We haven’t talked about price volatility in a while. But that doesn’t mean it’s been eliminated.
While volatility is a common feature of the dairy business today, many have learned to manage it with futures and options. Unfortunately, that doesn’t apply to milk powder or the milk prices that are priced off of it. Risk management tools don’t work as well here, because of the complexity and inconsistency in the way milk powder is priced. Futures and options aren’t liquid enough, in part because there’s no common benchmark price.
To be clear, this isn’t just a powder issue. The nonfat dry milk (NDM) price has a direct impact on more than one-third of the milk priced in the United States, and an indirect impact on just about all the rest, regardless of region.
Since nearly half our powder production is exported, the U.S. market is tethered to the global market through its ups and downs, which makes managing this volatility especially crucial. But global powder markets are particularly susceptible to volatility because nonfat dry milk/skim milk powder (NDM/SMP) is the last product produced from the milk stream. Therefore, even small changes in global milk supply have big impacts on the NDM/SMP supply picture.
On top of this structural volatility, there’s no single, acknowledged benchmark price for NDM in the United States. Unlike cheese or butter, there are a variety of auctions and surveys and they all have different rules on which transactions are included. Each company may price off a different series.
Meanwhile, the government surveys that value NDM in the federal orders and California, which determine farmer pay prices, don’t count certain transactions (like SMP) that are more reflective of international pricing.
None of that would matter so much if the United States wasn’t typically the global price follower on NDM/SMP, rather than the price leader. When the international market turns, our pricing mechanisms lag on the way up, denying us optimal valuation, and lag on the way down, often leaving us uncompetitive. This is particularly destructive in a declining market, when we accumulate inventory due to unfavorable pricing. Since co-ops can’t hedge their inventory values, farmers typically pick up the tab for the losses.
In addition, delayed or obscured market signals aggravate volatility. It can take months to get the message back to the farm to boost output or cut back, so we may be overproducing in a down market or underproducing in an up market.
In short, our ineffective price-discovery system for milk powder makes it almost impossible to manage volatility and impairs our ability to respond to market signals, extracting costs to everyone in the supply chain. If we’re going to be consistent global suppliers, we have to get powder pricing right.
Finding remedies
An industry work group, gathering under the leadership of the Innovation Center for U.S. Dairy – a pre-competitive forum for the industry established by America’s dairy farmers through the dairy checkoff program – is addressing this issue and formulating solutions.
Collecting input from a wide range of stakeholders, the work group is evaluating various remedies to improve price discovery and reporting. Most agree the CME cash market can be a good price indicator, but improvements are needed. They also agree government reports don’t always reflect current market conditions, rules regarding which transactions are included need to be examined, and lags in price reporting delay price signals to the market. The group recognizes that if you improve price discovery and link it to futures, the futures volume and liquidity will naturally come.
Several potential fixes are in the works. Representatives of the work group met with CME officials last month to discuss improvements to the CME NDM markets. This includes moving CME spot trading to an electronic platform to boost activity and make the exchange more relevant. The CME also is working on updating the specifications for the NDM spot market to better align with commercial activity. And the work group is facilitating further consultations on the best ways to improve price reporting. They are drafting solutions and engaging interested industry participants. There is widespread industry support for change and a sense of urgency to make it happen.
The health of the entire U.S. dairy business is predicated on becoming a consistent supplier of milk powder – our largest export product. Now the industry needs to improve its milk powder price-discovery process to get a handle on volatility, improve competitiveness and ensure we continue to gain global market share.
Source: Agriview