There is an old saying, “Talk is cheap!”

I venture to say it is true simply because supply often exceeds demand.

Milk is cheap when the same can be said about the dairy industry. The last 18 months have been one of supply and demand imbalances and corresponding price volatility – a trait common to perishable commodities such as milk. Even the most subtle change can cause dramatic movement in price. And the last 18 months have been anything but subtle.

What will change? What should be expected as we go forward in 2008? What do I do about it? Let’s take a look at the state of supply and demand in the dairy industry and some practical things that we can do to manage the price volatility that is born from it.

Supply
Much of the early conversations in 2007 centered around production … or a lack thereof. Industry outsiders held to the idea that producers would reduce the use of or choose alternatives to higher priced corn and soybean feed sources in an effort to minimize input costs. They rationalized that this decision would ultimately lend itself to year-long production declines. Not only did production-per-cow fail to trend lower throughout the year, but rather it moved to all-time highs. The American dairyman came shining through.

The story doesn’t stop here. One of the simplest and perhaps the best price direction indicator can be found at the source of milk supply … the cows. A very simple conclusion can be drawn from the relationship between cows and milk price – as one increases, the other decreases. Figure 1* illustrates this. Notice the very instant, opposing response of herd growth (or reduction) relative to price movement and vice-versa. However, take note of the anomaly of today’s market – both prices and cow numbers are at historically high levels. Like the days of the Roman Coliseum, only one will be left standing. Will it be cows or will it be price?

Demand
There are two planes on which demand is measure – domestic use and exports. While exports have caught a great deal of recent attention, the domestic market reigns supreme over U.S. dairy production. To get a better understanding of where we are at, we must first look at how we got here. With the exception of a few spikes over the past decade, prices of both milk and product have maintained an equilibrium level that has kept the wheels of the dairy industry turning. Any surge of demand was met immediately with increased production. Any ideas of product scarcity were squelched by large government holdings. Both conditions helped to keep world prices somewhat depressed for the consumer. Promotional efforts aided consumer awareness of the nutritional benefits of dairy ingredients. New diet trends created a greater demand for protein. To meet this demand, end users began to incorporate more dairy protein products in a growing range of applications.

On a global front, foreign economies began to boom. In typical fashion, consumers within these growing economies began to demand more protein in their diets. During this same period, policy changes greatly reduced government supplies of skim milk powder which catered well to the growing demand by keeping product very affordable relative to other animal protein sources (a condition that still exists today). A collision of these trends (together with an ethanol and commodity investment boom) has created one of the strongest demand markets in the history of the dairy industry. Enter 2008.

In recent months, the value of the U.S. dollar has substantially weakened relative to other currencies around the world. This may sound like a bad thing. To the contrary, it is quite helpful to our trade balance. The weakening dollar gives other countries greater buying power and limits their selling power. In other words, it helps to encourage exports by making us more competitive than other producing countries and at the same time it discourages imports. Any dramatic increases in dollar valuation could begin to curtail the robust exports that we are currently experiencing. A bit more alarming is what has been happening with domestic demand.

Recently consumption has begun to stagnate and decline. Some explanations exist. The Consumer Confidence Index (CCI) was released at 87.9 (1985 = 100) in January, a decline from the July 2007 peak of 111.9. In simplest terms, a rising CCI number translates into greater consumer optimism and in turn greater spending. The opposite is true when the CCI is falling. The release of this information comes at a time when sub-prime mortgages have plagued the finance community, the stock market has raised some serious concerns about a potential downturn in the economy, and the government has begun to issue band-aids to fix the first two problems. Secondly, the Consumer Price Index (CPI) for dairy and related products grew to 204.6 in December 2007 relative to the 181.4 release in December 2006. This may seem like a dramatic rise in prices. However, when viewing wholesale prices relative to retail levels, there is a chance that these numbers could continue to rise substantially. For example, while the CPI for cheese rose 12 percent on the retail level, wholesale prices rose 58 percent ... a suggestion that further price increases may be coming. Increased prices coupled with fleeting optimism create a recipe for tightening domestic demand in the near term. Be prepared!

The balance sheet beyond the border
Among leading dairy-producing regions, there are two areas outside of the U.S. that bear watching … Oceania and Europe. In 2007, drought stress in New Zealand and Australia kept world buyers scrambling for adequate product supply. According to Dairy Australia, milk production was down 7.2 percent after the first half of the production year (July-Dec. 2007). This shortfall has had a rippling effect on product supply. Although cheese exports were up slightly (4 percent), butterfat exports had fallen 23 percent, skim milk powder declined 34 percent and whey exports dropped 44 percent. New Zealand posted a 2.5 percent increase in milk production during this period. However, hot and dry conditions are already starting to eat away at these builds as the peak production season nears an end. As a result, very few (if any) product surpluses exist in the Oceania region.

Europe faced a different challenge. A worldwide scramble, as described previously, to satisfy demand kept inventories low and prices strong through the first half of 2007. Dairymen sought a 2 percent increase in their production quota. This proposal had more supporters when product prices were at record-high levels; recently that support has eroded with prices. This potential change in policy has not slowed down the cows, however. Milk production volumes in western Europe are considerably higher year-over-year and are expected to be maintained in the short run. When factoring foreign demand, this increase in supply will help ease the pressure of demand. However, it appears that the U.S. will play a very big role in the export market in the coming year.

Going forward
How do we manage all of these rapid changes? The first thing that we must understand and admit is that markets move. They change moment by moment with very little or no warning. Though it is impossible to predict these movements, it is important to be acquainted with their general tendencies. Consider the price that you have been paid for your milk over the last 30 years. The average price falls near $12.50, with the bulk of your milk being valued in a range from $9.50 to $13 (based on Class III values).

Changes tend to first favor a move upward. What we have seen as of late is no different. However, once a high is established, it is only a matter of months before the market recedes to its comfort zone. As a function of these tendencies, producers should favor minimum price strategies that allow them to establish price floors with an open door for upward price movement. This can be as simple as buying a put option or contracting milk and simultaneously buying call options. In future articles, I will focus on why this is so very important. In the meantime, a phone call to the person who assists you in your marketing efforts would be warranted.

What is important to recognize is that we are in a time and place where growing global demand has been met with growing global production. As we work towards finding new equilibriums, price will continue to be as or more volatile. This means that the highs of the market will be overdone and so will the lows. Producers must embrace marketing activity with the same demeanor that the processors of their product have so successfully employed. This will require a firm grasp on costs of production and calls for swift action when marketing opportunities cycle through the imminent volatility. The days of discovering your milk price at the mailbox are behind us. Action yields value, talk is cheap. PD

Figure omitted but is available upon request to editor@progressivedairy.com.

UPDATE: Since the publication of this article, Mike North has left First Capitol Ag and is now the president of Commodity Risk Management Group. Contact him by email.

Mike North
Senior Risk
Management Advisor