Strong Dairy Futures Coupled With High Feed Costs
Market Psychology
The market continues to provide interesting numbers that have market fundamentalists shaking their heads. Yes, it is true that March American cheese inventories are seven percent below a year ago and production was even with a year ago. Add to that increases in exports and one can say yes, cheese prices should be higher than normal. However, the implied cheese price given current futures data would imply that block cheese prices will be $2.01-$2.07 during June-December.
It strikes us as odd that the market expects cheese prices would be high and stable for this many months. But the market is very bullish and is looking at all commodity prices and saying, why not dairy?
Exchange rates, high energy costs and commodity fever are all adding up to higher futures prices for dairy. Adding to this is reduced productivity per cow during the first quarter of 2008. This has acted to curb the milk supply despite higher cow numbers. It has also provided a floor to these higher commodity prices. But why is the milk supply growth so weak?
Well, certainly California plays a role. Implicit plant quotas have acted to curb growth in the milk supply there. No one wants to make more milk if there isn’t a home for it. And higher feed and energy bills are likely making an accounting headache for many dairy farmers struggling to cash flow. Add to that the processor demand for rbST-free milk.
The bottom line is eventually prices will return to market fundamentals. But are current dairy commodity prices driven by fundamentals or market speculation? At the moment it may be a bit of both. But futures data and our calculations of income over feed costs suggest that earnings this year for milk producers will be below a year ago. So one can expect a reduction in the milk supply by the third quarter. So higher feed bills and reduced earnings, not exchange rates or oil futures, will be what drives milk prices.
Milk Production
U.S. estimated milk production grew 2.0 percent on a daily average basis in March to 16.462 billion pounds. This growth was due to higher cow numbers and yield per cow. Cow numbers grew 7,000 head from the month before to 9.259 million head. This rate of growth indicates a slowdown from the second half of 2007. And milk yields were on average 1,778 pounds, a mere 13 pounds above a year ago.
Yes the milk supply is growing, but at a lower rate than a year ago. The question is, are we experiencing a temporary reduction with more milk to come later? This would depend on our forecast of gross earnings. Our forecast is that cow numbers won’t begin to decline until the second half of this year and yields could rebound. So look for more milk.
PSU Income Over Feed Costs
Feed prices have been rapidly advancing, particularly for corn. During the first week of May corn prices at the Chicago Board of Trade (CBOT) rose from $6 per bushel in May to $6.305 per bushel by December 2008. In addition, soybean meal contract prices also rose, but not as much.
Soybean meal prices rose from $328.5 per ton in May to $334 in July, falling to $304 per ton by December 2008. Class III milk futures also rose in response to higher feed costs. Class III prices at the Chicago Mercantile Exchange as of the first week of May rose from $18 per cwt in May to $20.21 by September, settling back to $20 per cwt in December 2008.
We used these futures prices in developing a forecast of the PSU Income Over Feed Cost (IOFC) index. This index reflects the milk value less feed costs for a cow producing 65 pounds of milk per day. Essentially it reflects the gross value of milk. The PSU measure of IOFC rose from $6 per cow per day in early 2007 and reached a peak of $10.50. The second half of 2007 realized very high levels of gross profits for dairy farmers. However, by the end of the year IOFC began to decline. There was a sharp drop from over $9 in January to a projected $6.85 by April 2008. We are forecasting that IOFC will improve somewhat to $7.60-$7.80 by the second half of the year. This level of IOFC will be between the very high levels of 2007 and the very low levels of 2006.
Our forecast of IOFC is based on the following prices: the all-milk price, corn price, soybean meal, and premium alfalfa hay. We based our forecast of the all-milk price on our modeling work and individual forecasts for cheese, butter, nonfat dry milk, and dry whey. The corn and soybean meal prices are based on futures data. And for hay, we fixed our Illinois premium quality hay price at $180 per ton.
The forecast of IOFC can be useful as a hedging tool for producers who would like to lock in milk and feed prices, but don’t know how. It would be risky to lock in one and not the other. Thus a greater focus on the gross margin, reflecting both milk prices and feed costs, would provide a sound guideline. Producers should collect their own IOFC and compare it to the data presented here. Then, they can take the futures data and compute an implied IOFC. This could then become a basis for locking in both milk prices and feed costs.
Cheese Supply & Demand
A fundamental analysis of the market conditions supports current cheese prices in the $1.80-$1.20 per pound range. Cumulative American cheese production for the first quarter of 2008 is 993.5 million pounds, up just 0.8 percent from a year ago. Ending stocks as of March 31 for American cheese is 529.1 million pounds, down seven percent from a year ago. And exports of American cheese during the first two months of this year are up from around 4,000 mt/month during the first quarter of 2005 to almost 11,000 mt/month in 2008 during January and February.
It’s still too early to estimate first quarter domestic commercial disappearance. During the last quarter of 2007 domestic use of American cheese fell 0.1 percent from the same quarter a year ago. The latest data through February indicates that domestic commercial disappearance for the most recent three months is down 0.3 percent.
Our analysis indicates that cheese prices are fundamentally driven by ending stocks of American cheese. As long as stocks are lean, prices will be high. Data indicates that American cheese ending inventories are following 2005 levels. In that year, for example, block cheese prices during the first quarter averaged $1.5505 per pound. During the first quarter of 2008 American cheese prices averaged $1.8838, or $0.33 per pound higher. Why the difference in price? This is likely due to speculation in the market place. It could also reflect a premium for an expected future reduction in the milk supply.
If the milk supply rebounds, more milk will flow into cheese production. That would depress prices. However, for this analysis, we used implied futures prices in our forecasts. Thus we assumed cheese prices would remain around $2 per pound for the remainder of the year. If production rebounds, look for cheese prices to weaken.
