Markets remain sluggish. Anna, Ted and T3 discuss whether that’s partly due to a retrenchment in demand for dairy products. Ted and T3 believe milk checks are as low as they’re going to get, and it could be mid-summer before a spike in milk prices is anticipated.

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Episode transcript

Anna: Welcome to “The Milk Check,” a podcast from TC Jacoby & Co. where we share market insights and analysis with dairy farmers in mind. Today’s February 15th and we have Ted Jacoby and T3 with us to discuss current prices. Most producers will be receiving their January final checks in the coming days and they will see yet another drop in the Class III or blend prices on their checks. When we’ve talked about prices in our office, one of the topics that keeps coming up is lack of demand. We did touch on this in the last episode. But for anyone who missed that conversation, can you give us a bit of a recap of where demand is now and any new thoughts or information you have on the issue?

T3: It’s interesting, the other day, the “Daily Dairy Report” actually had an article about the disappearance of demand. And I thought that it painted the picture pretty well. It talked about how domestic demand has been surprisingly flat in 2017. But it also talked about how exports were up, I believe it was somewhere around 14%,15%. And I think that paints a pretty clear picture and it jives pretty closely with anecdotally what we’ve been seeing in the office. And unfortunately, I think what we’ve seen so far in the short time we’ve been in 2018 is a continuation of what we were seeing in ’17.

Exports are okay, to decent. No one’s hitting home runs but there’s exports getting done and domestic demand just continues to be lackluster. And this isn’t a phenomenon that’s just happening in the dairy industry. If you look at just about every CPG company in the Fortune 500, they’re all having the same problem. They’ve seen their sales flatten and in most cases, they’re actually down. Yesterday, I had a long conversation with someone who I think pretty highly of who made an argument that I think bears discussing.

He said that what we’re seeing, and I think in our office where we tend to really focus on the commodities side of the business, we’re seeing very clearly a flattening of demand. You’re not seeing growth in the commodity dairy products. And when I say commodity, I use that term loosely. I’m talking about everything from mozzarella cheese to cheddar cheese to, you know, yogurts that are sold on a mass level. And just about all of the high demand high volume dairy products, whether it’s through the retail channels or through the food service channels, that demand has been very, very flat, and even a bit negative in some cases.

Yogurt demand in the last 12 months are down about 5%. Processed cheese demand in the last 12 months are down about 4.5%. Fluid milk sales, we’ve been arguing for years has been on a steady decline. The commodity dairy products are down. We are seeing growth on the more specialty and unique side of the business. Fairlife is something that certainly has seen a huge increase in demand lately.

I think when you go over into the specialty cheese category, you’re seeing a lot of really good demand growth there too. And so, if you go into the places where there’s a lot of unique product mixes, you are seeing growth. The problem is that you’re comparing flat to decreasing demand in the high volume products that probably encompass 80% to 90% of the dairy industry. And where you’re seeing demand, it’s in the much smaller market segments that probably only use between 10% and 20% of the milk out there.

And I guess personally, unless we start getting some significant population growth in this country which I’m inclined to think is not going to happen, that demand for a lot of our commodity dairy products is probably going to continue to be relatively flat. And so, I think as an industry, what we really need to focus on is, how do we grow those market segments where you’re getting creative and you’re doing unique things? You know, whether it’s something like a Fairlife product or some of these specialty cheeses or other specialty dairy products. I think that’s where you could see growth.

And unfortunately, and we’ve talked about this before, and this is probably bears talking about here. You know, one of the things that prevent the dairy industry from being very creative is our federal order system. As much as our federal order system tries to create a fair marketplace for a dairy farmer’s milk, the flip side of it is it has a tendency to suppress creativity. Because if you don’t fit into one of the typical formulations, the risk level goes up and most people are afraid to go there. But that’s where the opportunities are.

Ted: Well, for once you and I are in agreement. And we don’t agree on everything very often, but we’ve been talking about all the factors of production. We in the industry have been talking about all the factors of production for the last six, eight months, for the last two or three years. And it hasn’t been until the last couple of months that we’ve been beginning to worry about demand. And in our last segment, demand was a big item, and it continues to be a big item.

