Dissecting the Current Milk Market Rally
Jul 23, 2012
As temperatures and prices soar, discussions of dairy herd liquidations grow.
By Will Babler, Atten Babler Commodities
The catastrophic drought of 2012 has propelled corn and soybean prices to new all-time highs. Milk prices have also started to climb, though not as rapidly (Figure 1). This article will look at some of the supply side drivers of the current milk market rally.
Figure 1: Source: FutureSource, Atten Babler Commodities.
The July USDA report cut corn yields a full 20 bushels per acre to a 146 bushel per acre, national yield. Many grain producers and private analysts expect additional yield reductions as the hot and dry weather has failed to improve.
This unfolding supply shock has caused a drastic increase in corn and soybean meal prices that, without the corresponding increase in milk price, would have otherwise forced increased pressure for lenders to liquidate many dairy producers. While the relationship of these prices is usually unstable, under these extreme circumstances, milk prices seem to be pushing higher due to a stronger correlation with feed prices.
Figure 2: Source: USDA, Atten Babler Commodities
Milk prices are also being influenced by reduced supply on a per cow basis (Figure 2). In the short run, the high temperatures are expected to continue to reduce per-cow production levels. Over the longer term, feed quality and feed availability are likely to influence rations and also potentially reduce productivity. It is fair to assume that a portion of the milk price increase is also driven by realized and expected losses in productivity.
Figure 3: Source: USDA, Atten Babler Commodities.
Any sustained reduction in herd size has the potential to drive milk prices higher. The current market has been very difficult for dairy producer profitability, especially for those in the West, and discussions of liquidation are very common. The industry has been closely scrutinizing slaughter, replacements and overall herd size. Historically, as herd sizes have peaked and then entered periods of liquidation, much higher milk prices have followed (Figure 3). The last two USDA milk production reports have shown the first potential signs of liquidation since the summer of 2009. Much of the data available has a considerable lag and anecdotal evidence would suggest further herd declines. Taking this into account, the prospects for a sustained decline in the herd, while still not yet fully confirmed, are certainly contributing to the current price rally.
Commodity price volatility has been relentless on dairy producers, and it appears that the coming year will be a difficult one with many trap doors. While we can assess some of the reasons for the rally in milk prices, it is much more difficult to anticipate the factors that may lead to a rapid change in the trend. This is especially true when contemplating a grain market that is working to ration demand.
It is within this environment that dairy producers should lean on option-based hedging strategies. On the feed side, a focus should remain on strategies that cap out feed prices while leaving all of the downside open.
On the milk side, producers should look to either minimum price strategies or min/max strategies. Min/max strategies should leave plenty of upside opportunity on milk to allow for a favorable margin if prices improve. In all cases, producers should look to maintain matched hedge positions to avoid getting stuck with high-priced feed if the market collapses, or to avoid being capped out on milk without also having a workable feed price secured.
Will Babler is a principal of Atten Babler Commodities of Galena, Ill. Contact him at firstname.lastname@example.org or 877-259-6087.
Risk in purchasing options is the option premium paid plus commissions and fees. Selling futures and/or options leaves you vulnerable to unlimited risk. Transaction cost used throughout this report includes both commissions and fees. Atten Babler Commodities LLC uses sources that they believe to be reliable, but they cannot warrant the accuracy of any of the data included in this report. Past performance is not indicative of future results. Unless otherwise stated the information contained herein is meant for educational purposes only and is not a solicitation to buy futures or options.