In this episode, Ted and T3 are joined by Eric Meyer, President of HighGround Dairy in Chicago. Eric explains the CME’s new block cheddar futures contracts, which will begin trading on Jan. 13.
The panel also reacts to surprising NDPSR data for the month of November. Eric is reminded that the St. Louis Blues won the 2019 Stanley Cup.
Anna: Welcome to “The Milk Check,” a podcast from T.C. Jacoby & Company, where we share market insights and analysis with dairy farmers in mind.
T3: Welcome everybody to the T.C. Jacoby & Company Milk Check podcast. Today, we have a guest speaker: Eric Meyer, President of HighGround Dairy. And we thought we’d talk about the milk production report and a little bit about markets, and then also talk about the new cheddar block futures contracts that are going to be introduced on the CME in the middle of January. Eric, welcome.
Eric: Thank you very much. It’s great to be here in a cold and snowy St. Louis. It’s almost colder here and snowier than up in Chicago, so I feel for you.
Ted: How about the St. Louis Blues who played Chicago on Monday night?
Eric: Oh, do we need to talk about that? I was also told, I think, four or five times since arriving last night that you guys are currently the Stanley Cup champions. That’s always nice to hear after three of them in the previous five years.
T3: I’m glad you know that. It’s Wednesday, December 18. It just so happens the milk production report was released not ten minutes ago, before we started this, recording this podcast. Milk production in November came in at up 0.9% in November for the country and up 0.5% in the 24-state. And that’s a bit of a surprise to the downside. I think most people were expecting something up about 1.5%. Eric, what are your thoughts on that?
Eric: So we were in that same camp, so we thought that the all U.S. number was gonna be in the 1.2 range with the 24 states that have been trending a lot higher. And we’ll talk about that. I think there’s a big shift in the last year of the 24 states straying from the all U.S. number, a big dichotomy between the larger farms in the dairy-centric states and the rest of the country. So we were in that camp, 1.5% was what we were thinking. Those were the numbers from both September and October, and so these numbers are definitely below expectations, a bit of a change in trend from the previous two months. With that number being up 0.9%, we also had a 60 million-pound downward revision in the October number, which represented a 0.3% decline.
So USDA originally reported a 1.3% all U.S. gain and now it’s down to just 1% higher. We are getting more milk. I think there is, from a fundamental perspective, the first half of this year, we were down on milk production. And we hadn’t been down on milk production since 2013. I mean, it’s been four, five-plus years that we’ve been growing milk production. And so the poor economics in 2018 and in the early 2019 kinda did the market in. Farmers finally responded, which, you know, we rarely see. That said, the large scale farming communities, the ones that are larger that are more apt to hedging that have brought costs of production down, economies of scale, we feel like they’ve maintained, and are now starting to pick up that growth.
So one of the items in this production report that we saw that is notable, we didn’t have any change this month from October to November from a herd perspective. But we now are in the 24 states which represents right around 96% of total milk production in the country. We’re now above previous year on the overall milking herd while the all U.S. is down 27,000 head. So certainly a surprise in the marketplace, especially after a unprecedented decline in cheese prices here over the last two weeks.
Ted: Question about the timing, you know, we’ve had high pricing during October, November, and on a Class III particularly, up in the $2-plus range. Farmers basically are seeing that right now. And yet all of a sudden, boom, in the time when they haven’t seen the check that reflects the new drop in the cheese market yet.
T3: And they won’t see that check until February.
Ted: That’s right. They won’t see it for a couple months. So, suddenly the production drops almost 1% year-on-year.
T3: Well, you’re still up almost 1%.
Ted: Excuse me for being skeptical, but it seems like it’s a little counterintuitive, that the productions should suddenly drop like that during actually the highest prices we’ve had for the last five or six years.
Eric: My opinion is that the numbers from September, October were well above expectations. And we’re speculating here, we need to see more months ahead, especially with relatively decent milk checks on the way, the outlook is still fairly favorable. We haven’t seen a ton of movement in the futures market outside of Jan-Feb, you’re actually seeing a shifting back of the forward curve, where we’ve been inverted for the last number of months, meaning, spot is high, futures are lower. All the while feed cost has been relatively stable. It was an interesting year, but it wasn’t like we had $7, $8 corn. We went from $4.40 corn to $3.50 corn, and we’re at $3.80 corn. Still, the economics of making milk are currently quite favorable.
