a dramatic increase in exports.

Ted and T3 explain why the financing model for massive new cheese plants is a partial contributor to the phenomenon and try to predict farmer and agency responses.

An image showing the title of the episode.

T3: Let me start by throwing a couple of overall milk production numbers out, so we can establish what we think milk production is going to do in general in 2022. So the challenge with talking about milk production, especially when you’re talking about it in terms of year over year right now, is we’re measuring against last year. And last year was the pandemic, and everything was a mess, and I’m not sure if measuring against last year with all its volatility really helps us understand the real situation. So I went back really quickly, and I actually calculated what milk production has done so far this year relative to 2019 rather than 2020, and it was kind of interesting. In the first quarter, milk production in 2021 was up 4.3% over 2019, so a little over two percent a year of milk production growth. In the second quarter of 2021, milk production was up over 2019, 4.3%, the exact same number as the first quarter, and a little over two percent.

The third quarter, which we just wrapped up a little under a month ago was only up 3.1% over 2019. Now the fourth quarter of 2020 was up 2.9% over 2019, but it’s starting to look like we might go negative for the fourth quarter of this year — which means on a two year basis, we may be up less than 2.9% over a two year basis. And so when you’re comparing everything against 2019, it becomes a lot more clear that we’re seeing overall milk production shift into an almost negative decline, rather than measuring against the year over year noise that we’ve been trying to figure out when we’re dealing with a pandemic year last year from 4.3% to 4.3% to 3.1%. And I’m going to guess in the fourth quarter we may end up at 2.7%, so it’s clearly declining at an increasing rate.

Ted Jr: I think it would be useful to discuss the dynamics of that. And referring back to Jacob’s chart where he charted all the prices for agricultural commodities: corns, soybeans, sorghum, cotton, you name it. And then in the same chart, he included the milk pricing and it showed 25-30% increase in agricultural commodity prices but only a nominal increase in milk pricing. It was very stark. We have had increases in production that basically have caused us to have inventory, up to now at least in both powder and cheese. Class I sales have been less than lucrative. They’ve been declining on an annual basis. We’ve built new cheese plants. And when we build a cheese plant, we’re building a multi hundred million dollar plant these days which requires that it be kept full. Cheese plants need to be balanced just the same as class I plants need to be balanced.

The difference comes out in the class IV market, and class IV is butter and powder. So we look at the last month’s results, then we see that there is in the last several months a decrease in production. And I think the reason for that is probably pretty simple: the costs of making milk have not warranted increasing the production for the milk. We have increased feed costs. We’ve got increased maintenance costs on equipment, everything, land, you name it. The cost of running a dairy have gone up. It doesn’t make any difference whether you’re a big dairy or a small dairy, but I would guess that the costs of running a small dairy percentage-wise are a heck of a lot greater than running a big dairy, where you’ve got economies of scale. This dynamic, based on what we’re seeing with inflation and so on, is likely going to continue.

What we’ll see, I believe, will be increases in a butter and powder particularly. Class I prices are based on an average of butter and powder prices and cheese prices. Class IV is about 15% of the milk production. Class I is about 20% these days, and it’s based on an average of the two. So the increase in price of Class IV milk could be quite substantial because only 25% of the result radiates back to the dairy farmer in terms of higher blend prices. I think you see the math that I’m looking at, it’s pretty simple, but obviously it’ll vary from location to location depending on what your Class I utilization is and so on. But 25% means that the dairy farmer is going to see a lag in the increase in pricing, which will mean that more than likely if the laws of supply and demand prevail, we’re not going to see a substantial increase in milk production until such time as the price radiates down to the dairy farmer in such a way that he benefits from it.

That could be a while, depending on how fast these prices increase. We’re assuming here; one of the assumptions is that the milk is locked into Class I plants, Class II plants, but also locked into cheese plants. I think for the most part, that’s true these days, much different than it was 10 or 15 years ago where we were much more flexible with what we were doing. We could go to butter powder, we could go to cheese, and we could switch back and forth more easily than we can today. I think with the construction of these big mammoth cheese plants — most of them are commodity type plants — they’ve made contracts for milk supply. So where is extra milk going to come from that’s going to be motivated to be produced over and above the requirements of the cheese industry that’s going to go into butter and powder?

