American Butter Institute Market Situation & Outlook

First Quarter 1999
Volume 2, Number 1

Editor: Chris A. Nubern

The new year is well underway and the dairy industry is currently evaluating the Final Rule on Federal Milk Marketing Reform. Although dairy policy will likely dominate the industry's agenda for the remainder of the year, markets continue adjusting to the lagged effects from historic milk prices in 1998. In this issue of the ABI Market Situation & Outlook, an analysis of first quarter market trends is presented. Also included in this report is a summary of the Final Rule and its potential impacts on the butter market.

Current Status of Dairy Markets

Within the U.S. dairy industry, changes in price levels and the corresponding effects on the milk supply are not instantaneous. There is a definite lag between the two market adjustments. Although the exact duration of the supply lag is unknown, one can say with a reasonable amount of certainty that dairy markets are still adjusting to last year's historic price levels. The strongest indication of this market adjustment is recent increases in the milk supply.

U.S. milk production through April totaled 54,500 million pounds, which represents a 3.5% increase for the first four months of 1999. This is the fastest growth in milk supply experienced in the last five years. Weather conditions throughout the country remain very favorable for milk production. Although daytime temperatures are increasing, stress levels for dairy cows are at a minimum. Production conditions can shift from good to bad in a relatively short time period, but many analysts expect milk production to remain at or near current levels through May and possibly until the first week of June.

Because of the counter-cyclical nature of milk production and demand, the recent surge in the nation's milk supply is exceeding dairy consumption by a wide margin. The surplus milk is being manufactured in storable products; consequently, production and inventory levels for butter, cheese, and nonfat dry milk are rising. For example, butter production in the first quarter of 1999 is estimated at 344 million pounds - up 8.5% compared to 1998. Butter inventories for March were estimated at 109 million pounds - almost twice inventory levels for the previous year. Figure 1 illustrates the dramatic differences in inventory levels. If historical trends are an accurate indicator, butter production will reach a seasonal peak in April and inventory levels will continue building until May. Based on first quarter statistics, annual butter production could easily reverse the declining trend that started in 1992.

• Market Prices

The average Basic Formula Price (BFP) from January to April is $12.49. This average price level is relatively high, but most of the strength is attributed to January's historic price of $16.27 per hundredweight. Marketing conditions for the near future point to lower milk prices. Despite good demand, milk production remains strong, and this will continue to put downward pressure on milk prices. Currently, BFP futures for the next three months average $11.07. Prices are expected to decline for May and June, possibly reaching a bottom near $10.60 per hundredweight. The seasonal declines in milk production, accompanied by the ice cream and cookout seasons, should result in rising prices from July to November. Milk prices this year are not expected to peak anywhere near those from one year ago. The current high for BFP futures is $12.70 (November milk).

The price response to increasing production and inventory levels in the butter market continues to be unsettling and very difficult to predict. With the available cream supplies more than ample to satisfy current demand, economic principles would suggest low to flat price levels.

This has not been the case in recent months. Grade AA butter prices started the year slightly above $1.40 per pound and gradually declined for three months until settling at $0.95. Given increasing production and inventory levels, a sustained decline in prices was expected. What remains difficult to comprehend are price movements during the last two months. Even though supply conditions have not changed dramatically, cash market prices have increased by about 26%. Current prices are about $1.20 - compared to $1.49 one year ago. Competition for cream is beginning to tighten, but supplies remain more than adequate. Activity in the butter market may be attributed to the recent production reports. During the first week of May, production reports for March were released. This report indicated that March butter production was 109 million pounds - 2% down from February but almost 9% higher than March 1998.

A slight decline in butter production when the milk supply is increasing so rapidly could have initiated a wave of buying activity in the butter market. Based on quarterly production, one should not be too concerned about available cream supplies. The supply variables for the current market clearly point toward a soft market for at least another 2-4 weeks. Concerns over limited cream supplies for the near future are premature.

Summary of Federal Order Reform

• Order Consolidation:
  The 1996 FAIR Act required the consolidation of federal marketing orders to not less than 10 and no more than 14. Special provisions in the Act would allow California to be designated as a separate order if producers in that state voted to become part of the federal milk marketing system. The Final Rule creates 11 consolidated milk marketing areas. Some of the criteria used to establish the consolidated orders included overlapping shipping routes and milk supply, number of handlers, natural boundaries, and milk utilization. Although some previously unregulated areas are included in the new orders, the consolidation process mostly involved the combination of existing regulated markets. Order consolidation is not expected to have any substantial impact on the marketing of raw milk.

• BFP Replacement:
  Because of the declining production of Grade B milk, the statistical reliability of the current BFP as a national reference price for the value of raw milk is increasingly questionable. As part of the reform process, the USDA identified an alternative. The Final Rule identifies the BFP replacement as a multiple component pricing (MCP) system. MCP will be used to determine the value of butterfat, protein, nonfat solids, and other solids using surveyed commodity prices obtained from the National Agricultural Statistics Service (NASS). Butterfat prices will be determined from a butter price; other solids and protein values will be based on whey and cheese prices (both blocks and barrels), respectively, and nonfat dry prices will be used to establish the value of nonfat solids.
  Producers in seven of the consolidated orders will be paid on the basis of milk components. Producers in the four remaining market orders (Florida, Southeast, Appalachian, and Arizona-Las Vegas) represent high utilization markets for Class I milk and will maintain a per hundredweight pricing system. Prices for these markets will be determined using the value of milk components and standard component levels for milk. Prices for Class I skim and butterfat and Class II skim and nonfat solids will be announced on or about the 23rd of each month and applied to milk deliveries in the following month. All other class and component prices will be announced on or about the 5th of each month for use in the preceding month.
  The Final Rule also identifies some changes in the classification of milk. For example, Class III represents milk used to produce cream cheese and other hard manufactured cheeses. Butter is no longer a Class III product. Milk used to produce milk powders and butter will be classified as Class IV milk. The definitions for Class I and II utilization remain essentially unchanged from the current system.

• Class I Pricing Surface:
  With the current market structure, fixed differentials are added to the BFP to determine the value of Class I milk. The Final Rule maintains the same framework for determining Class I prices, but differentials are lower and the Class I price mover is the higher of the Class III or IV milk price. Differentials are lowered by an average of $0.29 per hundredweight across all federal order markets. Compared to current differentials at federal order pricing locations, the differences range from a high of +$0.40 in the Upper Midwest to a low of -$1.06 in Texas. The basis for the Class I pricing surface in the Final Rule is Option 1B plus an additional $0.40 per hundredweight. The additional $0.40 is expected to help reduce the possibility of class-price inversion, which occurs in a month when manufacturing milk prices are higher than fluid milk prices.

Final Rule & New Opportunities

The Final Rule creates a new class of milk - Class IV. Class IV prices will reflect the value of milk used to produce butter and nonfat dry milk products. Currently, butter is classified as a Class III product. The minimum price level for Class II milk will be determined by using Class IV prices. These changes in the Final Rule create some unique opportunities for butter/powder manufacturers. With a new class of milk, there exists the opportunity to create a Class IV milk contract at the CME. This new contract could allow butter/powder manufacturers to more effectively hedge the cost of raw milk used to produce butter and nonfat dry milk. The implications of the Final Rule on futures markets are currently being discussed with representatives from the CME.

The ABI Market Situation & Outlook is a quarterly publication. This publication is provided to ABI members by the Economics staff of National Milk Producers Federation. Any comments or questions should be directed to Chris Nubern (CNubern@nmpf.org) or Peter Vitaliano (PVitaliano@nmpf.org) or call (703)243-6111.