Anna, Ted and T3 shift gears to 2018, forecasting the impact on the industry in a time of oversupply. Ted and T3 predict milk production will have to drop off before prices recover and farmers start making money again. They also discuss what would happen if make allowances in the classified pricing system were increased or decreased.
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Episode transcript
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. In this episode, we’re going to focus on looking forward through 2018. To start with, you guys just got back from Dairy Forum, what were the main takeaways?
T3: I just came from the IDFA Dairy Forum, and the best way that I would describe the tone at that meeting was most people were generally bearish, but I think most people also had a general attitude that the low prices are in. In other words, we are already low. I didn’t spend a lot of time talking to people about prices going a lot lower than they are now. Now, that’s not a pretty picture. Let’s face it, what we’re talking about is something around $13, somewhere between $13 and $13.50 in terms of a Class III price, which with the premiums that in the basis, I guess, if you will to use a grain term, that we’ve lost on the mailbox price for the dairy farmer.
You know $13 dollar milk today is the equivalent of almost $10 dollar milk five years ago. And so, we’re at very low prices at this point, but I’m beginning to believe that we’re somewhere right around the bottom where we are. Going forward though, to me it’s a cart before the horse issue. Prices can improve but only after we start to see milk production go negative. And I mean milk production go negative both here and in Europe. And one of the issues that we have in the US right now, we’ve had four or five years in a row of consistently increasing milk production, and that has put in a position where we have a surplus of milk right now.
At the same time, you know the latest figures out of Europe that in November, Europe was up over 6% over the previous year. And Europe is a milk shed that is almost two times the size of the US milk shed. And so if Europe’s 6% in the largest milk shed in the world, that’s going to be a problem for dairy farmers, not just in Europe but worldwide. And so I think that we’re going to need to see not just start to see a shrinking milk production in the US which at these prices I think we will, but we’re also going to probably have to start to see something similar in Europe. And they’re probably farther away from getting negative on their milk production. In fact, most of what we’re hearing is that they probably won’t start seeing smaller milk checks or milk checks that will cause contraction until March or April. Well, the rule of thumb is usually it takes about six months after you get milk checks that are at the contraction level before you really start seeing a contraction in the milk supply.
Ted: Another factor that has an impact on the price to the dairyman is the inflation in hauling costs. The hauling costs have been going up at least 50% in the last year and a half to two years. You actually could argue with fuel surges and fuel adjustments and so on that it has gone up even more than that. And regardless of whether the dairyman is paying the hauling out of his milk check or whether his customer is paying the hauling, it still comes out of the dairyman’s milk check, directly or indirectly. And so if the hauling right now, the hauling two years ago was 50 cents, the hauling today is probably 75 to 80 cents, regardless of who is paying it. So you’re looking at 5% to 10% reduction in the dairyman’s milk check just by hauling alone.
T3: And I wish I could give you better news on the end product front, on the cheese front, but the fact of the matter is we’re having the same problem on our side of the dairy plant. And so not only are we seeing the hauling cost of getting milk to the cheese plant go up, we’re seeing, especially in the last couple of weeks, a new regulation, electronic log recording went into effect. And so it makes it much more difficult for truckers who are shipping our cheese, let’s say from Wisconsin to the East Coast, from cheating on those logs and driving 10 hours and saying they only drove eight, now they can only drive eight, which they pretty much have to pull over if they want to keep their hauling license. As a result, we’re seeing hauling rates, they’ve gone up 25% in the last four weeks, unfortunately.
So the bad news about that is, that has a tendency to compress prices all along the chain. And ultimately the dairy farmer will even feel that reduction in price in their pay price. It may not actually manifest itself in a way that you can point it out, but when the hauling price goes up, it doesn’t just mean the consumer is going to pay more for cheese. Because what happens is the consumer sees the higher price and buys less. And if they’re buying less cheese, ultimately that means the milk price goes down.
Ted: We’ve had a similar problem, not to the extent that you have with finished product, but we’ve had milk sitting five miles from the plant because of the electronic logbook. And then have it rejected because it didn’t make the wash tag deadline.
T3: Oh, jeez.
Ted: So this is a problem that we’re dealing with today that we haven’t had to deal with in the years past.
Anna: I know we have seen recent rate changes on the producer side. Do you think that those are stable for now or will those increase again in the near future?
