With all 10,000 of our lakes here in Minnesota currently frozen solid this may be a strange analogy, but dairy prices move like the waves rippling out from a rock thrown in the water. The bigger the rock, the bigger the initial waves are, but they eventually get smaller and smaller until everything is back into balance. It only takes seconds for the waves to flatten out on the lake, but it can take 1 to 2 years for the dairy markets to find equilibrium after a large shock. I bet you think I’m going to talk about the pandemic, but I’m not, there is another shock to the dairy market that will be playing out into early 2022 that deserves some attention.
Feed costs have shifted dramatically higher in the past six months. There wasn’t any large single driving event that has tightened feed supplies, but it has been a number of smaller issues all coming together at the same time. US corn and soybean yields weren’t horrible, but they were below trend. Crops in parts of Europe and the Black Sea region also suffered some adverse weather this season. On top of the generally weak production, demand has turned out stronger than expected, particularly from China. The net impact is that expected carry-out stocks of grain and oilseeds have been trending down for the past seven months and feed prices have consequently been trending higher.
Back in May the corn and soybean meal futures were suggesting that the cost of feed to produce a 100 pounds of milk in 2021 would be around $6.19, but with the rally, futures are now suggesting a price closer to $7.34. That means the cost of production for dairy farmers is up more than a dollar per cwt. in the past seven months. That is nearly a 19% increase. In terms of individual dairy products, it adds about 12 cents per pound to the cost of cheese or 25 cents per pound to butter.
It’s important to recognize how the higher feed costs translate into higher dairy prices. In the standard economic view of commodity markets, the higher feed costs will reduce farmers’ willingness to produce milk. The lower milk supply eventually pushes dairy prices higher. The higher dairy prices eventually offset the increased feed costs, milk production become profitable again and farmers will expand production which will push dairy prices back down and the cycle starts over. The price fluctuations should be smaller in the second cycle, like the ripples spreading out from the rock in the lake. This process takes a lot of time. In our models, farmers take 3 to 6 months to adjust milk production in response to milk prices and feed costs, and the demand side takes about 3 months to adjust to prices as well. That means the higher feed costs that farmers are currently seeing wouldn’t start to reduce milk production until the middle of 2021, and it would take a while for the falling milk production to align with demand, so the higher dairy prices would probably hit in Q4. The higher Q4 milk prices would drive an increase in milk production in Q2 of 2022. And the market finds relative equilibrium around late 2022 or early 2023.
I don’t want to get overly optimistic on prices here. The pandemic is still depressing U.S. dairy demand. Government purchases are absorbing the currently expanding milk production. If milk production growth continues to run at 2.5%+, it will be hard for the government to absorb all of it. It’s also possible that the new administration may be less willing to purchase commodities, so we can’t be certain that the purchases will continue at their recent pace either. There are downside risks in this market, and even if production growth slows a bit and government purchases continue, dairy prices will still be volatile as they bounce between the underlying bearish fundamentals and the bullish government purchases. But the increased feed costs mean that breakeven for dairy farmers is now somewhere around $16.00 Class III milk or $1.70 cheese. So if you’re thinking about where dairy prices might be in late 2021 or early 2022 this is the price level where the ripples should flatten out, unless another rock (or boulder) is thrown into the water.
Editor’s note: Nate is the Director of Dairy Market Insight at StoneX Financial Inc. and has been applying his interest in large complicated systems and statistical analysis to the international and U.S. dairy markets since 2005. As a consultant, he has worked with clients at all levels of the dairy marketing chain from the farm level up to processors and packaged foods companies, food distributors and restaurants as well as connected industries like banks, private equity groups, government agencies, and industry associations. Through ongoing reports or one-off client specific projects, he helps them understand the short and long-term trends and the underlying relationships driving the market and what that means to their businesses.