Slowing demand impacts the market

July 20, 2008 07:00 PM
 
Robin Schmahl

It was anticipated that milk production would slow significantly this year as a result of high feed prices. This certainly has not been the case.

Production has steadily increased; in fact, the first half of the year shows an increase of 3% over the same time last year. An increase in cow numbers of 133,000 head in June versus the previous year does not indicate a slowing of expansion or production despite high grain prices. The average corn price last year was $4.35 per bushel while the estimated average corn price this marketing year is projected at $6.00 per bushel.  

Why is production continuing to grow in the face of high feed prices? The main reason is that a significant portion of feed was contracted last year, resulting in lower feed costs in spite of rising feed prices. Milk prices have remained high, giving farmers the incentive to continue to push production and capitalized on high milk prices. The real concern has been the potential for high feed prices later this year when contracts will be running out. Grain prices escalated to new record highs in June as delayed planting and flooding pushed prices higher in an attempt to slow demand and keep supply from running out. The effect of high prices is to cure high prices, as demand slows. This is exactly what has happened.

Demand for corn has slowed in many areas and weather is now being viewed as beneficial to the crops. In my previous column I wrote that grain prices may have reached the top as market action and fundamentals were giving some indication of a possible change. Corn price has now fallen approximately $1.70 per bushel over the past three weeks and has exceeded the expectation of the correction for this time of year. This proves that markets are driven by trader psychology, and once the psychology changes, the market changes.

A second aspect causing prices to decline is the current state of the economy. There were concerns whether things would get worse before they get better, and they certainly have become worse. This factor can cause prices to decline further than expected as the market attempts to find a level where demand will continue, but at a slower pace. Since the beginning of the year, five major banks have faced financial problems and either had to be bailed out or taken over. These are no small events and are barometers of the state of both domestic and world economy. We all know what happens when the economy slows especially when costs have risen. A slowing of demand occurs as disposable income tightens. This is a real concern for dairy prices.

For the most part, dairy has been immune to the economy until recently. Demand has slowed causing some products to back up in the pipeline, decreasing prices. This has not yet been overwhelming, but is a cause for concern. The continued growth in milk production along with slowing demand could result in lower prices than anticipated in the coming months, or more likely, next year. The previous Class III futures average price for 2009 of over $20.00 may be a thing of the past. In fact, an average price over $19.00 per cwt. may also be vulnerable to slipping away. We do not like to entertain that thought, but the market does not care what price you receive for your milk or whether you remain in business. It cares about the balance of supply and demand.

The latest Cooperative Working Together Herd Retirement program was expected to shore up milk price in the face of slowing demand. However, it is a disappointment. The removal of 25,474 cows and 358 bred heifers is the lowest amount of the animals removed over the five installments. If milk prices would remain lower and decline further, the CWT may initiate another round in a short period of time, but so far, traders are viewing this as a disappointment and bearish to the market. After all, farmers added nearly 25,000 cows over the past four months. One thing to remember about this industry is that higher prices will cause more production as long as it is profitable. The idea that tightening milk supply will increase milk price and thereby profitability, is correct. However, higher milk price causes higher milk production, and the cycle continues.

I recommend hedging at least 25% of 2009 production at an average price of $19.50 or higher in Class III futures or initiating fence positions through purchasing $18.00 put options and selling $23.00 call options for 30-40 cents. This allows for a wide window of opportunity to capture price will maintaining a floor.  I recommend holding off on contracting feed for 2009 as the market is weak. I feel contracting will need to be done prior to harvest beginning in the Midwest.

Upcoming reports to watch for are the June Cold Storage report on July 22; the July Agricultural Price report on July 31; and the June Dairy Products report on August 4.


Robin Schmahl is a commodity broker and owner of AgDairy LLC, a full-service commodity brokerage firm located in Elkhart Lake, Wisconsin. He can be reached at 877-256-3253 or through their Web site at www.agdairy.com.

The thoughts expressed and the data from which they are drawn are believed to be reliable but cannot be guaranteed. Any opinions expressed are subject to change without notice. There is risk of loss in trading and may not be suitable for everyone. Those acting on this information are responsible for their own actions.

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