The last few weeks have been some of the strangest for an industry in the midst of its weirdest year in memory.
Listen as Ted, T3 and Anna get to the bottom of why spot cheddar prices maintain a steady hold on improbably high prices and why the Federal Order system appears to be doing the opposite of what it was meant for.
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T3: So here’s where we’re at. It’s July 8. Today, cheddar blocks on the CME spot market are trading at $2.7375 a pound, barrels are trading at $2.40 a pound, nonfat is trading at a dollar three and a quarter, butter is trading at $1.68 and three quarters. You have over a $10 difference between where July, Class III milk will probably come in and where July, Class IV milk will probably come in, which is really about as big a disparity as I’ve ever seen in my 25 years of trading cheese and powder in the United States. It’s amazing. Talking a little bit about the markets and what we expect going forward, starting with cheese, there has been for the month of June a genuine tightness in cheese specifically in cheddar blocks and cheddar barrels. We talked about this in the last podcast, you have a unique situation where retail sales continue to be much stronger than normal because of the pandemic. At the same time, the anticipation of the world opening back up, restaurants opening back up was causing food service distributors to order in large quantities to refill their pipelines, and you had the USDA’s purchasing program and Food Box Program on top of all of that. And that created kind of a perfect storm of all the usual demand for cheeses across the whole Food Industry, whether it’s restaurant-based, whether it’s supermarket-based or whether it’s government-based were all ordering it levels much higher than they normally do, which caused the shortage on cheddar and drove the market up to, you know, prices at $2.50 or higher.
You know, the question everybody’s been asking already for a month is how sustainable are we up here? And the answer that I think I would give everybody is we are not going to be at $2.50 for the rest of the year, but we’ve been at $2.50 for over a month now and it is not out of the realm of possibility that we stay here for another two to four weeks. Furthermore, if we do drop off these lofty levels, I’m not sure we’re dropping, let’s say to $1.50 or to $1.75. There is enough underlying demand, that that probably that first place where you drop to is still probably above $2 a pound. And the reason I say that is all of the converters out there, those who buy the cheese and shredded or chunk it or slice it and put it into the packages for retail or restaurant demand, they’re telling us that their inventories of cheddar block and cheddar barrel, if you’re a processed cheese manufacturer, are on the low end of where they like them to be at this time of the year. Keep in mind that usually right around the end of June beginning of July is when cheese inventories peak. And then as we get through the second half of the year and demand picks up for the holidays, and milk production decreases because of the heat of the summer, you start seeing cheese inventories dropped back down. Well, at least by the tone that I’m hearing from a lot of our customers, you’re actually at a place where people are very uncomfortable with how much cheese they have in inventory. And they’re inclined to say “We don’t have enough and we’re concerned about having enough cheese for the remainder of the year.”
Now, the flip side of that is they will also say in the same conversation, “We have absolutely no idea what to expect when it comes to demand.” We would expect that it’s possible the food service distributors have over-ordered in terms of the restaurants opening back up, because everything we’re hearing about restaurants is they’re running it, let’s say 50% of capacity. On the flip side, QSR, which is your McDonald’s of the world, your Panera bread’s, your Chick-fil-A’s, etc., that those restaurants are running probably at levels similar to where they did it this time last year, at pre-pandemic levels, let’s say. Meanwhile, the data we’re seeing out of the retail side of the business is that while we are still running ahead of last year on a week-to-week basis in terms of demand, that number is dropping. What was 20% a month, a month and a half ago, dropped to 10% and is now dropping to about 5%. So you’re seeing let’s call it a normalization of the curve in terms of demand and pull through sales at the supermarket level.
Ted: Let me interrupt a minute. We’ve talked about the demand side of the ledger, which is not something we normally talk about too much. But isn’t the key to the situation, the other side this time? I mean, what is milk production doing? I mean, the bottom fell out of it in, was it April and May? It was down big numbers. If milk comes back, where’s it gonna go? It looks to me like if milk comes back, given the current market situation, the milk is gonna go into cheese. Regardless of whether or not you pool or what the margins are, and so on cheeses where it is. So pooling is irrelevant as far as your option of which direction you’re gonna go. You’re gonna head towards cheese with whatever additional milk comes to the table.
