We welcome our Jacoby trading team back to discuss the rapid increase in milk production so far in 2021, compared to 2020 in which the national herd decreased by 30,000 cows. 

Don Street, our director of global strategy, explores production issues like the hefty 3% increase in cheese as compared to last year, driven by American and cheddar. 

Jacob Menge, future and options trader, leads a discussion about what inflation could mean for dairy as foreshadowed by the increasing cost of many commodities, from lumber to diapers. 

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T3: Welcome, everybody to our monthly mass balanced discussion. Today, we’ve got my father, Ted Jacoby. We’ve got Joe Maxtor, who’s our butter trader. We’ve got Don Street who tends to lead the mass balance discussion and heads our powder group. We’ve got Diego Carvallo, also from our powder group. We’ve got Gus Jacoby, who heads our milk and fluid team. We’ve got Greg Scheer from our milk team. We’ve got Jacob Menge, who’s gonna lead the charting discussion who also heads up our risk management group.

We’ve got Anna Donze who handles pooling for the milk group. Welcome, everybody. Don, why don’t you take it away?

Don: I think we have a real roller coaster that’s getting ready to happen, certainly on milk production. And I’ll just get right into this, we’ve seen a very tight protein market in the last 10 days. Cheese has been a bit more sideways but price-wise hanging in there. When you just kind of look where we’ve been for Q1 we had 2% more milk, and we were running 90-some-thousand cows more than a year ago. The roller coaster starts because in Q2 of last year, the cowherd shrunk by over 30,000 head. When you look at when we start in April, instead of being 90,000 head higher than a year ago, April is going to be 110,000, let’s say, it’s going to be a significant jump up. That number only grows to when we get to June, we could be 150,000 cows ahead of one year ago.

T3: Don, has that jumped because we shrunk the herd at this time last year because of the pandemic? Are we expecting the herd to grow over the next three to four months, or is it a combination of two?

Don: I think mostly the drop of Q2 last year when the pandemic really began because we had from 5,000, 13,000, 9,000 cows every month. Take that times 12, you have 8,000 on average, you get 96,000 more cows every year. So most of this is simply the drop that took place a year ago. Plus, milk per cow a year ago was also pulled back as more co-ops instituted base programs. So my milk gross projection for Q2, it’s a really solid 3% out, which is 50% more than the growth we had in Q1. To me, that’s the biggest change that’s coming down the dairy road in this Q2.

T3: Is it fair to say, Don, that the number is going to be twice as big in Q2 and Q1, but the real trend from Q1 to Q2 isn’t more increased milk, it really reflects what happened last year because the pandemic hit and we shrunk the milk supply?

Don: That is correct. If I look month-on-month, you’re clearly going to have more cows. Productivity growth seems to be pretty reasonable. Ignoring the seasonal trend on milk, Q2’s gonna be just a really quarter for milk. Try to think about this in terms of what we do with the milk that’s produced. In Class I, bottled milk, same old story, for the two months that we’ve reported in 2021, were down about 2.5% over the prior year. Last two has been really strong with the exception of cottage cheese, sour cream, ice cream, yogurt has just been on a tear production-wise, 8% to 10% up, which even on a small class of milk is significant.

Total cheese production was negative in January. February was really up strong. And when you look at the two months together, we’re up about 3.5% over January, February of ’20. It’s a big change and it’s all driven by American and cheddar cheese. Q2 of 2020 was up 2.1% on total cheese while Q1 was flat. So I think the growth in cheese will pull back a little bit but will still be up a really solid 3% in Q2.

On Class IV, butter up pretty strongly 5% for the 2 months. Nonfat and skim up almost 11%. And just hold that number in your head because I’m going to try to turn that upside down in a little bit. At this point, I think nonfat and skim can be up 4% to 5% in Q2, which would be similar for butter. So where does this lead us as a summary? Milk production will be up strongly in Q2 over Q1. Cheese production will clearly be up because of the new plant in Michigan. And we believe for a better food service demand that we’ll finally see some increases in mozzarella cheese on a prior year basis. Fluid milk just in the tank, I don’t see any recovery on that at all. And just note that Q2 of last year on fluid milk was only up 1%. So it’s not like it was up 4% or 5% and we’ll have a big drawback. It was modestly up 1% and it’ll likely be negative compared to that this year in Q2.

