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Profit margin outlook remains poor for dairy next year

Chip Whalen Published on 29 October 2010

With the exception of the spot period for nearby Q4 2010, the forward profit margin outlook for dairy producers is unfortunately poor as negative returns are reflected throughout next year. In our last installment of this margin outlook in July, forward profit margins in 2011 were still projected around a breakeven level through the first half of 2011, although this has since changed as forward values of feed costs and milk have diverged over the past few months.

As of mid-October, profit margins for the first half of 2011 were projected at a loss of around $2.00 per hundredweight (cwt), with losses of about $0.80 per cwt projected in Q3 2011, which we have also started tracking since our last update in July.

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Nearby Q4 margins are also currently projected at a loss, although still around breakeven compared to a forecasted profit of about $0.50 per cwt when we last updated this piece earlier in the summer. Generally speaking, prices have increased over the past three months, although feed costs have gone up much faster than milk prices in that time frame.

Milk prices have shown the greatest strength in nearby Q4 contracts – particularly October and November futures. Looking further out, however, the higher feed costs projected in 2011 have not similarly been offset by higher milk prices, with deferred milk values actually lower than where they were this past July.

Figure 2 shows. As you can see from the current profit margin profile for Q4 2010 through Q3 2011, profit margins remain quite weak from a historical perspective, with the first quarter projection, in particular, only weaker around 5 percent of the time over the past five years.

1610pd_whalen_2 (Click image at left to view at full size in a new window.)

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As some of our readers may already know, we are using corn and soybean meal futures prices to represent the energy and protein equivalents in a dairy’s feed ration, understanding that actual corn and soybean meal may not be part of a forage-based diet.

Similarly, the Class III Milk futures price at the CME Group is not necessarily the price received by a dairyman in their actual milk check; however, there is a strong relationship or correlation between this price and how a dairy is paid for their milk. There is also a strong relationship between the movement in CBOT corn and soybean meal futures to the various feed ingredients that make up forage-based diets.

This allows us to model forward profitability because futures contracts trade out many months in time and therefore provide us a non-biased, market-based indicator of our forward profitability (or unfortunately in this case, lack thereof).

The recent movement in futures prices and corresponding change in margins brings about a couple of interesting points that deserve more attention. First, because these futures contracts represent agreements to buy or sell in different time periods, the prices of the various components of the profit margin are likewise different depending on the time period they represent.

Why are milk prices projected to be lower next year than next month? Why are feed costs projected to continue increasing over time, while the same is not true for the price of our milk? These are good questions and certainly have a big impact on one’s projected forward profit margin.

Second, you might ask yourself why it would even make sense to try protecting a negative profit margin in a deferred time period? If the margin is already negative out in 2011, would it not be better to simply wait and see if it turns around? Perhaps milk prices will increase over time to where spot contracts are trading. Maybe feed costs will decline to help lower expenses.

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Fortunately, there are tools in the market that allow a dairy producer to protect a margin without committing to a firm price level.

Before we get into that, let’s review why profit margins have deteriorated during the past few months.

On the feed side, corn is over $1.00 per bushel higher than where it was earlier this summer as the fundamental outlook has changed significantly. Corn prices already began to move higher following the June 30 USDA report that reflected smaller planted acreage and lower quarterly stocks than what the market had expected.

Since that time, the USDA has reduced the yield outlook on this year’s crop, dropping it well below trend in the October WASDE report by 6.7 bushels per acre to 155.8 bushels per acre. As a result of the adjustment, corn production declined 496 million bushels from September, and ending stocks also declined by 214 million bushels to 902 million bushels.

As a percentage of total use, the ending stocks figure now reflects a stocks-to-use ratio of 6.7 percent – the tightest since the 1995/96 crop year when corn rose to an all-time high of $5.50 per bushel for that particular point in history. What is dangerous this time around is that we have already experienced $7.50 corn only two years ago, and the world supply/demand balance is now also similarly tight to the U.S. situation with a global stocks-to-use ratio of only 15.8 percent – the tightest since the 15 percent during the 2006/07 crop year. If we dip beneath that level, the global supply/demand balance will be the tightest in 35 years.

Fortunately, the USDA provided some relief on September 30 in their small grains report, which revealed quarterly corn stocks on September 1 at 1.708 billion bushels – 300 million above the average trade estimate. While there continues to be some confusion over whether or not newly harvested bushels may have been counted in what would really represent “old-crop” stocks, the figure nonetheless immediately raises beginning stocks for the new marketing year that just began.

This may prove timely because corn yields across the Midwest continue to disappoint, and there are widespread expectations that the USDA will lower their yield estimate in the November- through-January reports. In 11 out of 12 years where the yield was reduced from September to October, yields continued dropping all the way into the final report in January. The higher beginning stocks figure provides some cushion to a lower production estimate, with each bushel-per-acre drop in yield representing some 80 million bushels in production. The market will continue to monitor the progress of the corn harvest as well as demand, which is expected to remain very strong. With limited supply of feed grains outside of the U.S. and a weakening dollar, exports should be robust. In addition, the EPA just announced a higher ethanol blending limit of 15 percent in domestic gasoline for vehicles produced on or after January 1, 2007. A similar ruling on older vehicles from 2001-2006 is expected in November.

