(This article was first published in the US Progressive Dairyman magazine, September 22, 2011)
I wrote some time ago about the drivers of US milk production and in particular the link between the dollar margin over feed cost and production growth trends (‘US milk production - Shouting down the supply chain’ Dr Jon Hauser, Xcheque.com, 1st April 2011). It seemed clear at the time that the sharp decline in seasonal production during the latter part of 2010 was due to a margin squeeze on dairy producers – feed prices were rising and milk prices falling. In the first quarter of 2011 milk production lagged well below the long term growth trend line. A milk price rise was required to stimulate growth and feed the normal increases in US milk demand as well as rapidly increasing dairy exports. At the time the buyers were not listening. In fact they were suggesting the reverse should happen with Class III and IV futures seeking a lower price point during the course of 2011. Almost 6 months later, it is an interesting point in time to see how the US dairy industry has responded to the tension between market demand and producer margins and profits.
The price signal resets
In my earlier article I noted that if the buyers wanted more milk they would need to show producers the colour of their money, and so they did. During May the short term futures for Class III and IV milk started rising again. This translated into higher milk prices in June and record high prices in July and August.
Figures 1 and 2 show the US average All Milk price and Class III price respectively. Also shown is the cost of a typical feed mix (corn, soybeans, alfalfa). The blue area at the bottom of the chart shows how much money is left over after feed costs - the margin available to contribute to all other costs and any residual profit.
Figure 1. US All Milk price, feed cost and margin after feed cost.
Figure 2. US Class III milk price, feed cost and margin after feed cost.
The buyers appear to have played their part in the supply / demand game, lifting the margin after feed cost back above the level of $10 / cwt. From our prior analysis this appears to be the point that supply growth is stimulated and starts to accelerate. Significantly, the increase in margin for Class III milk is very sharp, doubling from $5 / cwt to just under $10 / cwt.
… and production follows
My comments here may well be in conflict with the sentiment in the mainstream press over the past few months. I have seen comments like “July saw the lowest rise in year on year US dairy production since February 2010”. The implications are that milk production growth is slowing. In fact the reverse is true.
Figure 3. Seasonally adjusted US milk production and long term trend line
In figure 3 the daily US milk production is shown after correction for normal seasonal variation. The long term trend is for approximately 1% annual growth in production. The chart shows that in the past two months milk production has climbed back above the long term trend line, recovering much of the ground lost in the early part of the year. Figure 4 shows that the reason for the production increase has been an ongoing increase in cow numbers. Producers must have some confidence in the future as they have increased cow numbers by just over 1% when compared to the previous year.
Figure 4. Comparison of US cow numbers – 2010 vs 2011
Bang, bang control in action
The cause and effect relationship in US and global milk production can be hard to find. My contention has been that production responds to price signals very crudely – it drifts along until there is a strong and obvious market signal to change, or when critical limits are reached – the so-called bang, bang control theory. The past 6 months of data has provided more evidence for this theory.
Figure 5 shows the deviation from the milk production trend over the past 18 months. This is the difference between seasonally adjusted milk production and the long term trend line. A number greater than zero means that milk production is growing faster than about 1% per annum. Negative numbers signal a growth rate lower than this long term trend. Also shown on this chart is the margin above feed cost using the All Milk price and the Class III price. The past 3 months has seen margins track back towards the magical number of $10 / cwt. This has prompted a supply response and moved production growth back above the long term trend line. It is all quite simple really – if you want the milk you have to pay for it.
Figure 5. Comparison of the trends in margin above feed cost and change in milk production
The outlook from here
As you might imagine, predicting the future direction of the market is a much more difficult task than explaining past history. On the supply side there is plenty of incentive for production growth with a reasonable margin above feed cost. International dairy commodity prices are however trending weaker with significant falls in the Fonterra Auction in the past two months. The US dairy futures market echoes that sentiment. At the same time feed costs are projected higher still and so if the futures prices held, margins for Class III milk would fall back to $5/cwt again (bang, bang, bang). This is not a recipe for continued production growth and, notwithstanding the fall in international market value, export prices are still high relative to the US market. The opportunity for export growth remains and milk prices within the US will need to stay high to service both domestic and export demand.
For those watching US dairy production from Europe and Oceania there is one final piece of data that will be somewhat of concern. As noted above, the increase in US milk production during 2011 has been driven by increased cow numbers (figure 4). This is a relatively unusual situation. Historically cow numbers have been relatively stagnant and production growth has been achieved via ongoing increases in milk production / cow. Figure 6 shows US daily milk production / cow / day for the past 4 years. What you see here is the continuous improvement in milk / cow. Milk / cow is currently tracking at about the same level as last year. There is every indication from historical trends, and the milk / cow performance in early 2011, that if margins remain relatively high, milk production could be lifted by a further 1% and very quickly. In other words the US has plenty of latent capacity to increase production and take up any short term slack in the international market. The media has noted that the US is moving up in the rankings of international dairy exporters and at Xcheque.com we see no reason why that trend won’t continue.
Figure 6. Comparison of US milk production per cow 2008 - 2011