You’ve had a forward curve that’s allowed for many farmers that have a low cost of production to hedge this whole way. Certainly, they’ve lost out on some opportunities. So, my feeling on the milk production side is that perhaps it was overcooked to the upside through this fall, and that maybe we return back to a norm of something near 1% growth. As we fast forward to next year, what will milk production growth look like? Well, we’ve already turned the needle on the milking herds.
The milking herd is likely to continue to grow over the next six months, and you’re gonna be comparing against some poor numbers. The comparables in the first half of 2019 are gonna be quite low. So it’s very possible that we start to see numbers that are closer to one half in the first half of the year, because we’re comparing against flats below previous year of production from 2018.
T3: Well, it’s interesting. If we’re only 1% to 1.5% up in the first half of next year, considering that for most of those months, we’re comparing against 0.5% to what, 0.7%, 0.8% down. That’s actually not very strong growth. From a trend line perspective, that means we’re actually relatively flat over the last two years, and that shouldn’t cause a big pullback in prices.
Eric: True. 2019 was one for the ages from a volatility perspective. We saw the barrel cheddar market, just as an example, because it was the most volatile, we went from $1.16 in mid-January of this year to a high of $2.39 in October, I believe. We bounced around in the mid-twos for a little while, in the $2.20 range. And then we have from early December to 2 days ago, we fell almost $0.70, it was over 30% move in the market. But we went from low to high, a 106% increase. That’s unprecedented. You throw that against any commodity market, food, non-food, metals, that was the most volatile commodity of the year.
And we’ve also seen for the first time in four or five years, a decline in American cheese stocks. And those numbers were very poor in October’s numbers. And I would imagine with this type of milk, the cheese production in November also will not show any major strength. And that those cold storage figures are still gonna be well below previous year. In October, they were down 8.5%.
So, should the market have gotten up to the historically high levels? Well, you put a few different things together and we caught a perfect storm to catch a multi-year high. We’re moderating and maybe we’ve overshot to the downside given how traumatic the fall is, the calendar time of year, but we’re still expecting above-average prices for 2020.
Anna: Costs are rising, margins are shrinking. Markets are more complicated. A lot has changed since T.C. Jacoby & Company started in 1949. What hasn’t changed is our commitment to helping farmers focus. With the latest administrative support tools, we work every day to keep co-ops and family farms running at their peak. Start by emailing me Anna Donze at email@example.com. That’s firstname.lastname@example.org.
T3: One of the things that I found interesting looking at the milk production report today, you know, as a country, we’re up 0.9%. But we were down, what, 1.3% in Wisconsin?
T3: I think that does say a lot about why cheese had gotten as tight as it had. I was traveling in Wisconsin in November, and I can tell you, it was a mess. It kept raining, nobody could get the corn out of the fields. Silage was bad, pasture was non-existent. It was not the kind of conditions that milking cows thrive in and produce a lot of milk in. So in hindsight, thinking back on that, it’s not a surprise that milk production in Wisconsin was down. Well, that will directly—Wisconsin is such a Class III state, just about all that milk goes into cheese. Not a surprise that cheese was a little bit tighter than people expected in November and going into early December.
And I guess it’s almost not a surprise now that it seems we really bounced off a hard bottom here after falling almost $0.70 in barrels. We’re stabilizing in what I would call still a relatively high market. Usually, once Christmas orders are filled, you know, you go back to a place where people are willing to build inventories. Historically, that’s a $1.30, $1.40. This year, you’re right, it might be more like $1.60, $1.70. You know, I usually tend to be the bear in the room, but that would make me optimistic, at least for the first half of 2020. And given that dairy farmers right now could hedge the whole year for something above $17 a hundredweight for Class III, you know, that’s a promising start to next year.
Eric: Absolutely. I agree. I think the fundamentals suggest that we are in and across a number of different commodities. Butter may be the exception, but in general, from both the U.S. as well as on a global scale, we’re in a bit of a destocking environment right now. The previous two years, we made a lot of cheese in this country, and we built up inventories quite large. And that’s changing, similar in the non-fat market that’s a lot more of a globally traded commodity market. We’re now in this destocking environment, we lost the billion pounds of European intervention stock that’s now, you know, gone.
