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0309 PD: Should I get out now or ride it out?

Published on 06 February 2009

Dairy financial consultant Bob Matlick writes journal entries after participating in regular conference calls with Jon Spainhour, a dairy market analyst at Rice Dairy, and his dairy producer clients. He says most times he writes what he is thinking. Sometime in late October last year he remembers scribbling the thought: “Oh, *&^%!”

That’s when Matlick says he and others started to see international demand for dairy products taper off and the domestic financial crisis develop. Then even as he calculated cost of production numbers for his clients at $16 per hundredweight, futures prices at that time for January and February of 2009 hovered between $14 and $14.50. Yet what scared Matlick was the thought that $11 to $12 milk was possible.

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“It doesn’t take a lot of time to punch a calculator and say, ‘Oh, &^%$!’” Matlick says.

Things turned out worse than he imagined. The USDA predicts the Class III price will average between $10.60 and $11.40 for the year. That could mean as much as a 36 percent drop in price from 2008’s milk price average.

“Both domestic and international milk demand have fallen on their face while supply has steadily increased,” Matlick says. “The bottom line is we have a huge problem. Dairies will go out of business; contractors, supply companies and feed vendors will suffer and/or fail.”

Many have asked: How did this happen? Spainhour describes it as a “recipe for disaster.”

“As a dairy industry, over the last year and a half, we saw a tremendous amount of demand not only domestically, but it was coming out of every corner of the world. And I don’t mean that jokingly or off the cuff,” Spainhour says. “We saw demand for dairy products, specifically U.S. dairy products, coming from places in the world we hadn’t seen before.”

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Demand for dairy products from Asia contributed to growing dairy demand. Meanwhile producers in New Zealand and Australia fell into a drought.

“That supply disruption meant that people had to come to someone else to get the supply. That left the United States as a prime supplier,” Spainhour says.

The demand absorbed our marginal product and drove dairy prices higher. Spainhour says the U.S. responded to this huge international demand by pushing a lot of supply onto the market. At its peak, nearly 11 percent of dairy solids produced in the U.S. left to meet global demand. But in early summer 2008 Spainhour says he saw the first evidences demand had started to crumble. Global dry powder dairy prices were too high; customers started to turn to alternatives. Then world economies began to unravel.

“In those export markets we were servicing, dairy is still very much a luxury commodity,” Spainhour says. As economic situations worsened, luxury buyers had to settle for more staple commodities.

Overall, the U.S. quickly built a dairy production system capable of exporting a tenth of production in order to supply world demand. But that demand doesn’t exist at the same level today. Spainhour says we may be lucky to export 5 percent of our solids this year.

“It’s not fair. It doesn’t feel good,” Spainhour says.

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So what type of dairy producer is well-positioned to take advantage of this downturn? Matlick says one with a lot of liquidity, either cash or borrowing ability.

“It’s no different than the housing market. Somebody with cash is going to buy that foreclosed home at a distressed sale. There are going to be opportunities around like that,” Matlick says.

Producers who were making $4 or $5 per hundredweight last year and were paying down debt will be well-positioned. Unfortunately, that’s not the majority of cases Matlick sees. He offered the following suggestions for producers in one of three categories.

WORST-CASE SCENARIO:

Producers who are heavily leveraged. Their equity has already been diminished, and they operate without a positive margin.

“I’d see how much equity we are going to burn up between now and the fall. I think we’ll get back to $14 milk. And have the frank discussion to answer: Do you want to burn $150,000 in equity which is going to be centered in payables to your feed company and vet? Or would you rather take the equity and go home? I’m going to encourage the latter with some clients.”

MOST-LIKELY SCENARIO:

Producers who are not heavily leveraged. They still have some equity and are near breakeven or better.

“I think they have to do everything they can to manage their costs. I think there is a future for them. They have to manage the margin between expense versus income and be in constant contact with their lender. And I think a majority of lenders are going to stick it out with that guy.”

BEST-CASE SCENARIO:

Producers who contracted a positive margin last year and have liquidity and/or equity. “I would tell that kind of a producer to stay put for three or four months until we get a clearer picture. But that guy probably has a desire to grow and expand. I’d advise him to search out opportunities to expand. There are going to be opportunities from the other two groups we’ve talked about they can take advantage of.”

Matlick calls many of the decisions producers are making today “gut-wrenching.” Many are family decisions that go beyond finances.

“The dairy industry has been through many downturns. I don’t think the dairy industry has ever been caught in a downturn that is the result of a global and domestic recession,” Matlick says. “In the past I could quantify what I thought was going to happen in agriculture and the dairy industry and take a case to the dairyman and the bank for why we should stay in. But right now we have issues with global recession, and it’s hard to quantify where the end is.”

The USDA’s prediction is the same. The success of 2009 for dairy producers will “largely hinge on the financial health of major economies.”

“I really hope it ends tomorrow. Unfortunately, the odds of that are not very big at all. I think the odds are that we could have nine months of this. I hope I’m wrong.” PD

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