While the American dairy industry is collectively obsessed with trade wars and tariffs, that’s not the biggest elephant in the room. Ted and T3 look past the headlines to discuss the trend that could have a far greater impact on markets over the long term.
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Anna: Welcome to The Milk Check, a podcast from T.C. Jacoby and company, where we share market insights and analysis with dairy farmers in mind.
Toby: We welcome you back to The Milk Check. It’s July 17th, 2018. I’m Toby Wall, I’m in for Anna Donze, she is out today. And with me today is Ted and T3. And we’re here to talk about what we think is the biggest problem or at least the biggest challenge right now, in the dairy industry, and it’s not what you think it might be. So the conversation about tariffs has occupied everybody’s mind lately, but it’s not necessarily the biggest issue, right? Since these have been announced, prices have come down in dairy markets. They’ve come down significantly. But is that the result of tariffs? Or is there something else going on here?
T3: The first thing that we need to keep in mind when it comes to price is markets are not just a matter of math, they can be emotional as well. And I think that one of the things that’s happened in the last month and a half is that, as we kept hearing over and over again, about the retaliatory tariffs and how China and Mexico have put tariffs on cheese, and China’s put tariffs on whey and other dairy products, the emotional side of the market has really come to bear. Fear. People are afraid that those markets, we’re gonna be…our demand is gonna be reduced because we’re going to be exporting less to those markets when prices come down.
To me, there’s an underlying issue that is a bigger issue than the tariffs. But the talk and what everybody’s talking about is what’s going on with the tariffs. What concerns me though, is milk production over the last three months has only been up about 0.8%. That is below the natural growth rate in demand in this country. The assumption has been over the last 30 years, the demand for dairy products tends to grow at an annualized rate of somewhere between, 1.5 to 2%. That correlates very closely with increases in population in this country. But it also correlates with a slow and steady increase in dairy consumption on a per capita basis.
So if we’re only up about 0.8% in terms of milk production, we should start seeing our inventory numbers stagnate, if not go down a little bit, as we are continuing to consume at an increasing rate, but we’re supplying less milk. That’s not happening. We’ve seen our cheese inventories continue to increase this year at a faster rate than they did last year, and at a faster rate than they did before. Inventories are up, for cheese are up this year, relative to last year, even though milk production is down. And the fact of the matter is, even though right now, that all the discussion is about the tariffs, the truth is, for the first five months of the year, January through May, exports have actually been excellent. They’ve been way better than last year, way better than the year before. So why is our cold storage…why are inventory numbers going up?
That’s what has me concerned. Somewhere, whether it’s we’re producing more cheese or we’re producing less of other dairy products because they’re not being consumed, somewhere in the domestic demand data, and we haven’t been able to pinpoint exactly where it is, we suspect there’s been some decreases in domestic demand for dairy products that really isn’t coming to the forefront, that’s not obvious to people who really studied the numbers.
Ted: I tend to believe that only the most isolated segments of the industry attribute the current problem to trade and exports. Demand goes up 2% a year and milk production goes up 2% a year. Up until the last year or so, that’s been the case. And now all of a sudden that paradigm is changing, where the demand seems to be lagging. We tend to attribute that to ersatz dairy products, soy milk, or almond milk, or other kinds of so-called milks that are eating into our sales. And I think that to some extent that that’s probably true. I also think that people’s dietary habits are changing a little bit. I think cheese and hamburgers, and cheeseburgers and so on, people are beginning to realize that cheese is indeed a fattening product and they’re cutting back a little bit on their usage and trying to be more “healthful”.
Two-fold. First, you have ersatz products and secondly, you have what possibly is a change in dietary habits. Which then brings to mind some of the fractionated products that we’re looking at that basically support the dairy industry, but maybe aren’t being really looked at properly. One is, and I don’t really wanna get into trade names here, but there’s only one out there. Fairlife, for example, concentrates protein, takes out the sugar and right now, they cannot keep up with orders. They’re building plants in Arizona and in Canada. And I went into the grocery store last night and their chocolate was cleaned out in all sizes, they only had two of the whole milk left. And I question whether or not those sales are being counted in the total.
