From The Sacramento Bee, June 27, 2007

A look at how milk pricing works

Deep in the "dairy" section of the state Department of Agriculture's Web site, there's a five-page flowchart that shows how to determine the price of ordinary milk.

With milk prices at all-time highs, The Bee spoke to four dairy experts about how that complex system works, and what factors are driving the rocketing cost of a supermarket staple: Joel Karlin, a market analyst at San Joaquin Valley feed giant Western Milling; Kelly Krug, director of milk marketing services for the California Department of Food and Agriculture; Roger Hoskin, a dairy economist at the U.S. Department of Agriculture's Economic Research Service; and Leslie Butler, a dairy economist at the University of California, Davis.

Q: What determines the price of milk?

A: Unlike any other food, the base price of milk in California is calculated each month from a formula. State officials plug in the market prices for the four globally traded dairy commodities -- butterfat, dry milk powder, whey powder (a byproduct of cheese-making) and cheddar cheese -- and churn out the price that bottlers must pay farmers for their milk.

The prices of two of these commodities -- milk powder and whey -- are very high right now, thanks to a supply shortfall driven by a variety of global trends, including dairy policies in Europe, a long-term drought in Australia, growing demand for milk powder in Asia and the rapid growth of cheese consumption in the United States. Those trends have raised the base price of milk paid to California dairy farmers.

Until the dairy industry was deregulated in the late 1990s, the federal government maintained huge stocks of milk powder and cheese that were used to dampen price fluctuations in world markets. Without those stocks, prices have become more volatile.

Q: How does all that translate into the price at the supermarket?

A: Under a state law passed in 1947, retailers are prohibited from selling milk below cost. So the lowest prices in stores are equal to the cost of the milk paid to the dairy farmer, plus the cost of putting it in a carton and getting it onto store shelves -- which usually adds up to about $1 a gallon.

Each month, state regulators post a "lowest lawful price" for milk, which applies to all retailers. There's no ceiling on the price of milk, though, so retailers can mark it up as they choose.

Q: Did Californians actually drink all of the 3.3 billion gallons of milk produced by the state's cows last year?

A: No. Only 14.5 percent of the milk produced in California last year was bottled and sold as, well, milk. The rest got made into cheese (48.5 percent); milk powder and butter (28.8 percent); yogurt and cottage cheese (4.4 percent); and ice cream (3.8 percent). Much of this production, especially milk powder and cheese, is sold out of state and internationally.

Q: Is the demand for corn to feed ethanol refineries leading to higher dairy prices?

A: No -- or at least not yet.

Corn is a staple feed on large dairy farms, and it is about 35 percent more expensive this year than last, largely due to the demand from new ethanol plants.

But feed costs are not part of the formula that determines the price of milk, so there's no direct way for dairy farmers to pass on their costs to bottlers and consumers.

However, if farmers collectively reduce the size of the national dairy herd in response to high feed costs, there'd be less milk to go around, which would tend to raise prices.

But that hasn't happened yet. Milk production in California rose 3.4 percent last year -- and now milk prices are so high that farmers are willing to pay premium prices for cows to expand their herds and cash in on the boom.

Q: Is it true that milk in California is more expensive than in the rest of the country?

A: Over the long run, no. Retail prices for milk in California tend to be below the national average, according to AC Nielsen data and state dairy analysts. And a gallon of milk is still less expensive than many other products often used as substitute, such as soy milk.

But when dairy commodity prices rise very quickly, as they have this year, the price of milk in California responds more quickly than it does elsewhere in the country. Next month, for instance, the bulk price for bottling-grade milk produced in California is 10 percent higher than the national price. That's because California uses its own unique pricing system, while the most of the rest of the country is under a similar, but slightly different, federal scheme.