With higher cheese/lower milk in Q1, one lower meaning 2%. We’ve seen this rally in protein prices, part of that is the pull of higher international prices than what we had in the U.S. But it’s also a question of, has there been less nonfat production and skim milk powder production than we thought? Butter, to my way of thinking, seems to be adequately supplied, except for the disruptions in the free market caused by the new cheese plant in Michigan.

I asked you to remember that we had nonfat and skim up 11% year-to-date for months, and butter up 5.4%. But if I just plug in what we have measured for January, February, last one down 2%, last two up 6%, last three up 3.5%. And we had a milk production increase of 2% for the quarter means that we should have expected lower Class IV production, which obviously was not the case because we know butter’s up, we know nonfat skim combined are up. And I don’t believe March will be negative year-on-year for either of those product groups. But it’s just a reflection in a very broad sense of why the protein market, in particular, is tighter. Reflecting Q2, I have fluid milk down 1%, Class II up 2.5%, so a bit more modest, but by any measure, a solid performance for that product category, and cheese up 2%. And again, against a 3% expected increase in milk production now that a negative Class IV products seen up almost 7% in Q2.

Does this mean we’re overly enthusiastic on our price rise and protein prices that we get a bit of pullback as this quarter plays itself through? Or is international pricing simply too strong a force that will keep our prices higher in any event? I’m going to suggest at least that we will see a correction on the U.S. market in Q2 before we get into what I think is the period of real strength, which is the second half of the year. That’s my projection.

T3: How do we think increases in milk solids manifests itself in this?

Don: Generally speaking, you’re picking up at least a half a percent more solids genetically every year and that will vary a bit between fat and protein, but it is the equivalent of more milk. It’s rare to see those solid components decrease on a year-on-year basis. They certainly have a seasonal trend to them, but the long-term trend is higher every year.

T3: A half a percent is a lot different than a 5% difference between Class IV utilization and how much nonfat seems to be being produced.

Don: Correct. Sort of the fallacy of flying at 50,000 feet when cows walk on the ground. So there’s no way that regardless of how March production gets reported would turn negative on Class IV utilization for Q1. But it’s a big flag seen sticking out there that supports, you know, why we saw the powder market run 15 cents up.

T3: I’m having trouble getting past the idea that nonfat and skim milk production is up 11% and yet Class IV utilization is supposedly negative.

Don: Part of it would be what’s up and what’s not up, mozzarella being flat to even down a little bit. It always kicks off cream but now it’s enough for protein solids as well.

So, Ted, even if you say that there was a small increase in Class IV, whether it’s fill-over reporting as you go from month to month, milk comes into the plant, it’s processed tomorrow, which is in the next month, to me still the biggest thing that I’m trying to project here is in Q2, we’re going to have even more milk flowing to a Class IV status.

T3: One of the things that I think is going to be hard to predict, you know, we’re talking about measuring milk production year-over-year. We know milk production went negative in Q2 of last year because of the pandemic. Intuitively, we also know that mozzarella production, in particular, went negative significantly in Q2 because we know there were a lot of mozzarella plants that had to really push back their milk supply, which contributed to the decrease in milk production. We’re up 3.5% in the first quarter. We will probably need to be up 5% or 6% minimum in the second quarter in Class III. But it’s for the same reason, we’re measuring against weakness.

Don: So Q1 of 2020 on cheese was right at zero change and Q2 was up 2.1%. That would argue that Q2 changes in 2021 will be a bit more tempered, except for the fact that you have an 8-million-pound-a-day plant that is presumably now nearing full capacity.

T3: Anybody else have any thoughts?

Don: Three percent more milk in Q2. That’s my story, and I’m sticking to it.