T3: I’m gonna completely disagree with you and here’s why. This is what we are hearing right now, this week, the week right after the Fourth of July. The cheese plants, especially the big cheese plants do not want the milk. They do not want the milk for three reasons. First, Class III milk is gonna price itself in July at almost $25 a hundredweight, close to all-time highs. Two, unless they have a guaranteed sale for that cheese, they are not interested in paying that much for milk in speculating that the price is gonna stay up here. The third and I think probably the most important component of all of this is that whey protein sales, whey protein prices, whey protein demand right now, is not very good. And keep in mind, somewhere between 65% and 75% to 80% of all profits for most cheese plants, comes from their whey plant, comes specifically from producing various kinds of whey proteins. That is the market that’s driving profits in cheese making right now. So if your whey protein market is not very good, and nobody feels like they’re making money with whey, combining that with close to all-time high prices for cheese, combining that with a, very large uncertainty in demand for that cheese at these price levels, those Class III plants right now are doing the exact opposite of what you would expect a normal economic situation to be. They’re actually pushing that milk away. They don’t want it up here. Unless they have a guaranteed sale for the cheese they don’t want the milk. The milk is going to Class IV. You talk to any Class IV plant in the country right now every single one of them is gonna tell you they’re running full. And they’re not running full because we’ve got too much milk, they’re running full because the cheddar plants don’t want it.
Ted: Well, how are you gonna correct that problem? Who’s sitting on cheese right now that can meet the specs that the market? Is that the only thing holding it up is CME specs?
T3: Well, let’s talk about this. You’re a cheese plant that can produce cheddar that could be sold on the exchange on the CME. But when you’re looking at the profitability of your plant, there’s no guarantee you’re gonna make money on the cheese because you just don’t…because keep in mind they’re usually somewhere between five and 10 days between the day you make the cheese and the day you can sell it on the CME, because it has to age out a little bit, it has to settle down a little bit. The tests have to come back before it can be cleared for a sale. Well, when you’re sitting at 270, there’s this feeling “I’m sitting at the edge of a cliff.” Tomorrow, this cheese market could be $2. A couple of moments ago in this conversation, I was saying demand seems to be pretty good and we’re staying up here. It becomes a question of why though? What we’re sensing out there is there’s just not enough cheese to really push this market down because everybody’s afraid to make the cheese. Unless they know they have the sale, they’re afraid to make the cheese.
And what’s the incentive for the cheese plant right now? They’re not making any money on the whey. A lot of times what happens is they’re making so much money on the whey, that they’ll go ahead and risk losing money on the cheese because they can cover that in the profits of their whey. Well, if they’re not making any money on the whey, if the whey protein market isn’t very good right now, and everything we’re hearing is it’s a difficult market at the moment, there’s no incentive for them to take that risk. So unless they have a contract that they can’t get out of, which is the case in many places, if they can push that milk away, they’re gonna do it. They’re gonna take that risk off the table.
Ted: Let me ask a question. If you sell a load of cheese on the CME today, how long do you have to deliver it?
T3: Let me give you the simplified methodology. The cheese that you sell on the CME has to be between five and 30 days old when you sell it. On day one, you sell the load on the exchange. Within 24 hours, you have to provide the certificate of analysis to the CME who then forwards it to the buyer for that load of cheese. When we are a buyer on the CME, we assume that it’s gonna take us between at least three and more realistically five days before we can pick up that cheese once we’ve bought it. So if we buy it on a Monday, we can probably get it out of there by Thursday or Friday the same week. But more often than not, let’s say we’d be out by it on Wednesday, Thursday, or Friday of a week. It’s gonna be the following week, Monday or Tuesday of the following week before we can move it. Now, you can stretch that out maybe to a week and a half to 10 days, 10 business days, you know, there’s some flexibility in those rules. But usually, the rule of thumb is that cheese is gonna move between five and 10 days after the transaction has taken place on the CME. But that loaded cheese has to be ready, it has to be tested and it has to have testing results pretty much immediately when you sell it because you’re gonna be expected to provide that CMA within 24 hours of when you sold it. Now, if you sell it on a Friday, maybe you’ve got, you know, three days’ worth because you can wait till Monday to provide the CMA. But what we always do because we’re not actually an owner of a cheese plant, we’re a trading company, is we make sure we have a CMA on that load before we sell it so we don’t break the rules. And if you break the rules, the CME does not take kindly to people who try to make a transaction that they’re not fully prepared for and they can come down pretty hard on you.
Ted: In order for the market to go down, you’ve got to have somebody sitting there with cheese with CMAs in hand, and facing the prospect of buying milk down the road. He’s already got July underneath his belt so he’s got to be worried about his August price, right?
