CHEESE MARKET ANALYSIS: Are producers manipulating cheese prices?

May 3, 2004

So you think the big cheese powerhouses—manufacturers and dairy co-ops—are manipulating the cheddar block market?

You're not alone.

I get e-mails aplenty from operators who are nauseated by the price roller coaster ride and befuddled as to why it recurs so often. Surely someone's behind the curtain and pulling the price strings, they say.

But they're probably wrong. It's not that simple, not that cut-and-dried, I'm told. According to two dairy experts, the problem is multifaceted.

Dairy & Food Market Analyst editor Jerry Dryer said that as much as 98 percent of the cheese made in the U.S. is sold via what's technically called a private treaty—basically a contract between a buyer and a supplier. The other 2 percent of the nation's cheese heads to a public market only when a manufacturer has more cheese than he's got contracts for, or a buyer has less cheese than he needs. Each then has to sell or buy on the open market.

Unfortunately, those open-market sales—which represent a meager slice of the overall supply—form the baseline for cheese pricing nationwide.

Dave Deal, a cheese purchasing consultant, whittles this point down even further. In dairy market conditions such as we have now, seemingly minute shifts in supply and demand can send prices soaring or plummeting, depending on: perceived supply (such as data in USDA reports, actual volume of cheese trades on the Chicago Mercantile Exchange, etc.) and perceived demand (prices on the CME milk futures market). Just a handful of bids (by parties needing cheese) or offers (by parties selling cheese) on the CME can move prices substantially.

"You don't see bids and offers in the double digits on this exchange. It's one guy or a handful of guys on one side of the buy or one side of the sale, and that sets the pricing for everybody," said Deal, founder of the Food Source in Detroit. "Right now we're at a point of relative (supply and demand) equilibrium, so it doesn't take a lot of activity to keep the market at its current level ($2.16 for blocks). But a move of one load (40,000 pounds) could change the price."

This doesn't happen with wheat or corn!

Compared to grain-related commodities, milk has an incredibly short shelf life. According to Dryer, cheese sold on the CME must be less than 30 days old—half the shelf life of mozzarella. So unlike wheat and corn, which can be dried and stored for many months, the dairy byproducts that most strongly influence cheese prices are short-lived commodities.

Here in particular is where Dryer and Deal say manipulation of the cheese market would be possible, but very difficult. In theory, a large dairy co-op could create artificial demand by buying a few loads of cheese every day at the CME. Problem is, that cheese's short shelf life necessitates its eventual movement from the stockpile to the hands of end-users. That means it likely would have to head back to the open market from which it came, which is, well, highly unlikely. Long story short: If prices are driven up, then they'll go right back down.

The replacement cycle of wheat and corn is also relatively quick compared to that of a dairy cow. Even a catastrophically bad corn crop in one year likely could be replaced by the following year's crop. But the natural production of a dairy heifer takes a minimum of 27 months, and though U.S. dairy farmers used to increase their herds with Canadian heifers, the mad cow scare has closed that door for now.

More hedges needed

Everyone thinks Pizza Hut, Domino's Pizza and Papa John's would be natural candidates for milk hedging, which would give some stability to the cheese market. But as Deal explained, doing so is not that simple for such large franchise companies. Though those chains purchase enough mozzarella to influence the market through futures contracts, each company's purchasing agreement with its franchisees might not even allow it. And even if it were possible, it's likely not everyone would be happy with that kind of speculating. Here's why:

At present the block price is $2.16. So let's say a large pizza company buys futures contracts that would allow them to lock in a cheese price of $1.72—a great-sounding number to any operator right now. But six months down the road, if the milk market tanks and the CME cheese price is $1.40, franchisees, Deal said, likely will be upset that they're paying 32 cents more. In other words, what seemed like a great idea at the time, might not settle well in the future, and franchisees probably won't cotton to the idea of covering the franchisor's lost gamble.

The ideal scenario, Deal said, is for more cheese users to move into the milk futures market (see related stories Back to the futures and Hedging on Price). If dairy producers have a solid idea of their customers' upcoming milk needs, supply will better meet demand, and the market will stabilize—in a perfect world, anyway.

"This market does not have enough participants yet to provide protection on a grand scale to major end-users of the product, but that's changing," Deal said. While he's encouraged that the number of milk futures contracts spoken for in April of 2004 is triple that of two years ago, all in all those contracts represent just 8.4 percent of the total cheese produced in the U.S. each year.

What will move more pizza players into the futures market? More anxiety, Deal said. Clients of his who were skeptical about the futures market when cheese prices were low two years ago have since had a change of heart.

"If they were only on the fence before as believers, they are dedicated long-term converts now," he said. "You need volatility in a market to get them anxious enough to implement risk-management strategies. But when it goes from $1.10 to $1.30 in a year (as it did from 2002 to 2003), there's not a lot of motivation to get in."

That motivation may be on the way. According to some dairy sources, cheese prices could hit $2.35 by summer's end. Neither Dryer nor Deal are surprised by that prediction, saying that if the forces at work in the dairy market continue pressuring supplies, a new high is possible.

But when it comes to the dairy market, Deal warned, anything is possible.

"It's not going to take much of a change to knock the market out of the situation it is in right now," he said. "It only took a couple of percentage points on the supply side and some increasing demand due to the economy to get us to the $2.20 level. If the product starts backing up because of demand not growing as expected, this market will correct in a hurry. And it will be a major correction. One truckload is the difference between surplus and shortage in this market."

Topics: Cheese

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