With timed trades through Chicago's Merc, Dairy Farmers of America's Gary
Hanman has found a way to support cheese prices, earning farmers an extra $1.3
billion this year.
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By Andrew Martin Tribune national
correspondent
December 30, 2004
Tucked at the back of the chaotic
trading floor of the Chicago Mercantile Exchange, behind the flashing electronic
signs that show the prices of pork belly futures and foreign currencies, traders
with telephones pressed to their ears call out bids that are then scribbled on a
white board labeled "Spot Cheese" in magic marker.
You can thank them for
setting the price of a gallon of milk.
The obscure cheese exchange opens
with the blare of a siren each trading day at 10:45 a.m. and closes about 15
minutes later. Some days there are no trades. But the low-tech methods and
limited trading don't reflect the huge influence of the exchange. The dairy
industry uses the quotes for the price of cheese on the exchange to set raw milk
prices, in much the same way the financial industry uses benchmarks like the
prime rate to set interest rates for everything from home equity loans to credit
cards.
The trouble is, the cheese exchange is a secretive operation that
is essentially unregulated and heavily influenced by a key industry insider who
has a huge stake in how much dairy farmers are paid for the milk, which in turn
affects how much consumers pay for a gallon at their local store.
For
that insider--Gary Hanman, chief executive officer of Dairy Farmers of America,
the nation's largest dairy cooperative--the higher the price the
better.
A barrel-chested, red-haired 70-year-old who is known for his
country charm and trademark red suspenders, Hanman is responsible for finding
markets for about a third of the nation's raw milk and for keeping the dairy
farmers who make up his membership happy by paying them a high
price.
Traditionally, dairy cooperatives have haggled with milk plants or
cheese manufacturers over the price of milk. Hanman has figured out another way
to boost his members' profits, and that is by increasing the price of cheese at
the Chicago Mercantile Exchange.
It's a strategy that has made the dairy
group the dominant buyer of cheese at the Mercantile Exchange, conducting more
than half of all purchases, according to several sources who track the exchange,
where trades are confidential.
Here's how it works: The cooperative buys
hundreds of truckloads of cheddar cheese at the Merc each year, timing its
purchases for maximum influence on the cheese price. If Hanman can boost the
cheddar cheese price at the Merc, dairy farmers are paid more for their raw
milk.
And if raw milk is more expensive for milk production plants, they
pass along those higher costs to grocery stores. Ultimately, those costs are
included in the price of a gallon of milk or a package of cheese.
Hanman
refused to discuss his strategy, saying through a spokeswoman that such
information was proprietary. But in an October speech to dairy farmers in New
York, he was expansive.
"The Chicago Mercantile Exchange is the tide that
moves all boats, up and down," Hanman said. "As that market moves--since that
market is the basis on which all people sell cheese--if you can have a positive
influence on that market, you can have a positive influence on price."
By
supporting the price of cheese last spring and again in August and September,
Hanman argued that his group increased dairy farmers' milk checks by an
estimated $1.3 billion.
The strategy has had a clear effect: Dairy
farmers have been paid higher prices for their milk, at least in the short term,
and consumers have been stuck with the bill.
That's because the cheese
exchange is what is called a "thin market"--it handles a relatively small number
of transactions, but those transactions help set the price for a much larger
universe of cheese and milk sales across the nation.
"If you are a large
cooperative and you are holding up the price of cheese, it has huge implications
for our economy because it affects the retail price of milk," said Kenneth
Bailey, a dairy economist at Penn State University. "There's a direct impact
[between] what happens at the Chicago Mercantile Exchange and what a family pays
for a gallon of milk."
System's integrity questioned
Ed Jesse, a
dairy economist at the University of Wisconsin-Madison, said the dairy group's
actions raise questions about the integrity of the system for pricing dairy
products because it appears to be governed by factors other than supply and
demand. When that happens, he said, someone ends up "getting ripped off,"
whether it's consumers, farmers or cheesemakers.
"It's a situation that
smells," Jesse said.
Whether the dairy group's strategy is legal, though,
is a matter of debate. That's partly because the market is so obscure it falls
into a gray area of the law.
The Commodity Futures Trading Commission,
which regulates futures for everything from fertilizer to live cattle, does not
oversee the cheese exchange because it's a cash market, meaning it acts much
like a live auction where actual products are bought and sold.
No other
federal agency regulates the cheese exchange either. Instead, it's left entirely
to the Merc's oversight, which includes a staff of 120 that monitors millions of
trades each day.