T2: I’m gonna take the under on that, Don.

Don: All right. All right, Ted. You’re on. I like your attitude here.

T3: Gus, what do you think?

Gus: I think we might underestimate what the West is doing from a Class IV production standpoint. I would also guess that there probably is some unreported things that some of this Class IV production is going into as well. But still, I struggled trying to figure out where the gap is, what is being considered production, and what is actually being utilized on the spreadsheet in Class IV.

T3: Meaning you think maybe we’re not actually producing as much nonfat as the dairy products report?

Gus: That’s possible. To me, it seems like milk has been long enough over the last few months. And I’m talking about all over, not just areas like the MidEast that we really tend to focus on. And that there is a fair amount of Class IV production going on, and there’s a need to balance a lot because not just your typical balancing marketplace, but as the economy opens up here, doesn’t open up here, closes back up, those types of things, that milk is in and out of Class IV a lot more than we might think. And we’re not as sensitive to it, perhaps, the normal because of the exportability, you know, we’ve got so much going out of the country right now, we’re a lot higher than we have in a while.

My point being is that those numbers may not completely align. But it doesn’t surprise me that we’re making a whole bunch. And I would expect that we will continue to make a whole bunch of Class IV for the next couple months as we get through the flush and as the economy fully opens up toward the end of Q2. At some point, going to be an issue and it makes me wonder if we’re going to hit probably in June, I would think, where demand exceeds supply on pretty much every level.

T2: Let me ask Greg a question. You’ve got $7 corn, but how are you gonna feed your cows?

Greg: I do think there’s a lag effect. Some of these producers have feed coverage locked in. And some of them aren’t going to cut back yet because they see higher milk prices. But it is going to affect your ration. It is gonna affect how many cows you’re milking and moving forward. But I don’t know that you’d see the $7 corn and all of a sudden cut back right away. I think it’s, kind of, a gradual thing for most producers. And as they work through the feed that they already have coverage on.

T2: Right, so you’re looking at maybe the $7 corn being a factor in the third and fourth quarter?

Greg: Yeah, I think so. I think as you hit that, it will be a much bigger factor, currently.

T2: You know, you’re already shipping less a smidgen milk to the Southeast. Obviously, not necessarily for Class I, more for political reasons. But the simple fact that you’re shipping it.

Greg: That seems to be the one spot, you know, where you can ship milk. Every other area is very full so that’s about the one spot. And then we’ll probably really be the one in need this fall when we get there.

T2: So Don, I’m still taking the under.

Don: Okay. Well, Ted, I appreciate the challenge, and we’ll settle this up in July.

T3: All right, Jake. Let’s talk about what the technical aspects of our markets are telling us to expect going forward from here.

Jake: You bet we’ll dive into that. We’re gonna start in the obvious place first, though, and that is talking about diapers. Actually, a quick follow-up on our last podcast where we, kind of, dove into inflation. And I, kind of, posited that maybe we were seeing inflation right now today, or rather inflation’s happening right now today, but we’re not necessarily seeing it. Well, we’re seeing it. I think a very, very good example is diapers.

Kimberly Clark and Procter and Gamble both came out two days ago, and said they’re going to increase the price of diapers about 10%. That’s a perfect example of something that factors into the CPI, which is what we had discussed last time, that is going to be something that will be reflected and is no doubt inflationary. And a 10% jump on something like diapers is just huge and that’s never going back, that’s inflationary. They are not selling diapers like crazy or anything like that. This is truly due to logistics and material issues.

T3: Just to add to your inflation comment, just in the last couple of weeks, I’ve had four separate conversations with dairy plants that have talked about significant increases in hourly wages. Raising their starting wage, $1, $2 an hour just because that’s how badly they are in need of people and they’re at the point where they have no choice but to increase wages to fill their plant. And that ultimately becomes very inflationary. And wage inflation is really, I think, one of the biggest CPI drivers.