And I would point out at this point in time that as we said before, that the dairy industry has a knack for anticipating overall changes in the economy. And since our last segment, you have to observe that the stock market, the Dow at least but also the Nasdaq and the S&P have all taken a huge hit. Now, I don’t think that there’s any major recession or depression on the horizon, but I think it’s simply an adjustment because it’s gone up too fast too soon.

But by the same token, it’s obvious that the financials, or that the economic situation is not quite as rosy and brisk as everybody was thinking here a month or two ago. So, I think the dairy industry is reflecting that. I agree with you that exports are carrying us right now. The Class I sales. We really need to do a better job of marketing the thrust of Class I sales and also with Fairlife has switched back from skim and fat-free and also on yogurt, I might add, and switched from fat-free to full-fat dairy products.

And I think that’s good and I think at this point in time some marketing would be very appropriate. I also would agree with you that the federal order system has outlived its usefulness but I don’t necessarily feel that the classified pricing system is not advantageous to the industry. The regulatory system requires us to ship certain quantities of milk depending on your order to what are called distributing plants or which in effect are bottling plants, in order to participate in the classified pricing system. Basically, you got two systems. You’ve got the regulatory system, you’ve got the classified pricing system.

Classified pricing system has the advantage of enabling you to build a plant for either cheese or butter powder. You don’t have to build both. So there’s a big advantage to not having it come up with the capital, particularly in today’s environment, to protect yourself. If you build one plant for butter powder and all of a sudden the cheese market takes off as it’s wont to do, suddenly your milk supply is gone, and they’re selling the butter powder, or the cheese rather. So I would point out that maybe the solution to the regulatory system is to find a solution that keeps the classified pricing system but revises the regulatory aspect of it.

T3: I’m going to shoot one hole in your defense of the classified pricing system. And that’s that when you’re talking about Class III and Class IV, you know, one of the problems with blending those two together to pay to the farmer is there is no incentive to make sure milk goes to where it’s going to earn the highest return. Because if you’re going to blend the Class III and the Class IV price together in any federal order, let’s just say, for example, the Class IV price is at $12, and the Class III price is at $15. I think any dairy farmer would prefer that all the milk possible would go to Class III so that that blend price to the dairy farmer ultimately gets paid on is as high as possible. But the plant itself has no incentive to move the milk away from a Class IV plant at $12 to a Class III plant at $15.

Anna: Well, I think the primary goal for producers that we want to achieve is to talk about where prices are going to go in the coming months. So, using the forecasts I look at most often, it seems like we can continue to expect prices to stay low and not really pick up until about July. Does that sound about right? I know you’ve mentioned some optimistic signs coming up, but I think we should probably do bad news first and wrap up on good. What do you guys see coming?

Ted: I feel that our prognosis is pretty much unchanged. Again, I would point to the stock market. That the stock market is, in my view, corrected. And I think from here on, we’re going to see the economy remain reasonably exuberant. And I think in the second half of the year that we will see our sales and demand recover. The question is, how much? I also think that the low prices right now are going to take a toll on supply and that will probably be manifested itself between now and August and September.

T3: The way I look at the market is this. I think if you go all the way back to January of 2015, you’ve seen both Class III and Class IV prices bounce essentially between $13, 100 weight and $17, 100 weight. Right now, both are right around that $13.50 to $14, 100 weight range. So we’re clearly at the low end of the range. I think January came in at $14 even for Class III. I think February is going to come in something very close to $13.50 for Class III. And I think between now and June, I would expect Class III to probably be bouncing around between about $13.50 and $14.50.

Anna: That’s what I am too.

T3: And I’m inclined to believe we’re going to spend a little bit more time closer to $13.50 than $14.50 for most of that time. But there are some optimistic possibilities on the horizon is, I think, the way I’d put it. The first is the weather in New Zealand right now is awful, their milk production is down and they’re struggling. Combine that with the weak dollar and I think there’s a very real chance that we could see some good exports in the coming months. A couple of our traders are right now heading to Gulfood which is a big trade show in the Middle East where a lot of times decent export sales get done.