International Trade
Trade data is not yet available for March, but all indications are that U.S. exports of dairy products will remain very strong. This export boom is fueled in part by a weak U.S. dollar and strong growth overseas. It appears that the U.S. has a clear price advantage particularly for butter and nonfat dry milk where U.S. prices are surprisingly lower than global prices. In fact, for the week ending May 2, Western mostly prices for nonfat dry milk were $1.34-$1.37 per pound. For the week ending April 25, the Oceania price of skim milk powder was $3,200-$3,800 per mt, or an average $1.588 per pound. This price differential is much higher for butter.
For the week ending May 2, the Chicago price of Grade AA butter was $1.428 per pound. For the week ending April 25 the Oceania price of butter was $3,500-$4,400 per mt, or an average $1.79 per pound.
Under more normal marketing conditions, arbitrage opportunities would result in a closing of the gap between low U.S. and high international prices. However, there appears to be two obstacles. First, even if the EU wanted more imports (EU prices are the highest in the world), tariff barriers create an obstacle. Second, many sources note there is a large shortage of containers for export. Perhaps a third reason for a continuation in this apparent price gap is due to differences in production standards between the U.S. and world. The U.S. produces nonfat dry milk, and the world demands skim milk powder (skim milk has a standard protein content).
We produce a white salted table butter that contains on average 81.1 percent milk fat, whereas the world prefers an unsalted more richly colored butter that has a higher milk fat content. And finally, while we produce and consume mainly American style cheese or low fat mozzarella, the rest of the world consumes many varieties including Gouda.
Our expectation is that the U.S. will export larger quantities of dry skim milk, whey, lactose, butter, and yes, American cheese. During the first two months of 2008 exports of dry skim milk reached 74,598 mt, or 87 percent ahead of the same two months a year ago. The major markets for dry skim milk during the first two months of 2008 were Mexico (22,183 mt), Philippines (8,544 mt), Indonesia (5,361 mt), Algeria (5,177 mt), and China (5,172 mt). In total the U.S. exported dry skim milk (less than 1.5 percent milk fat) to 44 countries. Our exports depended on availability of U.S. product, output from our competitors (the EU and New Zealand), and the strength of the world economy in Mexico, Asian countries, and select Middle Eastern countries. The point is, there isn’t just one factor (e.g. exchange rates) that is driving this export boom for the U.S.
Commodity Prices
There appears to be three distinct price movements for U.S. dairy commodities. Nonfat and whey prices have bottomed out and are showing a slow recovery. Butter prices are rebounding stronger than expected. And cheese prices appear to be trading sideways in a range of $1.80-$2 per pound.
Nonfat and dry whey prices have bottomed out due to two factors. First, unusually strong prices in 2007 damaged U.S. and overseas demand and resulted in product substitution. Both of these commodities have substitutes in both food and animal feed rations. Second, a strong rebound in ending inventories in the U.S. helped create a lower price environment. But this is changing now that global demand is firm and New Zealand production is limited due to insufficient rainfall. Thus there appears to be a slight rebound.
Its not entirely clear why butter prices are exceeding $1.40 per pound in the U.S. Inventories as of March 31 were 226.4 million pounds, up over 17 percent from a year ago. Commercial domestic disappearance the last quarter of 2007 was down 4.2 percent. We expect the higher price is attributable to greater export sales.
That brings us to the mysterious cheese price. The outlook for cheese prices is unclear at the moment and the market is trying to find direction.
On the one hand a rebound in the milk supply will result in more cheese production, which could put downward pressure on market prices. On the other hand, weak milk output due to rising corn prices and restricted manufacturing capacity could place a $2 per pound floor on cheese prices for the remainder of the year. As stated earlier, we expect more milk because of a moderately higher IOFC measure. That will generate a slight rebound in cheese inventories and some moderation in prices. But that assumes a normal summer and greater cheese production.
Outlook 2008
As stated earlier, we switched gears a bit and have now based our forecast on the futures prices. We assumed that nonfat dry milk prices (Western mostly) will rise from $1.40 per pound to $1.50 by July and remain at that level for the remainder of the year. We also used futures prices for dry whey and butter. For cheese we estimated the implied cheese prices from the Class III futures prices and federal order formula. Finally, we used futures prices for corn and soybean meal and kept Illinois premium alfalfa hay constant at $180 per ton.
Our forecast is that Income Over Feed Costs (IOFC) for 2008 will average $7.63 per cow per day. That compares to an average $8.99 in 2007. Cow numbers are expected to continue to rise through May and then begin to decline thereafter as earnings are squeezed. Thus the milk supply is forecast to grow just 2.5 percent in 2008 relative to a year ago.
Our analysis indicates that current futures prices will generate an IOFC number that will be somewhere between the higher earnings of 2007 and the losses in 2006. Yes, an all-milk price of $20 per cwt does look attractive, but loses its luster under $6 plus corn prices. Still, gross earnings will be high enough to generate some additional milk supplies in 2008.
Again, most of the surplus milk components will find its way into butter and nonfat dry milk production. We expect flat to declining fluid sales due to still high retail prices for fluid milk. And given plant constraints and a recessionary environment, cheese production will be limited. Thus we should see a fairly strong rebound in butter and nonfat production. If export markets remain firm, it may justify $1.40-$1.50 butter prices and current nonfat dry milk prices. However, if exports wane just a little, butter prices and nonfat prices will come crashing down. As for cheese, we expect cheese prices will actually fall below implied futures prices based on market supply and demand, but we’ve been saying that for months now.
The key factors to monitor are ending stocks of cheese, butter and nonfat exports, and of course U.S. milk production.
