Volatility Continues in Dairy Markets
6/28/2018
grain falling into a container

Market activity this month illustrates the intense volatility in the marketplace 

Dairy cows feeding in alley of barn

The U.S. dairy market has faced increased volatility over the past decade with the Class III milk price ranging from as low as $9.31 per hundredweight (cwt) in February 2009 to reaching as high as $24.60/cwt. in September 2014. For the 2014 calendar year, the Class III milk price averaged over $22/cwt. That surpassed the previous annual average high of $18.37 just three years earlier in 2011, a 21.7 percent increase from the previous high. A significant driving force behind the expansion of U.S. milk production the past decade – the global dairy market - has also been one of main causes of the increase in volatility. In 2001, U.S. exports of dairy products accounted for less than four percent of total U.S. milk production on a milk equivalent (ME) basis. That level climbed to as high as 14.4 percent in 2013 and 2014 and has remained at or above 13 percent of production since. Historically, the U.S. viewed the global dairy market as a source to rid excess product, with prices often needing to be discounted relative to other exporters to complete sales. Likewise, importers tended to prefer sourcing dairy products from the EU and/or New Zealand. 

The development of export markets over the past decade and a half, and the ability of the U.S. to increase milk production, have changed perceptions of the U.S. market both domestically and abroad. However, being actively involved in the global dairy market has brought challenges with it as well. Changes in milk production for the other major dairy exporters (EU, New Zealand, and to a lesser extent Australia and Argentina) are often more rapid and volatile than the U.S. due to their respective production models. Changes in international dairy demand can also be more significant and more rapid than the domestic market due to geopolitical risks and more notable changes in income. Those risk factors drive the volatility, a situation that will persist for the U.S. dairy market for the foreseeable future.

Growing Global Dairy Demand

A very positive point is that the U.S. is poised to fulfill the growing global dairy demand long-term, as incomes rise in developing and emerging economies, and the other major dairy exporters will eventually face geographical constraints on future expansion. Volatility will remain, and there will be periods of time where U.S. producers face significant margin pressures like they did in early 2016 and the first part of 2018. However, producers who are able to weather the storm of low margins will eventually see a return of favorable margins, which should drive an increase in the share of global dairy trade for the U.S. dairy market. 

The Main Exporters

There are three main players in the global dairy export market: the EU-28, New Zealand, and the U.S. Australia and Argentina typically get mentioned as well when talking about global milk supplies; however, the latter two have waned in significance due to falling milk production in recent years and their corresponding decline in global dairy trade market share over the past several years. The EU and New Zealand rival each other as the top exporter on a volume basis, but policy changes in Europe, which removed production restricting quotas, has allowed notable increases in EU dairy exports over the past three years. 

Key Importers

China is the leading global dairy importer by a large margin, and it imports more than twice as much as the next country (Mexico). Population growth, rapid urbanization, and increasing incomes have been some of the significant drivers in China’s growing appetite for dairy products. The Chinese dairy industry is in its infancy relative to the established producers in the EU, NZ and US. 
Mexico is the second largest dairy importer and is a critical market for the U.S., especially for U.S. nonfat dry milk (NFDM). The short turnaround time, low shipping costs and developed supply chain allow a very large portion of U.S. NFDM to be exported to Mexico.

Russia had historically been one of the top export destinations for dairy products, but Russian dairy imports abruptly stalled in 2014 and have been small in subsequent years. The annexation of the Crimean peninsula in Ukraine by Russia led to a variety of sanctions against Russia. In response, Russia announced reciprocal sanctions including a ban on all food imports from the U.S., the EU, Australia, Norway and Canada. The ban has been extended multiple times and currently is in effect until the end of 2018 with a high likelihood of being extended again.
Some other notable large dairy importers are Japan, Algeria, Indonesia, the Philippines, Malaysia and Saudi Arabia. Outside of the top 10 dairy importers there are a vast number of small importers that constitute roughly half of all global dairy imports.