Merc officials declined to answer questions about Dairy
Farmers of America activities at the cheese exchange.
"CME believes
strongly in the integrity of all of its markets, including the spot dairy
market," the Merc said in a prepared statement in response to Tribune inquiries.
"The exchange devotes significant resources, through our market regulation
department, to maintaining this integrity and closely monitors all of our
markets."
Dairy Farmer of America officials contacted for this story
declined to comment.
The Tribune reported in August that the dairy group
is being investigated by the Justice Department and several state attorneys
general because of allegations that the group is trying to monopolize the
nation's raw milk market by forcing dairy farmers and competing cooperatives to
join it. The cooperative represents about 23,000 farmers.
In previous
interviews, group officials have said they are cooperating with the
investigation and denied wrongdoing.
Although less than 1 percent of the
cheese manufactured in the United States is traded at the cheese exchange, it
determines the price for most of the other cheese--and raw milk--sold in the
U.S. Yet by tradition, simply because a way is needed to set the price of cheese
and milk nationwide, buyers and sellers look to the exchange for
prices.
"There's no place else to look, no other central market," said
Jesse, the Wisconsin economist. "By general agreement, the industry has agreed
to use the CME as the barometer for prices."
That can be a recipe for
trouble.
"It's an extremely questionable method for setting the price of
milk because it is a thin market, and thin markets are notorious for their
vulnerability to manipulation," said Peter Carstensen, a law professor at the
University of Wisconsin-Madison.
At his speech before dairy farmers in
October, a tape of which was obtained by the Tribune, Hanman laid out the
cooperative's strategy for pumping up the cheese price in Chicago.
At the
end of each fiscal year, Dairy Farmers of America executives meet to discuss how
much cheese they think they will sell the following year through the group's
subsidiary, Borden Cheese, he said.
By design, Hanman said, the
cooperative doesn't make as much cheese as it needs for the year, so it can buy
the remainder at the Merc.
"This year, our plan was to be 400 loads of
cheese [in] deficit and to buy some of that cheese on the CME [the Merc]," he
said.
So when the market for block cheddar cheese started to drop from a
record high of $2.20 a pound in April, Hanman's group stepped in at $2 and tried
to hold the price there, he said. When that failed, the cooperative tried again
and held the price at $1.80 from May 21 to June 22.
"Each day, we were
the main buyer of cheese on the CME trying to make a statement . . . that we
thought $1.80 was about the right price for 40-pound blocks of cheddar cheese,"
Hanman said. "On one day, the 7th of June, we, DFA, bought 52 loads of cheese on
that market that day, a record."
The group returned to the market in
August when it needed another 100 or so truckloads of cheese, Hanman said,
holding the price at about $1.55 a pound through the beginning of
October.
By keeping the prices from falling further in both May and
August, Hanman said, Dairy Farmers of America added $1.3 billion to dairy
farmers' milk checks, $278 million of which went to his group's
members.
"Our ability to be in the cheese business, to be a market-maker,
and yet to fulfill our needs in the marketplace is what led to that price
enhancement," he said.
Similarly, a Feb. 26, 1999, memo by the group's
chief financial officer, Gerald Bos, outlined the cooperative's financial
situation from the month before and described how it propped up the cheese price
at the Merc.
"We also supported the market on the CME through January 13
by buying 7.4 million pounds of cheese at an average price of $1.85 [per
pound]," Bos wrote. Because the cheese was worth far less than they paid, Bos
said, the cooperative lost $3.6 million.
"I want to point out that we
need to remember that by supporting the market we held the [average price
farmers received for raw milk] to $16.27 [per hundred pounds of milk]," he
wrote. "We estimated that if [DFA] had not supported the market the drop in the
[average price to farmers] would have been to $12.94. This should save our
members about $96 million."
While many factors influence the price of
milk at grocery stores, including the profit margins of the retailers, the price
jumped in two of three recent instances in which the group supported the price
of cheese at the Merc. In a third, the price held steady instead of dropping as
expected.
For instance, after DFA bought 7.4 million pounds of cheese in
late 1998 and early 1999, the average price of a gallon of whole milk in Chicago
jumped from $3.09 in December 1998 to $3.39 in January, $3.49 in February and
$3.42 in March, according to the U.S. Agriculture Department.