I’m actually really looking forward to hear their feedback when they get back because I think we’re going to find out within the next week or two how the international market looks for U.S dairy products. The flip side of all of that though is Europe. Europe is producing a ton of milk and I think the question becomes, who gets the export sales? Is the U.S. getting the export sales or is Europe getting the export sales? I don’t have the answer to that yet. The math says, with all of the milk Europe’s producing that Europe would get it. The feedback I’m getting right now is that Europe is getting some and we’re getting some. So that’s kind of optimistic.

That means maybe we’re holding up better than I expected us to hold up because if we would have had this conversation two months ago, I would’ve said Europe’s going to get it all. Their milk is up 6%, they’re the largest milk shed in the world by… They’re almost twice what we are. And so, when they have too much milk, the whole world is going to have a problem. The fact that in that time the dollar is weakened, it’s allowed us to continue to be pretty competitive in the international market. It’s given us the opportunity to maybe make some export sales that we wouldn’t have been able to make. At the same time, I think some European manufacturers have been reluctant to lower their prices and get really competitive.

And I think that’s optimistic. Now, it doesn’t mean that milk disappears. And so, that milk is still coming, that milk in Europe is still going to be a problem, it just hasn’t arrived yet. And when it does, I think European producers’ going to have a problem. On the supply side, I do think we’re low enough that we’re going to see some attrition in milk production. I think we are going to ultimately see negative milk production in the U.S. And I think, given enough time and that maybe 2019 in Europe, we’re going to see attrition in milk production in Europe as well unless on a global level, we’ve got some pretty big upticks in demand. And it remains to be seen if we’re going to get that. The news out of China seems to be pretty good but is it really enough to deal with a significant oversupply in milk from the two largest milk sheds in the world, the U.S. and Europe.

And that seems to me to be a pretty heavy lift and so I’m inclined to doubt it. And so, I’m inclined to say that what happens is we tend to stay down here around $13, $15, $14 / hundredweight through the flush. And then as we climb out of it, we climb out a lot more slowly than people think. And my gut tells me, and this is one of those where you’re really throwing something out there and I could be way off. But my gut tells me that as we get into the summer and into the fall, we’re going to see a bigger increases on the Class III side of the equation than the Class IV side of the equation. I think the powder side of the business, non-fat dry milk is burdened with too much supply, not just on the milk production level but also on the amount of powder and inventory level both here and in Europe.

And I think that that’s going to really limit that market’s ability to increase at all. On the butterfat side of the equation, I think we have probably peaked on a multi-year level in butter when we peaked last year, or when we peaked at $3 a couple years ago. But we haven’t quite gotten to the point where we’ve seen the butter market really fall apart. I don’t think it’s going to happen this year either. But I do think the butter market as it moves into the next couple of years is going to struggle to get much higher than it’s been lately.

And the only reason the Class IV price has even been halfway decent and believe me I’m not calling $13 / hundredweight decent at all. But given where the nonfat price is which is in the 70 cent range, if we go under $2 for a butter price, we’ve got some really big problems. And unfortunately, I’m a lot more worried about that butter price falling below $2 than I am optimistic that the butter price could go above $2.50 or $2.75 and stay there for a while. I don’t even think this year we can go as high as we went last year because last year things were driven by a shortage of butter in Europe.

And given Europe’s butter milk production this year at 6% at the moment, they’re not going to have the butter supply problem they had last year. Given that I think butter is going to struggle to get much higher than it is, and so I tend to believe that butter is going to be right around $2 for most of the year. We’ll have a couple of bumps up into maybe the $2.30s.

But the real big thing you got to watch for is butter dropping below two bucks because that’s a sign that things could continue to get worse. On the cheese side, I do think that we’re going to stay, you know, blocks and barrels are trading, you know, barrels between $1.30 and let’s say, $1.45. Blocks between $1.45 and $1.60. I think we’ll stay in those ranges for both of those through the flush and then I think we could climb into the $1.70s, maybe even $1.80s as we get later in the year. But that’s still quite a few months away, and so it remains to be seen.

Ted: I tend to disagree a little bit on the butter side of it. If [inaudible] charge the inventories right now or at least domestic are just about where they’ve been historically. And we are looking at a move away from low fat towards full-fat products.

