Milk Product Prices and Hedging Opportunities: Lessons from 2001
Dr. E. Bruce Godfrey
USU Extension Economics Specialist
The blend price farmers receive is a function of two sets of variables. First, the price of the products made from the milk, and secondly, the percentage of the milk going into each of the various types of products. These products relate to the various classes of use. These include Class I, II, III and IV, which correspond to the primary products produced: fluid milk (I), yogurt/ice cream/etc (II), cheese (III) and butter/non-fat dry milk (IV). In the western milk marketing order (primarily Utah, southern Idaho and eastern Oregon) cheese has been the predominant product produced for several years. For example, the data in the following table show that Class III utilization has averaged 54.4% during the period January 2000 through January 2002 with a high level of 65.9% and a low of 14.8%.
Percent utilization of milk by class in the Western Marketing Order (for the period January 2000 through January 2002).
As a result, the blend price received by dairymen in this region has been closely related to the price of cheese. However, starting in June 2001 Class IV utilization became more important. In fact, in October 2001, Class III utilization was at its lowest point in several years. October 2001 was also the month utilization for each of the other classes of milk peaked. Class IV utilization has continued to be high since October, but Class I and II utilization has declined. The net result has been an increase in Class III utilization. As a result, Class III and IV utilization combined is at the highest level it has been for at least two years. Several inter-related factors have contributed to this trend. First, cheese is the one dairy product that has experienced rapid growth in per capita consumption over the last several years. This is in contrast to the long term trend of declining per capita consumption of fluid milk, and the essentially stable trend in per capita consumption of most other dairy products. As a result, the price of cheese has become the key variable affecting milk prices in this area. Secondly, the price of butter rose relative to cheese in late 2001. As a result, more milk was diverted “to the churn” from the cheese vat. This resulted in a rapid increase in the amount of butter produced. This increased production caused stocks of butter to increase; the amount of butter in storage is currently at the highest level in about eight years. At the same time the amount of cheese in storage declined. These changes reflect what market price signals were suggesting should occur. One can therefore ask what does this teach us that might be used in the future?
High butter stocks and low cheese stocks suggest that butter prices should decline relative to cheese prices as processors begin to shift milk “from the churn to the vat” in an effort to build cheese stocks and reduce butter stocks. If more milk is wanted for cheese in the short run, it is likely that cheese prices will be bid up sooner than current futures prices would suggest. As a result, Class III prices may be too low relative to Class IV prices in the next 2-3 months, but the reverse may be true if cheese production and stocks increase rapidly, particularly in the summer and early fall.
The trends and changes noted above have implications for producers who are trying to hedge milk prices in the futures market or who are considering forward contracts. Given the current low cheese stocks and high butter stocks it is likely that the risk of reduced prices for Class IV futures contracts is much higher than it is for Class III contracts until July, when the price of Class III contracts becomes higher than Class IV contracts. The higher Class III futures prices in late summer and early fall (July through October) also appear to indicate a period when there may be some potential for reduced Class III prices relative to Class IV. If total milk production increases in 2002, as most analysts have suggested, the price of all classes of milk has the potential to decline. If this occurs, and given the trends noted above, it is likely that Class III prices will likely fall more than Class IV prices in the July through October period. This suggests that producers who are considering hedging, buying puts or forward contracting future milk production need to consider not only the general level of dairy product prices, but also the prices of components that will affect their blend price, and which futures contracts (class and month) can be utilized most profitably.