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More milk coming but fat rally persists

Alan Levitt

After nearly three years of oversupply and limited upside price risk, buyers have been lulled into a sense of supply security. Thus traders were caught by surprise by a global shortage of butterfat this spring, sending hand-to-mouth buyers into a panic to cover current and second-half needs.

Low SMP prices have incented processors to divert milk away from butter/powder. In Europe, where milk production has lagged year-ago levels and butterfat content is off as well, butter production in the first four months of the year was down 5%. Australian production was down 19% in the first 10 months of the season and U.S. butter production in the year ending April 2017 was off 2%. New Zealand butterfat exports August 2016-April 2017 were down 7% vs. prior year, suggesting lower butter production there too. We estimate production among the four suppliers is down 15,000-20,000 tons per month - while global butterfat demand, particularly from the bakery sector, remains very good and inventories outside of the United States are non-existent.  

Global butter prices have increased $900-$1300/ton in the last six weeks, rising to record highs. In Europe, butter topped $6100/ton for the first time. Where can we go from here?  

The "cure" for high prices is high prices, but in the U.S./EU summer months there's little scope to increase butter production. Further, history tells us not to expect a break for a while. This is the fourth time EU butter has traded above $5500/ton. In the previous three run-ups, the average price six months after crossing the $5500 threshold was still nearly 90% of the peak price.  

Intuitively, one would expect to see price resistance from end users. But while wholesale butterfat prices have doubled in the last year, retailers and ingredient users have been reluctant to pass along the full, higher cost to consumers. This lag stalls a demand response in the marketplace.     

Still, record butter prices are rationing the existing supply among the buyers who can afford to pay the most. In the case of Europe and the United States, that's generally the domestic market, leaving less available for export. To wit: butterfat shipments to the Middle East/North Africa region were down 42% in the first four months of the year and overall global butterfat trade from the major suppliers was down 17%.  

But, the second half looks a little different.

Milk production from the five major suppliers was down 1.6% in the nine-month stretch from June 2016 to February 2017 - an unprecedented period of contraction going back 20 years. Note that production posted a negative number in only two years over the previous two decades. It speaks to how severely the world was oversupplied that production pulled back so dramatically and yet the market is still looking for firm footing.  

Now production is back in expansion mode.  

In March and April, production from the top five was up 1.1% year-over-year, on top of 1.9% growth last year. What's more, farmer confidence is relatively high, weather has been decent in the world's supply regions and input costs promise to remain low - setting up a scenario of strong supply growth in the second half of the year.  

Milk production from the major suppliers could increase close to 2% in the second half of the year. We estimate this 2% growth over six months would generate close to 200,000 tons of product for the export market. World import demand would have to increase 5 or 6 percent, year-over-year, to absorb that volume - an ambitious task. This doesn't even take into consideration the 352,000 tons of SMP still sitting in EU intervention stores, which could limit further SMP price moves despite its increasing age, or the growing export supply available out of Canada and Turkey.

The indicators suggest a supply recovery on top of fragile demand growth, combining to pressure the market in the second half of the year. We expect the market to pull back by August or September as the New Zealand flush starts to come on. The weaker U.S. dollar since December has made imports more affordable, but higher commodity values make dairy relatively expensive in the price-sensitive regions of the world.

In the meantime, U.S. pricing is favorable relative to benchmark prices from Oceania and Europe, setting up U.S. suppliers to expand sales in the months ahead.

To read additional analysis and outlook of the market situation, see our latest Global Dairy Market Outlook report.