At a meeting with a client earlier this week I was issued with a "Please Explain". As something of a market skeptic I have been banging on about EU and US milk production growth and that this was all likely to end in tears. I was looking good up to the end of December - US butter and cheese prices had dropped from October to December, the corresponding futures were ordinary and the EU market was flatlining - the correction was underway.
Then in the first week of January the Fonterra Auction went north and the US dairy futures market followed soon after. As I said "Please Explain".
This all reminds me somewhat of that famous response to a question by former US Secretary of State Donald Rumsfeld:
"There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don't know. But there are also unknown unknowns. There are things we don't know we don't know."To which you might add:
There are those that know and those that don't know. There are those that might think they know but don't and those that might know but don't think. Amongst all this there is a lot to think about and a lot to know.
Personally I prefer the comment of Neddy Seagoon in the Goon Show episode "Tales of Old Dartmoor":
"Great heavily whispered asides! (aside) Little do they know how little I know about the little they know. If only I knew what the little that they know, I'd know a little. I'll have to keep my little ears open you know."
But I digress.
Let's start with what we know. Last month we published our Global Dairy Trader production charts. This shows the aggregated milk production data for the major dairy exporters. We have since added Argentina's estimated milk production to these charts and updated the data through to the end of November. When we speak of known knowns, this is not a perfect data set: New Zealand is a bit of a guess for October and November; some of the European data for November is still to come in; and Argentina is estimated from a subset of national production. None-the-less, the estimates are a reasonable guide to the global milk production trend and clearly show the dramatic turnaround from 2009.
The milk production data shows that the major dairy exporters have added over 4 billion litres of milk to global production since May 2010. This is extraordinary growth, completely wiping out the 1.3 billion litre reduction in supply from July 2009 to April 2010. Production growth at this rate is unprecedented - hence my prior concern for the sustainability of matching demand growth.
I have in the past warned against using the comparison to the prior year as a basis for judging the strength of a surge in production. In the case of EU, US and Argentina, we show in our chart library the data adjusted for normal seasonal trend and compared to the longer term average milk production. In all cases production growth has been above the long term trend line and is not just an artifact of low production in 2009.
The situation in New Zealand is a little less clear because of the lack of official data but there is no indication that they are going backwards. Indeed Fonterra reported peak milk production in late October that was almost 4% up on the prior year. The most recent intelligence suggests that the dry conditions have brought milk production back to just above the level of the previous year.
Only Australia is letting the team down. Production has grown by 0.5% since July, barely enough to cover normal increases in domestic demand. In the scheme of things Australia's influence on global markets is however small beer. The EU, US and NZ are normally the primary contributors to global supply movements.
Getting back to the initial question, with all this extra milk about why are commodity prices so strong and why has it kicked away again in the past few weeks?
The answer to the first part of the question lies in the demand side. The reports in Europe speak of a cheese led recovery with additional milk production being directed towards this product group rather than powder. There has also an increase in cheese exports to eastern Europe due to stagnant or slightly negative milk production in that region.
In Asia China has led the way with a substantial increase in whole milk powder imports. This is driven by the combination of a lack of confidence in Chinese product (melamine still attracts headlines) and demand growth exceeding increases in internal milk production.
In the background of this supply / demand balancing exercise, the bogeyman of EU intervention stock has just about disappeared as a factor. DairyCo UK report that there is only 27,000 tonnes of SMP and no butter available for general sale. The balance (approx 170,000 tonnes SMP, 1500 tonnes butter) has been allocated to 'deprived persons' schemes(1).
With cheese and WMP leading the demand side, plus the price risk that has been inherent in the large EU SMP stock, it is no wonder that the co-product groups of SMP/Butter/BMP and SMP/AMF/BMP have been getting short shrift in Europe and Oceania. That has led to reductions in the availability and stock of butter and AMF and butteroil prices holding at the upper end of historical price levels (in euro and USD terms).
And speaking of historical price levels, it is important to point out that the resurgence in dairy pricing over the past 12 months, and the price level we are seeing, is by no means extraordinary and unprecedented for European and US farmers and processors. My personal classification would be "comfortable to high" but no reason to think that the world was changing dramatically.
That aside was for the benefit of our Oceania (and Argentina?) readers, for whom this opportunity to enjoy the full value of the EU and US market does represent something of a paradigm shift (see also "The global dairy industry's paradigm shift" Dr Jon Hauser, 12th November 2010). Yes it is exciting, but don't for one second believe that these prices are here to stay or the market will forever be onwards and upwards.
This synopsis just about brings to an end the "what we know" part of this article. From here there should perhaps be a "government financial health" warning on the content.
Which brings us to the dairy futures market.
We have seen the Fonterra Auction prices rise in the first week of January and increase slightly again in the Auction this week. The US dairy futures market has also turned around. Does this mean that market prices will be higher than 2010 in the next 6 - 12 months and if so why?