Another way to look at it is, they’re taking out all the lactose, which is more than half of the product of the lactose that the farmer permeate is disappearing somewhere, probably in farm and cattle feed. And that I think also distorts the numbers. We have a lot of the movement that goes on into an area, is in the form of UF milk that ends up in the cheese industry in Texas, or Wisconsin, or wherever. And again, protein and fat are concentrated, the permeate disappears, because the value isn’t worth really handling. That’s a big number. So the question that I pose is, how is this being accounted for?
T3: There’s one place where I think that might have an explanation or at least a partial explanation of what’s going on with demand. If you recall, when Canada instituted that class seven, we lost a lot of UF milk sales to Canada. So what happened to that milk? I suspect a lot of that milk ended up in cheese plants because a lot of that UF milk was coming out of Wisconsin, New York, Michigan. Where…there’s not a lot of cheese plants in Michigan, but there is New York, and there certainly is in Wisconsin. And so one of the things that I think happened is, I think that milk was displaced either through UF, or just regular farm routes, was displaced into cheese planets. And so I think some of what’s going on in terms of what we’re seeing, in terms of cheese demand grow, or cheese inventory growth, has been…that milk has been displaced. And the result of that is we’re making more cheese.
But one thing we do suspect and have for some time is that the growth of specialty cheeses, that’s been growing at a much faster rate than commodity cheeses, like cheddar and even mozzarella. Mozzarella has been growing faster than cheddar. Cheddar has been growing a little bit. Many of the other specialty cheeses are growing even faster yet. But because cheddar and mozz is still 90% of cheese production, those are the two that move the dial. I think some of what’s going on is you are getting…you are continuing to get good growth on the specialty cheese side of the ledger. I think some of that specialty cheese growth might actually be eating into cheddar cheese demand, which is the commodity that everything’s priced on.
Ted: It sounds like what you’re actually saying is that the demand numbers may not be very accurate. It sounds to me like, to revert back to the example that I used with regard to ultrafiltration where the permeate disappears in cattle feed, that this has a way of distorting the overall demand, and that we’re seeing basically a change in the dichotomy of how people are eating. We know, though, that Class I sales are down, we know that processed is down. We also, I point out, we have discussed this, but we also know that yogurt is down. But on the other hand, there are new people in the yogurt business, and we wonder whether they’re being countered properly.
You go into your grocery store and look at the counter, I mean, you’ve got now a dozen different choices of people to buy yogurt, and I would think back three or four years, you had maybe two or three. So I don’t know, I would question whether or not it’s been countered correctly. But by the same token, there are some changes in how the industry is progressing, with regard to fractionated products and so on and how this affects the people who are actually doing the analysis as to what the demand actually is.
Toby: Let me put this question to you guys then. More and more segments of dairy products out there now than there were, you know, pick a number, years ago. So we can keep coming back month after month and have these conversations about what we’re uncertain about. Do you think that the industry just needs to catch up in terms of its data collection? Catch up with the segmentation that the industry has gone through over these last 15 years?
Ted: Yes. The issue is, you know, you look at how this is done. The USDA has a statistical service. Basically, that’s a couple of guys sitting I think up in Madison last time anybody looked, that are on the phone calling people and say, “Hey, what are your inventories? And how much did you sell?” And so on. And, you know, they have a bad habit of every once in a while coming out and saying, “Oh, the cold storage,” for example, “The cold storage inventory was this, but guess what, this warehouse that we weren’t counting has 54 million pounds of cheese in it.” And of course, then the markets go berserk. Or the opposite: “We counted something twice.” The USDA and the Federal Milk Market Administration are basically government or quasi-government organizations. And they tend to make the…do the counting, and we rely on their numbers. And quite often, their numbers aren’t the best.
T3: And I was gonna say something very similar. What I was gonna say was, one of the things…the USDA has not invested much in expanding…
Ted: No, it hasn’t.
T3: …the National Agricultural Statistics Service and the way that they go about compiling data. And the result is, they’re counting the same thing they were counting 20 years ago. But the dairy industry isn’t making the same stuff they were making 20 years ago. And that to me, is what the difference is.