T3: Where you and I disagree on that, is I believe we are towards the end of that move. I think that’s a five-year move and we’re in year five. And so, I don’t disagree that butter demand has been up significantly lately, I just believe that that demand increase is starting to plateau.

Ted: Well, I think we’ve gone through a period of correction here where the price of butter has gone from about $2.70 down to close to 2 bucks. Which represents a pretty good correction. So right now, and I think for the next several months actually, it’s probably going to be hovering around the $2-level maybe even a little below. That will mean low Class IV pricing for several months. And, of course, that will reflect back on our dairy men. But I also think that when we get to the second half of full-fat products including fluid milk, or probably in butter particularly and cheese, I think we could be surprised how quickly it turns around.

T3: What do you think is going to be the factor that would cause it to turn around quickly?

Ted: I think the economic situation, the overall economic situation right now is not as strong as we thought it was. But I believe that it will be much stronger later this year. Now, particularly now that we’ve already undergone a correction.

T3: I’ll go ahead and debate you on that. And my point of view is this. I think the economy could be a lot better and I actually do plan on it being a lot better. But I believe that the economic conditions that we’re dealing with right now are a lot more similar to what we were dealing with in the mid ’80s than what we’ve been dealing with more recently. And what I mean by that is this. I don’t think during the course of 2018, we’re going to get any huge increases in population. And so, we’re not going to increase dairy demand by having more people. We’re going to have to increase dairy demand by increasing per capita consumption of dairy products.

But I’m inclined to believe that if per capita income in the U.S. is higher in the second half of the year or as this year moves forward. That the population is going to be more likely to spend that surplus income on things like iPhones and technology than they are going to spend that income on buying more cheese or drinking more milk. And so, I’m worried that the dairy industry isn’t necessarily going to participate in our economic boom if that’s what we’re going to have. Because people aren’t going to be buying more dairy products as a result of it.

Ted: I think we’re going to see some erosion in supply and it’s not going to take a hell of a lot of an erosion to make a nudge up in demand the second half of the year having an impact.

T3: I think the question in my mind will be, when does that erosion in supply happen? Because I do agree with you that where prices are today, we’re going to end up with an erosion in supply. But my experience is that it always takes longer than you think.

Ted: Well, what could be longer? Today is February and you’re looking at the rest of February, March, April, May, and June, and probably July. And you’re going to have very low Class IV pricing during that period. And cheese is probably going to be unenthusiastic during that period too. That’s five or six months of low prices. So how long do you want in order to knock out some supply? My argument is that yeah, we’re going to see some erosion in supply and the way the economic picture is setting up you’re probably looking at a relatively strong economy going into the fourth quarter.

T3: The reason I think it’s going to take longer than we expect is even though we have a lot of conversations with dairy farmers who are hearing that their neighbor is going out of business, we’re also still having conversations with dairy farmers who are trying to build more farms. You haven’t quite gotten to the point where people are just finally ready to say, “There’s no way I’m building another farm in this environment.” You still have too many people who are thinking, “Hey, prices are low right now.

The price of cows, the price of heifers are low, this is a great time to build a dairy farm because this is when you can get things for cheap.” And unfortunately, as much as I tend to like that way of thinking as a business person, it’s probably not going to solve the problem. It’s probably going to make the problem worse. Or at least, it’s going to take too long for everything to play out.

Ted: Well, I do agree with you that it’s the small dairymen that’s going to step aside, okay? That’s just the way of things, I believe. It’s unfortunate but that’s the way it is. And I also agree with you that there are large dairymen in the wings who want to build a dairy and they want to sell milk. But I also know that right now, if he came on today, nobody would take him. So it’s going to take a while for the large dairymen to have an impact. And then I think you’re probably looking at 2019, 2020 in order for the large dairymen to start coming online and really start pouring out more milk. So my thinking is not quite that long, my thinking is that the cycle that we’re going through points in my mind towards more enthusiastic markets during the third and fourth quarter of this year.

T3: I will say this. One thing that I do think we’re going to have in 2018 is volatility. We’ve already started having it in the stock market. I believe that that volatility will bleed over into our commodity markets too, including our dairy markets. And the good thing about that kind of volatility from my perspective is, you know, $13 milk, $13.50 milk, $14 milk, those are the numbers that don’t work. But if that’s the bottom end of a volatile range and we’re somehow bouncing around between $13 and $15 or $16 over the course of this year, that means we’re going to average something closer to $15. And that’s going to be a lot more healthy for the dairy farmer than something closer to $13.

