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China’s Dairy Demand Leads the Way

Mar 24, 2014

High prices are said to cure high prices. So why does the dairy’s forecast seem different this time?

Curran FCStoneBy Brenden Curran, INTL FC Stone

The bull market that erupted in the fourth quarter of 2013 continues to have legs in the dairy complex, leaving many to question the long-term sustainability of high prices into 2014 and beyond.
Before that question can be answered, it’s imperative to grasp the origins responsible for the strength in the first place. At some point, high prices have to cure high prices, and a certain amount of demand destruction should play itself out in the market.

So, why does it seem like "it’s different this time"?

The dynamics with the Chinese and their seemingly insatiable appetite for dairy products have their roots in the structural changes being made to their domestic infrastructure, their long-term goals of self-sustainability, a growing middle class and a fear of food insecurity. In an effort to replicate the United States’ dairy industry, the Chinese have made the commitment to fewer farms while increasing the capacity of larger operations. This endeavor is ambitious to say the least and also a major contributing factor as to why the world suddenly finds itself exporting in bulk to them.

China Dairy Exports 3 24 14 jpg

Without the necessary infrastructure in place to accommodate such a radical shift, the Chinese dairy industry has found itself in the conundrum of smaller dairy operations being forced out of business and subsequently culling their herds in an effort to take advantage of high beef prices. Another factor contributing to lower milk production has been the foot-and-mouth disease that has been rampant across their herds. Coupled with water quality, forage and technological issues, their productivity has been hampered, declining over 6% compared to last year.

The burden of the Chinese shortfall has been placed on both the world market and the U.S. domestic market, with exports up across the board in New Zealand, Europe and the U.S. Another aspect to this bull market is the fact that many buyers in competition with Chinese purchasing eventually found themselves priced out of the market and have been waiting for a pullback in prices that has yet to materialize. This pent-up demand has yet to be satisfied, which will prove to be supportive to the market in the long term.

An argument could be made that prices will ease a bit with increasing production from Europe and an anticipated spring flush domestically, but this has yet to materialize and translate into lower prices. Upticks in production out West have largely been muted out by a stalled Midwestern flush, as winter has been reluctant to relinquish her grip.

Notwithstanding a "black swan event" from a macro perspective, such as continued negative economic reports out of China, or to a certain extent, a downturn in our own economic climate, the fundamentals driving this market will likely remain intact.

Class IV products lead the way to the upside, putting the squeeze on Class III and if prices do abate, look for Class IV to lead to the downside. This will be the first signal that the winds of change are blowing. However, look for any price weakness to be met with the previously discussed pent-up demand, which is why the trend higher could continue well into 2014. Sound risk management strategies should be implemented in order to navigate the extreme volatility that is likely to persist for the foreseeable future.

Brendan Curran is a Risk Management Consultant with the Chicago office of INTL FCStone. INTL FCStone offers comprehensive risk-management and margin hedging programs and services to dairy producers, processors, traders and end-users. You can reach him at 312-456-3613. 

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