Guest Columns

Perspective:
Dairy Markets

Making a change for the better in the nonfat dry milk market?

Andrew Faulman

Andrew Faulman is a risk manager associate at Rice Dairy*. He is a guest columnist for this week’s Cheese Market News®.

The dairy futures and options complex has a sleeping giant in its midst, one that could rival the size of the Class III and cheese. I’m talking about the nonfat dry milk market. Combining nonfat dry milk and skim milk powder production, the nonfat dry milk futures market has the potential to trade 50,000 contracts annually.

For that to happen, though, structural changes need to be made. The past couple of years demonstrate how the current pricing structure for physical nonfat dry milk has sent the wrong signals to the marketplace. Unlike the cheese and butter markets, the pricing structure for nonfat dry milk contracts at the manufacturing level have taken a different approach. While cheese and butter contracts are typically priced off the Chicago Mercantile Exchange (CME) spot market, nonfat dry milk contracts are typically priced off of the price reported in the previous week’s or month’s National Dairy Products Sales Report (NDPSR).

This method of pricing nonfat dry milk contracts creates a relatively stable price in terms of what gets reported. Unfortunately, it is a circular price: Today’s price is a function of last week’s price, and it may not be a reflection of current market conditions. On the surface this may seem beneficial: A significant amount of volatility is being removed from the market. When digging a little deeper, though, it becomes clear it has unintended consequences that have become too great to ignore.

An excellent example of these consequences occurred throughout this past year when spot nonfat dry milk prices were trading on a secondhand basis as much as 45 to 50 cents discount to what was being reported in the NDPSR. It wasn’t until the start of September when the price of nonfat reported by the NDPSR made a one-week drop from $1.7222 to $1.4862, and we saw prices start to more accurately reflect the actual spot market. The discrepancy between the NDPSR and the CME spot market was also very much apparent with the NDPSR coming in with prices in the low $1.8000s / high $1.7000s in the month of August while the CME was trading sub $1.4000.

At first glance one could say that referencing previous months’ and weeks’ prices in NDPSR didn’t do buyers any favors but that it was the gift that kept on giving for sellers. Not so fast though. Indirectly, I believe this method of pricing nonfat contracts has had a negative impact for both buyers and sellers and that it has sent the wrong signals to the marketplace. Case in point: An uncommitted load on the manufacturing level is typically sold through a broker on the spot market on or off the exchange. When the manufacturer has to make that uncommitted load by paying the milk producer a nonfat price of $1.8000+ while the spot market is trading anywhere from 40-50 cents per pound discount, it creates a very serious problem on the manufacturing level. This kind of pricing structure has had a definite unintended effect that has rippled across the market on the manufacturing level, but what about the signals being sent to the milk producer?

Throughout this past year we have seen international prices of products like skim milk powder (SMP) make a steady decline, sending signals to producers to contract in production. Referencing the Global Dairy Trade (gdT) auction, the price of SMP from the start of the year declined from $4,780/metric ton ($2.16/lb.) to the Oct. 1 price of $2,540/metric ton ($1.15/lb.). Internationally, a clear price signal was being sent to contract production. This was a signal that was not being sent to the domestic market because of the prices that were being reported by the NDPSR. This in turn provided a market signal to the dairy producer to not only make more milk but for more nonfat dry milk to be produced into a market that might have already been saturated by product. What if physical contracts are contracted at prices that are on the lower end of the price curve and spot product starts to tighten up? Because of the circular nature of NDPSR based contracts, the dairy producer will continue to get paid based on reported prices despite a tightening spot market.

Getting an industry to change contract pricing is a big proposition. Fortunately though, a viable solution exists that is already in practice for both the cheese and butter markets.

Just like the butter and cheese markets, there exists a spot market at the CME for nonfat dry milk. When buying or selling a load of cheese, odds are you are going to get quoted using the CME market, something like the weekly average for CME block plus or minus a basis premium. When using the CME as a single price barometer you in turn encourage participation in the use of that market — i.e., more buyers and sellers coming to use the CME spot market. Like any other market, increased participation not only improves liquidity, it also improves price discovery. The more sales priced off of CME, which is more reflective of the spot market, the more we start to see the spot market get reflected in the NDPSR. This not only makes futures and options which expire to NDPSR a better hedging mechanism, it sends better price signals to the market.

Remember when I said that the nonfat dry milk futures market is a sleeping giant? I believe using the CME as a pricing mechanism for pricing out physical contracts is just the thing to bring the futures market to a place that is comparable to the rest of the complex. Take, for example, the open interest for cheese futures and options that comes to roughly 34,000 contracts. Better yet, consider the open interest for Class III milk that comes to about 120,000 contracts. Compared this to the current combined open interest in nonfat dry milk of about 8,500 contracts; it is clear that there is a discrepancy between the products.

How big could the nonfat dry milk futures market get? Annual U.S. nonfat dry milk production, including only what is produced for human consumption is nearly 1.5 billion pounds, the equivalent of nearly 34,000 contracts that could be traded financially through the futures market.

The question is, can we change to a pricing structure that allows for the futures to be a viable product? The benefits of this change would not just be seen in the nonfat dry milk market but in the butter and Class IV futures as well. A more liquid nonfat futures market allows for more liquidity in the Class IV crush, a trade that involves trading butter, nonfat dry milk and Class IV at the same time. This way, you not only improve liquidity in nonfat dry milk but butter and Class IV as well, which will provide the industry a more stable way to manage price risk.

With the new year fast approaching and discussions for physical contracts already starting to pick up, now is the time to weigh the pros and cons of making this kind of change. Right now there exists an avenue by which we can avoid a situation like we saw this year and in years past, where spot prices and reported prices have sizeable discrepancies. Using the CME as the pricing barometer will not only foster the convergence between spot prices and reported prices but will also allow the nonfat dry milk futures market to become a more appropriate and useful hedging mechanism. So let’s ask the question, by pricing nonfat off of the CME are we making a change for the better? My opinion is yes, but I will let you be the judge of that.

CMN

The views expressed by CMN’s guest columnists are their own opinions and do not necessarily reflect those of Cheese Market News®.

*These observations include information from sources believed to be reliable, but no independent verification has been made and therefore their accuracy and completeness cannot be guaranteed. Opinions and recommendations expressed are the opinion of the authors and are subject to change without notice. The risk of loss in trading futures contracts or commodity options can be substantial, and investors should carefully consider the inherent risks of such an investment in light of their financial condition.

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