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COMMENTARY & ANALYSIS

December 29, 2017
 
Dairy prices take another dive
 
Rising milk production snuffs out a rally where a southern hemisphere drought was multiplied by spiking western demand for fattier milk and butter.
 
By Eric J. Brooks
 
An eFeedLink Hot Topic
 
 
For the third time in less than four years, dairy prices have aborted their recovery and trended towards their post-2014 bottoms. At 935, the Global Dairy Trade (GDT) overall index closed 2017 14% below its June 2017 high of 1,089 and 40.6% below its pre-crash peak of 1,573.  Once again, despite poor returns, supply race ahead of demand. From Q2 2017 onwards, the milk output of top exporters (US, EU, Australia, New Zealand, Argentina) surged back to the 2015 levels that had tanked an earlier market recovery.
 

While 2017's closing value of 935 is a large improvement over the GDT index's mid-2015 post-crash low of 514, it is the third time since 2014 that the market crashed within weeks of approaching the 1,000 level. What is more telling is not just that another price decline set in, but the intensity and product mix of this latest downturn.
 
With five of the last six trading sessions resulting in steep declines of 1% to 3.9%, the downturn picked up speed and momentum as 2018 approached. Moreover, whereas the index rose by less an average of less than 0.5% during the Q3 trading sessions when prices increased, it fell an average of 1.35% during the eight deflationary sessions and with exceptional steepness throughout Q4 2017.
 
Rather than supporting the market as they did previously, fatty commodities are now leading the deflationary swan dive: In 2017's last trading session, cheddar declined 7.9%, with AMF(-6.7%)  leading smaller declines in the cost of WMP(-2.5%), butter (-2.3%) and SMP (-4.8%).
 
At US$3,389/tonne, cheddar cheese is closing 2017 down nearly 21% from its early June peak of US$4,285/tonne. Moreover, with cheddar's February and March contracts down roughly 9% each, it implies that worse deflation is yet to come: This cheese may yet test its earlier US$2,500-3,000/tonne market bottoms.
 
Butter is faring even worse, cheese's US$4,474/tonne closing 2017 price is down 25.7% from its US$6.026/tonne post-crash peak earlier in the year. With its January and March contracts both down by more than 3%, butter is poised to trade in the US$4,000-4,300/tonne range for some time. Thus, after spending most of the last year up to 25% above its pre-crash peak, butter is poised to trade up to 10% below that level in Q1 2018.
 
At US$6,392tonne, AMF alone among fatty commodities still trades significantly (+11.3%) above its pre-crash peak, but even so, gave up half the 21.6% gains it had made since early 2014. With 6% to 12% price declines in four of its next five monthly forward contracts, the implication is that AMF could drop into the US$4,500/tonne trading range for the first time since mid-2016, when the price of fattier dairy commodities took off.
 
This is an important counter-trend that undermines the market support provided by fatty commodities in 2016 and H1 2017. According to an EU report based on European Commission statistics, during 2016  "a strong increase in [world ]cheese and fresh dairy products imports (+7% and +23% respectively) was fully offset by the decline in SMP imports (-6%), while butter and WMP imports remained stable. In addition, infant formula imports increased by 12% and whey by 4%."
 
Nor is there any support coming from protein-rich dairy products: Unlike AMF or butter, SMP prices fell to a whopping 72% from their 2014 high of US$5,142/tonne, and have never traded for more than half its pre-crash value. Despite being in such a depressed state, it has fallen another 36% in five months, from US$2,612/tonne in June to finish the year at US1,675/tonne.

 
Moreover, the pace of decline accelerated, with SMP falling 4.8% in its last 2017 trading session. Forward contracts for the first five months of 2018 project monthly price declines ranging from 3.8% to 7.8%.
 
