Blimling and Associates Blog

As people who are inclined to obsess about demand-side issues, we marvel at how often market participants and analysts forget that price matters in the consumption equation. This was plenty ignored -- with major consequences -- in the global commodity price rally that took the world by storm in 2007 and 2008. 

With that in mind, the latest crude oil demand estimates from the International Energy Association (IEA) caught our eye:

Global oil demand is revised down by 190 kb/d on average for 2009 and 2010, equating to 84.8 mb/d (-1.2 mb/d year-on-year) and 86.4 mb/d (+1.6 mb/d) respectively. Revisions stem largely from changes to non-OECD historical baseline data, as slightly higher GDP prognoses from the IMF are counterbalanced by a higher price assumption.

For several months, we have casually (if inexpertly) asserted that $85 crude oil was perhaps in the "too hot" area. It seems as though IEA analysts see something similar -- a slowdown in demand at the upper-end of the recent price range.

Naturally enough, the market already suspected as much: the crude oil market is down by more than 10% since reaching the $85 mark last month. And, inter-month spreads have widened, suggesting the market is over-supplied on the front-end of the price curve (and willing to pay premiums for storage).

Price does matter.

Over the past week, we have spent a lot of time pondering China's seemingly insatiable appetite for dairy powders. WMP and SMP imports continued to run hot through March. Is it real? Can it continue? What does it mean?

Those questions are difficult to answer without also pondering larger questions about economic health globally and in China. Events over the past week have shaken confidence in a view that all is well (or, at least, all is okay). Robert Samuelson comments on the phenomenon on the Investor's Business Daily website:

The United States and many countries approved "stimulus" programs of tax cuts and additional spending. Panic was halted. A downward spiral of falling private spending and rising unemployment was reversed. The resulting economic slump was awful. But it was not another Great Depression. The worst has passed.

Or has it? Greece's plight challenges this optimistic interpretation. It implies that celebration is premature and that the economic crisis has moved into a new phase: one dominated by the huge debt burdens of governments in advanced societies. Comparisons with the Great Depression remain relevant — and unsettling. Now, as then, we may be prisoners of deep and poorly understood changes to the world economic system.

It should not escape notice that China's equity markets have been under pressure for several weeks. The government seems intent on tightening in an effort to fight inflation. It seems reasonable to wonder about export prospects into a weak Eurozone. More to the point, will fallout from tighter credit conditions or a cooling economy put the brakes on dairy product imports? We don't yet know enough to know for sure...and there are other germane lines of inquiry to explore. At the same time, we get the sense that it would be a mistake to simply assume that everything is okay and conditions tomorrow will resemble those prevailing today or in the first quarter.

As the financial crisis began to spin out of control late in 2008, we occasionally had the feeling that the speed at which markets can be accessed was  contributing factor. In the computerized trading era, people (and firms) can act quickly and, arguably, impulsively in a way that wasn't possible 20 or 30 years go. Long gone are the days where executing a stock or commodity transaction required the involvement of a broker at a desk who would then call a broker on a trading floor. Gone, in other words, are the human circuit breakers. Our sense: at any given time, we could trade ourselves into oblivion. 

Those feelings were reawakened today when seeing US equity markets implode in a 20 minute span -- a downward move of more than 500 points. Within an hour, that ground had been regained. The talking heads on CNBC almost immediately began to speculate that some sort of an error was responsible. Nothing else, it seems, would explain some of the movement (more than a few stocks traded to near zero during the swoon). There was talk about a "fat finger" error -- perhaps some poor soul typing in sell billions in stock value rather than millions. Alternatively, various commentators thought it was possible that an algorithmic/black box type trade went awry -- that an uptick in something here created massive selling there. In any case, there is going to be a lot of talk in the coming days about somehow slowing down the trade execution process. (What kind of speed are we talking about? Legendary fund manager Mark Fisher, in a rare appearance on CNBC's Fast Money, said that in the time it takes someone to "tap your desk" electronic trading systems can initiate 10,000 discrete orders...)

Meanwhile, as everyone sifts through the carnage, the Euro endured another day of ritualistic abuse. Today's low was just over 1.25 versus the US Dollar -- a level not seen since last Spring. In a week, the Euro has lost more than 4% of its value....likely creating some upheaval in the valuation of US dairy commodities in the world markets.

An article in the Wall Street Journal points to improving restaurant sales and consumer confidence, though there are indications that the consumer is still budget-minded.  Accordingly, restaurant companies are seeking to showcase value.

