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Dairy’s journey through 2019 will be complex, and cheese is the driver

Peter Vitaliano for Progressive Dairyman Published on 11 March 2019

The past four years have been financially challenging for U.S. dairy farmers. That’s a relatively long time without a “good” year to give some relief.

While this year is showing some signs of improvement, it still does not currently look like it will meaningfully break this tough string by itself. In addition to some overall supply-demand imbalances that remain to be corrected, there are also several unusual market price relationships causing additional difficulties for dairy farmers and their marketing cooperatives.

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But first, a brief policy update.

Through a budget bill in early 2018, we at the National Milk Producers Federation (NMPF) helped enact improvements to the federal dairy farmer safety net, the Margin Protection Program for Dairy (MPP-Dairy). By lowering premiums and increasing the volume of milk eligible for coverage, net payouts (after premium payments for participating farmers selecting coverage at the $8-per- hundredweight [cwt] margin level) averaged about 44 cents per cwt on the first 5 million pounds of milk marketings.

Provisions in the 2018 Farm Bill have strengthened that safety net even further. The program’s name is changed to the Dairy Margin Coverage (DMC) program. The new maximum margin coverage level is $9.50 per cwt on the first 5 million pounds of milk production, and premium adjustments make coverage even more affordable.

If the DMC’s new maximum $9.50-per-cwt coverage level had been available last year, this maximum benefit would have been about $1.68 per cwt for the year.

While it’s always better when the market provides a supportive environment in which dairy farmers can profitably produce milk, it’s also better to have a strong safety net when this is not the case.

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An additional farm bill provision changes how the Federal Milk Marketing Order (FMMO) Class I skim milk price mover is determined. Previously, the Class I mover was the “higher of” Class III and Class IV milk prices each month, making it difficult for milk handlers to hedge risk. Under the new formula, the Class I mover is calculated using the average of Class III and Class IV prices each month, plus 74 cents cwt.

The change will have a neutral effect over the long term, but the particular price relationships that will likely occur in the markets this year should produce an initial modest price bump to dairy farmers of about 10 cents per cwt once it’s implemented this spring.

The supply-demand imbalance

The basic problem of the past several years has been that, even though prices and margins have languished, U.S. milk production has continued to exceed total commercial use.

A simple way to look at this problem is to note that average milk production per cow tends to grow in the U.S. at a somewhat faster rate than total consumption of milk and dairy products in the domestic market. Therefore, to maintain a balance between supply and demand that can support prices at decent levels, dairy exports need to grow to make up the difference. If that doesn’t happen, the only other way to keep this balance is for U.S. dairy cow numbers to fall.

During 1995-2003, U.S. dairy exports showed only modest growth, but a price balance was generally maintained when dairy cow numbers declined at an average rate of 0.5 percent a year. Exports grew more strongly during 2004-13, with the notable exception of 2009, enabling cow numbers to grow slightly while maintaining higher average prices – although higher feed costs absorbed much of this increase, at least for operations that purchased much of their feed.

However, U.S. dairy export growth stagnated during 2014-17, starting when China pulled back from its massive imports that had previously fueled record-high prices, and continuing when the European Union (EU) ended its milk production quotas. In addition to exporting much of the increased production that followed, the EU also redirected a lot of its dairy products displaced by Russia’s dairy import embargo into other world markets in more direct competition with the U.S.

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Yet U.S. dairy cow numbers continued to expand during this period, at an average rate of 0.7 percent, resulting in excessive stocks, weak prices and weak margins, even though feed costs had eased considerably. In the second half of 2018 – and for the first time since 2013 – U.S. cow numbers have finally moved below year-ago levels on a sustained basis.

Product market impacts differ

The overall supply-demand imbalance that has depressed prices and margins for the past four years has played out in different ways with respect to individual dairy product markets. The most important of these products are butter, cheddar cheese, nonfat dry milk and dry whey, due to their key role in the FMMO and state order class pricing formulas.

Their relative influence on milk prices varies by product. In the marketing environment projected for 2019 by the current futures markets, a 10 percent change in the price of each of these four products will result in the following estimated changes in the national average milk price: cheddar cheese, 4.6 percent; butter, 2.7 percent; nonfat dry milk, 2 percent; and dry whey, 0.5 percent.