And I do think that one of the things that could save us this year is we’re going to get a lot of that volatility. And we’re going to see for example, cheese prices which are, you know, have been in the $1.40s as of late, and the $1.30s as of late, I wouldn’t be surprised if we see them go to $1.70 and back 2 or 3 times between now and September. As these markets just try to figure out where they need to be in an environment that becomes increasingly uncertain. Because I think the economy as a whole is going to be also sending a lot of mixed signals, even though I do agree that it’s going to continue to be strong. I think you’re going to see things tend to come in chunks.

That consumer enthusiasm, if you will, or their buying power. They’re going to be eager to buy. And then the stock market may pull back again and then they’re going to be less eager to buy. And I think you’re going to see that dairy prices may follow suit a little bit.

Ted: Well, I can’t argue that the cheese market won’t move but I don’t think it will when it has no reason to unless you’re going to have a problem getting fresh cheese. You know, in a flush environment, I can’t imagine that anyone’s going to have a problem getting fresh cheese which would cause the market to go up. What I would see causing the market to go up and moving up would be exports. But that’s going to require a little better position price-wise versus the European market that we’ve got right now. So, you know, the market today for example, crept up a couple of pennies up into the low $1.50s.

T3: The good news, by the way, is the last couple of weeks, the European markets have actually been up quite a bit. And so, I think actually what we’ve been seeing just recently in our U.S. markets has actually been because the European market started gapping away from us. And so, we’re actually going into this Gulfood show next week where the U.S. market has the better pricing. And that’s why I’m pretty curious to see what comes out of that.

Ted: Then exports may cause the pricing to stay up. But if the pricing stays up, that would be a problem with regard to supply. In that, you would have people hanging on rather than throwing in the towel.

T3: And I agree. You basically kick the can down the road.

Ted: And that’s a problem, all it does is kick the can down the road. That’s a good way to put it. That’s where we are right now, we’re at low prices, and nobody’s making money at $12, $13 milk. And that’s where it is at the moment.

T3: You know, the one place where I am optimistic is this. I do think that prices have already gotten as low as they’re likely to go and so $13.50 Class III in February, I don’t think we’re going much lower than that. And so, the first step to a recovery is usually to find the bottom, and I do believe we’ve found the bottom. Step two is, we have to stay at the bottom long enough to have that change in supply we need to tighten things up which is what would cause prices to go higher. I think that’s the big question. How long will it take either from demand getting better or supply contracting? How long will it take for us to get to the point where things tighten up?

And I think if you and I disagree, it’s when that moment is is when we disagree. The second thing on the optimistic side I’ll say is this. And I don’t know if this is necessarily optimistic to a dairy farmer but it would be in terms of higher prices. I’m not a meteorologist but I think most people would agree, our winter has been odd. In St Louis, it’s been very cold, much colder than usual but we’ve had almost no precipitation. I am inclined to believe that we may also have an odd spring, and maybe even an odd summer. It just doesn’t quite feel right. If that’s the case, and feed prices increase especially if they increase significantly, you may force dairy farmers out of business sooner rather than later.

Ted: Or they elect to sell feed.

T3: Exactly. Well, and it’s still the same thing.

Ted: Right.

T3: So if that happens, everything may accelerate and then we get to a good place sooner. So my, the optimistic part that I’m saying is, we’ve probably as low as we’re going to go. It’s a question of, how long do we stay down here before we go up? And the more likely something that increases the financial pressure on a farmer happens, the more likely we’re able to get to the other side of the cloud. And so, that’s where I am optimistic.

Anna: Looks like that’s a good stepping point for today. Thank you both as always, and we’ll be back again in mid-March with hopefully some better news. We welcome your participation in “The Milk Check.” If you have comments to share or questions you want answered, send an e-mail to podcast@jacoby.com. Our theme music is composed and performed by Phil Keaggy. “The Milk Check” is a production of TC Jacoby & Co.

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