Dairy Futures

MATTHEW ENIS

For many U.S. consumers, declining food prices have been one bright spot in the current economy. Although 2009 has been a very difficult year for many homes and businesses, it is no small consolation that the economy did not enter the period of “stagflation” that it appeared headed for in 2007 and 2008, when incomes and employment levels were flat or down, even as prices for necessities like food and fuel kept rising.

During that time, fluid milk topped $5 per gallon in several U.S. cities. And, while the price has fallen and stabilized since then, the factors that led to that steep increase have not gone away.

Dairy has always been a cyclical industry, where prices are influenced by an array of factors including seasonal weather, herd size, current export trends and speculation in the commodity markets. Retailers are generally able to smooth out fluctuations in price, so their shoppers rarely see prices rise and fall more than a few cents per gallon from week to week.

That wasn't the case during the past two years, however. Between 1999 and the beginning of 2007, the average retail price for a gallon of whole milk ranged from about $2.70 to about $3.20, according to Consumer Price Index data from the U.S. Bureau of Labor Statistics. But, within that range, prices usually rose and fell steadily, with a few occasional spikes.

By contrast, from March through December 2007, the average U.S. retail price for a gallon of milk rose more than 80 cents. It went on to reach a peak of almost $4 per gallon in July 2008, and then within a year, plunged back to more typical $3 per gallon territory, where it remains now.

The severity of these price swings seems to be getting worse for the dairy category, noted Leslie Butler, an agricultural economist at the University of California, Davis.

“It's been happening over the past 10 years, and it seems to get worse every time. Up and down, up and down. With bigger ups and bigger downs each time,” he said.

Butler attributed the sky-high milk prices of 2007 and 2008 to a spike in U.S. exports. Demand for dairy products was rising quickly in large, developing markets such as China and India, and their own dairy industries could not keep up. Australia, which has long been a major dairy exporter to Asian markets, was coping with a prolonged drought that was tamping down production.

At the same time, U.S. fiscal policy had made the dollar cheap compared with other currencies such as the euro, making U.S. exports particularly attractive.

“The bottom line was that all of the sudden, our dairy products started to become very competitive in the world market,” Butler explained.

“And so our dairy guys started to export a lot of milk. Five years ago, we were exporting maybe 2% to 3% of our total milk and dairy products onto the world market. [In 2007 and 2008], we got up to 11% or 12%. So, there was a huge reliance on the export market to support dairy prices. And, that's what was happening to [domestic] prices — our own prices went up beginning halfway through 2007 and into July of 2008. Prices went all the way up to $20 per hundredweight. These were unheard of prices in the United States, where the normal price is usually between $12 and $14.”

Many media outlets, including this one, also placed some of the blame for rising dairy prices on the ethanol boom, which led to a significant spike in the price of corn and animal feed during the same two-year period. High feed prices certainly had a big impact on dairy farmers' bottom lines, particularly in Western states where arid conditions generally mean that cows are given more feed and less pasture forage. But, with the dairy industry, the spike in exports led the spike in domestic milk prices, while rising feed prices simply ensured that producers made less profit.

“Dairy producers weren't making money hand over fist, because commodity prices — and as a result, feed prices — were also headed up,” Butler said, noting that the break-even price for dairy farmers reached about $16 or $17 per hundredweight during this time.

“So, the $20 they were getting for their milk wasn't out of line with what they were paying to produce the milk.”

MARKET CURDLES

Rising demand from China and India, coupled with a weak dollar, led to the spike in dairy exports. And, the broader, global recession, coupled with a stronger dollar caused the export market to crash.

“In terms of the drop in prices, a major factor was the loss of the dairy export market,” said Bob Cropp, an agricultural economist and professor emeritus at the University of Wisconsin-Madison. “It's about half of what it was a year ago.”

The U.S. dairy industry found itself with a significant surplus of cheese and milk, causing prices to nosedive domestically as well. This has resulted in a brutal year for dairy farmers.

