Volatility sign.
September 21, 2017

The Good, The Bad and The Ugly of Dairy Processing Constraints

 |  By: Dairy Talk

The lack of dairy processing capacity is having all kinds of consequences, good, bad and long-term.

The inability to process more milk means farms can’t increase production until they find a home for that extra milk. While that may be bad news for farms who want to grow, it’s good news for farmers who would like to see more stable milk prices. Or, I would argue, it’s good news in the short term.

“Year-on-year growth in U.S. milk production is moderating, and we seem to be in a narrowing channel between peaks and lows in production changes,” says Marin Bozic, a dairy economist with the University of Minnesota “The effect of a more stable milk supply means more stable milk prices.”

Price volatility drives farmers nuts. It’s difficult to operate a business when milk checks are in a constant state of flux. It makes it even harder to plan and budget for future years.

At the same time, a stable price isn’t all that wonderful if it hovers at or near breakeven. And while risk management becomes simpler, less volatility means less opportunity to lock in profitable margins. Tools such as the futures market and Livestock Gross Margin-Dairy insurance, which relies on the futures markets, might become less valuable if exports stagnate and there’s less price uncertainty. Believe it or not, the Dairy Margin Protection Program, which insures against catastrophic losses, might then become more important, says Bozic.

The other point is that the U.S. dairy industry is no longer a domestic market. Fully half of our non-fat dry milk is now exported. And as butter and milk fat continues to increase in popularity, we will continue to need to find a home for the protein in the skim milk that results from increased butter production, much like the dilemma our friends in Canada are now experiencing. (Illegally dumping that protein on world markets is not a recommended nor long-term solution). 

Shortages on the world market can create price spikes (recall record prices in 2014). But if the U.S. cannot take advantage of increasing volume demand because of our maxed out production capacity, other producer regions, such as the European Union, will. We might get a short-term price jump, but other countries will respond by increasing their production to fill the void longer-term.

A recent report by CoBank points out the United States will need 27 billion lb of increased production capacity over the next decade to keep up with current production increases. That would require about 10 more cheese plants processing 7 million lb of milk per day. Each such plant can cost upwards of $500 million—more if you include whey processing. So the total investment would likely be in the range of $5 to $10 billion that is needed.

The problem is that processing plants participating in Federal Orders simply don’t have the cash for such investments. The reason they don’t goes back to the Federal Order make allowance. Make allowances only cover operating costs, not capital costs or return on capital.

The alternatives are plant expansions by co-ops paying less than Federal Order minimums to fund the expansions, expansions outside the Federal Orders where processors pay farmers less, joint ventures between co-ops and proprietary companies who are more willing to risk capital, or farmers themselves putting up capital to help finance new or expanded plants. Some of this is already happening. But all these alternatives mean farmers will have to participate—one way or the other—for growth to occur.