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Commodity Milk: What You Need to Know

Updated on March 30, 2023

the black letters on white background saying Commodity milk under this is the logo of dontbefooltrading and below the letters what you should know

This article, ‘Commodity milk: what you need to know,’ explores how investment in the most essential product in kitchens across the globe is traded and, indeed, what drives investment in the industry. Although milk is one of the most important products, most investors don’t fully appreciate the processes influencing market movements in this industry.

What are dairy products?

The term dairy refers to all products containing milk or its by-products, such as cheese, butter, dry milk powders, and others. Dairy products are popular because they are a valuable source of vitamins D & A and minerals such as calcium, magnesium, zinc, and protein in our diets.

The industry primarily involves collecting and processing animal milk (primarily from cows and goats) for human consumption. Milk is one of the world’s most widely produced and valuable agricultural commodities.

Dairy products

Milk is highly perishable and has a shorter shelf life than most products. Through the various methods milk production methods, storing it for much longer enables transportation and trade across different geographical locations. There are two main preservation processes farmers use to increase the product’s shelf life;

Cooling

Using this method, milk cools to around 4°C immediately after milking using mechanical refrigeration or cooling tanks. Producers then transport in milk cans or big insulated tankers.

Pasteurisation

With this preservation method, producers pump milk into a vat where it heats to a specific temperature for a certain amount of time and then cooled. The cooled milk is then pumped to the rest of the processing line.

Milk processing creates a wide range of products that are also base ingredients for other products. Consequently, milk enjoys high global demand, making it an exciting investment option for seasoned investors. Here are a few milk products you’ve probably come across;

  • Cheese
  • Butter and ghee
  • Margarine
  • Butter oil
  • Condensed milk
  • Evaporated milk
  • Fermented milk such as yoghurt
  • Milk powder
  • Casein
  • Whey powders

Overview of the US dairy industry

The milk industry in the US is a multi-billion dollar industry employing millions across the country. Although the industry is well-regulated and supported, it still faces many challenges in the product’s production, operation, and marketing. Cows are typically milked an average of 3 times per day, every day. Dairy farmers then process this milk and turn it into finished goods for many different uses, consumed anywhere within a few days, weeks, or even months. The time period can be much longer in some unique cases, such as for specialty aged cheeses.

The marketing chain runs from the producer to the consumer, and in the interim, milk changes hands multiple times before reaching the final consumer. With each change in hands, players must contend with the inevitable price risk, especially since the industry faces high price volatility.  

The dairy market often experiences such broad volatility in price from month to month, making it difficult for players to meet their breakeven costs.

A unique strategy to combat price volatility is using futures and options to hedge against the risks associated with being a player in a volatile industry. These also help astute players to win from speculation and bets placed on the price or spread movement in the industry.

Price risk

Owing to the fact that there is no foretelling of future prices, the milk industry is riddled with uncertainty. The uncertainty resulting from not knowing a commodity’s future cash price is what is commonly termed price risk. For instance, although a dairy farmer might wish to increase the price of his products, a processor in the industry would want the reverse. The milk futures and options market makes it possible for producers and processors to effectively respond to unfavourable price changes and price risk.

Milk futures and options

Currently, there are a few futures and options investments offered on the Chicago Mercantile Exchange (CME), each of which serves a different purpose in the industry, as shown below;

  • Class III Milk
  • Class IV Milk
  • Cheese
  • Butter
  • Nonfat Dry Milk
  • Dry Whey
Chart of the Class 3 milk futures

Class III Milk & Dry Whey

This is colloquially referred to as ‘cheese milk,’ as it is mostly used in the manufacture of cheddar cheese and whey is its by-product, which separates from the milk during the cheese-making process.

Dried whey has a high protein and low-fat content, making it an ideal ingredient for food products and also animal feeds. Dry whey futures contracts offer unique opportunities for processors and food companies to manage the price risk involved in the processing and purchasing of this vital ingredient.

Cheese futures and options

This asset class provides the opportunity to hedge across different parts of the milk “crush” with a single contract, thereby making it possible for processors and food companies to regulate price and supply.

Class IV Milk

This produces butter and nonfat dry milk and provides a hedge against the risk involved in buying and selling liquid milk plus dried milk and butter.

With the fluctuations in supply and demand for butter, the need to store the physical product also fluctuates. Butter futures and options hedge against price differences caused by the physical movement between close contract months and deferred contract months.

