No one can be certain how long the bull market in milk powder may last, but if history is any guide, this appears to be an opportune time to capture some of the price and margin opportunity.
By Will Babler, Principal
Atten Babler Commodities LLC
Dairy producers focus most of their hedging efforts on mitigating collapses in milk prices or collapses in margins. At more fortunate times, they can turn their attention toward capturing price or margin opportunity. One such opportunity is currently presenting itself in the Class IV milk market.
|Figure 1 – Class IV Futures Prices At or Near Historical Highs|
Following a year of short global production, and continued strength in demand for milk powder products, the Class IV market has moved near all-time highs in the front months while the forward curve is also at or near seasonal all-time highs. These price levels can be seen in Figure 1.
The current rally in dairy has been restricted to nonfat dry milk and consequently Class IV. Through October, the remainder of the complex has actually seen a decline in recent prices compared to the prior year. Figure 2 shows the relative outperformance of nonfat dry milk and Class IV.
|Figure 2 – Price Increases in Nonfat Dry Milk|
Class IV vs. Class III Prices
As Class IV prices have increased, there has not been a corresponding increase in the Class III market. This reflects a difference in the supply and demand fundamentals of the underlying products – butter and powder for Class IV and cheese and whey for Class III. Historically, the Class IV price has traded at a discount to Class III. In the last 10 years, the Class IV price has traded at a premium to Class III in only 34% of the months. On average, this premium has lasted five months, with the premium lasting at most 16 months from March 2010 through June 2011. In only 18 of months over the last 10 years, or about 15% of the time, has the Class IV price traded at a $1/cwt. premium or more to Class III. November 2013 will be the fifth month in a row of such premium in the current Class IV bull market. Figure 3 shows the current price premium of Class IV over Class III is at or near record levels and far from the average discount.
|Figure 3 – Class IV vs. Class IV Price Spread|
Class IV Utilization Rates
Current national utilization rates (ex-California) of milk for Class III and Class IV are 48% and 6%, respectively. Since 2000, the Class III utilization rate has ranged from 9% to 49% with an average utilization rate of 40%. The Class IV utilization rate has ranged from 5% to 22% with an average utilization rate of 10% throughout the same period.
Even though this USDA data excludes California, a major participant in the nonfat dry milk and butter market, it is still useful for understanding the potential swings in production. See Figure 4, which details the seasonal trends in Class IV utilization. This seasonal chart shows that Class IV utilization dropped off in the second half of the year compared to a year prior. It also shows that utilization levels could increase significantly if they move back toward their 10-year highs, especially on a seasonal basis as we move forward from this point in the current marketing year.
|Figure 4 – Seasonal Class IV Utilization|
To the extent that one product is carrying a greater value compared to the other, we would expect some switching in manufacturing utilization, or possibly some build-out of new capacity. As this switching or capacity expansion occurs, the supply of the scarce product should increase while the availability of the abundant product should decrease. This should put pressure on the price spread to converge toward the normal relationship. Historically, a tendency toward mean reversion in the price spread and utilization spread has occurred. Figure 5 shows that both the price spread and utilization spread have moved significantly away from their average. While we don’t know how long it will take, it is likely that these both normalize over time.
|Figure 5 – Class IV Price Spread and Utilization Spread|
The old adage that high prices cure high prices should temper some enthusiasm with regard to powder and Class IV prices. It is difficult to forecast the timing and the extent of demand destruction that high prices can bring, but a quick look at past history shows that the market has only tolerated prices north of $20.00/cwt. for Class IV for 11 months in the last 10 years, or less than 10% of the time. The dairy products market has a long and complex supply chain. This complexity continues to increase alongside the increase in U.S. dairy exports. We don’t know how long the international markets can remain strong, but we should at least proceed with caution if the past history shown in Figure 6 is any guide.
|Figure 6 – Short Lived Class IV Price Peaks|
Corn price, as a rough proxy for feed costs, shown in the Figure 6 also indicates a further force of gravity that could serve to pull down milk prices. Note that high prices in corn have served to cure high prices in that market. Also note that the prior $20.00/cwt price extreme in Class IV milk was in part tied to high prices in feed.
No one can be certain how long the bull market in nonfat dry milk, skim milk powder or whole milk powder may last, but, if history is any guide, this would appear to be an opportune time to capture some of the price and margin opportunity that is presented through extreme Class IV prices. Each producer should consider his or her risk tolerance, profit margin and financial capacity before pulling the trigger. Now is a good time to review these factors and take action.
Contact Will Babler at [email protected].
Risk in purchasing options is the option premium paid plus transaction. Selling futures and/or options leaves you vulnerable to unlimited risk. 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. The author of this piece currently hedges for his own account and has financial interest in the derivative product mentioned within: Class III & Class IV milk, butter, cheese, whey and nonfat dry milk.