And so the market needs to rebuild that, and we’re just now giving farmers around the world signals to make more milk. And so we thought four or five months ago, we would have expected milk production to take longer to recover. Those previous two milk production reports to this one suggested that maybe they were getting kick-started. And I think one of the other things that is different about the markets these days is we tend to think that because of how farms are set up these days, that weather doesn’t have an impact, but, boy, does it. I mean, as the numbers in Wisconsin said that we were down 1.5%, and the weather played a fairly decent impact of that.
While price next year won’t be an issue from a feed perspective, quality certainly may. I mean, it was one of the more odd growing years, you know, that we’ve seen in history, while it may not be expensive, it may not be effective once it’s been fed to the cows.
Ted: What do you think about the retrenchment in pricing as far as international sales are concerned? Are we gonna move inventory internationally with this retrenchment on cheese? Are we at that level yet or are we gonna stay there or what?
T3: We’re probably too late. It’s the middle of December. I think most of the export orders, those sales contracts tend to be closed before Thanksgiving, tends to be an October, November timeframe that gets the first quarter done. Europe got the orders because they were probably a good $0.20 lower than the U.S. on a delivered basis through most of Asia and the Middle East this year for cheese.
And that doesn’t mean we’re not gonna export, it just means that all that marginal business, those users of cheese in Asia, in the Middle East that could use either European cheese or U.S. cheese this year bought European cheese for the first half of the year. We are still, even with this pullback, keep in mind that what was driving this cheese market was the barrel market which was a real surprise to many people.
And so the pullback, the $0.70 drop from $2.24 to $1.57 before we bounced off the bottom this morning was barrels. Blocks had only dropped about $0.15 in the same timeframe. And blocks is really the driver of the export market. We export some barrels, we export a lot more block cheese or cheese that’s priced off the block markets such as mozzarella. And we are still priced too high to be truly competitive in the export market.
Eric: I think the only things that can help that, which I think at the very earliest would be Q2, but most likely a second-half play would be a really generous CWT subsidy that’s pushed through, just aggressive pricing to keep market share. We’ve heard some rumors that some, particularly pizza cheese exporters moving product just to keep the business that they have currently so they don’t lose out on that market share.
It seems like, but particularly on the pizza side of the business, both New Zealand as well as Europe are pretty darn competitive and are growing their capacity to try and fill that need, as they recognize that there is a lot to go, specifically in Asia at a per capita consumption. So I think that’s an area where, could we get there? The futures need to fall further. We need a very generous CWT subsidy to push some of that through. And I think we’re at somewhat of a disadvantage. We don’t talk about it much, but there’s currently a tariff in place for European cheese. So…
T3: You mean for American cheese.
Eric: Correct. Well, we have an import tariff on current European cheese at 25%.
T3: Oh, into the U.S.
Eric: Into the U.S.
Eric: So I don’t think that has a huge impact on the U.S. market. But I do think that Europe now may have issues on moving cheese. And so they will have to discount or their price won’t move higher, they’ll have to move that elsewhere, and they’ll find places to… They’re very good at moving product. When the Russia ban kicked in 2014, when they weren’t able to ship a lot of product to their number one customer, it took a little time, but they were quite effective at finding new homes for their cheese. So I wouldn’t put it past them. They’re great export partners with folks they work with.
Anna: Dairy markets move on an international scale. Buyers and sellers thrive when they think globally. Put T.C. Jacoby and Company’s 70 years of market expertise to work for your organization. If you’re looking for someone to help you market your products or you’re looking to source supply, get in touch with us now. Email email@example.com or dial 314-822-5960.
T3: Let’s talk a little bit about the new block futures contract.
Ted: Let’s talk about how that might affect our ability to export too.
T3: Sure. That’s a great idea. First, just as, kind of, a point of reference for those listeners who don’t know the nuances of the cheese market and how it trades on the CME, there’s both a block cheddar market and a barrel cheddar market. And the barrel cheddar market is really driven by processed cheese sales. And the block cheddar market is really driven by natural cheddar sales including, you know, when you go to the store you buy cheddar shreds, you know, cheddar trunks in the store, that’s natural cheddar in block form, and that’s priced off the block market. When you buy processed singles, that tends to be priced off the barrel market. For the most part, as well, most mozzarella is also priced off the block market.