Ted: So it makes it very difficult for us to quantify this problem. We know there is a problem with demand, but we don’t know exactly where it is. We know it’s Class I sales, we know maybe it’s yogurt, we know that the usage is going down, and we know we’re selling a lot of surplus that we shouldn’t be selling. So there’s a demand issue out there. But whether it’s quantified properly is another question. There is another thing that’s coming up now that will affect demand, I believe. And that is the Farm Bill. There are provisions in the farm bill to provide for forward pricing on bottled milk. The farm bill right now is in conference committee between the Senate and the House, and what’s gonna come out of it is anybody’s guess. But what’s being discussed is an average of the Class III and the Class IV price, plus 74 cents, plus the location. So if, like, the average is $15…
T3: This is for the Class I mover we’re talking about.
Ted: The Class I mover, which makes it hedgeable. What’s not in the farm bill is any changes in the minimum price provisions under the order. And what that means is, is that handlers are obligated to pay their supplier the minimum price under the order. But the handlers then are gonna do the risk management. Now, how’s this going to percolate back to the dairy farmer?
T3: Wait, before you go there. When you say handlers, who is a handler?
Ted: A bottler.
T3: So, a Dean Foods, a…
Ted: Prairie Farms.
T3: A Prairie Farms, etc., they’ll be responsible for the risk management.
Ted: Well, theoretically. I guess my perception of what’s being put together is that it can’t help but percolate back to the dairy farmer, whose…
T3: It will.
Ted: Yeah, it’s gonna percolate back to them one way or the other, directly or indirectly. I mean, there’s gonna be a minimum price provision under the order which is gonna be enforced somehow. And it’s hard for me to visualize how that’s going to be enforced.
T3: What will happen is the cooperative will still bill the bottler as they always do with the minimum price.
Ted: I agree.
T3: But there’s a whole industry out there now, in the risk management industry. Whether it’s something called an over the counter swap, or it’s simply, you know, futures and options positions that are indirectly related because they both flow into through the clearing firms and into the CME, where both sides can hedge. But do so independently. And so what will happen is…first, if it’s an OTC swap, you’ll actually get the bottler going into the OTC market through an intermediary saying, “Okay, I wanna hedge this, the class one mover.” And then you may get a co-op or someone else going into the market and doing the same thing, and taking the other side of it. They’ll do a swap, it’s completely independent of any kind of milk billing, but it’ll get the job done. If it’s…
Ted: That’s exactly the way that I see it.
T3: It’s the way I see it, too.
Ted: I think we’re gonna be in a position to look at that very seriously, given the experience that we have in risk management.
T3: Sure. But we’re not gonna be the only ones who are gonna do it, there’s a number of people who’ll be able to participate in that market. For us, you know, you can do it a couple of different ways. You know, whether we have a Class I sale that we wanna hedge or more likely because it’s an average of the Class III and the Class IV. You know, we’re constantly hedging our cheese business, we’re constantly hedging our non-fat business, and our butter business, and our whey business. We can actually take that hedge and we can splice it up into the different parts of our business. And whether it’s another trading company, whether it’s another manufacturer, there’s a lot of people that are gonna be in a position to do things like that. The market’s gotten pretty sophisticated.
Ted: I agree. But is it sophisticated at the bottling level? And the answer to that, I think, is no. I think it’s sophisticated at the cheese level, okay? Or at the fractionated level even. But whether it’s sophisticated enough at the bottling level, you know, the customers that we have, at the bottling level, they don’t do any risk management right now, zero.
T3: They don’t do any right now. But…
Ted: They’re gonna learn
T3: The minute… If this is in the farm bill, and if the farm bill passes, and this becomes law, I don’t know this for sure, and I have not had any conversations with the CME. But I would speculate that relatively quickly, the CME will add a Class I mover future to their basket of dairy futures that they have. And then all the bottler is gonna need to do, is go to the CME and hedge the Class I mover, and boom, they’ve got what they need to do. And it’s really not…it’s as simple as it is for a dairy farmer to hedge his milk. In fact, it’s probably even simpler because most dairy farmers have to figure out what…have to hedge on a blend price basis. Whereas the bottler is just going to have to hedge on an average of the Class II and Class III.
