STATEMENT OF
GARY A. CORBETT

ON BEHALF OF THE INTERNATIONAL DAIRY FOODS ASSOCIATION

ON PRICE VOLATILITY IN MILK MARKETS

BEFORE THE U.S. SENATE COMMITTEE ON AGRICULTURE, NUTRITION AND FORESTRY

JULY 29, 1997

Mr. Chairman and Members of the Committee, thank you for the invitation to appear before you today to present the views of the International Dairy Foods Association (IDFA). My name is Gary Corbett and I am Vice President for Governmental and Dairy Industry Relations for Dean Foods Company, of Rockford, Illinois. Dean Foods is a diversified food processor and distributor with operating plants located throughout the country. Nationwide, Dean ranks as the leading fluid milk processor. Dean Foods is also an active member of the International Dairy Foods Association, and I currently serve as Chairman of the Milk Orders Committee of the Milk Industry Foundation and International Ice Cream Association, two of the IDFA constituent organizations.

The International Dairy Foods Association is a trade association which represents the processors, manufacturers, distributors, marketers and suppliers of dairy food products. Our members total more than 800 companies, and account for approximately 85 percent of the dairy products consumed in the United States. IDFA is an umbrella organization, which encompasses three constituent organizations, the Milk Industry Foundation, International Ice Cream Association, and National Cheese Institute.

Price volatility in dairy and other agricultural commodity markets IDFA appreciates the opportunity to present our perspective on dairy markets, as well as our views of volatility in milk prices and related tools for risk management. Mr. Chairman, we applaud your approach to this subject, by looking not just at one commodity sector, but more broadly at the subject across sectors. The ability of prices to move up and down in response to changes in supply and demand conditions is a fundamental attribute of a free market system. Also, these price variations are often interrelated to other commodity prices, as was the case with respect to the significant increase in farm milk prices last year resulting from high grain prices and feed costs. Dairy policy has been gradually moving in the direction of more market orientation since the mid-1980's, adding more potential for price volatility as prices are more responsive to the fundamental supply and demand conditions of the market.

Price volatility occurs in many markets, however, so it is important not only to review our experience with dairy markets, but also learn from a broader examination of commodity experiences.

Major Points

Mr. Chairman, I would like to make three major points today:

1. Price volatility is a necessary and appropriate characteristic of markets that are responsive to fundamental changes in supply and demand conditions.

2. Price volatility is less in the dairy industry than for most other agricultural products. However, in the case of the dairy industry, the tools to manage price risk are less developed, and the knowledge of how to use risk management techniques is well below that of most other food commodities.

3. Federal milk marketing orders interfere with managing price risks in the dairy industry. Forward contracting, a tool used by many other industries, is nearly impossible under the current pricing provisions of Federal milk marketing orders. This should be corrected during the Federal milk marketing order reform process mandated by the Congress in the 1996 farm bill.

A Brief History of Dairy Policy and Markets 1980-1990 Frequent policy changes in the dairy price support program during the 1980's, including dairy herd reduction programs, drought and drought relief measures, and aberrations in the world market that allowed over 300 million tons of U.S. nonfat dry milk to be exported through commercial channels in a 12-month period, all created temporary shortages in milk supplies. These market developments caused price spikes in the domestic market for milk.

During this same period, the price support level gradually moved downward as a result of a supply-demand adjustor incorporated in the dairy price support program, which was intended to send market signals to dairy farmers and keep production in balance with the marketplace. This brought the milk support price from its all-time high of over $13.00 per hundredweight (cwt.) in the early 1980's (a level which generated burgeoning surpluses of milk and annual government expenditures of $2 billion) to a level that undergirds the market (making the government the purchaser of last resort) and lets the marketplace set the price.

Milk supplies were tight in 1989 and '90 following drought in many areas of the United States and the unexpected exportation of nonfat dry milk in large quantities. In response, prices moved up during 1989-90, hitting a then all-time-high in July 1990 -- a $14.10/cwt all-milk price.

All dairy processors paid significantly higher prices than ever before, and for some, it was more than they could afford. Many companies that carried large debts had to get out of the business by selling to other better capitalized companies. Some were actually forced into bankruptcy. Others were able to make ends meet by selling some of their facilities and becoming more efficient.

At the same time, most dairy farmers were doing quite well, paying off past debts and improving their facilities and production capacity. Not surprisingly, milk production started to respond by the end of 1990, resulting in more milk than was needed by commercial markets. The government once again started buying excess butter, powder and cheese, and market prices responded by plummeting almost to the government support price level.