One of the real challenges that hedgers have had over the last few years is that the volatility in the spread between the block and barrel markets has been historically volatile. And that is putting it mildly. The typical spread between the block and barrel market is about 3.5 cents, with the block market usually trading about 3.5 cents above the barrel market. Over the course of a year, historically, that would vary between maybe as much as a seven or eight cents spread when it was wide, and maybe invert to a negative one or two cents, when it goes the other way.
In the past three years, we have seen spreads of $0.40 and we have seen spreads of $0.20 and $0.30 the other way. And it has made hedging cheese extremely difficult. It has affected not only the overage for milk prices, for example, if you’re part of a co-op who’s primarily making cheddar barrels, there have been a lot of times where it’s been extremely difficult for those barrel manufacturers to get the kind of value out of the milk-selling barrels that you would normally expect from a Class III price. So you’ve probably seen discounts on your check. And there have been times where it’s gone the other way, and the block producers have had difficulties.
So the industry I would say over the last, oh, probably 12 to 18 months, really started talking to the CME and begging the CME to help us try and figure out a solution to this, and they came up with one. And Eric, I’ll defer to you, tell me about what the CME is doing and how do you think it’ll work?
Eric: Sure. So two years ago, as we started to see the cheese futures contract was having an impact where, in particular, our block hedgers, people that are procuring cheddar, mozzarella, nearly almost all natural cheeses are priced off of a block market, were struggling with the hedge effectiveness of the current cheese futures contract.
So, the way that cheese pricing is done, where there’s a weighted average every week, the block and barrel manufacturers report into the USDA what their price and their volume is for 40-pound color cheddar blocks and 500-pound barrels. And that flows into the final settlement of the cheese futures, which is a weighted average of both of those components.
But most end users, most buyers are likely buying one or the other. They’re either buying processed cheese or they’re buying mozzarella or buying cheddar shreds or using it as an ingredient or in food service or what have you. And their effectiveness of using these tools as well as suppliers and traders that are offering risk management solutions for those customers were struggling to provide a fair price.
And so what we started to see in my side of the business, so we are on the futures and options side where we’re working directly with customers to manage that risk is we were seeing them stray away from the exchange into the over-the-counter swap market. And what that was allowing them to do is allowing them to better their hedge effectiveness.
Now, a lot of times they were paying for that effectiveness. So their price that they were getting from their over-the-counter counterparty was providing them 100% effectiveness. Because the tool that they were using was matching up with how they were buying the product, their cash price. That said, they’re paying for that. There’s a privilege and a convenience for getting that 100% effectiveness. So they were paying up to get it done, but we were losing liquidity on the exchange. And we’re such huge proponents of exchange-based trading.
And so we started to push the CME to start exploring alternatives that their current cheese futures contract which has been around since 2010, and up until last year, has been wildly successful. It’s a very, very powerful tool. Speculators liked it because they understood it, Class III milk, for even those of us that have been in the market for a long time, it’s a hard thing to explain that that’s a part of cheese, and whey, and a little bit of butterfat. So prior to 2010, it was hard to get a lot of people on the boat to jump into this hedge thing. So cheese futures had been great, but they’re starting to lose their shine because it wasn’t as effective.
So there was a lot of work that went into it, a lot of prodding the CME. The cheese industry doesn’t have, like, the non-fat in the butter markets, where we don’t have a great, centralized, decision-making, kind of, a working group. Although, we now have one with IDFA setting one up, but, the CME finally announced last month, with more details that were published yesterday, that they are going to launch a block cheddar futures contract, which allows anyone that’s hedging a natural cheese product a much more tighter and effective hedge. That launches on January 13, and I think we’re very excited about the opportunity to have this contract.
It’s not exactly what the industry asked for, the industry had asked for the ultimate… There’s a lot of debate about what to do and if we should have changes to the spot markets, but ultimately, we asked for two separate futures contracts. We wanted a block cheddar futures and a barrel cheddar. And then due to resources, the CME said, “Look, we can launch one, and we can do it fairly quickly if you’d like to see that. And if there is a need for barrels down the road, we’ll act on it.”
Now what’s nice about this opportunity is that barrel hedgers, people that are hedging processed cheese or managing inventories of the raw material, the barrel cheddar, can still utilize a spread between the new contract and the current contract in order to get an effective hedge. So, we expect that the arbitrage, people-to-people that can make markets and make spreads between Class III, and cheese, and whey will also jump in with open arms on the block contract as well.
