Milk: Strategies for A Challenging 2015

The McCully Group

Feed Prices and Farm Margins: After a long harvest, record corn and soybean crops are largely in the bin. However, despite the large crops, corn and soybean prices have rallied over the last 2 months due to a shrinking crop size, speculative buying, and slow farmer selling.

A recent Wall Street Journal article highlighted how farmers were content to store the crop and wait for higher prices. However, the underlying fundamentals aren’t particularly bullish, and with a corn carryout near 2 billion bushels, prices can remain in the $3.50-4.00 range. Wildcards include speculator/fund activity and South American weather. While feed prices will be lower in 2015, the sharp drop in milk prices is projected to result in a lower than average milkfeed margin. It seems dairy farmers have prepared themselves for the possibility of $15 milk. However, few have thought about what $12 milk might mean. If cheese falls into the $1.30’s and milk powder drops under $1.00, both real possibilities, class 3 and 4 prices would be $13 and sub-$12, respectively, and even lower in California.

DSA Milk-Feed Margin
US Milk Production

Milk Production: US milk production continues to post strong gains with October up 3.8% vs. year ago with all top 23 states posting gains. Texas led the way with a gain of 11.6%. Cow numbers are up 78,000 this year and are at the highest point in 5 ½ years. Anecdotal reports of increasing heifer supplies point to continued expansion of the herd into 2015. Milk production is expected to grow 3-4+% for the balance of 2014. And this growth trend is expected to carry over into 2015 with growth forecasted near 3-4% vs. 2014 in the first half. However, growth in the 2nd half is expected to be more modest as year-ago comparisons become more difficult and output slows due to lower margins. Full year growth is estimated at 2-3%, but is dependent on how robust the spring flush is.

Milk production in New Zealand is off to a good start with season-to-date output up 5% vs. last year through October. With milk prices at or below break-even, farmers could slow production gains as the season progresses and cutback on supplemental feed. Recent reports out of New Zealand indicate Fonterra is considering lowering their farm gate milk price for 2014/15 to around $4.55 to $4.85/kg of milk solids given continued declines in commodity prices on the Global Dairy Trade (GDT) auctions. This is a reduction from the current forecast of $5.30/kg and down from $8.40 last season. It is also below the break-even costs of $5.00-5.50/kg. Reports note farmers in New Zealand are resigned to the fact of low prices and returns for this season. There is more concern about what prices will be the following season. Like US farmers, New Zealand farmers built up some cushion in the last year to withstand a season of low prices. However, they likely cannot endure 2 low price years in a row.

US Stocks: While cheese and butter stocks, or lack thereof, were a major catalyst for record high prices this year, they have become less of a factor. The combination of increasing production, slower exports, and the end of the holiday demand period is resulting in increasing stock levels, at least anecdotally. With these trends expected to continue into the first half of 2015, stocks will likely track closer to 2013 levels. Milk powder (NFDM) stocks are a different story as they have been at record high levels in recent months. The July reading was the highest month ever while the recently released October number of 195 million pounds is the highest October in history. This is driven by several factors: NFDM production is up sharply as SMP production has dropped concurrently with the decline in exports, which have fallen roughly 50% from June to September. In addition, milk powder production in key export regions, New Zealand and Europe, is posting solid growth. With demand from China, discussed on the next page, well below earlier levels, milk powder stocks are becoming burdensome and will likely result in depressed milk powder prices for at least the first half of 2015, and possibly well into the 2nd half of the year.

Total Cheese Stocks
NFDM Stocks

US Exports: Overall, US dairy exports have been declining with September hitting the lowest level in 19 months. Cheese continues to be the best performer, up 23% YTD through October, but the pace is slowing. More pronounced losses are visible in butter exports where October volume was down 85% versus year ago and 88% lower than March 2014. Given the price disparity between US and Oceania and EU prices over recent months, these trade trends are expected to continue resulting in a challenging environment for US dairy exporters.

US Cheese Exports
US Butter Exports

The story isn’t any better for milk powder. While NFDM and SMP exports were up 1% vs. year ago through October, the pace has slowed dramatically from earlier in the year. October export volume did increase from September, but was down 25% from last year and 36% from June. For the first 9 months of the year, total whey product exports were about even with last year. WPI volume was up 29%, WPC volume was down 3%, and dry whey was flat. Overall whey product volume was lower in September, slipping 9% vs. year ago. October volumes rebounded slightly, but were still below year ago for WPC (-4%) and dry whey (-11%), overwhelming the small gain made by WPI. Like the other products, US whey complex prices have been above global prices, notably EU and New Zealand. With those regions being more price competitive, the trend in US whey exports is expected to continue into the first half of 2015.

US Milk Powder Exports
US Total Whey Exports

China: A major driver, if not “the” driver, of lower milk powder prices has been the sharp reduction in dairy product imports into China, most notably milk powder. In October, whole milk powder imports were down nearly 85 million pounds or 72% from last year, skim milk powder imports were 13 million pounds lower (- 27.5%), imports of whey products were down 14%, and butter imports were down 39.5%. Cheese imports were the only “winner” posting a 19% increase. However, this cheese was largely from New Zealand and Australia, as the US volume declined. The drop in European dairy prices has enabled an increase in dairy exports to China with Ireland and Denmark claiming over 20% of the market share in October. For skim milk powder, the US share has dropped from 34% in 2013 to 25% in 2014, while Ireland climbed from 1% to 16%. The big question with China is when do they come back to the market in a sizeable way. While some reports say China is out of the market, in fact, they are still buying product, just well below levels where they bought in late 2013 and early 2014. With reportedly better internal milk production, a large stockpile of milk powder, and a relatively weak economy, it will likely take some time before large-scale Chinese buying returns to the market. There may be an uptick in January related to trade deals/tariffs, but sustained buying interest doesn’t appear to be in the near future.