On the protein side, soybean meal prices have also risen over the past few months, but not nearly to the same extent as corn. Unlike corn, soybean yields have generally been favorable across the Midwest as harvest progress ramps up, although the USDA did lower yield slightly in their October WASDE report. The current yield forecast is 44.4 bushels per acre, down 0.3 bushels per acre from the September estimate, although within the range of pre-report expectations.

Unfortunately, along with the lower yield forecast, the USDA also reduced planted and harvested acreage for soybeans by 1.2 million acres. The combination of lower acreage and reduced yield translated to a production loss of 75 million bushels. At the same time that supply is declining, demand is also expected to increase, with both exports and crush raised a combined 50 million bushels from September.

As a result, ending stocks are forecast down 85 million bushels in October to 265 million bushels, although the main difference between the soybean and corn balance sheets is that the supply/demand balance of soybeans is easing year-over-year. When divided by total usage, ending stocks for the current crop year that just began are projecting a stocks-to-use ratio of 8.0 percent compared to 4.5 percent last year. In addition, the world stocks-to-use ratio for soybeans is projected at 24.3 percent, which is down slightly from 25.3 percent last year, but hardly tight from a historical perspective.

Soybeans and soybean meal remain buoyed by strong demand from China, and export volume has been robust over the past several weeks. The market will continue to monitor crush margins and demand from China, as well as the progression of the South American crop this fall and winter.

The presence of La Nina increases the risk that Brazil and/or Argentina may run into weather issues during their growing seasons, and this could potentially become a bullish factor for the market to contend with. In the meantime, soybean meal prices will likely remain supported by the uncertainty in the market concerning both the size of the U.S. crop along with weather considerations in South America. To be sure, higher protein prices have definitely been a factor in deteriorating profit margins for dairy producers over the past few months.

The milk market has also been interesting, given a sharp difference in value between nearby prices and those of more deferred periods next year. Class III Milk futures have been supported by strong cheese prices, currently trading around $1.77 per pound (lb.)

Butter prices have also been quite strong recently, supported by increasing demand. The export market has been a key with the weaker dollar and firm demand helping to boost volumes. Butterfat exports jumped in July totaling 16.0 million lbs., up 1,101.0 percent over July 2009 according to USDA/FAS trade data. July cheese exports increased 65.7 percent above a year earlier also, totaling 34.5 million lbs.

One thing that should be noted is that NASS prices have increased significantly since the beginning of the year relative to Oceania, and increasing production from that region may begin to apply more pressure to exports going forward, which along with increasing milk production here in the U.S., helps to explain the difference between spot and deferred milk prices.

Fortunately, the USDA is currently forecasting that continued strength in the demand for cheese and relatively tight supplies of butter are supporting higher expected prices in 2011, with both Class III and Class IV price forecasts increased from last month in the October WASDE report due to higher product prices.

The Q4 average of Class III Milk futures at the CME Group is currently $16.00 per cwt, while the Q1 average price drops to $14.30 per cwt, and the average of Q2 prices is now $14.25 per cwt. It is hard to realize a profitable margin when the price you receive for your milk is declining while the cost of feed to produce that milk is increasing.

Unfortunately, this is exactly what the market is forecasting for dairy producers, who are facing difficult management choices in trying to protect their profitability. It should be pointed out that nearby October milk futures increased sharply over the past six weeks to converge with strong cheese prices.

If dairy product prices remain firm, deferred futures will likewise have to increase in order to converge with the stronger market. The problem is that dairy product prices may also go down, such that the deferred futures market reflects a correct assumption of what those values will eventually be in forward time periods.

Fortunately, there is a way to protect current values without committing to a milk sale. A put option allows you the right, but not the obligation, to sell milk at a predetermined price at some point in the future. If the market goes up, you do not have to exercise that right, and you simply lose the premium you pay for your option, although you are now able to sell milk at the higher market price.

Such a strategy may be appropriate for the current market, allowing one the flexibility to participate in higher prices over time, should they be realized. Similarly for feed costs, a maximum price can be established on corn and soybean meal by purchasing a call option.

This allows you the right, but not the obligation, to purchase these contracts at a predetermined price at some point in the future should the market go up. If the market declines, you are free to purchase your feed ingredients at the lower market price without any further obligation besides the premium you pay for these options.

Other strategies can be employed at a lower cost that allow for a minimum and maximum range of prices to be established for both feed purchases and milk sales. These also can be effective combinations to protect a profit margin while maintaining the flexibility to allow for an improvement over time.

Protecting a projected loss from increasing further may provide greater comfort than hoping the situation will turn around for the better. Given high projected feed costs and weak milk values in 2011, dairy producers will need to remain flexible in their strategy selections to allow for better margins to be realized over time. Fortunately, these tools exist in the marketplace and dairies have many choices on how to protect their forward profitability. PD

Chip Whalen

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