T3: I look at it this way. If you’re a cheese manufacturer and you wanna know whether or not you’re gonna buy that extra load of milk, well, if you buy that extra load of milk the question is gonna be “What would I need to pay for that milk in order to make sure that I am profitable on my whey stream, whey protein and lactose, and I’m profitable on my cheese?” Well, the first thing you’re gonna do is yes, the market’s at $2.70 but I’m not going to make the assumption that it’s gonna be at $2.70 in two weeks, because it could easily be at $2.20 in 10 days. Do I think that within the next three weeks this market will move lower? I do because I don’t think we’re sustainable at $2.70. But it’s this weird dichotomy right now where because everybody’s anticipating this market’s gonna drop, everybody’s that can avoid making cheese is doing so, and it’s actually making it a longer period of time until this market actually drops.
Ted: Well, what would probably happen under these circumstances is somebody who is making cheese every day, 24/7 is looking at this and he’s stacking up cheese and he’s looking at a $2.70 price and he’s looking at the Class III where it is, and he’s got the fresh cheese with the CMAs, you know, it’s in his interest for the milk that he’s buying to get the market down to something more reasonable. When that guy comes to the table, the markets gonna drop. And the question is, where is it gonna drop to? And I tend to agree with you, Teddy. I think the place where it’s gonna end up at probably a jaw-dropping level is probably about $1.90 or so, $1.90 to $2. And now all of a sudden everybody will be very happy to buy milk and put it into cheese at that level. And that’ll then sharpen up the butter powder end of the spectrum.
T3: Yeah. If it drops, you’re right. It’s gonna be interesting to see how easily this market gets there, though.
Ted: Yeah, it will be interesting. But the guy who’s sitting there piling up cheese at this Class III price has got a vested interest in changing it. And we’ll see whether or not he comes to the table here in the next week or so. The next week or so is critical because unless they’ve changed the rules, the August pricing starts on the 16th, right?
T3: More or less, yeah. You’ve got this week, you’ve got the remainder of this week and next week, and then you’re essentially pricing August. That’s correct.
Ted: He’s gonna have a vested interest in making sure the market gets to the point where he’s comfortable with taking and making the cheese and so he can move forward with August.
T3: Yes. Now, let me throw another element into this conversation. Have you looked at the weather map lately for the next 10 days in just about any part of our country?
Ted: It’s hot.
T3: This heat is gonna have an effect on milk production, but just when we’re expecting that they’ll probably a shift lower and cheese prices, the lack of milk may shift that. And what could happen usually about this time of year what the heat tends to do is it tends to drive up…it tends to shorten up the butter power market and the cheese plants stay full. But with this situation we have where there’s almost a $10 difference between Class IV and Class III and the protein market being weak, what you may have happen instead is the Class IV plants stay full and the Class III plants are able to take on less milk and they’re gonna be able to resolve their problem that way, and that might actually keep the Class III price up.
Ted: Well, it could. However, you know, let’s consider the differences between plants located in Texas and New Mexico and plants located in Idaho. I mean, these people are dedicated to cheese. They don’t have butter powder options, and the milk’s coming at them. And just because let’s say production gets hit because of the temperature, and it’s, probably it will. But what’s it…what effect is it gonna be? Two percent, 3%, something like that? That’s not gonna solve the dichotomy of the problem we discussed just a second ago. For the fella that’s got this milk coming at him, it’s gonna end up in cheese because it’s got no place else to go.
T3: I don’t know. A 3%, change in milk, you know, that’s the thing about dairy, Dan. It’s a pretty inelastic market. Small changes in production can have big changes in price.
Ted: Well, that’s true, but the change is already there. So I would argue that under that scenario, what would probably happen is that when this price goes down prior to the August price, either early on the August pricing, it would go down less, or maybe step it down less. You know, we’re speculating on this whole scenario, but it is hot. That’s gonna have a big effect on milk production.
T3: Nope, I agree.
Anna: Costs are raising, margins are shrinking. Markets are more complicated. A lot has changed since T.C. Jacoby & Company started in 1949. What hasn’t changed is our commitment to helping farmers focus. With the latest administrative support tools, we work every day to keep co-ops and family farms running at their peak. Start by emailing me, Anna Donze at anna@jacoby.com. That’s anna@jacoby.com.
T3: Let’s talk about the Federal order system. Is the Federal order system doing the dairy industry a service in an environment like this? To me, it almost seems like because of the blend price, you’re actually encouraging milk moving away from where its highest value would be, which is, cheese towards where it’s lower value would be, which is butter and powder. Is that what the Federal order system is designed to do?
