New study gauges outlook for California dairy co-ops

Justin Ellerby, Cooperative Specialist
California Center for Cooperative
Development

Editor’s note: This article is adapted from
a new report produced by the California
Center for Cooperative Development:
Challenges and Opportunities for
California’s Dairy Economy, available
for download at: http:\\cccd.coop/events/
DairyOpportunities.



airy producers nationwide faced a major economic crisis from mid 2008 through 2009 as on-farm milk prices plunged below production costs. Operating at a net loss drained farm equity from tens of thousands of dairy farms. Many farms were pushed into foreclosure.

Since early 2010, milk prices have generally stayed close to producers’ break-even point, but there has been little chance for a recovery of the massive losses suffered. While milk prices may enjoy modest growth in 2011, the medium-term outlook is still uncertain. During the past 15 years, there have been five national boombust cycles in milk prices, each of increasing severity. Further, the fundamental causes of this cyclical volatility have not been resolved by the industry, nor by public policy.

In order to address the ongoing challenges faced by America’s dairies and the rural economies that depend upon them, the California Center for Cooperative Development (CCCD) embarked on a research and outreach project to examine causes and solutions for some of the long-standing economic challenges facing dairy producers. The project was funded with a Rural Business Enterprise Grant from USDA Rural Development, awarded to the Center in 2009.

Although CCCD’s work focused on California, many of the findings apply to the entire U.S. dairy sector. By interviewing stakeholders throughout the dairy economy and reviewing reams of literature, CCCD staff identified a variety of subjects for further investigation.

Supply/demand balance
There is a seasonal imbalance in the supply/demand situation for milk, a perishable product. There tends to be too much milk in the summer and too little in the winter. Therefore, this seasonal oversupply of milk is manufactured into various lessperishable dairy products, particularly butter and milk powders.

However, these products are less valuable than processed fluid milk and return substantially lower profits to dairies producing milk for those uses. To equalize profitability among producers of milk sold for the fluid market and producers of milk used for other dairy products, California uses a Milk Marketing Order to create a single statewide pool of prices paid by processors to producers. Producers in the pool then enjoy the same price for their milk, irrespective of the end-use of the milk each producer has supplied.

In past decades, USDA has also purchased large volumes of lower value dairy products (including milk powders and butter) to support the national price of milk. California became the largest milk-producing state in the nation, in part, by building much of its dairy industry to supply the federal program. Therefore, state milk pooling — exacerbated by a major market intervention — has had the unintended consequence of incentivizing the overproduction of both lower value dairy products and the milk supply used to create them. That infrastructure has remained in place long after federal price-support levels were greatly reduced in the late 1980s, which removed a major support for the state’s total milk pool.

California’s dairy cooperatives account for a large share of the nation’s manufacture of these products. These same dairy products also make up most of U.S. dairy exports, and so are more vulnerable to the higher volatility of global markets than is domestically consumed fluid milk.

Besides the need to manage the state’s milk supply, several other areas for reform and improvement have been identified by dairy industry experts and stakeholders in recent years. The California Milk Advisory Board commissioned consultants McKinsey and Company in 2007 to conduct a widely disseminated study of the California dairy industry. Currently, a package of fundamental industry reforms, “Foundation for the Future,” is being promoted by the National Milk Producers Federation (NMPF), a trade association representing the majority of America’s dairy marketing cooperatives.

Supply management efforts
Supply management programs encompass a wide variety of possible methods and stakeholder roles aimed at reducing the amount of surplus milk on the domestic market. Although individual dairy cooperatives instituted caps on the amount of milk they would accept from their members in the most recent dairy crisis, those reductions were not large or coordinated enough to sufficiently impact nationwide milk supplies, which would probably require a nationwide program including all, or most, U.S. producers.

The most recent large-scale effort to reduce national milk supply has been NMPF’s Cooperatives Working Together (CWT) program, which collects a 10-cent per hundredweight assessment from its producer-members, who collectively represent two-thirds of the U.S. milk supply. From 2004 to 2010, CWT operated a herd retirement program, which bought out some of its members’ entire dairy herds and sent them to slaughter, thus reducing the national milk supply.

