Guest Columns

Perspective:
Dairy Pricing

Dairy markets provide a wake-up call

Mike McCully

Mike McCully is owner of The McCully Group LLC, New Buffalo, Michigan, and contributes this column for Cheese Market News®.

Class III milk futures have surpassed $20 for the first time in five years. Cheese and nonfat dry milk (NDM) prices are at the highest point since late 2014 and early 2015, respectively. Conversely, butter prices are flirting with falling below $2.00 for the first time since November 2016, and whey markets have taken a tumble this fall.

How did we get here? Over the last 20 years or more, milk production growth under 1% has often resulted in higher dairy product prices and, sometimes, record highs. The seeds for this year’s rally were sown last fall when U.S. milk production rose only 0.5% vs. prior year. Milk output has been weak for most of 2019, but there are signs the trend is turning back up. However, cheese stocks, particularly American cheese, are below last year, and milk powder demand has been solid both domestically and globally. Moving in the opposite direction, butter production and stocks have been above prior year levels, and with global prices near $1.75-1.80, the possibility grows each day of U.S. butter prices dropping below $2.00 before the end of the year.

Butter prices have historically been more volatile than other dairy products, but they have sat out this rally.

This year’s higher dairy prices have brought a renewed focus on risk management. Buyers that have only been in their job for a few years are experiencing tight dairy markets for the first time. After four years of little volatility, and in the case of NDM, historically low prices, dairy costs have risen substantially in the second half of 2019 for cheese, milk and milk powder buyers. For companies using some form of risk management, they have been rewarded with a more predictable cost structure. However, for companies that grew complacent after several years with little price volatility, this year’s run-up has likely resulted in more interest in locking in prices favorable to their budget for 2020.

One area of concern for the cheese industry is the volatile nature of the block-barrel spread. For manufacturers of barrels, the historically wide spreads seen this year have been painful as their milk costs got out of line with the cheese sales price. Several barrel plants have invested in block capacity in order to react to market signals by changing packaging types. Additional block capacity in 2019 and 2020 also will help bring the spread closer to the historical range. Unfortunately, for most end users, the volatility in the block-barrel spread has made their hedges less effective. For a company hedging block cheese, and using the CME cheese futures contract, the wide spread seen over most of the year has resulted in more basis risk, and a hedge that didn’t perform as expected.

There have been numerous discussions over the last 1-2 years on how to “fix” the barrel market. As I wrote last fall, while some may not like it, the market is working. There has been a surplus of barrel cheese in the country for the past few years, while demand for 40-pound blocks has grown. Eliminating the cash barrel market at the CME or removing the barrel cheese volume from federal milk marketing order pricing seems like an overreaction. An easier solution would be to base barrel cheese prices off the CME block market. The buyer and seller would voluntarily agree to a fixed premium or discount for the volume contracted in the future.

If enough companies did this, the National Dairy Products Sales Report weekly cheese price would be more predictable, and barrel manufacturers would have a known spread to work with. Buyers would give up periods of wider spreads than negotiated, but it could help make their hedging program more predictable. One concern is relying on a thinly traded block market to price even more cheese, but it would help address the problem some are having with the block-barrel spread.

And a discussion about dairy pricing can’t ignore the impact from the federal milk marketing orders. The block-barrel spread, lags in the National Dairy Products Sales Report price, a whey price that can be misaligned with whey protein prices, outdated make allowances and other pricing problems create market distortions because of the use of product price formulas to value milk in the federal milk marketing order system. Twenty years ago, the majority of the dairy processing industry and dairy cooperatives believed using end product pricing was a better mechanism for pricing milk than using reported prices for manufacturing milk in Minnesota and Wisconsin. With various discussions occurring about potential changes to dairy policy, there is a strong need to review today’s federal milk marketing order pricing system, taking into account dairy product demand now and into the future, and determine the changes needed to position the U.S. dairy industry for success over the next decade.

CMN

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

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