Got milk futures?

October 29, 2015 09:00 AM

The extreme volatility recently seen in the stock market and crude oil market was amazing to behold. 

A correction of this magnitude had not been seen in years. On Monday, Aug. 24, the Dow plunged, recovered and plunged again for an aggregate 3,000+ point move in one day. The days that followed continued to provide amazing opportunities for traders that exercised good money management and discipline. Imagine if, instead of having to wait years for moves of this magnitude, they occurred on a regular basis. There is a market where it does: Class III milk futures.

The U.S. dairy market is a $36 billion per year industry. While most people are familiar with dairy products such as milk, butter and cheese, the milk cows produce also is turned into a multitude of products such as powders for commercial baking, infant formula and protein drinks. The CME Group offers a full range of dairy futures and options that trade electronically nearly 
24 hours a day on CME Globex, including Class III milk, Cheese, Dry Whey, Class IV milk, nonfat dry milk and butter. They are cash settled against USDA published dairy prices, so there is no hassle with notice days or fear of needing to make or take delivery of the physical. Class III milk futures are the most mature of the dairy complex in terms of volume and open interest.

Milk futures began trading on the CME in 1996 based on the Minnesota-Wisconsin (MW) price, then the Basic Formula Price (BFP) price in 1997, and since 2000 the Class III price. It is a very young product. Class III is known as manufacturing, or “cheese milk,”because it is used typically to make cheese. There is a contract for every calendar month going out 24 months. The contract size is 200,000 lbs. The contract is traded in dollars per hundreweight (cwt), thus the minimum tick size of 1¢ works out to $20, and it has a daily price limit of 75¢ ($1,500). The symbol for Class III milk is DC.

So, why are Class III milk futures so volatile? In the early to mid-1980s, the government support price for milk ensured there would be an oversupply. As the government was forced to buy and store more excess dairy products, it began lowering the support price. From $13.10 in 1981, the support price steadily fell to $9.90 in 1999. While still technically a support price, it was unprofitable to run a dairy operation, and thus allowed the natural forces of supply and demand to move the market. One can see this change in “Got volatility?” (below) as milk prices initially are very steady in the early 1980s (high government support price) but  gradually succumb to supply and demand signals. From a low of $8.75 in November 2000, prices nearly doubled to $15.90 in September 2001, then plunged back to $9.52 by August 2002. More recently, prices moved from $17.38 in July 2013 up to a record high of $24.60 in September 2014 only to hit a low of $15.46 in February 2015. 

Class III milk is unique in that very small changes in supply or demand typically result in dramatic price moves. One reason is that milk has a short shelf life. While grains can be stored in bins for years, milk must be consumed or thrown out. Who doesn’t look at the “good until” date in the milk coolers and grab those jugs with the longer duration? Milk can be made in to cheese, butter or powder, which extends its life, but it is still far shorter than other tradeable commodities, especially the non-edible varieties. This “use it or lose it” attribute plays a role in why prices can move so much, so quickly. Another reason is the inability to ramp up or slow down milk production quickly. Dairy operations have limited capacity in the number of cows they can milk. Expansions take time and capital. It takes months to years for producers to respond to a stronger demand signal. Likewise, once production is online, it’s hard to turn off. Cows must be milked 2-3 times per day, every day.

Seasonality and weather also play a role in volatility. Milk production often reaches its peak in the spring as temperatures begin to moderate and cows have their calves. But shortly after that, schools and universities let out, so government lunch programs no longer need those fluid milk cartons we all remember, causing some excess supply. However, as summer heat finds its way into the southern regions of the country, milk production begins to decline. Dairy cows milk best in 45-60 degree weather, and they do not like humidity. Fans and misters help keep cows cool, but with sustained heat, cows use more energy to keep cool and just like us, they lose their appetite, thus milk production drops. Nationally, milk output hits bottom right around late August to early September, right when there is a surge in demand from schools and universities reopening. Not only that, commercial sellers begin ramping up production of specialty items for the holidays (aged cheddar, eggnog, etc.). Suddenly there is competition for milk for its various uses and end-products.

For a long time, the U.S. dairy market was mainly domestic. However, as the population of the middle class began to grow in countries like China and India, one of the first things they did was improve their diet, specifically with protein. Western influence has resulted in adoption of a more Western diet with, good or bad, more American fast food chains like Pizza Hut expanding in the regions. Finally, China has suffered through a credibility crisis with its own domestic brands of dairy products, as recent tainted milk and infant formula scandals have local populations more willing to buy “trusted” imported brands. The result has been a swift and dramatic increase in U.S. dairy exports in the last 10 years (see “The world’s teat,” above). With more and more dairy products being exported, the percentage of the U.S. total annual milk production being shipped overseas is on the rise. Indeed, from a low of roughly 3.6% in 1996, exports peaked in 2013-2014 at 15.4% of total milk production. With the slow-down in the Chinese economy, the devaluation of the yuan and rise in the U.S. dollar, dairy exports have gotton more expensive on the global market. U.S. dairy exports, as a percentage of total milk production, have dropped to  14.5% of milk output in 2015. Recall the earlier point about small changes in supply or demand causing dramatic changes in price and one can see why we are still far below our peak from last September. There are many other factors that affect milk prices: Beef prices, grain prices, feed quality, etc., but this gives you an idea of why this is an exciting market to trade.

Why should you trade milk? In addition to the frequent and large moves providing numerous trading opportunities, Class III milk is non-correlated to just about everything so constitutes a nice portfolio diversifier. In addition, open interest generally is increasing over time as more hedgers (long and short), commodity trading advisors and market makers participate in the dairy complex. Open interest for both futures and options peaked in March of this year at nearly 112,000 contracts (see “Building a market,” below). While obviously too small for billion-dollar-plus funds, it is large enough to accommodate smaller programs and CTAs. Class III Milk presents an opportunity for the trader willing to study the market and trade accordingly.

About the Author

Daniel Schindler is owner of Schindler Capital Management. He is a commodity trader and licensed broker.