Just as rapid and unexpected increases in farm milk prices harmed milk processors and manufacturers, the precipitous drop in those same prices hurt dairy farmers. Abrupt changes are difficult and sometimes impossible to weather, especially without adequate tools to manage the risk.

Current conditions During 1996 and 1997 we have experienced a similar peak and valley in milk prices, for somewhat different reasons than in the earlier period. This time, however, the peak was higher -- reaching a $16.50/cwt all-milk price in September 1996 -- because government no longer held surplus stocks that could be released onto the market dampening prices, as in past years. This allowed farmers to receive prices sufficient to cover their higher feed costs. But then prices dropped precipitously during the last two months of 1996, recovered in the January-March period to levels well above normal, dropped again in April and May, then started back up in June. Now we expect prices to continue to increase through October, when the normal seasonal decline begins.

Dairy Compared with Other Agricultural Commodities While we have described two recent periods of volatility in dairy markets, when compared with prices of other agricultural commodities, milk prices are significantly less volatile than other sectors, due in part to the more extensive regulation of milk prices by the Federal government. Under the dairy price support program, the Commodity Credit Corporation (CCC) stands ready to buy any milk that is surplus of the market at the government established support price. During the 1980's and early 1990's, the CCC regularly purchased butter, powder and cheese under this program, but as support levels were decreased and market prices held above them, CCC purchases declined. The government programs forced consumers to cover the costs of volatility by using tax dollars to balance supplies -- the CCC would buy surplus during periods when supplies exceeded demand, then store the surplus product until demand exceeded supplies -- primarily using taxpayer dollars. (In more recent years, dairy farmers were also assessed to help cover these costs.)

In addition to the price support program, Federal milk marketing orders impose minimum pricing requirements on purchases of milk by handlers. Over [80 %] of the milk marketed in the United States is subject to regulation under Federal milk orders. As a consequence of such extensive government regulation, domestic milk prices moved only within a certain range, and volatility was to some extent "managed" by the Federal government and paid for by taxpayers.

We can see this by comparing changes in milk prices to changes in corn, soybean and wheat prices. One way of doing this is by taking the highs and lows in monthly prices and then expressing the difference as a percentage of the low. During each of the past twelve years (1985 through 1996), the all-milk price was less volatile than soybean prices in 8 of the 12 years; less volatile than corn prices in 9 of the 12 years; and less volatile than wheat prices in 11 of the 12 years (see attached Table 1).

Moreover, the differences in the relative degrees of volatility are significant -- the average price volatility during the period 1985 through June 1997 was 46% for all-milk prices, 89% for soybean prices, 156% for wheat prices, and 216% for corn prices (see attached Table 2).

It is true that price volatility for dairy last year (19.6%) was higher than it has been since 1992. Nevertheless, last year's volatility was less than the price volatility of the period 1988-1991 (when it ranged from 20.4% to 32.5%). Even last year's big change was about one-third as volatile as corn prices and about half as volatile as wheat. Although new tools are needed to better manage the risk of volatile milk prices, we think it is important to keep the proper perspective on volatility of milk prices.

Future prospects and risk management tools Over the past decade, U.S. agricultural policy has been gradually reducing the role of the government in the marketplace. Reforms in the dairy sector, one of the most regulated of agricultural commodities, have come at a somewhat slower pace than in other sectors; nonetheless, dairy policy, as well, is now on a path towards greater market orientation.

The Federal Agricultural Improvement and Reform (FAIR) Act of 1996 made various changes to U.S. dairy policy to reduce the role of the Federal government and move dairy policy in a more market-oriented direction. The price support level is declining with a complete elimination of the price support program occurring at the end of 1999. Federal milk marketing orders are also in the process of consolidation and reform.

One of the natural outgrowths of a more market-oriented dairy industry will be, and is, an increase in the volatility of milk prices relative to past periods. This is a part of our adjustment process, and should not be cause for alarm. It does, however, pose new challenges to members of the dairy industry -- producers and processors alike -- for effectively managing price volatility. Futures and options markets One important risk management tool used in many commodity sectors is futures and options contracts. Other agricultural commodities already have more active and developed futures markets; the dairy industry needs to move more aggressively in this direction. Although dairy futures and options contracts do exist, and are trading at designated commodity exchanges (the Chicago Mercantile Exchange and the Coffee, Sugar and Cocoa Exchange) today, most of them suffer from a lack of liquidity (i.e., sufficient trading to permit companies to buy and/or to sell contracts easily at any time they want to enter or exit the market). Trading activity in futures contracts for fluid milk, cheddar cheese and nonfat dry milk simply have not gathered much momentum, although considerable interest is being shown in butter futures. Most promising of all, a new contract at the Coffee, Sugar and Cocoa Exchange based on the BFP is off to a great start and has the markings of a huge success. The Chicago Mercantile Exchange has begun trading a similar contract this month.