Let’s start with butter, which directly determines the value of milkfat in all classes of milk. One of the most positive developments for U.S. dairy farmers’ bottom lines has been the recent resurgence in milkfat consumption following decades of negative nutrition advice based on what subsequently turned out to be faulty science. Products experiencing increased sales include whole milk, full-fat yogurt and premium ice cream, as well as butter.

Since butter is basically produced as a residual product from cream not used in other dairy and food products, this increased demand has significantly increased butter prices. Starting in 2017 and continuing through the current futures projections for 2019, butter prices are about 50 percent higher than they averaged during 2000-16. The proportion of producers’ milk checks from just their milkfat have risen from around 40 percent to about 60 percent due to this change.

Since butter has unambiguously boosted producer incomes, it’s the skim milk portion of producer milk checks that’s been responsible for the weak milk prices in recent years. The U.S. exports a large proportion of its dried skim milk and whey products since it produces relatively more skim than fat compared to domestic market demand. As a result, world markets largely determine their U.S. prices, and the tough export environment of the past few years has kept these prices low.

This has depressed Class IV, Class II and, to some extent, Class III skim milk prices. Rising prices will boost Class IV and Class II skim milk prices this year, but they will still likely end up averaging one-third less in 2019 than they did during 2010-14.

Class III skim milk prices continue to be the major problem weighing on milk prices. Cheese prices are the major determinant here, working through the protein component price, and cheese is where much of the excess milk production of recent years has been channeled.

Cheese prices took an especially large hit midway through last year, following Mexico’s announcement of retaliatory tariffs on cheese imports from the U.S. and China’s similar tariffs on all U.S. dairy imports. Cheese prices weakened even further later in the year due to softening domestic sales of American-type cheese.

Cheese prices have also been pressured lower by swelling excess production of barrel cheese, which is being produced increasingly for the valuable noncolored whey it generates, rather than for its value in producing processed cheese, for which per-capita consumption has been stagnant. This ballooned the “spread” between block and barrel cheese prices from the traditional 3 cents a pound to an average of 15 cents since the middle of 2018.

Since Class III skim prices reflect an average of block and barrel cheese prices, this has put great pressure on cooperatives, and their members, that produce barrel cheese primarily for processing. Cooperatives that produce cheese are already struggling because they are receiving a lower return for milkfat used to produce cheese rather than butter, which is pricing the fat.

A final factor weighing on Class III skim prices is the fact that the milkfat price is part of the formula, as a deduction, and the relatively recent high butter prices are lowering it more than in the past. The futures markets are currently projecting a significant improvement in cheese prices during the first half of this year, but 2019 Class III skim prices are still projected to be about 45 percent below their average during 2010-14.

Summary

American consumers are gifting U.S. dairy farmers with high butter prices, while the world markets are slowly providing improved prices of dry skim ingredient products. However, several factors are converging to hammer Class III skim milk prices. That’s a key problem considering how much milk is priced in Class III, and Class III will soon be determining half the Class I skim milk price every month.

Getting excess milk production under control will fix only some of these problems. Others will require a variety of approaches. They include regulatory actions to tighten up the rules for trading barrel cheese on the Chicago Mercantile Exchange (CME) cash markets and potential changes in Class III and other FMMO pricing formulas. The FMMO pricing formulas are already going to come under scrutiny this year following the release of a cost study by the University of Wisconsin, which will shed light on whether the formula make allowances and yield factors may need updating after many years without change.

One of the most important challenges facing U.S. dairy farmers is on the demand side of the equation, and that is to entice both U.S. and global consumers to consume more U.S.-produced cheese. As cheese consumption grows and the other major dairy product category, fluid milk, continues its long-term decline, producer prices are becoming ever more dependent on continued cheese sales growth. U.S. cheese exports, which currently account for only about 5 percent of total U.S. cheese sales, have lagged considerably behind dry skim ingredients in capturing shares of world imports. This has to be improved. But that applies equally to the 95 percent of cheese sales sold right here at home.  end mark

Peter Vitaliano
  • Peter Vitaliano

  • Vice President, Economic Policy and Market Research
  • National Milk Producers Federation
  • Email Peter Vitaliano

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