“It only takes about 2% or 3% surplus milk to make prices plunge, and all of a sudden, we had 10% too much milk,” Butler said. “So, prices basically halved, plunging down to $10 per hundredweight over a period of three to four months. And dairy producers were still paying huge prices for feed. It was costing them somewhere between $15 and $16 [per hundredweight] to produce the milk, and they were only getting $10 or $11 for it. Dairy producers were losing between $100 to $150 per cow, per month.”

The situation has stabilized since the first half of 2009. Pay-prices for farmers have inched back up, and retail prices are back to what most shoppers would describe as reasonable.

“Clearly, production has dropped below year-ago levels, and there is some evidence of improvement on the demand side,” said Cropp. “Fluid milk in particular has been up partly because restaurant traffic has been so terrible. When people eat at home, they tend to drink more milk, so that's been positive.”

And, dairy farmers have responded to this crisis year the way many industries would — they have cut supplies and asked state and federal lawmakers for help.

For example, dairy producers in California recently petitioned the state's secretary of agriculture to increase pay prices by 0.50 cent per hundredweight. One can hardly blame them after this year when so many small dairy farms went bankrupt, but the attempts to adjust production and price are one of the primary reasons why this industry has become so susceptible to booms and busts. So, boosting the pay-price, even temporarily, can end badly, Butler said.

“If you're a dairy farmer, and prices start going up after you've been through one of these terrible situations, then you, as a dairy producer, will think, ‘I can put a few more cows on now. I think I should start producing a little more milk.’ The unfortunate thing about this is that most other dairy producers do the same thing. … And when everybody does it, what's going to happen eventually is another crash.”

SUPPLY LINES

The industry is also making significant efforts to align supplies with current demand. Through Cooperatives Working Together, a voluntary, producer-funded program geared toward strengthening milk prices, U.S. dairy farmers have slaughtered or otherwise retired more than 250,000 cows from their herds during the past 18 months. CWT itself noted in its October newsletter that “not since the [federal] Dairy Termination Program in the mid-1980s has such aggressive action been taken to rebalance the milk supply with market demand.” The organization estimates that U.S. dairy production has been reduced by an estimated 4.9 billion pounds during that period.

These efforts have undoubtedly contributed to the market's near-term equilibrium. But, for retailers, processors and others who deal with the buying and selling of dairy products, the concern going forward is that any significant shock to the system — like renewed export demand as the world climbs out of the recession — could be enough to jolt prices back to 2008 levels. Industry supplies can be cut relatively quickly through herd reduction, as CWT demonstrated this year, but they take longer to restore. And, at least one key condition is making the U.S. export market favorable. Last week, the dollar fell to a 15-month low against a basket of six major currencies, including the euro.

Both Cropp and Butler said they did not anticipate a change of that magnitude within the next few months, but both also agreed that for now at least, prices are headed up again.

“There's a fair amount of differences in opinion as to how much improvement [farmers can expect], but there's a 100% probability that prices are headed up,” said Cropp.

“I may be more optimistic than most … but I think it will continue strengthening. I could see the base price by April 2010 up in the $15 range compared with $13.80 today. By July or August, it may be in the $16 range.”

Until farmers get back to that range, there will still be a lot of stress on the industry at the farm level, Cropp noted. And, he didn't dismiss the possibility of an overcorrection.

“Several farms have gone bankrupt, and more might still. If these prices improve, hopefully it will ward some of those off. … But either way it's going to take a long time for farmers to build back equity for expansion. So, prices should go up through 2010 and also through 2011.

“Could there be an overcorrection? There could be if production slows and the domestic economy recovers, and the world market recovers more than we think — we could see $20 [per hundredweight] milk again in 2010 and 2011. It doesn't look like that now, but nobody forecast $20 milk in 2007 and 2008, and nobody forecast $10 milk in 2009. It's very volatile, there's a great deal of price risk, and prices can move a great deal with relatively small changes in production or demand.”