Jake: Yeah, absolutely. I mean, you mentioned the CPI, it’s still very muted. I mean, it’s at, like, 2.6%, I think, which has been a level we’ve hovered around since 2013, maybe 2012. But I don’t have it up in front of me. But you still aren’t seeing that crazy jump in the CPI that everyone’s screaming inflation, inflation, myself included, would really, kind of, expect to see. But things like diapers, lumber, which we’ll touch on a little bit, it’s really hinting that the CPI jump is around.

T3: Jumping the CPI, they measure the CPI at the supermarket level at that sales level. So when the price of cheese goes up, if supermarkets are not passing along that increased cheese price to the consumer, you’re not going to see an increase in the CPI. And it usually takes a sustained price increase at the CME level to cause supermarkets to increase their cheese price. And so it doesn’t surprise me that we could go 6, 8, 10 months with some pretty high cheese prices without seeing increases in price at the supermarket level. But ultimately, we’re at $1.90, $2.00 or higher, and we’re there for 12 to 18 months, that’s when we start seeing food prices, at least in terms of dairy, really start to affect the CPI. And I should add, dairy as a percentage of total food purchases is big enough that if we do see Class III prices high for 18 months, it will have a material effect on the CPI.

Jake: All good points. One other thing in the news this past week that I think is actually kind of important to note for our dairy markets is all the rumors flying around about tax increases. And specifically, I’m going to touch on the capital gains tax increase, the rumored capital gains taxes are going to double from 23%, 24% to 38%, 40%, 43%, I think I saw. And it caused the market selloff on either Wednesday or Thursday last week. And I think the market was very reactionary on it. It’s nothing that’s going to impact us tomorrow. But as we know, markets are anticipatory. And I think if this capital gains tax increase comes to fruition, I think, it’s gonna have really interesting implications on dairy markets.

So our dairy markets trade a lot on what are called section 1256 contracts. And they have a special tax treatment where 60% of capital gains are treated as long-term gain. You could enter a trade today and sell it tomorrow. And normally that would be a short-term gain, which has a higher tax rate. But these section 1256 contracts, 60%, no matter what, is treated as long-term capital gains tax. If we start getting into this high capital gains tax environment, you might see money move to these section 1256 contracts, which dairy is a part of. Just again, kind of a side note, but all things to keep in the back of our mind here as we were talking inflation driving prices higher, things like tax increases might driver our prices higher.

Now the final thing before we really touch on dairy itself is just going to be the dollar index. We’ve had a really interesting reversal on the dollar index over the course of April. We hit this 90 level at the end of March and now we’re falling insistently almost every day in April back down to that 90 to 90-and-a-half level on the index. I don’t have as good of an explanation for that. The coronavirus situation in the U.S. still is outperforming, if you will, Europe and the rest of the world, especially if you look at places like India. India has had a really, really bad last week here. I’m interested why the market is, kind of, off the dollar at this point. I think one explanation could be that the market thinks inflation will be worse in the U.S. than other places in the world. I’m not sure that I’m buying that if that’s the reason the dollar has sold off. I would disagree with the market.

Now, I am not a currency trader, any currency trader listening, you’d be laughing right now. I’m sure there’s an obvious explanation. But I’m surprised to say the least to see the dollar being as weak as it has been over the past month. Now, if you’re a product trader, somebody trying to get exports done, it’s been a welcome sight, this weakness. I really don’t have a great guess where we go from here. If I had to pick a direction, I would say the dollar is going to strengthen again, but we’ll see.

Let’s go ahead and move over to Class III, just talk about milk for a moment. We’ve had a really interesting milk trade, then cheese trade for the past two to three weeks, or maybe even a month. We can’t talk about Class III right now without also talking about corn. So back on March 31st, Class III was at $17.60. And we had a limit update, when basically nothing happened in our cheese stock market or any other stock market for that matter. If you’re just looking at our Class III market, you’d be left scratching your head. And it all comes down to corn. Corn had a limit update on March 31. And if that doesn’t show the correlation that is in our Class III ag markets right now, I don’t know what would. There is a tight correlation, I think.

