CHEESE MARKET ANALYSIS: Cheese price volatility is here to stay

April 3, 2005

If you can recall a time when block cheese prices averaged $1.35 year round, you might be a pizza veteran.

But if you choose to dwell on those happy days rather than the reality of today's high prices, you might be delusional.

Brokers and dairy analysts agree that a return to the dairy market's placid past won't happen anytime soon, and they predict record prices — both highs and lows — are possible within the next few years.

"We're going to take out $20 (milk) at some point in the not-too-distant future, and we're probably going to take out $10 (milk) again," said Jeff DeGrand, a broker for Downes-O'Neill in Chicago. Convert those numbers to cheese prices, and the range is roughly $2.13 to $1.13. "That's the new paradigm, and it's not going to change anytime soon."

From the perspective of cheese and milk costs, the early 1980s truly were the good old days. Back then, the United States government routinely paid dairy farmers about $12 to $13 per hundredweight (per 100 pounds) for milk — a profitable, if not princely sum — which kept cheese price averages between $1.37 and $1.43 for nearly five straight years. And knowing the government would buy any and all of their excess milk, dairy farmers readily overproduced.

"When you look back, you're generally seeing that 10 to 15 percent of the milk supply was bought

What's Important

Expect cheese price volatility for at least a few years to come, experts say.

The combination of tight milk supplies and strong demand make prices vulnerable to wide swings.

The volatility will lessen as the milk futures market draws more players.

by the government," said Al Levitt, a dairy industry analyst in Crystal Lake, Ill. "Imagine now if (dairy farmers) could overproduce by 15 percent and had some place to take it."

When Reagan-era legislators contemplated the enormous cost of dairy subsidies, it was clear that the end to the ever-flowing milk and money supply was nigh. To help a number of dairy farmers exit the business without going broke, the government offered a final helping hand in the form of a whole-herd buyout.

Change in the industry came steadily and irreversibly. By 1990, the government milk support price was at $10, the number of dairy farmers had shrunk considerably and milk supplies were tightening. Before the end of that year, milk prices soared to a then-shocking $15, before sliding back to $12. By late 1991, prices were at the $10 support level before climbing again to $12.50 a few months later.

Good-bye tranquility, hello volatility.

"What causes volatility is tightness in the market," said Levitt. "You never have volatility when the market's long. But when supplies are tight, tiny changes in supply or demand make prices go kind of whacky."

And yet, the ripple effects of an erratic milk market weren't yet affecting cheese prices. From 1990 to 1994, the lowest average weekly price for 40-pound blocks of cheddar was $1.08, while the highest weekly average was $1.42. The market was surely shocked when the average block high crept to $1.69 in 1995, but buyers likely hadn't a clue that this was only a foretaste of what was to come in 1997, when prices would break the $1.90 barrier.

That same year also marked the beginning of milk futures trading at the Chicago Mercantile Exchange.

Does it have to be this way?

Dairy market zigs and zags have all but rendered historical data useless as a tool for predicting future prices, said DeGrand.

"In the past couple of years, our imagination has widened because we know what can happen to the milk price," he said. "You may have to throw history out the window ... because you can't go back and use 10- or 20-year averages as a good rule of thumb anymore."

Milk pricing formulas (set up and determined by the government) have changed multiple times over the past several years, as have market rates paid for milk. In the past five years, dairy farmers received as little as $8.57 per hundredweight, and as high as $20.58 (a rough cheese-price equivalent range of $1.02 to $2.13 per pound).

As Levitt mentioned, market supply also affects volatility, but so does the number of players in the milk futures market, DeGrand said. Unlike grain markets, such as corn, where tens of thousands of contracts trade daily, fewer than 1,000 trade daily in milk.

To be fair, DeGrand added, the dairy futures market is very young compared to other commodities markets. And just as those markets matured, he expects dairy will as well.

"It's a process that takes time," he said. "Grain has traded for 150 years, livestock has traded for 50 years and dairy has

Cheese Price History

* Following are the average weekly low prices and high prices paid for 40-pound cheddar blocks for the last 25 years.

           Low     High

1980     1.21     1.36
1982     1.35     1.37
1983     1.31     1.36
1984     1.31     1.39
1985     1.21     1.34
1986     1.21     1.30
1987     1.19     1.32
1988     1.14     1.54
1989     1.17     1.54
1990     1.08     1.35
1991     1.08     1.38
1992     1.15     1.39
1993     1.16     1.39
1994     1.18     1.42
1995     1.20     1.69
1996     1.37     1.43
1997     1.28     1.90
1998     1.28     1.90
1999     1.11     1.90
2000     1.00     1.32
2001     1.09     1.72
2002     1.07     1.30
2003     1.08     1.60
2004     1.30     2.20
2005     1.46     1.74

traded for eight."

Until more traders get in the game, volatility will remain an issue as a relatively small market play — such as a purchase of a few loads of block cheese — can send market prices soaring.

"As the milk futures market matures, it should dissipate the overall volatility," DeGrand said. "Then you'll have thousands of traders casting their votes for where the price should be."

Dairy farmers also have developed the ability to affect prices through the Cooperatives Working Together initiative developed in 2003. Per every hundredweight of milk sold, participating dairy farmers pay 5 cents into a fund that, in the event of a milk glut, will pay them back to trim or sell off their herds and reduce milk supply. Levitt called the tool "unbelievably successful" at boosting milk prices, which farmers desperately needed after 25-year-lows recorded in 2002-2003.

"You'd have to say that for a nickel a hundredweight, they got their money's worth," said Levitt. "To go from one of the worst years on record (2003) to the best year on record (2004) is amazing."

Of even greater concern to cheese buyers is the market price influence of large traders, such as Dairy Farmers of America. Sources quoted in a Dec. 29, 2004, article in The Chicago Tribune said large co-ops like DFA tell dairy farmers and cheese producers to limit production in order to drive prices higher. Additionally, DFA reportedly makes large and strategically timed purchases on the cash cheese market at the Chicago Mercantile Exchange to prop up low prices by filling planned shortages.

The strategy worked well in June of 2004, when DFA's purchases helped hold the price for blocks at $1.80 for several weeks.

That was then, this is now

Levitt suggests that pizza operators put their profits in danger when they continue longing for the days of $1.30 cheese. That price will become more the exception than the rule, he said.

"The volatility will be different now that the floor seems to be about $1.40," he said. "Maybe it will fluctuate between $1.40 and 1.80."

Is a 40-cent range truly volatile when the market has seen wider swings over the past several years? It is when it the market turns on a dime every couple weeks as it is now, Levitt added.

Does that mean pizza operators' margins are at the mercy of the dairy markets? Not if they rethink their own pricing, Levitt said.

"Over the last 20 years or so, we've really conditioned consumers to expect their food to be relatively inexpensive," he said. "You can still buy a pizza for less than 10 bucks, which is part of the problem the industry faces. Consumers don't expect to pay $20 for a pizza, which would maybe be a more reasonable price.

"So if we're in a new reality of $1.50 average cheese instead of $1.30 average cheese, somehow that has to flow through. The consumer has to pay more for their food ... that seems to be the only option. I don't see how a pizzeria is going to continue to take the hit on 20 cents a pound."

Topics: Cheese , Operations Management

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