Dairy Prices Decline as Orders Slow

Published on: 10:23AM Apr 04, 2011

As cheese and butter prices retract, the outlook for near-term milk prices turns south. Meanwhile, LGM-Dairy reaches its maximum funding, and the potential grows for the Class III and Class IV price-spread to narrow and even invert.

Unfortunately, the risk management tool known as LGM-Dairy has reached the maximum funding for the fiscal year. The government's Risk Management Agency (RMA) appropriated $16 million for this insurance product, and this has now been reached.
Interest in this insurance program increased dramatically once RMA began subsidizing the insurance premium. Many farmers used this as a risk management tool to protect against rising feed costs and lower milk prices, or at least this is what it was designed for. The results of this program will be if the Actual Gross Margin is less than the Gross Margin Guarantee, an indemnity payment will be received. If not, there will be no payment.  
It is unfortunate this program will not be available until October. Of course, that will depend on whether money will be appropriated again. I have asked the question whether a dairy producer could still do an LGM-Dairy policy if they were willing to pay the full premium, but have not yet received an answer on this.
Recent weakness in cheese, butter, and nonfat dry milk prices and the strength in grain prices increased the odds that indemnity payments under the LGM-Dairy insurance program may be realized. This would certainly increase interest in this type of risk management tool in the future.
USDA released its “Prospective Plantings” and “Quarterly Stocks” reports last Thursday, indicating higher grain prices will continue.  This created quite a stir in the market, not from intended acres but from the stocks numbers. Corn stocks were lower than the trade expected at. 6.52 billion bu. compared to 7.694 billion bu. a year ago. This gave the impression that 92.2 million acres of corn intended to be planted is not enough.
This resulted in old-crop corn futures posting limit up gains for two days. Prices were not able to remain limit up on Friday as they might have moved to a level they need to be for now. Corn demand needs to slow down, and higher prices are needed to do this. Soybean prices jumped, but are not remaining as strong as corn.
At the same time, dairy prices are weakening. Cheese prices fell overall last week despite the jump at the beginning of the week. Cheese prices fell below $1.60, followed by butter declining below $2.00. This does not bode well for milk prices in the near-term. Higher prices had an impact on demand. Reports are that dairy products have seen a reduction in orders, resulting in a growing supply. Lower prices will eventually stimulate orders again, but there always is a lag time. As usual, activity on the daily CME Group spot market has increased. Buyers who had sidelined purchasing for aging programs at higher prices are back picking up cheese to rebuild these stocks.
World dairy prices have shown signs of weakening, primarily in the powder market. This along with weakening butter prices should move Class III and Class IV more in line. March Class III and IV prices were only a penny apart and the closest they have been since March 2010. This happened because cheese prices moved higher to remain competitive with butter/powder. However, once it seemed butter and powder prices reached their peak, cheese quickly retreated as fundamentals did not suggest it remain above $2.00.
This brings up an interesting scenario and one that may be taken advantage of. I normally would not suggest a somewhat speculative trade for dairy farmers, but this is one that I believe holds some potential. Trading the spread between Class III and IV provides opportunity for profit. Purchasing Class III contracts and selling Class IV contracts in expectation of the spread narrowing looks like a good trading position. Since January 2007, Class III price has been above Class IV for 25 months while IV has been above III for 26 months.
Now, this in itself may not look like very good odds until we look at the average price spread over the period. The Class III price has been higher than the Class IV an average of $1.89, while Class IV has been higher than Class III an average of $0.99. The highest Class IV has been above Class III was $2.61 while the highest Class III was above Class IV was $4.93. Currently, all 2011 Class IV contracts are higher than Class III by varying amounts.
With weakening butter and powder prices, there is potential for the Class III and Class IV price spread to narrow and even invert with III moving above IV as it nearly did in March. This is certainly something worth considering.   
Upcoming reports:
-          Fonterra auction on April 5
-          World Agricultural Supply and Demand report on April 8
-          Fluid milk sales on April 8
-          California Class I on April 11
-          Dairy Export Statistic on April 12
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.