What's next?

by Keith Nunes
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The unprecedented market volatility that has rocked the global and U.S. economies as well as the dairy industry was the featured topic at the International Dairy Foods Association’s Dairy Forum. Throughout the meeting, which was held Jan. 11 to 14 at the Disney Yacht & Beach Club Resort, speakers assessed the current market and attempted to provide participants with a sense of where commodity markets may be headed.

Bruce Scherr, the chairman of the board and chief executive officer of Informa Economics, Inc., Memphis, Tenn., opened the discussion by noting that the past four decades were a period of commodity deflation. When commodities experienced a period of inflation during that four decade period it was due to what he called a "glitch" due to extraordinary events such as OPEC pulling supplies off the market, drought or other events that may have affected crop or production yields.

"The most recent (commodity) price spiral is a very different animal," Mr. Scherr said. "This price spiral had little if anything to do with a shortage. There was one commodity that was short for about a 12- to 18-month period and that was wheat.

"This commodity price spiral, the big daddy of them all, is a result of dramatic demand and expansion. This is an interesting thought, because as you watch crude oil prices go from $40 per barrel to $150 per barrel and back to $40 per barrel, you have to say to yourself, if this was all demand based then where is it going?"

He called this period of commodity price expansion the "quintessential description of economies working around the world."

"(The market) expanded because of economic growth and it collapsed because of economic downturn, which in this case was caused by institutional failure," he said.

Using emerging economies such as China, India and Brazil as examples, Mr. Scherr said the world has been in a period of expansion as 1.5 billion people migrated away from subsistence living to what he called "culturally defined middle income."

"What I mean by culturally defined is when you think about middle income in China you don’t think about $40,000 per year (in income)," he said. "If you are making $4,000, $5,000 or $6,000 you may be middle class or above."

As these populations have evolved and demanded more, governments have had to invest in infrastructure, providing roads, housing and other services.

"Up until this recessionary period, China was utilizing concrete at the rate of 1.5 Los Angeleses per year," Mr. Scherr said. "That is amazing."

Looking ahead, Mr. Scherr believes the pending infrastructure investment in the United States, China and other parts of the world will reignite market growth.

"We are talking in this country of spending between $500 billion and $1 trillion in infrastructure spending," he said. "In China they are talking about a $600 billion investment in infrastructure and similar programs are being talked about around the world. I don’t think that you can hold back the dramatic movement of people from sub- to middle-income or above unless the world continues to live in a situation of institutional failure and economic collapse.

"Are we going to go back to $150 crude oil in the near term? Probably not, but what about $75 to $100 crude oil — Probably.

"In an environment of infrastructure development or economic reignition of economies, commodities will migrate back to levels of real economic value. Now crude oil at about $90 a barrel presents crude that is adjusted for inflation and a real value. Four dollar corn is a real value."

Mr. Scherr predicted that during the next two to four years the world is going to see two broad classes of economies develop. In the industrial world, which consists of North America, the E.U.. and Japan, the economies will evolve in a period of slow economic advancement that will create the dilemma of slow growth during a period of strong commodity inflation.

"That will create an era of difficult profitability," he said.

The second class of economies will consist of new and emerging markets that feature strong population growth and greater infrastructure development. He said these regions will offer economic growth prospects that are far greater than industrially developed economies.

"While our economy moves forward at growth rates of 1% to 3% over the next one to three years, the other regions of the world will reemerge at growth rates that will continue to exhibit per capita expansion of G.D.P. near 8.5%," he said. "This is where the growth of the world will take place."

For dairy processors considering how their businesses will evolve, Mr. Scherr had several recommendations.

"Domestically, I would suggest following the money," he said. "By following the money I mean follow the infrastructure investments. Where the infrastructure investment is made, whether they are in particular cities or towns that will be where the economic activity will be the greatest and that will be where we see the greatest expansion."

Internationally, Mr. Scherr said China’s culturally defined middle class of 300 million to 400 million people is larger than the entire U.S. population.

"Those consumers will continue to migrate over the next 5 years to 15 years into higher income levels and will demand higher value products," he said. "What this says for the dairy industry is from a strategic standpoint you need to sit back and think about how you will balance your domestic business against the prospects of international activity.