T3: So if I understand, Eric, you wanna hedge 20,000 pounds, which is the size of one futures contract, 20,000 pounds of block cheddar, you’d buy one future. If you actually want to hedge 20,000 pounds of barrel cheese, you’d actually go long two of the current existing cheese futures, and then short one of the block futures. And that nets out basically as a barrel future.
Eric: Correct, correct.
T3: And I will admit, I was someone who was asking the CME dairy team to put in both, because I felt that would be easier for the industry. But at the end of the day, I would have rather had one than none. And so when they came back and said, “We’ll give you the block.” I said, “We’re good.”
T3: “Give me the block.”
Eric: We were the same way. We also asked for a number of items. I’m a big proponent of making the option strikes more granular. So right now, cheese futures, when they were set up in 2010, they mimicked or cloned what the Class III futures were. So we have strike increments in Class III of $0.25 a hundredweight, which the industry has just generally accepted. But we had 2.5-cent spread or increments for our option strikes in cheese futures. I think that is exceptionally wide.
And it also doesn’t tie into the tick increment, which is a tenth of a penny. So I had asked for penny increments, I was told that that can be put into the project pipeline for coming down the pike in the next couple of years. It was more important to launch the product and to get the tools trading right away to solve this problem than it was to, you know, change some of the smaller things.
But, my gut tells me this will be a big win for the industry. I think over the last two or three years, we’ve seen a lot of liquidity on the exchange-traded volume dry up. We’ve seen both open interest and overall, volume trading go down over the past year or two years in the cheese futures and options contracts. Some of that may be market-based. It has not been an exciting time. We tend to see volumes get lower in bear markets, but we do know that there has been a lot of market share removed from the exchange and taken into the OTC market. We think it’s very important.
And I think there are reasons to use OTC contracts. We are actually partnered with a new company to be able to provide that to our customers. We think there are benefits to it. But if the benefit is purely hedge effectiveness and the CME can solve that problem, it should bring a wave of liquidity back into the marketplace. And that’s great from a transparency perspective. And so, as someone that’s been a big proponent of exchange, our business has grown because we’ve stuck to that and a lot of the market has moved away from the old nostalgic pit market trading, which is so much fun to see and view. But in reality, I think all market participants, producers, farmers, end-users, and everyone in the middle benefits from more transparency on the screen, that we can all see it, we can all feel it, we can all trade it. And that that provides, I think, a legitimacy to the marketplace.
T3: Do we have a date yet when block futures are going to be posted?
Eric: January 13th and they’ll start with a February contract. And the specifications of the contract are virtually the same as the current cheddar cheese contract with the only exception that they’re just breaking out the block portion and settling that to the USDA’s monthly settlement of blocks.
Nicely enough, the USDA made that separation this past summer. And so there’s a track record for it, there was always a way to calculate it. All those numbers exist in the weekly publishing of the “National Dairy Product Sales Report,” NDPSR. But now the USDA has helped facilitate this to make it an easy process. So, it’s coming less than a month away. Now, the race is on. Before I got into the office here, I just realized that all of the clearing firm back offices and all the software providers need to get this together. And dairy isn’t necessarily something that’s on these companies’ radar screens. So it’s my job, it’s the broker’s jobs to shove that down their throat to make sure that we’re all prepared to trade this product on day one.
T3: Options, same day? So we’ll be able to trade options on the 13th as well as futures?
Eric: Yes, that’s what… They’ve released all their specifications. Everything’s the same, they even reduced. So we have a relatively high threshold for… I know this is gonna sound really confusing, but the CME has a method of trading, which is called block trading. So that’s different from the block cheddar cheese. It is a method to be able to pre-negotiate trades off-screen. For brand new futures contracts, sometimes people don’t want to show their hand on big size in the market because of the lack of liquidity. Currently, with all dairy futures, you’ve got to transact at least 20 contracts per leg in order to qualify for one of these block transactions where it can be pre-negotiated off-screen and then brought to the screen that would…so it’s still an exchange-traded product at the end of the day.