In early April of this year, the Coffee, Sugar and Cocoa Exchange launched a new futures contract that is cash settled against the Basic Formula Price (BFP). The unique cash settlement feature of the contract eliminates many of the problems posed by physical delivery contracts. The way this contract works is quite simple. Traders can buy or sell contracts for 100,000 pounds of milk (basically equivalent to two tank loads of milk). The contract settles at the Basic Formula Price which is used by the U.S. Government to price milk under Federal milk marketing orders, and announced by USDA by the 5th of each month.

All the other dairy futures contracts are settled by buying or selling an offsetting contract or by delivering the product called for in the contract. Usually only a very minute number of contracts are actually settled by physical delivery. In the case of the new BFP futures contract, the settlement is accomplished by buying or selling offsetting contracts or by transferring cash equal to the difference, plus or minus, between the contract price and the USDA-announced Basic Formula Price.

Open interest on the BFP contract crossed the threshold of 1,000 contracts in late June, and now exceeds 1,400 contracts plus more than 640 in open interest on options. The momentum of this trading activity is very encouraging, and may signal a growing appreciation by members of the dairy industry in the value of futures as risk management tools.

There is still, however, a widespread lack of familiarity with both the principles and the mechanics of futures and options trading among members of the dairy industry. For these reasons, IDFA supports increased efforts to educate dairy producers, processors, and other interested parties in the ways that futures and options trading can help them manage risk. On September 8 of this year, for example, we will be cosponsoring an interactive satellite video conference for the dairy industry being presented by the Coffee, Sugar & Cocoa Exchange and the University of Wisconsin on how to manage price risk using BFP milk futures and options.

We noted with interest Secretary Glickman's reference in his July 9 letter to Chairman Lugar, to USDA's intention to stage a forum on research and education initiatives on improved risk management strategies for dairy producers. Education in this area is indeed needed, and we would urge that all members of the dairy industry -- dairy processors and manufacturers as well as producers -- be included in these initiatives.

The 1996 FAIR Act also authorized, under section 191, an options pilot program for one or more agricultural commodities, to ascertain whether futures and options can provide producers with reasonable protection from financial risks due to fluctuations in price, yield and income. The need for an options pilot program in the dairy industry is clear. Last October, the Coffee, Sugar & Cocoa Exchange submitted a proposal for an Options Pilot Program for Farm Milk, which we believe has considerable merit. We urge your support of the Department in helping this program move forward.

For our own part, IDFA has been using and continues to use various means of promoting greater understanding of dairy futures and options opportunities. We often include guest speakers from the Coffee, Sugar and Cocoa Exchange or the Chicago Mercantile Exchange at our board and committee meetings. We include sessions on futures markets at many of our seminars, workshops, and trade shows. We have been engaged in an ongoing dialogue with both Coffee, Sugar and Cocoa Exchange and the Chicago Mercantile Exchange on ways we can either jointly or respectively increase awareness by the dairy industry of the value of futures markets for risk management purposes.

Forward contracting Another tool for managing price volatility is the use of forward contracts with fixed pricing. Long term contracts for supply are the norm in many industries. In fact, this is a business practice successfully employed by Dean Foods in our frozen vegetables line of business. The prices we pay for our vegetable purchases are not set by government. Instead, we pay based on competitive factors, and contract forward for purchase. Both the buyer and seller benefit by knowing what to expect in the coming months. The growers know what to plant and harvest based on their costs, the quantities contracted for, and the price they will receive. The processors know what their costs will be and whether they can sell the finished products at competitive prices to their customers. The dairy industry could similarly benefit from a more market-based pricing system that would allow for forward contracting between buyers and sellers. Unfortunately, the Federal order system of price regulation stands in the way.

Interest in forward contracting in the dairy sector clearly exists. Kraft Foods, another member of IDFA, recently began offering quarterly forward contracts with fixed prices to its producers in Idaho. The program benefits both Kraft and producers for the same, simple reason: it provides a period of price predictability which enables both to plan their business activities better. Kraft benefits because it knows its major material costs in advance, just as it knows in advance its costs for packaging, labor, energy and many other inputs into its finished products; it thus can better determine the resources it will have available to support sales and marketing initiatives for its products. Farmers and their banking community know their revenue streams for at least the next three months and can make commitments based on those revenues.

According to Kraft, the response has been phenomenal. The program was initiated during the second quarter of 1997, and interest has grown to the point that, even at this early stage of the program, producers are looking to commit to volumes of milk in excess of one third of the plant's total milk requirements at preset prices. Producers are even bringing their bankers to the information meetings.

