American Butter Institute Market Situation & Outlook

Second Quarter 1998
Volume 1, Number 2

Editor: Chris A. Nubern

To say that butter markets are tight is a gross understatement. The combination of seasonal product demands and limited cream supplies is causing spot market butter prices to reach near record levels. Strategic decision making is also constrained by the fact that these market conditions are occurring so early in the production year – historically a time period when price levels are at their seasonal low. The first reaction by some economists may be to attribute this long-term strength in the market to a growing demand for products where milkfat is the primary input. Even though this assertion does contain some factual basis, the extreme nature of butter’s current price volatility suggests the presence of more substantial structural adjustments in the butter markets. In this Market Situation & Outlook, possible explanations for current trends in the butter markets are explored. The analysis focuses on supply conditions as well as recent export activity.

Supply and Demand Conditions

When allowed to work unobstructed, market forces show that increasing demand for a product in limited supply will lead to higher prices. If the product has a close substitute, price strength will continue up until the point where consumers begin to purchase the lower-priced, substitute product. If there are no close substitute products, rising price levels will attract limited production resources from other markets. Product supplies will increase and downward pressure on market prices will develop. These are some of the economic principals that are constantly interacting in the input and output markets for butter.

Current price levels in the butter market cannot be sustained for extended periods of time. Inevitably, butter stocks will grow as consumers purchase lower-priced substitute products like margarine. Also, imports of butter become an economically feasible alternative once domestic prices reach a certain level. Even though market forces and import provisions will eventually correct the current shortage of butter, questions concerning why the market supply was so tight during the heavy production months will remain the subject of many discussions throughout 1998.

Growth in demand for products where milkfat is the primary input is obviously one economic variable that is contributing to the volatile marketing conditions. The domestic demand for products like butter, ice cream, and other frozen desserts has been strengthening over time. For example, since 1990 the demand for butter and ice cream has increased by 3% and 10%, respectively. Although most of this growth is attributable to population increases, the price effects are the same irrespective of the source of increasing demand. In contrast to the demand in these product markets, the total supply of milkfat has increased only 6% since 1990, less than one percent annually. Based on these statistics, the combined demand for products that use milkfat is increasing faster than total supply. Because of these marketing conditions, competition for the limited supply of milkfat is intensifying among manufacturers that produce ice cream, butter, and other milkfat products. Without any substitutes, the value of milkfat increases and these higher input costs are reflected in the product markets. Among other factors, butter prices are high because milkfat supply is limited.

· Butter Stocks

Factors leading to the current volatile marketing conditions for butter have been developing for a number of years. Prolonged price strength and volatility of this magnitude are not solely attributable to shifts in demand. The existing supply of butter stocks also influences price levels. Figure 1 illustrates the graphical relationship

Figure 1; Source: NMPF

between butter stocks (government and commercial) and monthly average Grade AA prices at the Chicago Mercantile Exchange. Although there is not a statistically significant relationship between butter prices and government stocks, Figure 1 does illustrate a pattern between these variables that helps explain the seemingly uncharacteristic price volatility in the butter markets.

Butter stocks have declined from 781 million pounds in July 1992 to its current level of 68 million pounds (Figure 1), a 91% decline in seven years. In the past, government stocks represented a substantial reserve for the industry during low production months and holiday seasons. In fact, government holdings of butter have reached as high as 97% of total industry stocks. Because of the price support program, substantial quantities of government stocks have always been available. With changes in federal policies and the diminishing role of price supports, government stocks are now less than 500,000 pounds, only about 2% of total butter reserves. Without these government reserves, butter manufacturers are dealing with severe shortages and must bid prices up to attract sufficient quantities of milk and milkfat.

The internal supply pressures in the butter market have been steadily building with the increases in demand. Annual butter production has declined by 15% since 1992. Unfortunately, government stocks and the lingering effects of the price support program concealed the market signals that would usually alert the industry to these problems. The most common market signal in competitive markets is price volatility. Since butter stocks have declined below 100 million pounds, Grade AA price volatility has doubled. Price support programs are effective at reducing price volatility, but current marketing conditions in the butter markets are a clear indication how these programs can distort market signals and ultimately lead to increased price risk.

· DEIP Effects

Recent subsidized product exports using the Dairy Export Incentive Program (DEIP) may have also contributed to the tight supply conditions in the butterfat market. For July 1, 1997 through June 1, 1998, maximum DEIP allocations for butterfat total 75.5 million pounds. For the first six months of this period, DEIP awards surpassed 33 million pounds, or about 44% of total allocations. Although DEIP awards have slowed (e.g., only 1.2 million pounds have been awarded since January 1998), there remains some residual supply effects in the domestic butter market from DEIP exports.

Figure 1 is a graphical illustration of estimated DEIP shipments of butter and anhydrous milkfat. With DEIP awards, delivery periods can be very specific (e.g., April 1998) or very general (e.g., January 98 – June 98). Because detailed data on actual delivery schedules are unavailable, DEIP shipments are estimated in Figure 2.

Figure 2, Source: NMPF

Estimated shipments are derived by dividing the quantity awarded by the total number of months in the delivery period. This methodology yields an average monthly shipment for a specified delivery period.

As shown in Figure 2, estimated DEIP deliveries are quite substantial since May 1997. In fact, estimated 1997 deliveries totaled about 4% of 1997 butter production. Estimates show that the majority of these deliveries occurred from September to December, a time when the butter markets were already dealing with seasonal shortages (Figure 2). Because of the extended delivery periods, some DEIP commitments from 1997 may be fulfilled in the first quarter of 1998. This compounds the internal supply pressures that were already surfacing in the market in late 1997.

At current price levels, additional exports of butterfat using DEIP in 1998 are unlikely. If outstanding awards are fulfilled, an estimated 14.7 million pounds of butterfat may be shipped to the export market before year-end. Given current price levels, there is a distinct possibility that some of these remaining shipments may be canceled. Any canceled shipments will offer some reprieve in domestic markets, but recent DEIP activity is a relatively minor contributing factor to the current state of the industry.

Concluding Remarks

Butter prices for the remainder of 1998 are likely to remain high. Supplies are short, government stocks are nonexistent, and demand is steady. The economic forces that have caused the current marketing conditions are not likely to correct themselves before 1999. There are suggestions that import restrictions should be temporarily lifted. If market prices remain at the $1.70 level for long, butter imports will flow into the domestic market without any additional government intervention. In any case, this would be a short-term fix for a butter market that needs a long-term solution.