A NMPF-commissioned study of the program found that it had increased milk prices by many times over its initial cost, until reaching a point of diminishing returns in 2010. The second function of CWT is its stillactive Export Assistance Program, which subsidizes exports of dairy products. One of the program’s main goals is to stabilize the volume of U.S. dairy exports, which some believe has otherwise been so sensitive to price as to disrupt sustainable trade channels.

Indeed, NMPF points to this disruption of exports as a prime factor in the 2009 dairy crisis. When the willingness of global dairy importers to pay for dairy products fell in the global recession, major exporters, including New Zealand and Australia, reacted by dropping prices. Essentially, the Export Assistance Program succeeds when the cost of short-term export incentives are exceeded by the value of the long-term trade channels they maintain.

However, “supply management” has been more closely associated in the dairy industry with several proposed programs that would use various mechanisms to establish a limit for producers’ milk production. The essential idea of these plans is to provide incentives for producers to keep their milk production within the amount of supply that is expected to return an acceptable profit margin to all producers. There remain, however, significant practical and ideological concerns about these kinds of supply management programs.

Price-risk management
strategies
Price-risk management (PRM) strategies allow dairy producers to moderate the volatility of their milk and/or feed prices by paying some sort of service cost to a third party in order to limit their exposure to the risk of unfavorable price changes. Although producers hate having to forego some of the value of unexpectedly high milk prices (or low feed prices), many have found it worthwhile to do so if it protects them from the perils of price volatility: disrupted production plans, dangerous financial squeezes and wasted management resources.

Purely market-based PRM strategies include locking-in prices through forward contracts or hedging price risk through futures contracts or options. These tools incur brokerage fees and other transaction costs. They are available through commodities brokerages and some dairy cooperatives, which operate these PRM tools as a member service.

Forward contracts and futures have been widely used by producers of grains and other commodities for more than a century, but have not been as widely adopted by dairy producers. However, the continuously increasing volatility of milk and feed prices has led some agricultural lenders to ask, or even require, their producer-borrowers to manage long-term profitability through PRM tools.

Besides a general tolerance for risk and initial unfamiliarity with PRM tools, dairy producers have been dissuaded from using the PRM tools described above for a variety of practical reasons. However, many of these issues are specifically addressed through the USDA Risk Management Agency’s Livestock Gross Margin-Dairy (LGM-D) insurance program. Made available nationally last year, LGM-D is being promoted as a means to address some of producers’ issues in using other PRM tools.

The volume of milk insured under the program tripled last year. In February, an additional $15 million was made available to fund the program. Lastly, the National Milk Producers Federation’s “Foundation for the Future” reform proposals include another federally implemented PRM program designed to complement LGM-D.

Finding value in wastes
Dairy biogas systems process manure into energy (usually natural gas or electricity) and other products, such as compost and liquid fertilizer. Many public organizations and private businesses throughout the nation support and service the dairy biogas sector, including some federal financing programs.

However, the adoption of dairy biogas systems by producers has been hampered by problematic regulations, lack of access to capital, disparate technical information and difficulties in securing financial arrangements and physical inter-connections with energy utilities.

Developing dairy biogas systems that incorporate waste sources from outside of the system owner’s dairy can achieve beneficial economies of scale, but these “co-digestion” facilities face challenges regarding particular environmental regulations and operational constraints.

Nonetheless, the success of certain dairy biogas systems throughout the nation proves that this sector has the potential to reduce environmental impacts while generating energy and/or income for dairies. Use of the cooperative business model and other forms of collaboration have achieved many different kinds of economies of scale in dairy biogas systems, and might do so further.

This developing sector could bridge the needs of producers, regulators, environmentalists and the public good. If so, it will require consistent public financing, improved access to information, effective financial and legal model agreements, streamlining of regulations to maximize net environmental benefit, political support from the general public and further collaboration among stakeholders.

Role of cooperatives
Dairy cooperatives are a major player in California’s dairy industry, as they are nationally. Their role in aggregating producers’ bargaining power with processors and in processing members’ milk themselves has long been important to producers’ profitability. In California, cooperatives such as California Dairies Inc., Dairy Farmers of America and Land O’ Lakes all have substantial membership, processing facilities and economic impact.

