Dairy: New Cheese Contract, Lackluster Price Outlook

Published on: 12:23PM Jun 28, 2010

By Robin Schmahl, AgDairy LLC


A successful launch of another futures contract took place last week with the CME Group’s cash-settled cheese contract.


Trading has been light, but I term it as successful due to trading interest and an open interest of 77 contracts -- unlike the International Skim Milk Powder deliverable contract which has yet to show any trading or open interest. 


The key to trading activity in dairy contracts is that they need to be cash-settled. Speculators and hedgers alike do not like to trade markets with limited open interest because it could result in having to give up quite a bit of price when the contracts needs to be offset rather than taking delivery.


We do not have to look back in history very far to see the evidence of this. Both the New York Coffee, Sugar and Cocoa Exchange (CSCE) and Chicago Mercantile Exchange (CME) launched milk futures for the first time in 1996. Not much trading activity took place due to the fact that it was new and also a deliverable contract. Those holding contracts many times found themselves having to give up a significant amount of money in order to buy or sell their way out of a contract when it neared delivery. This kept trading interest very limited.


Once these contracts were converted to cash-settled contracts without delivery, trading interest increased steadily and substantially. In time, only the CME offered milk contracts, and open interest has grown nicely. Butter went the same way with trading interest increasing after cash-settled contracts were offered.


The current cheese contract will follow suit with cheese manufacturers, buyers or speculators able to use this contract to protect price and purchase cheese through other channels without the worry over offsetting a contract when the time comes.


Some concern has been raised whether this new contract will reduce trading activity in the Class III market. The question is whether cheese manufacturers or buyers who have been using Class III contracts will switch to cheese futures, hence reducing volume and open interest in milk futures. Personally, I do not think it will have a noticeable impact. Yes, some may switch, but if anything I think it will bring more activity into the markets. Manufacturers who hesitated to use Class III contracts will likely use cheese futures to better manage their price risk. It will provide a better hedge correlation for them.


What concerns many is that cheese futures do not look very optimistic through the last month listed, which is June 2012. The highest cheese price listed out two years from now is $1.63. Of course, many things can and will happen during the next two years, but for now it is not indicating a significant upside price potential.


Price outlook is dampened by several factors. One factor is cow numbers. The latest Livestock Slaughter report released by the USDA indicates dairy cattle slaughter in May decreased from May 2009 as well as from the previous month. There were 209,000 dairy cows slaughtered during the month of May, a decrease of 26,000 head from April and 3,000 head less than a year earlier.


This indicates dairy farmers are buckling down and have likely eliminated most of the cows they wanted to get rid of though hard culling, leaving just their best cows. Yes, there will always be cows that will be culled, but sufficient heifers are available to take their place. Better genetics keep improving production per cow resulting in higher milk production.


USDA estimates milk per cow this year to increase 2% to 20,980 pounds. Its forecast for 2011 production per cow is estimated to increase another 1.8% to 21,355 pounds. Although this may sound bearish at the moment, an increase in domestic and world demand could absorb this readily, keeping milk prices from decreasing and in fact improving significantly. However, the economic situation is not as strong as was hoped it would be at this time.


My hedging focus is on feed right now. An improving weather forecast in the Midwest could bring grain prices lower, allowing for feed needs to be hedged. Another dip in prices should be taken advantage of with the use of call options or call option spreads. This is preferred as these strategies will allow you to take advantage of a lower price if one were to develop while at the same time protect against higher prices. It is critical that you not hedge a direct price to allow for flexibility.


Upcoming reports to watch for:


-          The Agricultural Prices report on June 29.

-          The Dairy Products report on July 1

-          California 4a/4b prices on July 1

-          The June Federal Order class prices on July 2.

-          Fonterra auction on July 6.

-          The World Agricultural Supply and Demand report on July 9

-          The California Class I price on July 9.



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 website 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 my not be suitable for everyone. Those acting on this information are responsible for their own actions.