Global Demand

Demand is harder to pin down due to data limitations, but by using trade flows, demand can be derived. Solid production has frequently been cited as the main driver behind the weakening of dairy prices the latter part of 2017 and in early 2018, but lackluster demand has also played a key role in the price declines. While Chinese demand was up, the weakness globally was due to a slowdown in demand from Mexico, Algeria and the large collection of smaller importers. 

A few key indicators would suggest that dairy demand will increase more substantially in 2018. One of those factors is the lower prices of late 2017 and early 2018 which should drive a rebound in demand into mid-2018. Demand should be stronger from those importers that are more price sensitive. Oil prices are also on the rise. That should eventually boost some demand from oil exporting countries due to rising incomes, but that potentially comes at the expense of some weaker demand from oil importing countries, particularly smaller/developing countries. Global population is forecast to rise another 1.1 percent in 2018 according to the International Monetary Fund (IMF) estimate, but more important to global dairy trade is the continuation of urbanization which drives income growth and increases the number of consumers in developing countries who are adding dairy to their diets. 

The U.S. Dairy Market

The U.S. dairy market has faced declining prices and eroding margins since the recent high made in November 2017. Gross farm level margin (all milk price minus feed cost) dropped to its lowest level in almost two years in March 2018. Solid milk production growth in the U.S. paired with gains in Europe have kept milk supplies more than ample in the northern hemisphere, while the weak global demand in 2017 and just moderate increases in domestic sales have led to burgeoning stocks of most dairy products. Despite the declining margins, the U.S. milking herd has held higher than many had expected and didn’t start contracting until March. That may seem counterintuitive given the significant deterioration of margins, and there has been a lot of chatter about how bad dairy conditions are, but The figure below sheds some light on why there hasn’t been a more significant contraction in the U.S. milking herd – yet. Historically it takes a few months with margins running below the orange contraction line before we see a consistent reduction in the size of the U.S. dairy herd and there is typically a two to six month lag behind margins and the response in herd size. Even when the gross margin dipped into the mid-$8 range two years ago there was only one month that the U.S. experienced a contraction that year due to margins. 

The herd contracted by 3,000 head in September 2016 which is consistent with the typical lag between margins and changes in the herd. Prior to the loss of cattle due to the winter storm Goliath in late 2015 in Texas/New Mexico, the last time there was a prolonged stretch with a notable decline in the U.S. dairy herd was in 2013. Very poor dairy margins occurred for most of 2012 but there was a brief respite in late 2012 before gross margins dropped back to the low $9 level for the majority of the first half of 2013. The result of the poor margins in 2012 and 2013 was a 75,000 reduction in the U.S. herd over a span of a year and a half. 

Outlook

Dairy farmers have faced some significant financial stress in early 2018. There are widespread reports of producers exiting the business in this downward cycle, but there have also been large producers executing expansion plans which have offset the smaller producer exits. This is not a new phenomenon but rather the long-term trend of the dairy industry and one that will continue. The poor margins starting in late 2017 have finally started to cause some reaction in the herd size on a national basis. The estimated U.S. milk herd declined 6,000 head in March and another 2,000 head in April. The decline in the herd has been widespread with Michigan and Ohio down 3,000 each, Virginia dropping 2,000, and a few other states down 1,000 head. The low milk price during the first half of 2018 should drive additional modest herd contraction into the second half of the year before the more modest milk production growth and less burdensome stocks begin to drive a rebound in pay prices during the third quarter. 

Fourth Quarter Class III futures were trading just shy of $17/cwt. at the beginning of the summer, only to make a drastic drop back to the $15/cwt range a few weeks later. The recent decline, most likely triggered by uncertainty around trade disruptions in the export market, put the brakes on some upward momentum in the market that had some analysts predicting a Class III of $18/cwt later in the year. The quick reversal this month in market prices illustrates the intense volatility in the marketplace making long-term price forecasts difficult to make with any accuracy.

Information provided by AgriBank



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