I think reasonably, you have to conclude that butter and powder production is going to lag. Class IV prices are going to go up and then when they figure out how short it is, it’s probably going to go up a lot more. But there’s got to be a lag before this whole dynamic radiates back to the dairyman. You’re probably looking at Class IV prices in the $25-$26 range before it starts to have any particular effect on the blend price that the dairyman is going to say, “Hey, it’s time to start cranking up milk production again.”

In the meantime, the milk’s going into cheese. Why should we see cheese prices take off? It’s pretty hard to imagine in this kind of dynamic that we’re going to see a really traditional cheese market similar to what we saw here seven or eight years ago.

T3: I agree with what you’re saying, and I agree that cheese is going to lag Class IV. And I think if there’s a prediction I’ll make for next year that is uncommon it’s that the average Class IV price is going to average significantly higher than the average Class III price for the year. There’s two things though that I think are going to happen; the first is, mozzarella plants can buy non-fat dry milk to extend their yield. They’re not going to do it when the skim milk powder price is a lot higher than the Class III price. Class III solids are going to be cheaper than Class IV solids and so they’ll be buying UF milk or more milk to get their solids that way and spinning off the cream is my guess. It’ll ultimately have an influence of suppressing the price a little bit on the Class IV side.

The second thing that’ll happen, and you never know where this number is until you arrive at it: in order to get to $25 Class IV milk, you’re going to have to have a $2.50 butter price and you’re going to have to have at least a $2 skim milk price. By the time you arrive at those prices you’re going to lose some of your demand for those products. And so that’s the other thing. It’s like, how much of this is going to be mitigated by lost demand because the price got too high? How much of it is going to be mitigated by some places where you pull milk through in Class III instead of Class IV to supply some of these mozzarella plants? You know what it’s going to do? It’s going to make your timeline even longer.

Ted Jr: I think you’re right, and I guess that’s what I think is unique here and probably a situation we haven’t really seen before. You’re right. Supply and demand laws have not been suspended and as the price of powder goes up, butter goes up, we’re going to see less demand. But remember, we’re starting at 15%. These big cheese plants have got milk obligated to go in there. So the milk you know it’s going to happen, and what’s left over will go into powder and butter. Now, if the demand languishes a little bit, well yeah it’ll suppress the price, but how much? And what effect will it have on the pricing that radiates back to the dairyman?

T3: And I think your question about how it affects the price that the dairyman actually receive is really important for multiple reasons. I think we’ve talked about in previous podcasts how the cost of production for the dairy farmer has increased quite a bit in the last year and the market probably doesn’t have their head around the fact that break-even for a dairy farmer right now is close to $18 cwt, $18 cwt traditionally is a very high price for milk in general. And so for people to get their head around the fact that that’s actually a break-even price based on all the different ways costs have become inflated, I think that’s hard for people to accept.

But the result of that is, there are not a lot of… I think the combination of those prices, those costs and the fact that last year was pandemic-ridden and highly volatile and very difficult to think about anything regarding long-term planning: there are not a lot of dairy farms scheduled to be built in the next year either. You’re going to see milk production losses, but usually you go through this trough where as you’re still losing milk, you’re also starting to get farms being built that replace that milk. There’s going to be a gap this year because of the pandemic last year so you’re going to be losing the milk longer and you’re going to have higher prices longer before you get the typical supply side jump that has to do with new large farms coming online.

Ted Jr: I think one of the things that’s happened recently that’s a little different: we’ve seen dairy men hanging it up and going out of business, selling the cows. For the first time that I can recall, the cows haven’t wound up on the neighbor’s farm. They actually went to slaughter more than we’ve seen in years past. The national dairy herd now is smaller. It’s actually going down instead of up.