Sales at quick-serve and family-style restaurants open at least a year have been up four of the past six weeks, research firm NPD Group reported, something that hasn't happened in 11 months. Still, the firm expects the industry will remain weak for the next seven months.

Restaurants haven't been able to raise prices. Instead, they have developed new, lower-cost items or reduced costs by substituting lower-priced ingredients in their recipes.

At Yum Brands Inc., owner of KFC and Pizza Hut, lower prices have become a way of life. First-quarter sales at Pizza Hut were driven by a successful promotion, said CEO David Novak. "We were simply too expensive and now we're working on ways to sustain this value," he told analysts last week.

Chipotle finance chief John Hartung said the restaurant hasn't had any menu price rises "for over a year," and while he expects food and labor costs to creep up this year, "I think we'll be patient before we rush into any price increase," he added.

Consumer food prices were up only 0.2% last month even as producer prices rose 2.4%. That means restaurants aren't passing along their higher costs.

It isn’t clear to what extent increased restaurant traffic will improve demand of dairy products.  But marketers are surely heartened to see a little momentum back in the food service space.

Stirred Up…

Less than a month ago we wrote that the dairy markets were entering an “especially crucial” period for price path determination.  In just a few weeks time, the marketplace has been vigorously stirred up, most notably by the April 6 Global Dairy Trade auction which showed 20+% month-to-month increases for SMP, WMP, and AMF.    Piecing things together, we are more bullish parts of the complex than was the case a month ago.  This doesn’t mean that we are set to revisit the market of 2007-2008, however.  Yes, demand in Asia is persistent and commands respect, but it would be a mistake to underestimate latent supply-side potential, particularly in the US.  What’s more, compelling arguments can be made suggesting that unexpected strength today will breed weakness that we have not heretofore expected for tomorrow.

With supplies tighter, demand a bit stronger, and the complex stirred up by the GDT results, we believe the world is going to go into front-load mode on powders and butterfat.  We expect that the US will participate from an export perspective, but as we have noted in the past, mainly as a function of supply gaps created elsewhere.  The complex is edgier and behaviors of both buyers and sellers will shift to avoid future shortages and take advantage of higher prices, respectively.

We continue to watch the developments with a wary eye.  A fundamental foundation for stronger prices exists, but can a significant, sustainable rally be built upon that?  There are a number of obstacles.

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Make-or-Break Time?

It intuitively feels as though events over the next 90 days will be crucial for determining price prospects for the third and fourth quarters.  What happens with milk supply – specifically cow numbers – will be pivotal.  Cow number increases over the first two months of 2010 and higher milk production in February – the first increase in a year – lead to a serious swoon in dairy commodity prices in January and February, dragging milk prices down to or below production costs.  These declines indicate that the market is still confronting at least a modest supply overhang and, while prices would seem low enough to drive a measure of contraction, convincing evidence of that remains elusive.  Even so, it appears the entire dairy complex may be getting a boost from the global powder markets.  Prices are rising and product is a bit harder to find…does this mean the market is on the leading edge of a strong price run?  The butter market continues to stir up the most debate, but in the grand scheme of things, the market hasn’t done all that much.  Is it possible that the fact that just about everyone is prepared for “something” will make it less likely that anything dramatic will happen?  And what about prospects for the cheese market?  The cheese market is frequently restless and prone to wide swings related to the 4-30 day-old rule, but we wonder if prices may have reached something of a “put up or shut up” level.  What is clear is that the arbitrage opportunities of two weeks ago are gone.  Prices indicate that more work remains on righting the milk production supply, but a look at Implied Margin Over Feed estimates based on the futures market suggests another wave of herd contraction may be slow to develop – if at all – and argues against robust pricing in the third and possibly the fourth quarter.

How Much Cheese is A Lot of Cheese?

While near unanimous agreement holds that current prices are not sustainable at the farm level, massive cheese inventories weigh on price prospects.  Class III futures and most forecasts predict a significant rebound in cheese prices for later this year, but cheese stocks seem to stand in the way of a sustained rally.  Just how large are cheese inventories?  Compared to last February, stocks are 91.1 million pounds greater and 168.5 million pounds greater than the five-year average for February.  We sought to figure out what magnitude of milk supply adjustment would be necessary to trim cheese inventories back to five-year average levels.  We found that the problem is just too large to mend quickly from the supply side alone.

