Consider the following set of events.  You open up the envelope from your favorite milk buyer expecting to find a price per hundredweight of $14.77 plus some additional money.  BIG SUPRISE, instead you find that your milk price is short of $14.77!  What is going on here?  You know that the announced July Basic Formula Price (BFP) is $14.77 and that this price represents the Class 3 price for milk in Ohio.  You also know from experience that Class 1 and Class 2 prices are always higher than the Class 3 price.  You know that your milk is being pooled under one of the Ohio Federal Milk Marketing Orders (FMMO), either FMMO 33 or 36.  As an informed milk producer you also know that the utilization for Class 1 typically runs about 50% (53% #36) and Class 2 about 25%(13% #36) in July of the year.  That leaves Class 3 at 25%(34% #36).  With these typical utilization rates and Class 1 and Class 2 price higher than the Class 3 price, then how could your milk check be for a price LESS than the Class 3 or BFP price?  This raises a number of questions.  The primary one of course is why is there a deduction in my milk price for July?  And, second, what happened to the money that was deducted?

In this short article I will attempt to provide an answer to each of these questions.  In case you are in a hurry and inclined not to read the entire explanation, I will provide a short answer to each of these questions before a more detailed explanation is offered.

First, why is there a deduction in my milk price?  The answer is that in July of 1998, sets of events occurred that are not typical of Ohio milk markets.  Class 1 and Class 2 milk prices are LESS than the Class 3 price.  Because of this "class price inversion", the typical addition to the Class 3 price becomes a subtraction from the Class 3 price.

Second, why are Class 1 and Class 2 prices less than Class 3 price?  The BFP has increased very strongly after reaching its low price in May of $10.88.  Your Class 1 and Class 2 milk prices are based on the May price of $10.88, NOT the July Class 3 price of $14.77 and the relative amounts of milk being pooled in each class.

Third, what happened to the money represented by the deduction?  Who received this money?  The answer here is simple.  It did not go anywhere because it does not currently exist.  The deduction is an accounting adjustment only.  It keeps the current total value of the milk in the Federal Order Pool in line with the Uniform Milk Price based on all uses of milk in the pool; Class 1 and 2 as well as Class 3.

Fourth, when will I see the benefit of these high Class 3 prices?  Your milk check for milk delivered in August, September and October will reflect the high Class 3 prices recorded in June ($13.10), July ($14.77) and whatever August brings.  If you are in Order 33, these prices (not accounting for farm specific factors) for August and September will be $15.14 and $16.81.  If you are pooled in Order 36, the August Class I price will be $15.10 and the September $16.77!

If after having read the short answer version of my explanation and you are interested in the details about how your milk price is determined get a cup of coffee, have a chair and read on!  Here is my explanation (as brief as I can be and still get across the key points) for why the Uniform Milk Price announced for July of 1998 is $ 12.47 in the Ohio Valley Federal Milk Order-33 and $13.33 in the Eastern-Ohio Western Pennsylvania Order-36, while the announced July BFP is $14.77.

The key to understanding why there can be an announced BFP price that is greater than the announced Uniform Price is (1) the timing of the pricing calculation for the Class 1 and Class 2 prices, (2) a rapid rise in the BFP from May 1998 to July 1998, and (4) the effect of less Class 3 milk being pooled in an Order and therefore an increase in the Class 1 and 2 utilization rates.  I will explain each of these items in turn, but first we need to review the calculation of the Uniform Price for both Orders 33 and 36.

Uniform Price Calculations and Component Prices

In the Ohio Orders, multiple component pricing is used as the basis to determine the value of a producer's production up to the Class 3 level.  Producers are paid based on the calculated value of protein and butterfat.  Because these protein and butterfat values are calculated at the current market values and Class 1 and 2  prices are calculated at the values reflecting the BFP two months before, there must be an adjustment made to bring these two valuations into line.  The implications of this adjustment in markets where prices can change by a large dollar amount from one month to the next will be discussed in some detail below.  First let us calculate the July 1998 Uniform Price based on class utilization in each Ohio Order:

Table 1.  Federal Order 33 / 36 Uniform Price Calculation, July 1998.
__________________________________________________________________________
                                         Federal Order 33                                Federal Order 36
                              ____________________________     ____________________________
                              Class Use   Class Price    Class Value   Class Use   Class Price    Class Value
Class I calculation     65.0         $ 12.92          $ 8.39              53.5          $ 12.88        $ 6.89
Class II calculation    30.2         $ 11.18          $ 3.37              12.0          $ 11.18        $ 1.34
Class III calculation     4.8         $ 14.77 (A)   $ 0.71              34.5          $ 14.77(A)   $ 5.10
                                                                      $ 12.47(B)                                            $ 13.33(B)
(A)-(B) The amount needed to reconcile
the current BFP with the Uniform Price: $ (2.30)                                                 $ (1.44)
__________________________________________________________________________

I will use the FMMO 33 July 1998 numbers for illustration.  The FMMO 36 calculations are would be the same using FMMO 36 numbers.