Ted: I tend to think that inflation is going to be with us for a while. We built up a lot of a reservoir of deficit spending, and the only way that that can ever be paid is through inflation. To say that hauling costs have plateaued I think is probably wishful thinking. I think inflation is already here in a lot of areas, it just doesn’t show up in the statistics. What probably distorts inflation is the fact that the oil price has gone down from a hundred plus dollars a barrel down to $40-$50 and it is a little bit higher now, but it’s starting to head back down again into the fifty-dollar a barrel range.
So that distorts inflation a little bit. But we’ve spent a lot of time in the last few years trying to look at building manufacturing facilities, and we know that the cost of building manufacturing facilities has doubled in the last 10 years. The cost of bricks and mortar has gone up substantially, the cost of the stainless steel and the various fittings and process controls and all the things that goes with it have more than doubled. So those things are inflationary already and it’s already built into the system, and those prices are continuing to go up. And it’s unlikely that they are ever going to go in the other direction with the reservoir of inflation that is now underlying the system.
T3: I will say this though, there is one, if there’s one thing we have been seeing in the last few months in keeping track of that is a silver lining to a difficult situation, it’s the fact that the dollar has continued to weaken. And the dollar, just the other day, hit the weakest price that it has been at in over three years. A weaker dollar leads to higher commodity prices and that would include higher dairy prices. And so that would be a good thing, and we really haven’t seen that manifest itself yet in dairy prices. But the one argument I could make is this, is if we have seen the dollar get 15% weaker in the last three months, and we’ve seen dairy prices, they’re probably weaker by 10%, let’s say. That means that if you’re in Europe, and you’re getting paid in Euros, it’s a 25% drop, and so the price pressure on the dairy farmer is Europe is actually greater than the price pressure that the US dairy farmer is experiencing ultimately I should say, they should experience that. The word I hear is that they haven’t started to see their paychecks drop, but everybody is expecting them to really drop pretty hard in the next couple of months. And so they’ll get a pretty strong signal just like the US dairy farmer is, that now is probably not a good time to increase your milk, add cows to your herd and increase how much milk you’re selling to the dairy plant.
Ted: It’s easy to say but most dairymen do exactly that when the cash flow gets to be a problem and they see the corn silage sitting out there, but then their cow down at the end of the barn works to eat some of the corn silage and crank out a little more milk, so…
T3: You know, well, and I think probably in 2016 and 2017 that was exactly what was going on. I’d be willing to argue that 2018 prices have gotten low enough now that it may be a little bit of a different story.
Ted: Well, I guess we’ll see. And I think we’re maybe going a little bit overboard on doom and gloom because we do think that there will be a retrenchment of milk supply here in the first half of 2018. And you put that together with economic conditions that are favorable, inflation, and you could be looking at a very quick turnaround when you get to August of 2018. Not something you can go to the bank with, but the potential is there. When this turnaround occurs, it could just be a slap in the face when suddenly the demand perks up and you’re looking around and the milk that you all have is committed and the over-order premiums then go in the opposite direction.
T3: Yes, and I don’t disagree with you, I think it is very possible that we could have a real about-face and suddenly go from being long to short in a very short window of time. But I’ll emphasize my earlier point. It’s a cart before the horse issue. If we don’t get a reduction of milk supply, I don’t think we get any kind of a run-up in prices.
Ted: Well, I think at the price that we have now we should see that. We’ll find that over the next three months, that will tell the story here. It doesn’t mean the price is going to go up, but if we see production going down in January, March, and April, then I think when August gets here, we can roll up our sleeves and start looking at a new ballgame.
T3: I agree. But I think you have to get the red numbers first on milk production.
Anna: We know that in certain parts of the country there are farmers who are ready to build new dairies. Does that cause any concern? I know we’ve talked about thinking that the market will contract, but do we think that it might just make room for some of these new farms to come online?
Ted: The I-29 corridor is the current hotspot. South Dakota is a beautiful dairy country, beautiful. And there’s a lot of conversation about new manufacturing facilities in that area. That is offset of course by California, which becomes more onerous every day from a cost in production standpoint for the dairy industry. So I do think that we’ll probably see an increase in production no matter what in South Dakota and the I-29 corridor. Probably a continuing decrease in California, where for environmental reasons and regulation reasons and just in general harassment, the dairy industry in California will continue to decline.