Ted: Let’s get back on topic a minute, we’re talking about demand. Now, all of a sudden, a bottler, or Walmart, our latest shining light in the bottling industry, is going to be able to go out 24 months on pricing. I can see marketing programs coming into place based on those kinds of tools being applied that would greatly enhance the demand side of the milk business.
T3: I agree it will enhance the demand side of the milk business. But I think it’ll manifest itself a little bit differently. I do not expect retailers to be hedging on a 24-month basis. And the reason is very simple. If you have one bottler of who hedges and another bottler who doesn’t, and they’re both going into the retail environment, what happens if the price drops enough so that the guy who’s not hedged has a significantly better price than the guy who is? They’re gonna get all the sales.
Ted: I would disagree on that a little because look at a company like, and pick a name, Kellogg. They operate on budgets, they hedge based on budgets.
T3: But they’re all…
Ted: And they don’t hedge based on trying to gamble on what the market’s gonna do.
T3: But there’s two big, big differences. The first is, dairy is a small percentage of the overall ingredients in the products they sell. And the second is, you know, and let’s, you know…we want to use Kellogg, I’m just gonna pick one out of the air and say, you know, something like a Cheez-Its.
Ted: Pillsbury.
T3: Well, yeah, well, you know, the product has some cheese in it. But it also has some grains in it, it has whatever else goes into making a cracker. First of all, their margin on that product, I mean, the cost of production is probably well, less than 50%, it’s probably something like 20% of the price that they charge for that product. Which means they’re hedging in cheese is, again, probably less than half the cost of that production. So as a result, they’re hedging something that’s like 10% of the overall cost. Well, that makes sense, you do the budget. But if you’re hedging…if you’re selling fluid milk, where the milk itself is the majority of the cost, and you’re going against someone else who’s also selling fluid milk, that price difference, all of a sudden, can really screw up your budget because your sales dropped 10% because you’re the most expensive product on the shelf. Now you’ve got a problem, especially when you’re hedged.
We work with a lot of people who have products that they go to market in the supermarkets, and we work with them on hedging. And most of them are very reticent to go out more than six months because they are afraid of exactly that. They don’t wanna accidentally make themselves price incompetitive…uncompetitive. This is where I think even the bigger issue of demand comes into play, and that’s at the restaurant level. Restaurants, for the most part, have avoided milk as a staple that they offer. There’s many reasons why they avoid it. But frankly, one of the biggest reasons is because of the volatility of milk price. Now, you can take that out of the equation. You can create a comfort level for restaurants to start offering milk as a product again, that’s one. Now, the second to me is even more important.
When looking at those entrees, restaurants in general have looked for ways to cheapen and also take the volatility out of the marketplace for the entrees that they make. You put them in a position to really start including milk as one of the ingredients in as many of these entrees formulas and be comfortable that they don’t have to worry about price volatility that screws up their profitability. I think that’s where this becomes very powerful. And that’ll take a few years for this to really get back into the marketplace and in restaurants. But I think if you give food service establishments the ability to really have some price stability in their fluid milk, that you’re going to see a real nice demand growth opportunity on the food service level.
Ted: Well, we need something because what’s been going on the last decade can’t continue and it’s eventually gonna undermine the whole industry. And it’s reached the point now where it’s very dangerous. That’s why this sudden change in the dichotomy of how this whole thing is working is upsetting because the continual lack of demand on the fluid side is making a difference in what we’re doing. We’re winding up selling surplus that we didn’t plan on selling before and the cost of that is major.
Toby: It looks like we have a lot to look at over the next four or five weeks. We’ll be watching dairy production numbers, we’ll be watching those demand indicators we’ve talked about, we’ll be watching cold storage reports. It’s gonna be an interesting month. Look forward to having another discussion in August. We’ll see you there. Thank you, gentlemen, very much.
Anna: We welcome your participation in The Milk Check. If you have comments to share or questions you want answered, send an email to podcast@jacoby.com. Our theme music is composed and performed by Phil Keaggy. The Milk Check is a production of T.C. Jacoby and Company.
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