"You want to start thinking about how you are going to participate in those countries and regions of the world and the 100 million to 400 million people in each nation that will be demanding value-added products.

"Those regions of the world will not be able to meet the supply requirements exhibited by or required through the demand expansion of those peoples of the world. There is opportunity in those regions of the world."

From the ground up

While Mr. Scherr’s presentation focused on global economies from a macroeconomic perspective, other presentations drilled down into the details of what dairy producers and processors are dealing with today. Mike McCloskey, the chief executive officer of Select Milk Products, Inc., a cooperative in the Southwest, said the rapid decline in returns producers are receiving combined with the slow decline of their feed bills has created an extremely difficult situation.

"This is the first time in my experience where the milk check we will pay dairy producers in February, which will represent January milk production, will not cover the feed bill," he said. "You are looking at approximately $9.50 per cwt of feed costs producers are not going to get back."

Looking at prices today, Mr. McCloskey predicted that the dairy industry will experience a "tremendous cull" in the months ahead, which will accelerate as producers are unable to cover their costs.

The U.S. Department of Agriculture’s most recent World Agriculture Supply and Demand Estimate, released Feb. 10, supported Mr. McCloskey’s contention as it noted that "producer returns are expected to be heavily pressured resulting in a relatively sharp reduction in inventories during the latter part of the year."

The WASDE also said both domestic and export demand is forecast to remain weak due to economic uncertainty. Such uncertainty will put additional pressure on both producers and processors.

The potential for increased volatility will affect processors, because they are continuing to address high prices despite moderation in some commodity categories like energy.

"As someone with 20 or more years in the food and drinks industry I have never seen such a relentless, ongoing run up in prices," said Kevin Toland, c.e.o. of Glanbia USA, Twin Falls, Idaho. "What stood out to me on the cost side is every single cost increased. For us, the situation proved to be quite challenging and we had to put in place a range of tools to address it, whether it is hedging or cost containment."

Brian Haugh, chief executive officer of National Dairy Holdings L.P., Dallas, said the increase in costs forced his company to look at its business models.

"As for the volatile markets, we really were not prepared for it," he said. "We had to educate some of our customers about the rising costs of fuel and grains and there were times we had to completely rebuild our models. When they came up we did not re-do fixed price contracts. We shifted to variable price models to better help us run our business."

Spanning the globe

The international marketplace also proved to be a lively topic of discussion.

Mr. McCloskey noted some of the challenges presented to the U.S. dairy industry as its members gain more experience in the global marketplace.

"We have not been an exporting country and we are happy to be in this arena, but we need to understand that we were exporting somewhere between 9% and 11% of our milk when in the past it may have been closer to 4% or 5%," he said. "All of the sudden we are dealing with 5% to 6% more milk out there and I don’t know what percentage is coming back at us, but it may be as much as 50% of that milk is coming back. This is something we have never dealt with.

"What happened is we had a quick window to look at the future and some people said this is what is going to happen for the next 30 years. Other people had their necks out the window and when it closed they got decapitated in the process."

But looking ahead, Mr. McCloskey added, "I think what we are looking at is beautiful growth. I think we are looking at 10 years to 15 years of nice steady growth."

In the near term, the most recent WASDE data shows the export market for U.S. dairy processors to be slowing. Commercial export forecasts for 2009 have been reduced compared to the previous month as weak international demand and expected competition from recently announced subsidized EU-27 exports limit opportunities for commercial exports. Conversely, lower international prices are expected to result in slightly higher U.S. imports of dairy products, primarily cheese.

Asked how market volatility has affected his company, Mr. Toland made three points.

"First, we are trying to understand it," he said. "The second thing, especially with international operations, is getting the data early, converting it to some form of raw intelligence and making sense of it. The third thing is trying to develop tools to change it, smooth it and communicate everything that is relevant across the supply chain.

"You know, it is a big challenge, but necessary, because it is not going to go away."

This article can also be found in the digital edition of Dairy Business News, February 2009, starting on Page 10. Click
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