It builds open interest, it builds liquidity, it’s just negotiated off the exchange. This is the one change that they’ve made. They’ve reduced that number on this new contract from 20 per leg to five. So, it at least allows for the industry to maybe start with, which is exactly how the OTC markets work, where everything’s negotiated off-screen. And the prices really aren’t that transparent to being able to do this with an exchange-based product to, kind of, help facilitate liquidity in the early stages of a contract.
So, that to us, is also exciting. It gives the opportunity for market makers and commercials to, kind of, come together off-screen through brokers to facilitate some trading and get things going, particularly in the deferred months. But we do think it’s such a straightforward contract, and I think the market-making community and liquidity providers that we work with are going to adjust their algorithms and their, kind of, auto traders to work with this new contract. It just, it fits in the model of how things will be spread and so we think it’s gonna be a successful starts.
Ted: Most of the international business is 40-pound blocks anyway, isn’t it?
Ted: So won’t this new trading format just fit perfectly on that?
Eric: Yes. And we think a lot of those international customers are using off-exchange hedging methods to get things done. So, this has always been the benefit of the Chicago Mercantile Exchange over the other exchanges. Number one, they don’t have a cheese contract. There’s no central cheese index in Europe, which is a shame, and we hope that that industry figures it out, because that would make hedging those products a lot easier. But, for those that are trading overseas, they can come to the U.S. and use our market as a proxy hedge.
And a really good example of that is non-fat dry milk in this country. Over the last four or five years, we’ve seen the futures volume increase. There are competing exchanges, both the European Energy Exchange or EEX that does European Skim Milk Powder as well as the NZX, New Zealand Exchange that does Fonterra, GDT, skim milk powder. We have a global market that trades skim milk powder. Most of those products are…prices have consolidated. There’s a fairly decent correlation between all three of those regional markets.
But we’ve seen a lot more participation, particularly for long-dated hedges. If you wanna hedge six to 12 months out with the New Zealand skim or European skim milk powder, their exchanges are not a good place for sourcing liquidity, you won’t pay a fair price. So we’ve seen a lot of international companies come and hedge off those other non-U.S. regional skim milk powder into the U.S. non-fat dry milk market, because we do have liquidity to get things done.
Our contract size is a full truck or container versus a fourth of a container for Europe, and a twentieth of a container in New Zealand. So, there’s a lot of benefits to coming to the CME. We have a lot more members, we have better technology, we have liquidity in our market. This is just a no-brainer solution to manage that risk, whether on their own or through their supplier.
T3: Yeah. Speaking of liquidity, do you think the block futures will help or hurt liquidity of the current existing cheese futures in the Class III futures?
Eric: This is always an ongoing debate when a new contract launches. And so this was a really hot topic in 2009 when there was a thought to launch the current cheese futures contract. Will that capture liquidity, capture share away from Class III and make it a less attractive product? And in the early stages, very successful launch for cheese, Class III maintained its share. The industry has gotten much better with the solutions, so we’ve seen a much more robust options market, which is very healthy for our dairy markets to see that type of liquidity grow.
When it comes to a block cheddar contract, because there is a natural spread with the current cheese futures, and because there’s an overwhelming demand for…there’s a need for the block cheese because the majority of hedgers are leveraging. The vast majority of cheese in this country is priced off of block, we don’t make a lot of processed, you know, we only make as many barrels as we make. It’s one spec versus the prices that one commodity versus the current CME spot cheese market that pretty much prices most other products. A lot of liquidity could funnel into that, but, there is a need, specifically, for the farm community, a lot of farmers around the country are priced off of a cheese yield, that they’ll need to utilize that contract.
There’s a lot of larger players that are making both block and barrel. There’s a need for it, there’s a natural spread with Class III whey and the current cheese contract. Block fits into that nicely, and we think that the autoquoters will be quoting spreads against these contracts almost immediately. And so we think that won’t take away liquidity from some of the other contracts. It’s always a risk, but I think the history has shown, at least in dairy, that if people understand it, if we’ve made the product easier for people to use, that they will use it.
T3: Eric, it was a pleasure to have you today.
Eric: It was awesome. Yeah, thank you.
T3: Thank you so much for joining us.
Eric: Always fun.
Anna: We welcome your participation in “The Milk Check.” If you have comments to share or questions you want answered, send an email to firstname.lastname@example.org. Our theme music is composed and performed by Phil Keaggy. The Milk Check is a production of T.C. Jacoby & Company.
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