Item #1: Timing of Class Price Calculations
The Class 1 and 2 prices are not calculated from the current month announced BFP but from the BFP announced TWO months previous.  The July Class Prices are based on the May BFP.  For example, in FMMO 33 the July Class 1 price is calculated as May BFP($10.88) plus a constant $2.04 = $12.92.  The same calculation for the July Class 2 price is: May BFP($10.88) plus a constant $0.30 = $11.18.  The class prices for FMMO 36 are shown in the previous table.

The Ohio FMMO's stipulate that the current month Uniform Price will be calculated by taking the current month announced BFP($14.77) and adjusting by an amount that is called the weighted average differential value (WADV).  It is the calculation of this WADV that either increases or decreases the announced current month BFP to arrive at the Uniform Milk Price which is the base for what the producer gets in his or her milk check.  (Individual producer checks will differ based on other farm specific factors such as protein, butterfat, and somatic cell adjustments.)

The actual calculation, for each month, of the WADV is a somewhat complex matter of accounting.  However, without being too far off, it can be said that the WADV reflects either an increase in the value of Class 1 and 2 milk or a decline in the market value of Class 1 and 2 milk in the current month.  The key to this determination is the calculation that takes the current month Class 1 and 2 prices and subtracts the current month announced BFP from each.  Because the current month Class 1 and 2 prices are based on the BFP from TWO MONTH prior, this calculation turns out to be:

(BFP 2 months prior minus the BFP in the current month) + $2.04  for Class 1 milk
For July 1998:  $10.88(May's BFP) - $14.77(July's BFP) + $2.04 =  - $1.85

(BFP 2 months prior minus the BFP in the current month) + $.30  for Class 2 milk
For July 1998:  $10.88(May's BFP) - $14.77(July's BFP) + $0.30 =  - $3.59

Item #3: A Rapid Rise in the BFP May to July
Notice that these adjustments in the market value of Class 1 and 2 milk are both negative.  This reflects the rapid rise in the BFP from May through July which produces a negative adjustment that is larger than the constant $2.04 Class 1 differential or the $0.30 Class 2 differential stipulated in FMMO 33.  The final adjustment to arrive at the WADV of a minus $2.30 involves a set of accounting calculations that essentially (but not exactly) come down to dividing the total milk deliveries in the Ohio Valley Order by the change (in this case negative) in the value of that milk.  For example in the July calculation it is essentially:

Change in Value of the Class 1 and 2 Milk ( - $ 4,687,507.38) DIVIDED BY Total Milk In the Pool in cwts. ( 2,049,112.48) = - $2.30.  Note that this is exactly what is required to reconcile the current BFP with the Uniform Price calculation, Table 1.  Note also that this WADV of a minus
$2.30 is an accounting adjustment only and does not represent real dollars.

Item #4: Class 1 and 2 Utilization Rates
A last piece of information necessary to get a full understanding of the WADV is to recognize that it is based on a weighted average of the change in Class 1 and 2 milk value where the weights are the percentage utilization of milk in each class.  In the Order 33, these percentages are typically around 50.0% for Class I and 26.0% for Class 2 based on a pooled milk quantity of about 250 to 257 million pounds.  Because of the current price structure for all classes of milk, the quantity of milk delivered to the Order 33 Pool in July 1998 was 22% less in July than in June of 1998.  This affects the weights in the WADV.  For example in June of 1998, the Class 1 utilization was 49% and Class 2 was 27%.  In July, Class 1 utilization was 65% and Class 2 reported at 30.2%.  These rates are higher than typical for this time of year in Order 33.  They are higher because less milk was pooled as Class 3 in the Federal Order.

What's Ahead for the WADV and the Uniform Price:
As we now can see, the current announced Uniform Price is the current announced BFP price plus or minus an adjustment (WADV) that reflects whether or not the Class 1 and 2 value of milk in the current month has increased or decreased based on the change in the BFP from two months earlier.  If the BFP increases again in August relative to the June BFP, this situation could occur in the announced prices for August.

The August BFP futures contract on the Chicago Mercantile Exchange traded at $15.39 on August 24.  Using this as a forecast of the August BFP of $15.30, the WADV for Order 33 is forecast to be around a minus 58 cents with a Uniform Price of $14.62.  For Order 36, the WADV is forecast to be in the neighborhood of a minus 18 cents with Uniform Price of $ 15.02.  To arrive at these forecasts I have used protein, butterfat, and utilization rates from July as a base.  While protein and butterfat percentages may not change, the class utilization rates may and my price forecasts depend on how much Class 3 milk will be pooled in the Ohio Federal Orders in August.  If the utilization rates are more typical of August 1997, then the WADV will be a smaller minus and the Uniform Price will be higher.

The Good News!
Remember the good news is that the higher BFP prices for July and possibly August will show up in the milk checks in September and October (announced in October and November).