As the agribusiness and food industries have continued to consolidate over the past decades, dairy cooperatives have merged, grown and adapted their business strategies to keep pace with their peers. In doing so, however, they have risked losing their distinction from proprietary businesses, as perceived by some of their members, antitrust regulators and other dairy stakeholders.

Relations between dairy cooperatives and their members can sometimes be adversely affected both by food sector dynamics beyond the co-ops’ control and by the particular business practices of each co-op. Members, directors and management all have their own positions and responsibilities which should be mutually understood if the cooperative is to remain a cohesive and effective organization.

There are other dairy cooperatives that differ markedly from the three coops mentioned above. CROPP/Organic Valley — a marketing-only co-op — differs in that it typically does not invest in processing capacity and emphasizes returning value to members in the form of higher regular pay prices, instead of year-end patronage refunds.

Fonterra Co-operative Group has leveraged New Zealand’s unmatched advantage in low-cost milk production into dominance in the global dairy trade through strong emphasis on product innovation, adaptation to local markets and extensive collaborations with other dairy firms, including several in the United States.

Value-added opportunities
Value-added opportunities for the California dairy industry are an important topic for large cooperative processors in expanding their product mixes into new product categories, such as probiotics and pharmaceutical ingredients, and adapting to national demographics and lifestyle trends. However, producers working as individuals or in small-group collaborations also have opportunities to develop value-added products from their own milk supply, and thus diversify their revenue streams away from the volatility of commodity milk markets.

Strong consumer interest in local foods has created opportunities for such products and in marketing channels that connect consumers to producers and processors within a region. In particular, specialty cheese has enjoyed substantial research and development supports in California, which has been building a national presence in this product category in recent years.

However, prospective new entrants to California’s specialty cheese sector face significant challenges. These challenges include: The last two challenges could be met by specialty dairy businesses sharing resources in training, trial-run production, promotion, sales and/or manufacturing. While these collaborative functions have been explored in a variety of ways in the state, their further development could be a major asset for new small specialty dairy businesses.

As part of its research, CCCD conducted a survey that explored challenges and opportunities in valueadded dairy product markets. It targeted prospective and current specialty dairy businesses, including processors, producers and others. The survey found that financing was lacking among prospective new businesses. This situation could be addressed by improved access to traditional USDA funding.

Other financing solutions may be offered by innovative hybrid business models, such as the L3C (low-profit, limited liability company) model or through use of mission-based venture capital. These business models are intended to provide profits while also serving a public good by helping to preserve family dairies and local food systems.

Some support was found among survey respondents for business incubation models, such as the shared use of a mobile processing facility or arranging the use of excess dairy processing capacity.

Of the dairy products considered in this survey, specialty cheeses enjoyed both the most knowledge and interest among respondents. Organic producers expressed strong interest in developing dedicated processing capacity for organic fluid milk and cheese. They showed less interest in other emerging product categories, with middling interest in sharing promotional efforts.

Overall, California’s dairy industry maintains strength in its competitive cost of milk production, economies of size and general quality of infrastructure. The recent dairy price crisis and ongoing concerns about producer profitability underscore that individual producers, as do producers nationally, face important decisions.

National milk supply management programs probably could stabilize the industry against future milk price volatility, but would require broad industry consensus and careful implementation. Various price risk management strategies are available to producers but are probably underutilized. Newer programs, such as USDA’s Livestock Gross Margin-Dairy insurance program, deserve continued attention.

In California, the costs of meeting the state’s substantial environmental regulations are not likely to lessen in the future, but may be addressed in part by creative, effective implementation of dairy biogas systems. While some of these efforts are beyond the direct control of individual producers, they can still make themselves heard through their representation in trade associations and their cooperatives.

Lastly, policymakers and staff at state and federal public agencies have various capacities to assist the dairy industry in all of the major subject areas described above. With this support, and with consensus within the industry on its needs and goals, California can overcome the substantial challenges facing it and expand upon its decades of success in feeding the world and our nation’s economy.





March/April Table of Contents