The reason for the renewed downturn can be easily seen in the accompanying chart: Driven by Europe's mid-decade dairy production liberalization, the top four dairy exporter's monthly fluid milk production expanded at a 2% to 3.5% rates from the previous year from mid Q1 2015 through the end of Q1 2016: By mid-2015, that aborted the world dairy market's first attempted recovery. For a year, prices of all dairy commodities scuttled along near their previous market bottom.
 
The situation reversed itself in mid-2016: While US production still responded to its large market's exceptionally strong demand, falling dairy prices forced EU producers to throttle back production. Coinciding with drought in Australia and New Zealand, that caused the top four exporter's fluid monthly milk production -and output of downstream dairy commodities- to fall at a 1.5% to 3.5% annual rate on-year through the end of Q1 2017.
 
As is usually the case, dairy prices responded within three to six months: Led by unusually strong demand for fattier commodities everywhere from America to China, butter and cheese pulled up the entire overall dairy markets.
  
After years of focusing on emerging Far Eastern markets, the west's dairy demand was particularly surprising: Alongside rising demand for fast food and processed food, consumers in America, Canada and Australia made an unexpected demographic turn in favor of high-fat dairy commodities, be they full cream milk or using butter in place of margarine.
 
With North American and Australian consumers suddenly demanding a far higher dairy fat content in their milk and cooking oil, exporters were suddenly left with less milk fat feedstock in the face of rising fast-food consumption in China, Southeast Asia and the Middle East. That jacked up the price of fatty dairy goods in a disproportionately steep manner relative to the small decline in fluid milk production.
 
From their bottoms around US$2,750/tonne in mid-2016, a constellation of rising demand for milk fat, declining milk production and low inventories caused a 52% rise in the price of cheese and 118% rise for butter by mid-2017. At their peak, butter sold for 50% higher than its pre-crash price while cheese reached 90% of its peak price level.
 
By comparison, those dairy powders which had driven the previous decade's boom did not fare nearly as well. With Chinese dairy powder imports a shadow of what they once were, SMP's price only rose 58%  from its market bottom but only peaked at approximately half its pre-crash value. WMP rose a stronger 88% and peaked at 70% of its pre-crash peak price.
 
But every production boom creates its undoing and this one is no exception: To boost the supply of milk required for fattier dairy goods, New Zealand's Fonterra increased its farmgate milk price from NZ$3.90/kg (US$2.53/kg) in 2015 to NZ$6.60/kg (US$4.75/kg) by early 2017. European and US producers also found it necessary to boost farmgate prices and dairy cow returns in order to meet the surge in demand for fattier dairy goods.
 
By Q2 2017, European producers responded strongly to the higher returns while those in New Zealand stabilized their output. By mid-year, large increases in European production made up a lion's share of 1.5% to 2.5% on-year increases in monthly production. While US fluid milk increases tapered off, wetter weather in New Zealand and Australia saw these two producers finally show strong production growth from Q3 2017 onwards.
 
After growing at 2%+ rates for most of 2017 and accelerating to near 4% on-year monthly increases in Q4, the oversupply was more than the market could bear. With surging milk supplies finally providing sufficient fat feedstock, butter, AMF and cheese went from leading the price surge to spearheading the ongoing market decline. As top four dairy exporter picking up speed in late 2017, so did the pace of dairy commodity deflation.
 
Going forward, it seems that the market is now caught in a series of bear market mini-cycles: For three consecutive year, every downturn in milk production was cut short by a supply upturn that collapsed prices back to within range of their previous bottoms.
 
Without China or any other large buyer growing demand as quickly as before, there is no strong driver to allow for simultaneous strong production and demand growth. Over the short-term, the Australian Bureau of Meteorology reports that the equatorial Pacific Ocean is undergoing an overdue La Nina phase: That implies that there will be plenty of rainfall capable of boosting Australian and New Zealand dairy production over the next six months. Fonterra recently reduced its farm gate price, but at over NZ$6.00/kg and a pasture land recovery in the cards, the world milk oversupply -and dairy commodity deflation -will get worse for at least another quarter before it can bottom out or turn around.
 


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