Cheese prices get set once every trading day in a 15-minute frenzy at the Chicago Mercantile Exchange.
CHICAGO — 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.
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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 at their local store.
For that player — Gary Hanman, chief executive officer of Dairy Farmers of America (DFA), the nation’s largest dairy cooperative — the higher the price the better.
A barrel-chested, red-haired 70-year-old 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.
Typically, 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 — increase the price of cheese at the Chicago Mercantile Exchange.
Washington milk production
In millions of pounds
* Through November; November figures are preliminary
Top 10 milk-producing states in 2003
3. New York
7. New Mexico
Source: USDA — National Agricultural Statistics Service
Research by Gene Balk / The Seattle Times
It’s a strategy that has made DFA the dominant buyer of cheese at the Mercantile Exchange, conducting more than half of all purchases, according to several sources who track the exchange. The cooperative buys hundreds of truckloads of cheddar cheese at the Merc each year, timing its purchases for maximum impact on the cheese price. Here’s how it works: 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 DFA increased dairy farmers’ milk checks by an estimated $1.3 billion.
DFA’s strategy has had a clear impact: Dairy farmers have been paid higher prices for their milk, at least in the short term. The end result is higher prices in the grocery store.
Wider impact on prices
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 raw-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.”
Ed Jesse, a dairy economist at the University of Wisconsin, said DFA’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.
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 own oversight, which includes a staff of 120 that monitors millions of trades each day.
Merc officials declined to answer questions about DFA’s activities at the cheese exchange. Trades at the Merc are confidential.
“CME believes strongly in the integrity of all of its markets, including the spot dairy market,” the Merc said in a statement. “The exchange devotes significant resources, through our market regulation department, to maintaining this integrity and closely monitors all of our markets.”
DFA officials contacted for this story declined to comment.
The Justice Department and several state attorneys general are investigating allegations that DFA 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.
DFA officials have said they are cooperating with the investigation and denied any 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.
At his speech before dairy farmers in October, Hanman laid out the cooperative’s strategy for pumping up the cheese price in Chicago.
At the end of each fiscal year, DFA executives meet to discuss how much cheese they think they will sell the following year through DFA’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,” he said.
So when the market for block cheddar cheese started to drop from a record high of $2.20 a pound in April, DFA stepped in at $2 and tried to hold the price there, Hanman said. When that failed, the cooperative tried again and held the price at $1.80 from May 21 to June 22.
The main buyer
“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.”
DFA returned to the market in August when it needed an additional 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, DFA added $1.3 billion to dairy farmers’ milk checks, $278 million of which went to DFA 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.
While many factors influence the price of milk at groceries, including the profit margins of the retailers, the price jumped in two of three recent instances where DFA supported the price of cheese at the Merc. And in the 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 statistics from the U.S. Department of Agriculture.
Similarly, after DFA held the price of cheese at $1.80 per pound in May and June of last 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 DFA 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 DFA’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 DFA’s influence on the cheese exchange 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 and one of the authors of a scathing report on the Green Bay exchange, which was closed in 1997 amid allegations of price manipulation. “His business is in part to convince farmer members that they are out there battling for them.”
Others point out that even if DFA can manipulate the cheese market for several weeks, the market eventually corrects itself by plunging lower after DFA 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.
Experts differ on whether DFA’s strategy constitutes 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 DFA’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 DFA’s actions may 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 investigates cash markets only if they are affecting futures markets in a negative way.
Some critics have suggested that DFA’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 DFA’s activities in the futures market.
Others argued that DFA is not doing anything illegal, since 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.”