T3: I’ll add a little bit to what you’re saying. One of the ways it has always been described to me when we talk about increases or decreases in milk production is that the rate of dairy farms exiting the business is actually relatively steady and has been for 30-40 years. But what happens is when the rate of expansion, those new big dairy farms getting built, when that rate slows down, that’s when you get a contraction in milk supply. But what we’ve had in the last four or five years is a steady addition of more dairy farms, especially in Michigan, but in the 1-29 corridor and other areas as well. I think what we’ll probably see in 2018 is I think Michigan, for example, has already gotten to the point where I don’t think they’re adding much more milk in Michigan. I think anything that is coming online these days in Michigan was something that was decided on three or four years ago. I don’t think there are any new farms coming online in California right now. And I think the overall rate of expansion in just about every region of the country right now has slowed to a trickle, you know, maybe it’s a little bit stronger in the I-29 corridor, but even that’s probably at a lower rate than it was a year or two ago.
Ted: In the I-29 corridor, you can get the permit today. What you can’t get is your market.
T3: Right, right.
Ted: And that’s what’s the only thing that slows it down. In fact, you have some dairymen up there slow-walking their construction just to wait for the market to catch up.
T3: Well, and there is, I don’t want to spend too much time on that region of the country. But it is the one place where I know there’s two plant expansions going on. And so there probably is going to be some extra demand for milk in that region of the country. But here’s the thing, those are the only two plants, well, those are really two of the only plants in the country that I know are coming online. You’ve got another butter powder plant coming online in the Southwest, I think at the end of this year. But that’s it, and they’re closing a plant in California. There’s nothing that we know of in terms of expansion going in the Northeast or Mideast. And I don’t think there’s anything significant being added in Wisconsin either. I think the big expansions in Wisconsin mostly happened last year.
Ted: It’s already finished.
T3: Right.
Ted: We do have some conversation about expansion in Michigan, but you know I don’t think any ground has been broken yet on anything. So far it’s only discussion, so we’ll see.
Anna: Since we’re talking about capacity, manufacturing capacity, what are the biggest roadblocks to building plants? I know we’ve been asked that question before. So what’s really getting in the way of that happening?
Ted: Well, it’s a structural problem. It depends on how you look at it. But basically, it’s a structural problem. Most of the milk in the US is cooperative and so the people who have built plants are basically either coops or people who are going to buy milk from coops. And the financing the facilities like this if you’re not an established marketer of finished products, the 521 Coop does not really provide for the accumulation of equity in a manner that fosters spending anywhere from $100 million to $500 million dollars to build a state of the art manufacturing facility. Even if they had zero debt, and even if they had the ability to raise let’s just say $5 or $10 million dollars a year, how is a bank going to come in and finance the equity portion of a construction project of that magnitude? And that is a problem that has caused a lot of our industry to just say deteriorate in terms of their plant and equipment, where a lot of the plants that we have these days are 50, 70 years old that have been retooled and refurbished. And that also, I think, in a lot of ways is also the same situation in Europe where we have now a continuing litany of adulteration problems, salmonella, listeria and so on from plants that basically were new two or three generations ago, and it is difficult to keep plants like that clean. Also aside, also the testing for these kinds of organisms has become more and more easy, better, efficient and…
T3: And cheaper.
Ted: And cheaper. They can do it on infrared today in some cases, and then they confirm it on a plate. But confirming an organism like listeria is much easier now than it was 20 years ago.
T3: And so they find it more often.
Ted: And they find it more often, and also people who 50 years who were raised on raw milk, they don’t drink raw milk anymore, so they have no tolerance for any of these organisms. So this is a big problem. The industry needs to retool to sanitary modern equipment, and the financing facilities to do that are problematic, particularly for a coop.
T3: Now, it almost sounds to me like you’re making a case for an increase in the make allowance in the class price system? Here’s where I am going with that. We’re having trouble getting plants built. Basically what we’ve heard dozens of times about anybody who’s looked at building a cheese plant of any size in Michigan, is they’ve basically have said they can’t make the financial numbers work. The reason they can’t make the financial numbers work is between what they are going to have to pay for the milk and what they’re going to be able to sell the cheese for, there’s not enough profit in there for somebody to come in and say, I’m willing to invest $150, well, $350, $400 million to build a plant, which would mean probably about $120 to $150 million in equity, in cash before all your debt. Well, if nobody is willing to invest that kind of money, is it because we don’t have a big enough make allowance in the Class III price?