On the other hand, nonfat dairy is a storable product that farmers typically use in feed or food items and reconstituted milk. It can be a protein supplement or an ingredient in the baking and confectionary industry. Consequently, it has demand worldwide, making Nonfat Dry Milk futures both a price reference and hedging tool and benchmark for this product.

Brief overview

The standardized futures contracts traded on the CME are for delivery of 200,000 pounds of Grade A milk with 3.5% butterfat. Futures contracts for both Class III and IV milk trade monthly, with up to 18 months in advance. Additionally, Futures and options prices are typically quoted in dollars per hundredweight (cwt). Therefore, for every 1-cent change in a futures contract price, its value changes by $20. Alternatively, one options contract is equivalent to one futures contract in size.

Once the contract expires, there is no actual delivery or receipt of milk. Rather, contract prices are forced to the equivalent Class III or Class IV price for that month. One of the other unique features of the milk market is the announcing of prices for the previous month, roughly around the 5th of every month. Consequently, there is a spot market for milk aside from Grade A.

Margin Accounts

All investors who purchase or sell futures contracts must maintain a margin account for the entire time they hold a futures market position. A margin account is basically a performance bond, with the initial margin requirement dependent on the type of trader (speculator or hedger) and the contract.

Consequently, each contract is compared to the closing price at the end of the trading day. A contract is thus profitable if it increases the margin account. A hedger would have to sell their short position at a price higher than the closing futures price to earn a profit. Additionally, the hedger can close the position at a profit by choosing to buy a contract for the same month. The profit is therefore calculated as the difference between the price of the contract sold and the price of the contract purchased. For instance, supposing a November contract was sold for $13.27; the following day market closed at $12.87. The seller could buy the $12.87 contract, earning $0.40 per hundredweight or roughly $800 per contract.

Conversely, money is deducted from the margin account if the contract position is deemed unprofitable. Supposing the value of the margin account drops below the maintenance level, the hedger receives a margin call.

Basis

This refers to the difference between the cash and futures price.

Basis = Cash price – Futures price

Or

(Expected) cash price = Basis + Futures price

In calculating the basis, a negative result means the market is normal. Alternatively, supposing the calculation yields a positive result, it indicates a market inversion.

The basis can be determined using either a gross price or a “mailbox price,” alternately called the net price. This is the gross price minus hauling, promotion, and marketing costs. In some places, cooperatives might print the gross price on the check printout, while others only print the net price.

Interestingly, milk basis calculations broadly differ from other commodities such as livestock and grain. This is because milk price doesn’t only consider Grade or transportation. Inherent in milk prices are factors such as season, market location, quality difference, milk use, and others. Therefore differences in designation and destination determine the pool price.

For instance, a producer whose milk sells in a pool designated mostly as Class I (beverage) milk enjoys a higher price than a producer whose product sells in a pool designated as Class III (cheese) milk. This is true regardless of whether the quality of milk is the same. This. is because the end use of the milk is the determining factor. Aide from Grade B milk and certain unregulated milk, prices are typically announced after the product has been delivered and used. These prices remain for an entire month.

Additionally, no cash market prices are quoted or published daily for Grade A milk. Aside from a few spot market transactions and some deals involving Grade B or unregulated milk, milk prices are based on USDA formula prices.

Conclusion

With this brief overview of the milk industry and its importance as a commodity, you can determine whether this lucrative, albeit volatile, industry is one you could invest in. Commodity milk can be a great investment, especially if you consider the raging demand. However, the price volatility and marketing and distribution challenges might deter some investors.

What are the different types of dairy products?

Dairy products include cheese, butter and ghee, margarine, butter oil, condensed milk, evaporated milk, fermented milk such as yoghurt, milk powder and whey powders. Dairy products are a valuable source of vitamins D & A and minerals such as calcium, magnesium, zinc, and protein in our diets.

How does the US dairy industry work?

The US dairy industry is a multi-billion dollar business that involves the collection and processing of milk from cows and goats for human consumption. The industry is supported and well-regulated by the government, although it faces many challenges in production, operation, and marketing. There are various futures and options investments on the Chicago Mercantile Exchange (CME), such as Class III Milk, Class IV Milk, Cheese, Butter, Nonfat Dry Milk, and Dry Whey. These investment opportunities help producers and processors to regulate price and supply, as well as manage price risk.

How can investors hedge against price volatility in the dairy market?

In this case, investors can hedge their investments against price volatility by using the futures and options available on the CME. This offers a unique investment opportunity for people who are willing to make the most of the price movements in the industry.

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