The good, the bad and...

By Sam Miller, managing director, group head of agriculture banking, BMO Harris Bank

The year is half over, and for dairy farmers prices are rising, helping to fill in the cash flow hole built up over the past nine months. Dairy markets have been on a roller coaster ride with a pretty big drop and what looks like a slow climb back up the track. What’s creating the tight margins in the markets? There are several possible answers; let’s take a look at a few of them.

The good

The U.S. economy is growing and, in recent quarters, at a faster rate than in prior years. The economic recovery started in 2009 and is now the second longest on record. The impact of the Great Recession was felt for a long time, so while the economy has been improving for almost nine years, it hasn’t necessarily felt like it.

Slow GDP growth makes it seem like there was little in the way of improvement, but the general economy has steadily crawled out of the hole and is performing much better. Consumers and businesses are optimistic, and that means increased spending, which benefits all ag sectors. Consumers with a brighter outlook typically buy more cheese, butter, ice cream and dairy proteins.

Similarly, major economies around the world are growing and their populations are increasing consumption. Our major trading partners—China, Mexico, Canada and South Korea—are all increasing consumption of dairy products, which provides an underpinning to milk prices. U.S. dairy product exports reached record highs in April, following year-over-year growth earlier in the year. This is positive news for American dairy farmers.

The bad

Worldwide dairy supplies remain burdensome, particularly for skim and whole milk powder. Why? When Europe abandoned its quota system in 2015, dairy farmers across the EU increased production, which drove up supplies, leading to a decline in dairy product prices in an attempt to attract adequate demand to clear the market.

The European response to lower milk prices was to intervene in the markets and buy milk powders in an effort to stabilize prices. It worked, but this milk powder must come back on the market. The mound of powder is acting as a major governor on moving milk prices substantially higher. When prices increase, powder comes out of storage, suppressing prices. The likelihood of much higher milk prices is low until these burdensome stocks are reduced.

In addition, the Canadian Class 7 pricing system took effect at about the same time as EU quotas disappeared and introduced additional skim milk powder to world markets. The combination of the added milk from primarily the EU (but also Canada) is viewed as the current driver of dairy farmer returns regardless of where they farm. With the U.S. exporting about 15 percent of milk production in a multitude of dairy products, world prices and exports are expected to be the marginal driver of milk prices.

The graph below from the U.S. Dairy Export Council shows milk production changes from the major exporting markets of the world—the EU, New Zealand, Australia and the U.S. Historically there has been an equal and opposite response between milk price and the increase or decrease in European milk production from year to year. Therefore, it is expected that eventually, the Europeans will settle into a pattern similar to the U.S., where milk production increases about 1.5 percent per year, or about equal to domestic demand increases.

What about the and…? 

This is the big wild card—what will happen to trade deals and export markets? Mexico and Canada are important markets for U.S. dairy products. But as of this writing, there’s still no deal to renegotiate NAFTA, and Mexico and Canada have placed tariffs on dairy products in response to the Trump administration’s steel and aluminum tariffs. Whether, how and when these issues will be resolved are the open questions. The answers will determine if the end effect will be good or detrimental to the dairy industry.

The bottom line—pay attention to what’s happening on your dairy and on what’s happening with the U.S. economy and its relations with key trading partners.