Guest Editorial
Enter 2008 with caution

by John Spainhour

John Spainhour is a broker for Rice Dairy, Chicago. He is a guest columnist for this week’s issue of Cheese Market News®.

Despite the record prices established during 2007, it may not have been enough to stimulate the kind of growth typically seen after a bull run of this magnitude. Fiscal year 2006 was a particularly nasty year for dairymen, who spent almost the entire year underwater. Not only did Class III prices move to their lowest levels in several years, input prices across the entire spectrum began moving higher at the same time. While most producers typically enjoyed a break-even level of around $12.50 per hundredweight, many now feel that number has risen to somewhere into the low $15.00s.

While the pain of 2006 was not deep enough to cause an all out liquidation of the cow herd, it was enough to pull in the reigns of expansion and bring the year over year growth down from 4.0 percent to around 1.0 percent this year.

Many producers have stated very clearly that while they would like to expand based on the current prices they are receiving, they will have to use the higher than usual earnings captured during the last six months to make themselves whole on debts and expenses incurred during 2006.

It also is important to remember that not every producer received the benefits of the higher whey prices this year, which have contributed more than $3.00 per hundredweight to the Class III average. Producers in certain areas of the country are paid strictly on a cheese yield basis and were able to capture very little of the upwards movement in the whey prices.

While the financial situation will surely be a big hindrance to milk growth in the coming year, I see two other factors as possibly being bigger: water rights and environmental issues.

California and Idaho, where a large part of the milk production growth has taken place in the last decade, already are dealing with these two issues head on. As early as June this year, producers in both of these states were being warned that their well water rights could be curtailed due to water shortages that these states were facing. At the time of this writing, no producer had yet had their water turned off, but the possibility still lingers. While it is impossible to predict the weather patterns that exacerbate water shortages, it is safe to say that demand on water from both industry and the general population is going to continue to grow and keep the water supply volatile. Producers are not likely to add more cows to their herd when there is the possibility that they may not be able to water their existing herds.

From the environmental side, you would be hard pressed to find a producer who does not deal with this issue on an ever-growing basis. Even producers who have an extremely clean record of environmental strategies find themselves under the eye of environmental watchdogs and state agencies. Both the policies and tactics of these organizations are getting more and more aggressive and many producers fear they may be litigated out of business, especially in key producing states like California and Idaho. While I am sure that some compromise will be met on both sides that will allow for existing operations to continue operating, it is safe to assume that expansion permits will be harder to come by in the future than they have been in the past.

This by no means insinuates that we won’t see growth from the supply side this year, especially if the current price trend continues. States like Kansas and South Dakota have been and will likely continue to grow at exponential rates. Both states are making aggressive efforts to court producers into their states. It also is safe to assume that at the current price levels, producers will find extremely innovative ways to produce as much milk as possible with their existing herd levels. Production per cow has risen dramatically in the last five years, and while that rate of growth has slowed recently, I suspect new technologies and processes will be developed to get that rate moving higher again.

However, while I see expansion on the horizon, I just don’t see it unfolding in the same manner and pace that we have seen it happen in the past.

To say that demand was a big portion of the high prices that we have seen so far in 2007 would likely be an understatement: It was the driver. And while domestic demand played an important role, it was international demand that seemed to take to take the lead this year. Both whey and nonfat went into record levels and while the effect was delayed for awhile, these price increases seemed to force cheese prices to follow.

I didn’t coin the phrase, but in the last year I have heard the international demand function referred to as the “globalization of dairy products.” While this may sound a bit academic, I think it sums up what is happening in the dairy industry pretty well. Global demand for dairy is growing everyday and countries like China likely will continue to absorb these products at a growing rate as their population not only increases but becomes more affluent.

The countries that have traditionally serviced the demand from these growing economies continue to have trouble keeping up due to capacity and production issues. More and more, they are looking toward the United States as the supplier of these products. Even Europe, where dairy products are rarely imported, has been coming into the United States to source butter right now.

This is not to say that prices will continue moving higher and that we won’t have times of extreme volatility. Demand is always the X factor that is extremely difficult to analyze; international demand is even more difficult. Each country has its own issues when it comes to price resistance, purchasing arrangements and timing of the purchase.

I’m not sure we’ll ever again see a rally like we did this year. In fact, most people on both sides of the trade seem to hope we don’t. But I do think we’ll continue to see the economic functions that helped create that rally remain strong forces in our market.

In summary, due to the limitations surrounding supply side expansion and the ever-growing role of global demand, those end-users with price risk related to dairy products should enter into 2008 with caution. Prices likely will remain volatile, and if your bottom line is going to be affected by higher prices, then you should seek out ways of mitigating that risk through supplier arrangements or financial instruments such as Class III futures and options.

CMN

The views expressed by CMN’s guest columnists are their own opinions and do not necessarily reflect those of Cheese Market News®.