I have to declare that when it comes to the Fonterra Auction and the US futures market I am completely unconvinced that they represent a reliable forecast of future prices. I will show you why a little further on. For the moment however let's look at some of the factors that may provide some explanation on the recent market rise. Please note that this is just a list of possibilities and speculation based on recent news reports. These are not statements of fact or cause and effect:
- Dry conditions in NZ have reduced milk production to about the same as last year
- The Australian floods will disrupt milk supply and processing in Australia and potentially reverse the what little production growth there has been.
- As Oceania moves out of its normal seasonal production peak China and other buyers need to seek other sources of supply to feed their increased demand requirements
- Production growth in the EU is trending down. The snowfalls and cold winter conditions in December will accelerate this trend
- There is very little EU SMP intervention stock available to supplement that part of the market
- Higher feed prices in the US and EU will reduce the margin available in milk production, with a negative effect on supply
- China and other countries that are growing milk demand and supply have less opportunity to do this by importing heifers (because milk price opportunity is high in those countries that export).
- Vegetable oil and animal feed prices are also high, giving support to the butteroil price and applications of dairy commodities in the feed market.
So if you believe all that then you might also have the view that the recent lift in prices is justifiable and that the general market trend is stable or perhaps rising during 2011.
The NZX has introduced futures market for Oceania dairy commodities starting with WMP from October 2010. So far this market is extremely thin with just 225 tonnes traded up until about a week ago. This represents just 0.13% of the WMP volume on the Fonterra Auction for the same period and a much smaller fraction of total Oceania WMP. The data from the Fonterra Auction is perhaps a better indication of what the buyers think of future pricing.
Strictly speaking the Fonterra Auction is not a futures market. Buyers bid for physical delivery of product in competition with each other. The contract 2 and contract 3 bids are however for product delivery 4 - 6 and 7 - 9 months from the time of the auction. In that respect buyers are taking a punt on the future price. They are making a judgement on the availability and price of product in those future periods.
The chart below shows the price on the Fonterra Auction for contract 1 deliveries (the current or 'spot' price) as well as the projected price for contract 3 delivery (delivery 7-9 months from the auction). In this chart the contract 3 price has been pushed forward so that it is in alignment with the spot price. You can see what the buyers bid for contract 3 product in direct comparison with the actual spot price of the market when they were due to take delivery.
What this chart shows is that the forecasting skills of the Fonterra Auction bidders is pretty ordinary. For the most part they are prepared to pay today's price in 6 - 9 months time. When the market was falling in 2008 they paid more than they needed to. There was some payback during the market rise in the latter part of 2009. At the moment it looks like they are doing a reasonable job but it is just coincidence resulting from a relatively flat market. A closer scrutiny shows that the forward price is following the spot price but projected 7 - 9 months into the future.
The Fonterra Auction is relatively new phenomenon. What does it look like when we review the US market where they have been playing this game for a bit longer?
The US futures market on the CME futures exchange covers butter, cheese, SMP, NFDM, whey, class III milk and class IV milk. The US dairy futures market is much more interesting than the Fonterra Auction data because it reflects the sentiment of both buyers and sellers. The Auction is only a reflection of buyer sentiment. Fonterra have little influence the sale price except by setting how much and when product is made available.
The chart below shows part of our analysis of CME cash settled butter futures. As with the Auction chart above, the futures price 9 months in advance has been lined up with the actual market price that we see when the futures contract matures.
What we find on the US futures market is two types of behaviour. Short term futures (at or about 3 months) seem to follow the spot market in a similar way to the Fonterra Auction. The market simply "locks in" current pricing for a slightly longer period. The longer term futures (9 - 12 months) tend more towards the longer term average of the market. There is a response to the sharp rises and falls in the spot market but it is more muted. The longer term futures are in a sense doing their job of taking the volatility out of the market giving buyers and sellers a more uniform cost and return. That said, the most recent rises on the US futures market are a definite deviation from form.
On the chart above you can see that the butter futures for October 2011 have risen sharply to $US 4,300 / tonne. That is more than $600 above the most recent US spot price data (2). This is a very unusual situation. It suggests that there is an expectation of shortages in US supply in 2011 due to internal market supply demand imbalance or the influence of international markets as noted above.
The historical data suggests that the Fonterra Auction forward pricing and the US dairy futures market is a poor guide to the future. You can therefore understand my skepticism about the validity of their respective price forecasts for the 3rd quarter of 2011 ... but on the other hand the buyers and sellers might know more about what is happening than I do ... and they might be right.
... ~ ...
Well it is all very interesting and exciting isn't it. If you are still confused don't worry, so is the most of the known world. My suggestion for further insight and clarification is to listen to the balloon man.
(1) Agrifax report that there is a further 80,000 tonnes of intervention SMP due to be released for general sale. If that is the case then that will continue to influence SMP production in Europe and Oceania for some time (with a consequent effect on butter / AMF availability).
(2) January 15 USDA data shows an increase in US spot butter prices to $US 3980 / tonne ... and $US 4,400 as of January 22nd. This means that the futures market has moved up early but it is essentially just matching the current spot price (which is more normal behaviour).