T3: Yeah, and I agree with that. It looks like, at least according to the USDA numbers that I looked at in the milk production reports this morning, we have more cows today than we did at the beginning of 2019. So from beginning of 2019 into the beginning of the second quarter of 2020, cow numbers were increasing from about 9.3 million to 9.5 million. Then they went down a little bit at the beginning of the pandemic, then milk prices really rebounded and they went back up. But since they peaked I think in the third quarter of last year, they plateaued and in the last six months they’ve really started to drop. And I think we’re now at about 9.4 which is still higher than the beginning of 2019. But I think just with what we’re seeing anecdotally and dairy farmers we’re talking to in different parts of the country, we’re anticipating that number is going to continue to go down pretty aggressively for the rest of the year and we’ll probably finish 2021 with fewer cows than we began 2019 with.

Ted Jr: There’s another thing that adds to that is that high feed costs will mean that we’ll see lower components and lower yields on cheese and so on. So cow numbers going down, but with the high feed prices that we got, the amount of milk production and component production should take a hit also in addition.

T3: There’s one more five minute discussion I’d like to have, dad, and that’s this: I think you and I both agree we’re going to lose a lot more milk out of Class IV than Class III just because of the nature of how cheese plants like to run full year round and tend to contract their milk that way, whereas Class IV plants tend to be balancing plants to balance Class I. And just the way that we see the dynamics of how milk production is going to be affected this year, Class IV plants are going to bear the brunt of that decrease. But I’m going to take it a step further. Where are we going to lose milk? Q3 and Q4 of 2021 and into 2022. And it’s interesting. It’s not where we usually lose milk. I don’t think right now we’re going to lose a ton of milk in the upper Midwest.

We may lose some, but that’s not where we’re going to lose the bulk of our milk. My gut is, we know we’re losing milk in the Southwest, New Mexico for example. California is another place that’s turned negative and probably will accelerate into the negative as we get into the next year. Now, it depends on how fast that Class IV price is going to go up because California is the one oasis that will be significantly affected by higher Class IV prices. The rest of the country probably won’t, maybe Washington a little bit.

If we are losing milk in the Southwest, and then we’re losing it on the fringes in the upper Midwest, and we’re losing it on the fringes in the east, you’re going to lose the milk out of the Class IV plants in Michigan, Northern Indiana, the few on the east coast. You’re going to lose it out of Class IV plants in the Southwest. You’re going to lose a little bit of it maybe in California though I do anticipate we could have a little bit of a rebound in California, if the Class IV price gets high enough. But traditionally the Southwest is not where we lose milk, and so that’s a really odd dynamic to me.

Ted Jr: Yeah, they’re paid on Class III pricing down there rather than blend pricing. That’s not going to help them obviously that those things can change. But there’s another dynamic here too in effect. As milk grows shorter and the use in cheese plants accordingly percentage-wise goes up, then the percentage of Class IV is going to go down. So instead of being 15%, it could easily wind up at 10.

T3: Believe it or not, the only reason I disagree with you on that is because Class I is going to continue to decline, and that’ll keep it from getting that low.

Ted Jr: Well one of the things that will happen, I think, is that the agencies around the country will use the opportunity to double down on super pool prices for Class I milk.

T3: So you’ll see the premiums come up.

Ted Jr: Yeah. I guess I have mixed feelings about the logic of that because we’re having trouble with Class I sales to begin with and now all of a sudden we want to add to the price. But traditionally that’s what they do and probably will do again. So that may offset this scenario that we’ve been building here somewhat also. But the problem is, I think basically we have built these big cheese plants and committed milk to go into them to finance them. How can we take the milk out of them?

T3: And you can’t. So where are you going to take the milk out of Class III if the Class III price is below the Class IV price? And I think that is the real key. And I think about all these cheese plants around the country. If you think about the upper Midwest, they’re all cheese plants. It’s just a matter of, the milk just switches back and forth between various cheese plants in the upper Midwest, at least in Wisconsin and Minnesota in South Dakota, they’re all cheese plants.

So mixing and matching the milk up there doesn’t change the class of the milk. You think about the Southwest, there are three large cheese plants that are not going to lose the milk regardless, so it’s all going to be Class IV guaranteed. When you think about California, it’s all Class IV. There’s only a few cheese plants: two very, very large ones which will not lose their milk. So there’s no other place for the milk to give than in the Class IV plants.

Ted Jr: It’ll be interesting to watch. Let’s see if we got it right as we go forward.

Show Full Transcript


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 comprehensive 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