Similarly,
after the dairy group held the price of cheese at $1.80 per pound in May and
June of this year, the retail price of milk in Chicago increased from $3.49 a
gallon in May to $3.92 in June and $4.02 in July, USDA statistics
show.
Finally, when the group supported the price of cheese at about
$1.55 through August and September, the price of a gallon of milk in Chicago
held steady at $3.62 from September through November. While the cooperative's
actions didn't increase the price, they appear to have kept the price of milk
from continuing to slide lower. Some question whether Hanman overstates his
group's influence on the cheese exchange in an effort to woo new members and
impress existing ones.
"I think Gary's comments about raising the prices,
they're certainly self-serving," said Bruce Marion, a retired University of
Wisconsin dairy economist, "His business is in part to convince farmer members
that they are out there battling for them."
Marion is one of the authors
of a report in the mid-1990s that alleged price manipulation at a cheese
exchange in Green Bay, which was closed in 1997.
Market does
readjust
Others point out that even if the dairy group can manipulate the
cheese market for several weeks or a month, the market eventually corrects
itself by plunging lower after the group stops buying cheese.
"It may be
manipulated in the short run, but no one has enough money to do it for very
long," said Bob Cropp, a dairy economist at the University of
Wisconsin-Madison.
Experts differ on whether the strategy is illegal
market manipulation or simply taking advantage of a vulnerable system for
pricing dairy products. The disagreement stems in part from the fact that the
cheese exchange is unregulated and so obscure that few people understand how it
works.
The Commodity Exchange Act prohibits manipulation of "any
commodity in interstate commerce," and the Sherman Antitrust Act forbids anyone
from trying to monopolize trade. The Merc's rules say it is a "major offense" to
"engage in, or attempt to engage in, the manipulation of Exchange futures or
options contracts or cornering or squeezing the underlying cash
market."
Major offenses can result in expulsion from the exchange and up
to $1 million in fines.
The Merc also describes it as a "minor offense,"
punishable by suspension and up to $100,000 in fines, "to engage in uncommercial
conduct."
Carstensen, the Wisconsin law professor who has researched
competitive issues in the dairy industry, said the cooperative's actions at a
minimum raise questions.
"They are not in there as genuine traders,"
Carstensen said. "They are not in this market for the purpose of actually buying
butter or cheese or selling butter and cheese. But they are in there to
influence the price because of some off-market transactions."
He said
that while the group's actions might meet the legal definition of market
manipulation, they fall outside the usual scope of the federal agency that
enforces the law, the Commodity Futures Trading Commission. That panel typically
only investigates cash markets if they are affecting futures markets in a
negative way.
Some critics have suggested that the group's dominance in
the cash market for cheese may in fact be giving it an advantage in the futures
market. But trades are secret, and neither the Merc nor the Commodity Futures
Trading Commission would comment on the group's activities in the futures
market.
Others argued that the cooperative is not doing anything illegal,
because anyone with enough money is entitled to buy as much cheese as he or she
wants at the Mercantile Exchange.
"Any single company is free under the
antitrust laws to bid the exchange price up or down as they please," said James
Robert Nolin, a Los Angeles attorney who specializes in antitrust law. He said
the legal problems under antitrust law start when one company, or cooperative,
conspires with another to move the market.
The questions over pricing in
the dairy business, some experts contend, will likely continue as long as the
price of milk is linked to markets like the Chicago cheese
exchange.
"It's still a market that lacks the characteristics of a really
competitive market," said Marion, the retired dairy economist. "You still have a
very thin market with some dominant players that are trying to jiggle the market
one way or the other."
Mary Ledman, a dairy industry analyst, said the
cheese exchange doesn't function properly because only the buyers and sellers of
fresh cheddar cheese participate, even though all types of cheese and dairy
products across the country rely on the cheese exchange for pricing
information.
Makers of mozzarella cheese, for instance, don't participate
since only cheddar is traded. And many dairy cooperatives don't trade because
they can only buy cheese; selling would be perceived by dairy farmers as an
attempt to drive down the price and consequently, their milk
checks.
Meanwhile, some of the biggest buyers of cheese, including
fast-food restaurants and grocery chains, have found a way to avoid the Merc by
establishing long-term cheese contracts. But they are a small percentage of the
marketplace for cheese. The vast majority of buyers and sellers continue to look
to the Merc to determine their prices.
The reason, said Jerry Dryer, the
editor of the trade publication Food & Dairy Market Analyst, is that "nobody
has come up with a better plan."