The Kraft program is entirely voluntary. No producer is required to sell milk to Kraft at firm forward prices. It is an option which Kraft offers to its producers in Idaho.

This program works for Kraft and the Idaho dairy producers because Kraft is not part of the Federal order price regulation system in Idaho. Under Federal order regulation, which applies to companies like Kraft in most of the United States, there is actually a disincentive for processors to offer such contracts to producers or cooperative suppliers. Federal orders mandate that processors pay minimum class prices for milk in each month. If the forward contract price is higher than the class price, the handler would be committed under the terms of the contract to pay the (higher) forward contract price. However, if the minimum class price is above the forward contract price, handlers would have to pay the higher class price, regardless of the contractual commitments entered into. So even if the forward contract price exceeded the Federal Orders' prices on the average for the period of the contract, under Federal Orders handlers who are subject to Federal Milk Order regulations would be forced to pay the higher of the contract price or the Federal Milk Order price each month.

Since the processor in such a situation would be assuming all the risk of Federal order price volatility, there is minimal benefit of forward contract pricing to the processor. Under these circumstances, processors simply do not and will not offer forward contracts with firm prices in Federal order regions.

Producers and their financial institutions recognize the benefits of forward price agreements with firm prices and are embracing the concept, as is evident from the success of Kraft's program in Idaho. The Federal order reform process now underway pursuant to the FAIR Act should address this issue and adjust the system of Federal milk orders to accommodate and facilitate use of forward contracts.

IDFA has submitted a proposal to USDA to eliminate the regulation of manufacturing milk prices and pool only Class I (fluid milk) differentials under Federal milk orders. The IDFA proposal would eliminate the Basic Formula Price, resulting in the deregulation of pricing of manufacturing milk. Only a Class I differential would apply for each plant location, and USDA would pool only the Class I differential for all producers on the order. Class I handlers would still have a pool obligation equal to the quantity of milk used in Class I multiplied by the Class I differential

The IDFA proposal preserves the price enhancement benefits of higher prices for milk going into fluid use, but allows the marketplace to set the prices for milk. One of the many advantages of the IDFA proposal is that it would enable forward contracts to be fully utilized within a Federal order system. We urge your support of our proposal.

Increasing demand for U.S. dairy products Finally, another way to ameliorate some of the downsides of price volatility is to increase overall sales of dairy products. Expanding markets for dairy products, both here and abroad, provides greater assurance of higher utilization rates by dairy plants and stronger demand for dairy farmers' milk supplies. IDFA's members are actively engaged in a milk promotion campaign through MilkPEP, which is funded by milk processors' checkoff dollars and aims to build consumer demand for milk.

We are also increasing our focus and emphasis on the importance of international markets for dairy products, and advocate policies which reduce trade-distorting subsidies and open foreign markets. We cannot afford to focus only on conditions within the U.S. market. We live in an increasingly global economy, and cannot ignore the role of our foreign competitors and foreign customers in affecting our opportunities and performance.

The European Union (EU) is by far the world's largest subsidizer of dairy exports. The United States must continue to press for reform of EU dairy policies. In particular, export subsidies in dairy products should be a very high priority of the next round of WTO negotiations on agriculture. This is extremely important to the future of the U.S. domestic industry. Without the distorting effects of subsidized exports by the EU, the United States, the world's third-lowest cost producer of dairy products, would likely enjoy a much more significant share of world dairy trade.

We are also very concerned about Canadian dairy policy. Canada has recently introduced a program which subsidizes the exportation of dairy products produced in Canada while protecting the high domestic milk prices set by the Canadian Government. We believe this program violates Canada's commitments under WTO rules and should be challenged pursuant to the WTO dispute settlement procedures. We have urged the U.S. Trade Representative to move forward expeditiously to challenge the Canadian practice, and in fact are working together with the National Milk Producers Federation to assist the government in bringing this challenge.

Concluding remarks The rise and fall of prices in response to changes in supply and demand conditions are an inherent and fundamental characteristic of a market-driven economy. The free movement of prices enable resources to be allocated and reallocated to their most efficient uses. Flexibility in industry pricing structures encourage producers to take advantage of new or improved technologies, raw materials, and production methods, and still be able to recover costs. Discipline on prices is typically provided by consumers' purchasing behavior.

Price volatility per se is not, therefore, something to be eliminated. The challenge for us is how to deal with price volatility, both in terms of tools available to the private sector and the effect of government policies on the usefulness of those tools.

We appreciate the thoughtful consideration the Committee is giving to this important subject, and look forward to a continuing dialogue with you on this and other issues affecting the dairy industry.