Guest Editorial
Market volatility won’t decrease without industry involvement

by Phil Plourd

Phil Plourd is vice president of research at Blimling and Associates, Cottage Grove, Wis. He contributes this column exclusively for Cheese Market News®.

Last week, the cries of anguish about the cheese market seemed to reach a crescendo. One phone call from a client aptly summarized the sentiment: “Don’t folks realize the havoc this is creating for our customers?”

The “this” is market volatility. After several months, I have essentially run out of clever ways to describe the magnitude of day-to-day price movement in the Chicago Mercantile Exchange (CME) spot cheese market, at least the ones suitable for publication. Roller coaster ride … jarring … confounding … used them all.

Ultimately, the raw data speaks for itself. Last Friday evening I took a look at volatility in just about every market I could think of. Spot block Cheddar tops the list — by a wide margin, as the chart accompanying this column suggests. That’s right: Compared to the cheese market, wheat is for wimps, crude oil for cowards, the NASDAQ for neophytes.

Consider: The crude oil market is conventionally regarded as being hugely volatile. Yet the last time it was as volatile by the numbers as today’s cheese market was at the onset of the Iraq war in 2003. Not even Hurricane Katrina in 2005 pushed volatility high enough to top cheese.

Moreover, the volatility in the cheese market today is not unprecedented. A look at the long-term chart shows three periods with more volatility than the market is experiencing today (January through June 1999; June through July 2004; October 2004 through April 2005).

The extremes might make for great war stories. And, to be perfectly honest, it is not bad for the business of market analysts and brokers. But is it really a badge of honor? The disruption and flat-out despair created by the cheese market’s volatility reaches from end-to-end along the farm-to-market pipeline. True, the Class III and dry whey futures markets provide a highly effective way to hedge cheese market price risk. But at times it seems as though the emotional toll of seeing futures positions being whipsawed by the cheese market outstrips the textbook financial benefits of holding a position. Paralysis can set in.

Some measure of volatility in the cheese market is inescapable. It is elementary, as in most other agricultural commodity markets. At the same time, there are clearly structural issues that propel cheese to the top of the volatility leader board. Lack of liquidity is the main issue.

Theoretically what we have today at the CME could work. Widening the specifications would help a bit — say expanding deliverable supply to include 640-pound blocks as well as 40-pound blocks. But all manner of tweaks won’t matter if the majority of the industry stays away. Today so many view volatility and, at times, odd price behavior in the CME cheese market as a problem beyond their control. Sometimes we half-jokingly, half-seriously suggest to clients that one way to address the liquidity and volatility issues is to, um, actually participate in the process. That approach has seemed to work to some degree in the butter market over the past five years, where the participation has become more diverse and, not coincidentally, volatility has decreased. The butter market is hardly a paragon of efficiency and transparency. But it is arguably better than it was five or 10 years ago.

Logical as it may be, a call for increased participation in the current market seems to be a non-starter. There appears to be too much stigma attached to the process.

Where do we go for solutions? “Price discovery” will be on the table as a topic at the International Dairy Foods Association’s Dairy Forum this next week, where a panel of interested and informed market participants will discuss the issue. I suspect that using the futures marketplace as a principal vehicle will be talked about among the possibilities.

With that in mind, it bears notice that the second nearby Class III milk futures contract has actually been less volatile than the spot cheese market to which it is so closely tied. That has generally been true over the long run of history. Why?

For one thing, it probably has a lot to do with relative levels of liquidity. Volume in the second nearby Class III milk contract has averaged 1,280 contracts per week over the 20-week period ending Jan. 11. Over the same period, an average of 10 cars of block Cheddar changed hands each week. More volume means more diversity of price opinion which should mean less volatility.

In addition, while the barriers to entry are lower in the Class III market than in the cheese market, it takes real money to participate. Only real, committed capital can push prices higher or pull prices lower. That is not so in the spot cheese market where big price movement can take place on an unfilled bid or an uncovered offer. While there is the prospect of having to commit capital or product to the endeavor (should there be an actual transaction) it is not a given. According to our research, there were 175 sessions in 2007 that saw a change in the CME block Cheddar settlement price. In 54 of those sessions — about a third of the time — there were no actual trades consummated. Price moved on an unfilled bid or an uncovered offer.

Finally, I suspect anonymity is a factor. There is true anonymity in the Class III market — and even less ability to make educated guesses since the migration to the Globex system. There is presumptive and ultimately only temporary anonymity in the spot cheese market. Consequently, firms and individuals may participate in transactions in the futures market that they would not enact in the spot market for fear of being “seen” behind the trade.

I am inclined to believe that the futures markets offer a ready-made solution to the volatility dilemma. But there are other possibilities that will be under serious consideration and discussion. Daily price surveys of some sort, for example, could be a step in the right direction toward broadening and deepening the price discovery base. Such measures might be a useful transition step en route to an entirely futures-centric system. Or, they might somehow be combined/tied to the futures market. In any case I sense we are moving, however tentatively, in the right direction.

Hopefully the impetus for change builds coming out of Dairy Forum. When all is said and done it is the industry itself that has to make the decision and make the necessary push for change. It is not the job of the CME. It is not really the job of USDA. It won’t just happen on its own.

CMN

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