Milking Profits From the Dairy Sector

If the Village People had included a dairy farmer in their ensemble, their 1978 camp classic surely would have been written "U-S-D-A" in honor of the massive subsidies and price supports bestowed upon the industry by the federal government over the years. Besides, it would be a lot more fun watching someone trying to form an "S" with his body that any of the letters in "Y-M-C-A."

But lamenting the presence of market distortions in the agricultural industry and its dairy sector, especially in an election year or in any years either before or after an election year, is likely to be an unproductive endeavor. This, after all, is an industry characterized for years by the Depression-era Eau Claire rule, which allowed dairy farmers to collect a bonus for their milk on the basis of how far their cows were located from Eau Claire, Wisc.

Enough of policy, let's turn to economics and see whether a bull market exists in cow products as it does in so many other physical commodities. Or alternatively, is the dairy sector one of those corners of the economy in which inflation is missing in action, as the official data suggest?

Skimming Profits

USDA Class III milk, formerly known as basic formula milk, serves as the basis of a futures contract at the Chicago Mercantile Exchange, and more importantly, it is the marker grade for the manufacture of cheese, and by extension for life-sustaining pizza. The CME also lists a contract on Class IV milk, used in the making of butter and nonfat dry milk products, but this contract is less liquid.

No Squeeze in Milk Prices

Source: Bloomberg

While both classes of milk certainly exhibit a great deal of monthly price volatility and a surprisingly erratic seasonality, neither market appears to be in any immediate danger of a runaway uptrend at the moment, and that can perhaps be attributed to the high production encouraged by the subsidies. This is not idle speculation; the forward curves of the CME futures reflect expectations for tame prices over the remainder of 2004. The Class IV contract does not extend into 2005 yet.

No Expectation of Rising Prices

Source: Bloomberg