Ted: Obviously not, but by the same token I don’t see why the Federal order system has a big impact on the current dichotomy. I mean, the advantages of the pooling means for the cheese manufacturer he doesn’t have to put money into the pool because his Class III price is higher than the blend. It’s not a normal scenario. So he’s gonna do what he’s doing. He’s gonna avoid putting any milk into $2.70 cheese right now. Regardless of what the federal order says, he’s just not gonna do it. Now, I agree that there’s kinks of the Federal order that need to be ironed out, and they’re getting bigger every year, but most of them relate to Class 1 pricing and how that relates to the overall situation with regard to qualification. The current pandemic dichotomy is very unusual, and, of course, greatly exaggerated because of it. But I think when this thing settles down, and let’s just suppose that the cheese market drops to two bucks here next week. Well, guess what? All of a sudden gone and dog it’s just business as usual. And then the question is gonna be how much milk production is gonna be coming at us during the third quarter? So that’s the way I’m looking at it. And I think the Federal order system has plenty of problems, but this situation with the pandemic and so on, isn’t really a problem that needs to be solved.
Anna: I think the biggest issue really is just that you had a lot of producers get very excited about a really high Class III price. And I think a lot of them have been warned, and we’ve been getting questions from everywhere so I think they’re paying enough attention to know. But some people probably will be surprised that how big the negative, the PPD is when it hits their checks. I think that’s gonna be a shock for some and it’s also just a big letdown when you were expecting as $21 milk price and that’s not at all where you’re gonna come out.
Ted: And I agree with you, Anna, and that’s a public relations issue that cooperatives are gonna have to deal with including the ones that we support. And but most of the sophisticated dairymen would have a pretty good idea of how this is gonna work.
T3: So Anna, where do you think the blend price is going to be for June?
Anna: I was really hoping you weren’t gonna ask me that because it really depends on what everyone decides to do. You know, if somebody decided that they were just gonna get off for a month or two and play it safe, that’s a very different number at the end than if everybody decided they didn’t care if they weren’t back for five or six months. The estimates that I had were even if everyone pooled like they did in May, which is unlikely, it would be a minus five, somewhere in that neighborhood. I think it is possible…probable that it will be much worse than that. I’ve seen some people say as low as minus nine and it is possible. I don’t think that’s quite likely.
T3: Well, let’s talk this through a little bit about how that happens. So you basically have $10, let’s just round them up and say there’s about a $10 difference between the Class IV price and the Class III price. Your Class I price, that’s halfway between, the move is halfway between the two correct? In effect, so you’ve got some of the milk going in, you know it $20… I don’t even remember what the question price ended up being in June, $21.50. So you’ve got some of the milk at, you know, $22, you got some of the milk at $12 to $13. And then you’ve got the Class I mover halfway between the two. And then you’ve got a Class II price that’s more derived from the Class IV, you know, that’s how you end up with a $5 PPD. But it would be $9 which means it would be a lot closer to Class IV than Class III, as a result of everybody be pooling and so there’s almost no Class III milk in the pooling report. And so the blend price basically becomes a Class I in Class four average, because all the Class III is gone from the order. Correct?
Anna: Yeah. Now, you know, and part of the equation is how aggressive did people wanna be knowing that you would get some benefit in having your two pools, you know. Are you really gonna lose all of your two, to take the three off? And depends on your utilization, how much, you know, what percentage is in each one, whether or not that was a risk worth taking. But the more that’s pooled off, the lower this number goes, the more three comes off, the lower that PPD gets.
Ted: Even I have trouble getting my head around the situation, the Class III price where it is and during…and the timeline of it getting there just really makes a mess of any calculations for the month of June.
Anna: Unless you knew what everybody else wanted to do. Every other co-op, plants, how they were gonna pool their milk, it’s impossible to know where that number is gonna show up. And this month is really strange, you know, normally you’ve got order five higher than 33 and it is not, it is lower. You know, that blend difference between the two is usually, I think we have an average, you know, with component loss and things like that, that’s around 50 cents, and I think it’s $1 under this time, which is very unusual.
T3: So this is just gonna be a weird month, probably a weird couple of months.
Ted: Yeah, that’s what I was running through my mind too, is you’re gonna have the same problem with July.
Anna: Well, you’ll have to be trying to bring things back on. We still are looking at probable negative PPDs in July so people are probably giving themselves at least two to three months to get back on. You know, even if you had a positive quarter three months from now for the PPDs probably wouldn’t mind losing that if you were gonna pick up five bucks here. So I think that, you know, knowing what people are gonna do especially with qualification coming into the mix in August is it’ll be months before we kind of get back to normal, if we get back to normal.
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