Episode 19: Impact of Volatile Markets on PA Dairy Farms

Mike Hosterman, agbusiness consultant, helps us understand what producers price differential (PPD) is, why it is a concern in today's markets and steps dairy farms can take moving forward. 

Transcript

Impact of Volatile Markets on PA Dairy Farms

We recently interviewed Mike Hosterman, ag business consultant with AgChoice Farm Credit. Milk markets in the last several months have been extremely volatile, and one area of concern is the dramatic shift in the Producer Price Differential (PPD). Mike explained what PPD is, why it is a concern in today’s markets and steps dairy farms can take moving forward. Listen to the full podcast episode with Mike here.

For those who aren’t familiar with milk pricing, could you explain what the PPD is in layman’s terms and then share typically what Pennsylvania farms see as their PPD?

Milk pricing is very complicated and there are probably only a few individuals across the country who truly know how milk is priced. If you want to read a good article on PPD, Mark Stephenson and Andrew Novakovic on the Dairy Markets and Policy website have an article called Making Sense of Your Milk Price in the Pandemic Economy: Negative PPDs, Depooling and Reblending. The article explains this topic better than I probably will, so check out this resource if you are interested.

So what is PPD? Seven of 11 federal orders are paid on the basis of a Class III component system. The ones that aren't are Appalachian, Southeast, Florida and Arizona, and they're based off a skim milk and milk fat values. 

PPD is an accounting method that is the difference between the total pool value of the milk versus the Class III component pricing of that milk. So it's priced two ways and the difference between them becomes our PPD. 

Class III prices are valued for the entire month. While for the Class I mover, it's the end of the prior month, and it's the average of Classes III or IV plus $0.74. The PPD is created from those two different timeframes. 

For the southcentral Pennsylvania our PPD over last 15 years (2005 - 2019) has had a wide range. The low during that time was in November 2019 at negative $1.70. May 2011 was the highest at $3.02.

In 2020, we've already set a new low. Here for June, we saw a negative $5.83 PPD. During the last three and a half years, the average has been about $0.82 PPD for southcentral Pennsylvania.

Now that our listeners have a basic understanding of PPD, share with us what is happening in the current markets and the impact this is having on a farm’s PPD. 

We’re seeing negative PPDs, as mentioned earlier. At negative $5.83, it is substantially negative. 

So what caused it? Well, again, if you read the article from Mark Stephenson and Andy Novakovic, it'll explain some of this, but there's really, in my mind, two things that are causing negative PPDs. 

First, when there is a rapid run-up in one of the classes versus the other ones. So when either Class III or IV runs up rapidly compared to the other one, it'll drive the Class I mover in a different direction because the Class I mover is basically the first two weeks of the prior month. The rapid increasing component prices the next month make up the component value and the component value would then be higher. So as component value is higher than our Class I or our class pricing, the pool value, we get a negative PPD. 

In the past when we've seen this, it would correct in a 30- to 60-day period as those prices catch up with each other. In this case, the second part of the issue today is that back in May 2019, the old way for the Class I mover was the higher of Class III or IV which set our Class I price. Today, it is the average of Class III and IV plus $0.74. So the $0.74 was put on to that average because based on history, that would make it the same pricing as before, when it was the higher of. However, when it's greater than $1.48, the average of those two is actually going to be lower than the higher of. When it was the average plus $0.74, it actually ends up being basically the higher one. As Class III and IV get further into the $1.48 apart, it also creates a potential negative PPD. 

We could see additional negative PPD through the balance of the year, just based on the wide disparity between Class III and IV right now.

Extreme volatility makes it hard to manage any business including a dairy farm. What can producers do to help mitigate against this risk? 

Risk management has become a key part of any commodity business. Below are five steps producers should take to help manage their risk. 

1. Change their mindset. Producers need to be open minded and willing to set floors and even have negatives on the milk check to protect the bottom line. It is a mindset change because we aren't used to leaving some money on the table potentially to lock in a profit. Producers should be thinking about risk management almost daily, and it has to become a routine for their business.
2. Know their cost of production. Understanding their cost of production allows producers to know what price is good. Producers should also do analysis on what their normal basis is over Class III or IV for contracted milk. 
3. Have a budget. Producers need to have a budget to know what works for their operation. What price are they trying to protect based on that budget and what's out there and available? In that budget, producers also need to make sure to allocate funds for risk management. Risk management can take some of the highs and lows off the table, but it does come at a cost and it isn't always free.
4. Monitor and adjust regularly. This isn't a once and done type of deal. It has to become a routine. Producers should consider their budget and if they are on track or need to adjust. 
5. Educate themselves about the available tools. Producers should be familiar and work with professionals who understand the options including Dairy Margin Coverage (DMC), Dairy Revenue Protection (Dairy RP), tools through a cooperative/processor or even hedging for larger producers. 

Are there any other thoughts you'd like to share today?

The global pandemic has led to challenging times, not only for dairy producers, but for all of us individually. We all need to remember to not be afraid to change. We have to adapt. Our businesses have to adapt. It's okay to ask for help. Put together a plan.

Life is so short. Have fun and enjoy what you do. If you're not, maybe the plan needs to be thinking about what other alternatives do we have? What else can we do? Because life is so short, we've got to enjoy it.