Over the last month, cheese and butter cash price movements have been difficult to understand. I thought cheese would remain around $2.00 given solid holiday demand and less than burdensome stocks. Instead, prices have plunged into the $1.60’s. Some of this is due to more cheese becoming available, but there has also been a short-term transportation issue with getting trucks to move product from the West (e.g. ID) to the Midwest. If a buyer can’t find a truck to pick up the cheese, the price doesn’t matter. So, cheese prices fell to multi-year lows over the last few weeks with blocks at $1.58 and barrels at $1.55. Importantly, cheese prices have pierced an uptrend dating to early 2009. From a technical analysis standpoint, the next support level is around $1.50, not far from today, with the next stop in the $1.30’s and 1.40’s. While these prices seemed unlikely until recently, the fundamentals are bearish, so these price levels are in play. While cheese prices have fallen below what I (and others) thought, butter prices have stubbornly remained around $2.00. Granted, the dramatic drop in prices in October brought back some retail features for the holidays, but most of that business should be finished up. There may also be some thought about holding prices and inventory values through the end of the year, but there is a lot of time left on the clock. I’m expecting butter prices will take a step down, probably into the $1.60-1.70’s, within the next few weeks.

CME Block Cheese Prices 2008-2014
CME Butter Prices 1995-2014

As you’ve read the preceding pages, you have noticed a decidedly bearish tone to my outlook for 2015. There is the optimistic scenario, which is reflected in my “base” forecast, and a more pessimistic outlook, which is reflected, in my “low” scenario. I am hesitant to lower my forecast to the “low” scenario at this point, but believe 2015 could be a hybrid of the “low” and “base” with low prices in the first half followed by a modest recovery in the second half. If I were looking at budgets and contingency planning for 2015, this is the approach I would take with risk management strategies. In short, there appears to be minimal upside risk in the first half. The second half is more uncertain. If milk production slows and demand picks up due to low prices, 2nd half prices should recover modestly. However, if milk production keeps posting robust growth and demand can’t keep up, the price trough will last through most of, if not all of 2015. Either way, hedging 2nd half prices for most dairy products and milk will probably be frustrating. If prices drop to lower levels in the first half, the 2nd half futures price curve will build in a premium, which will slowly erode over time. Buyers and risk managers will end up either paying more than what they think they should pay to get coverage or be conservative with the strategies and maintain a lower coverage level. Both could be the right answer depending on the individual situation. Given this uncertainty, options strategies are a logical choice for getting some coverage on in the 2nd half of the year.

My thoughts on the milk powder market are consistent with the last several months – it is the weakest link in the dairy complex. Global prices are at or below $1.00. Anecdotal reports out of Europe have SMP trading around the intervention price of $0.96/lb. While global cheese and butter prices are not aligned, SMP/NFDM prices in the 3 major regions are fairly well aligned, yet published US prices remain premium. As noted earlier, milk powder supplies appear to be more than ample through the first half of 2015. If stocks do not decline, prices will likely be depressed through 2015.

In the whey and lactose complex, dry whey powder prices are forecasted to range in the mid-$0.40-0.50’s next year as production continues to decline. However, WPC 34 will catch a cold from the sick NFDM market and trade close to $1.00 for a good part of the year. Increasing production capacity is expected to put downward pressure on WPC 80 and lactose prices. Already, reports have spot WPC 80 prices around $3.50. Finally, lactose looks to be in trouble for a while. US cash prices average in the upper $0.30’s. However, Europe is offering lactose into China/Asia in the mid-$0.20’s and buyers there are telling US suppliers they need to be in that neighborhood to get the sale.

In closing, 2015 is not shaping up to be another 2009 for the US dairy industry. However, there are some worrying signs around the world that look a lot like 2009. Barring another economic meltdown or significant weather event in a key milk producing region (both low probability), dairy prices are forecasted to trade at multi-year lows in the first half of the year. The key will be how farmers react to lower prices and margins. If they tap the brakes on milk output, dairy prices likely recover to some degree in the 2nd half. If not, then 2015 could turn out to see low prices through the whole year. Just as high prices have cured high prices, low prices in 2015 will eventually be the cure for low prices. But as I’ve said in prior months, everyone underestimated how high prices could go in 2014 and how long they would stay there, cheese and butter in particular. The opposite could very well be the case for 2015.


AMS Cheese Price Forecast

2015 Coverage Strategy:
Futures are premium to forecasts, so opportunities are limited at this point. A first half strategy should be conservative given current bearish fundamentals. If budget buying is required, use a scale-down approach. For the 2nd half, the risk of higher prices increases, so layer in options strategies to get the desired level of coverage.

AMS Butter Price Forecast

2015 Coverage Strategy:
Futures are premium to forecasts, so opportunities are limited at this point. Wait for lower cash prices and then use a scale-down approach with futures and/or options. Unlike 2014, the butter futures market will evolve into a carry market in Q1. Inventory hedges that weren’t available in 2014 will be possible in 2015.

AMS Whey Price Forecast

2015 Coverage Strategy:
Whey futures have been artificially depressed with class 3-cheese hedges. As a result, futures prices are below forecasts for most of the year. Buying futures outright with a combination of options is a good opportunity to lock-in favorable prices for the year.

AMS NFDM Price Forecast

2015 Coverage Strategy:
While first half futures prices are in the $1.20’s, they remain premium to forecasts. Like butter, the NFDM futures market will have a carry structure soon. This will allow for inventory hedging, if needed. For end-users, a disciplined scale-down approach with futures and options should be used to get the coverage needed. For all markets, the tendency will be to take low amounts of coverage while waiting for lower prices.

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