Ted: No, I don’t agree with that. The make allowance has nothing to do with the margin. The make allowance is basically a regulatory illusion that says that the margin between the Class III price and the average cheese price has got to be such and such. And then they come up with complicated formulas to determine the make allowance. In my view, the smaller the make allowance is, the better it is. And the reason is, is that the smaller the make allowance the larger the over-order premiums. If the over-order premiums are larger, it gives you more margin to move the milk from plant A to plant B.
T3: It’s actually the other way around?
Ted: No, it is the other…the larger the over-order premium, the more margin, the more room you have to haul from plant A to plant B.
T3: I don’t disagree with that.
Ted: And the more competition you have for the milk, which in turn raises prices to dairy farmers.
T3: Well, no, and I don’t disagree with that, but an increase in the make allowance decreases the class price.
Ted: It also eliminates competition between plants for milk, which decreases the milk price to the dairymen. So it’s a two-edged sword, the basic premise is competition for milk increases milk prices.
T3: Agreed.
Ted: Okay? That’s the premise, and that works in California and it works in Wisconsin. If there’s no competition for the milk, the price to the dairyman goes down.
T3: Okay, good debate.
Anna: The other thing that I really wanted to ask is the over-order or under-order premiums, really got bad like in New York first, and then it kind of went in this wave, some like California obviously is kind of doing their own thing. But as that has gone across the country, is it possible that you have people in South Dakota that still haven’t felt the pain that Michigan has? Have they hit their worst on premiums, or do they maybe still have a ways to go?
T3: You’re saying have they gotten worse in South Dakota?
Anna: Well, you know South Dakota hasn’t been in quite as much pain as Michigan, or New York has been. Have they seen their worst of it, or are they going to bounce back before they hit the lows that people further East hit, or…?
T3: One thing that is happening right now in South Dakota, is there’s two plants that are expanding capacity, that is going to create more market for the milk in South Dakota. That’s not happening yet in Michigan, and it happened earlier in Wisconsin, but it’s not happening right now in Wisconsin. I think that gives South Dakota a bit of a safety valve. The other comment I’d make is the premiums that the farmers in South Dakota were getting five years ago were a lot lower than the premiums that the Wisconsin and the Michigan farmer were getting.
Anna: Yeah, absolutely.
T3: And so they didn’t have to fall as far to have the relative same impact. And I think what we’ve really seen more than anything else is we’ve seen an adjustment of the over-order premium in Wisconsin and Michigan to a lower value that maybe is a little bit more relevant to some of the surrounding milk sheds like South Dakota. But ultimately, I’ll also say this, the one thing that works against the South Dakota milk shed is that it is not near any major metropolitan area, the Twin Cities notwithstanding, when we’re talking about a major population area, we’re talking Chicago, we’re talking the East Coast, we’re talking Florida, Texas, the really big markets. And so you have to ship whatever product you make in South Dakota, you’ve got to ship a long way to get it to market. And as a result, the milk premiums in South Dakota will probably always need to be a little bit lower than what they may be in Wisconsin or what they may be even in Michigan and some of the other areas that are closer to the major metropolitan area. That’s probably not true today, but ultimately things are going to have to “equilibrate” for that to continue.
Ted: I think you need to get back to your basic equation. Competition for the milk increases prices to the dairyman, and in South Dakota, the I-29 corridor right now, you’ve got three or four handlers in that area, they are all large. They all basically compete for the milk, so the premium basically has been relatively stable, it’s gone down somewhat, but not that much, and you don’t have any of the influence of the huge surplus of milk coming out of the Midwest to the East of them going into Sioux Falls or into basically the I-29 corridor, so as a result, the premiums haven’t dropped as far as they have in Wisconsin, where all the surplus in Michigan keeps hitting in Wisconsin and the price keeps going down, down, down. The Michigan surplus has virtually eliminated the over-order premium in Wisconsin.
Anna: Yeah, what are things that the dairy farmer can look for that would signal changes ahead?
Ted: I would say that dairymen need to look at production numbers in February, March, and April. And if those production numbers drop in a significant way, in those months in key states, like Michigan, Wisconsin, the Upper Midwest particularly, or perhaps Texas, New Mexico also. If they drop, then you can, it’s likely if the economy stays strong that you’ll be looking at a turnaround in August and September, and the more they drop the bigger the turnaround.
Anna: Thank you both, we’ll be back with you all in February to give you an update on prices and market conditions. 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 & Company.
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