So ever since late March, early April, corn has basically been on a tear. We went from $5.22, and today, we’re at, I think, $6.80 in the front month. But yeah, ag is just nonstop for the past month. And we’ve had some breathers, I’ll call them, in Class III where maybe we didn’t go up quite as nonstop like corn did, but we are still pretty strong here in the mid-$19s. And I think a lot of cheese traders out there is, kind of, scratching their heads saying, “We’ve got a product out there, demand is okay. But that foodservice pipeline is probably filled. So there isn’t the foodservice demand that we had been seeing filled. So what the heck are we doing up here?” I think all signs point to outside both in the form of managed money, kind of, playing around in our markets as well as just ag in the background, s, so strong, kind of, pulling the markets that are related to ag but not necessarily ag itself pulling those higher as well.

Let’s look at our Class III carry. We’re going to look at a theory from May to September and we are dead flat. It’s showing that it’s at a 6-cent carry from May to September. That is the lowest it’s been besides 2014. 2014, it converted quite a bit. But this thing sticks out like a sore thumb. We’ve got every other year from 2008 until today had a better carry besides 2014, as I said, with almost all the years winding up somewhere between a 30-cent carry to a $1.80 carry, somewhere in that range. Almost every year is in that range. So really, kind of, a notable flatness, the curve in Class III right now.

Diego: Well, basically, do you think the market is telling us that we’re going to be pretty well supplied the rest of the year more in line with bonds like an oversupplied market?

Greg: To be honest, I think the market’s kind of tossing sand here and saying, I don’t really know what’s coming.

T3: I would argue, Diego, that what the markets telling us with cheese is that we added a significant amount of cheese production capacity with the Michigan cheese plant and that we’re gonna have more than enough supply as a result going forward from this moment in that unlike a usual year where your maximum cheese production happens in the second quarter, and then you’ve got to work down your inventories, I think the markets hinting that this year, we’re going to have more than enough cheese production and we’re not going to need to chase the market higher.

But because we’re coming off the pandemic here, I agree with Jake, I think there’s uncertainty at the market at the same time as if on one hand, logically, your mind wants to say we got more than enough cheese, these prices don’t need to be at that high. And on the other hand, they’re saying, I have no idea what’s going to happen. We’re still coming out of this pandemic and there’s a lot of variability.

Gus: Let’s talk about the Class IV curve, just like we were talking about the Class III curve because that thing has gotten really flat as well. A month ago, our Class IV carry was about 10 cents from $1.19 to $1.28. And now today, it’s from $1.32 to $1.36. So we’ve gone from about a 10-cent carry to a 4-cent carry, that has gotten flat. I think it’s probably for many of the same reasons that we’ve been seeing on the Class III side. So the non-fat option today to the fourth month out. So basically, how much higher price fourth month future versus the non-auction price. And even though nonfat futures carry has really flattened out, the nonfat auction versus the futures carry really has hung in there. We’re at 5 cents, call it, today. And we’ve been more or less between 3 to 5 cents over the past two months now. So kind of a really interesting market where the futures curve has gone almost flat but the auction futures carry has hung in there, really not very volatile at all.

I guess the last thing I’ll bring up is that we were talking about corn in Class III earlier as, kind of, having this relationship. And really commodities as a whole have moved strongly higher with few exceptions. You know, gold kind of been a laggard, but just in general, commodities are booming for the most part. Lumber sticks out because it is just a different animal. We’ve got what looks like a blow-off top forming. But we’re at $300. I think this is quoted as per 10,000 feet. But back in April of last year, we were at $300 on the lumber futures. And today we are at almost $1,300 with $400 of that coming in the past month. So April started pricing at around $827, and yesterday, we’re at $1,284. So we feel like we’re special in the dairy world, but everyone’s having their own fun.

T3: I think it’s been a great discussion. Don, Jake, thank you very much. Thanks, everybody, for participating. Really appreciate it. Until next time.