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How will the economic pieces fit together?

Phil Plourd Published on 12 November 2010


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On the one hand, dairy markets seem susceptible to downward adjustment, with heavy cheese stocks, the imminent passing of the holiday demand season, and plenty of near-term production potential here in the United States. On the other hand, exports have been excellent and markets have generally stayed elevated for longer than expected.

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On the one hand, high grain prices seem likely to alter milk production potential and, with that, prices at some point in 2011. On the other hand, while $6-per-bushel corn and $13 per hundredweight milk cannot coexist for long, they can coexist for awhile.

On the one hand, a recovery in New Zealand milk production and strength elsewhere in the Southern Hemisphere seems likely to limit opportunities for U.S. exports. On the other hand, China’s appetite for milk powders at times seems to verge on the insatiable.

Just what we need, right? Another dairy economist spelling out various contradictions and potential outcomes for markets, without ever really choosing a side.

“Please,” the people cry out, “find us a one-handed economist!”

The good news is that I am not a classically-trained dairy economist. The bad news is that today things are as “two-handed” as I can recall over the past decade. And that is saying something, considering all the drama that has unfolded over the past ten years. There are a lot of elusive variables swirling around the markets, domestically and globally, concerning supply and demand, for the near term and the intermediate term.

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The tension basically boils down to a nagging sense that the market could, at any time, soon feel over-supplied versus the harsh reality that, given where grain prices have gone, most dairy producers are not in a position to withstand much, if any, time with $14 or $13 milk. Further complicating the issue, prevailing Class III milk futures prices don’t seem to offer any whiz-bang risk management alternatives that ease or circumvent the pain. Hedging choices for producers seem to run from bad to, um, not good, especially for those with the most feed cost exposure (which is to say, producers in the western U.S.).

First, consider the fundamental landscape on a micro level. Cheese inventories remain high, with total cheese stocks on September 30 at the highest level for the month since the early 1980s. Milk production has been percolating, with a strong bounce-back in the West this summer offsetting seasonal issues in the Midwest. September output was up 3.3 percent according to the USDA. Cow numbers are at least adequate and heifer inventories are robust.

Elsewhere in the world, production has been decent in Europe and is expected to be solid in the Southern Hemisphere over the next few months. Recent history suggests that when the rest of the world has product, U.S. export opportunities diminish. Considering the U.S. exported 250 million pounds of cheese, 493 million pounds of skim milk powder and 72 million pounds of butter through August, any change in trade flow will likely matter, and not in a good way for dairy producers. That is especially true since domestic demand has been lethargic and, given a newfound frugality among consumers, doesn’t look to improve markedly over the near-term.

That seems bleak. Things get a lot brighter, however, when zooming out some. First off, China has been a significant buyer of milk powders in the world market. Through September, GTIS data shows skim milk powder imports at an average of about 7,300 metric tons per month, up 34 percent from the same period in 2009, and whole milk powder imports at an average of about 27,000 metric tons per month, up 93 percent on a year-over-year basis. Continued buying at that pace would help keep the world market bid on the firm side. And given the propensity for Oceania and the EU to produce WMP, there could be better-than-expected global opportunities for U.S. SMP and butterfat. The China powder story is a subset of a larger food supply/food inflation story playing out nearly every day in numerous markets; drought in Russia, solid economic growth in Asia, a weaker U.S. dollar. All of those factors could create a psychological tailwind for U.S. dairy markets. Put simply, prospective buyers may be inclined to own more rather than less and own early rather than late. Psychology alone cannot keep markets high, but it could help stave off a near-term collapse.

There are more moving pieces in the puzzle, to be sure, but those are the critical pieces. Those pieces could fit together in a number of different ways, creating radically different price pictures. Some scenarios point to only moderate price declines over the intermediate term. Others suggest swifter and more severe downside action. In our estimation, things will get sorted out as year-end approaches and the world gets a better sense for what the Southern Hemisphere has for sale, especially New Zealand.

So what is a dairy producer to do in the meantime? The quick answer: Tread carefully. The more complicated answer involves leaning toward protecting against disaster where necessary, while preserving at least a measure of upside. While every producer has different imperatives, our counsel of late has generally favored “risk reversal” or “fence” strategies that combine put option purchases with call option sales. In return for a price floor, producers agree to a price ceiling. We have been inclined to suggest that coverage not extend much beyond the first half of 2011. We are keenly interested in whether clients have done anything on the feed side. For better or worse, we have seen some producers take a bare-bones, survivalist approach to the next several months, especially in cases where feed costs have been addressed. There may not be much exciting about $14 or $14.50/cwt Class III milk, but, in their reckoning, getting by might be good enough for awhile.

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On the one hand, that isn’t very glamorous. On the other hand, it may beat some of the alternatives in highly uncertain times. PD

Phil Plourd is President of Blimling and Associates, Inc., a Wisconsin-based firm specializing in dairy market analysis and risk management. His views are not intended in any way to be a specific or general recommendation to buy or sell any commodity futures or options contracts.

Phil Plourd
President
Blimling and Associates

PHOTO: The more complicated answer involves leaning toward protecting against disaster where necessary, while preserving at least a measure of upside. Photo from thinkstock.com

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