In Many Ways, Housing is The Thing

When discussing macroeconomic conditions, it is easy to point to unemployment as the strongest headwind blowing against consumer spending.  The numbers are attention grabbing and the associated stories are visceral.  Accordingly, we have been among the voices saying that it is unreasonable to expect consumer spending to gain momentum absent improvement in employment.  But, what might create that improvement and what factors should we be monitoring for clues about improving consumer demand?  It could be argued that the US housing market situation has critical implications beyond employment.  The ripple effects of the housing crisis are numerous, not the least of which are consumer behavior, monetary policy, and the potential for inflation.

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A year ago today, the US stock market made a bottom. On March 9, 2009, the S&P500 closed at 676.5. Yesterday, it was 1138.5. So we have made a 58% comeback. According to a report published by Bespoke Investment Group, the current bull market so far ranks 14th on the all-time list.

At times it is not easy to believe that things have gotten a lot better since last March. That view is perhaps mostly deeply colored by unemployment, which is rampant. But a look at a number of indicators shows real gains. Look at the data "in hand" today versus the same month a year ago:

Consumer Confidence +84%

Retail Sales +5%

Auto Sales +13%

ISM Purchasing Managers Index +61%

Durable Goods Orders +10%

Housing Starts +22%

So: we survived and there has been traction.

Of course, that is not the same thing as saying "everything is great" or that there is somehow no bad news. The housing sector remains in tatters -- foreclosures, unsold inventory, "upside down" mortgages and construction spending all remain areas of concern. Moreover, the mood around everything remains tentative. In short, we could write the "glass is half-empty" narrative without straining.

But for today, on the one-year anniversary of the market making a major bottom, we'll stick with a "glass is half-full" view.

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Downside Revisited

Dairy product and milk prices continue to slide, with the declines in the cheese and nonfat dry milk markets now at or beyond the lowest numbers contemplated by many market observers three or four months ago.  For dairy producers, any good feelings and additional cash flow engendered by the fourth quarter rally is gone or will be in short order.  For marketers and end-users, the break in prices might be welcomed, but probably half-heartedly because it is weakness in their own sales that has contributed to the slide.  None of which is surprising as our view for several months has been that another round of lower prices was going to be necessary to trigger the last phase of supply/demand balancing.  It is our belief that as prevailing prices are conveyed to the farm level, another round of herd liquidation will take place.

Crude Correlation? A Look at Class III Ties

Not so long ago, the commodity markets were the mucky backwaters of the financial universe.  Over the past five years, however, the investment community has come to embrace commodities as an alternative investment or diversification play.  For the first time, the dairy industry is seeing the impact of the energy markets via feed cost impact on cost of production.  Consequently, more and more questions are being asked about the relationship between outside commodity markets and milk prices.  Our first impulse is to think about the structural relationship between the commodities, yet one cannot help but wonder if there is a more immediate correlation that is tied to market psychology than to structural relationships.  In an effort to provide answers, we did some quick comparisons and analysis.  The results were surprising...

More Bits of Evidence Point to Mild Rebound 

On February 16, among a bevy of quarterly earnings reports for restaurant companies was a note from Darden Family Restaurants increasing guidance on signs of sales and traffic improvement.  And, while not in the habit of holding out one data point as indicative of trend, the Darden experience was hinted at by other restaurant chains reports, anecdotes and observations that suggest the consumer may be making at least a tentative comeback.  Consumer spending momentum seems likely tied to overall demand for food generally and dairy products specifically.  Generally speaking, a sense of prosperity and any propensity toward indulgence – think appetizers and desserts – is probably a net positive for overall dairy product demand prospects. 

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Still Too Much…

By any metric and in every corner of the dairy complex, supply is running in excess of demand. The basic over-arching storyline, at least domestically, continues to be that of too many cows relative to demand.  And, harsh though it may sound, prices are not going to be able to move sustainably higher until stocks are worked down or demand improves. As for demand, prospects for this February and March are no better than those of years past, as those months tend to be a lull and prospects are no better from an international standpoint.  And, where demand is lackluster, forward-looking prospects for supply are staggering.  Based on the latest USDA/NASS Cattle report, heifer numbers are burgeoning and suggest that the US is positioned to have a lot more cows at a time when fewer are necessary to satisfy demand.

Lower Feed Prices Level the Field 

In January 2007, we introduced the concept of “margin over feed” as a replacement for the industry standard milk:feed ratio, a metric that has caught on and helped to explain the regional differences in milk production, explain how we got to this point, and inform future outlook.  Looking backward, 2009 was a dreadful year for dairy producers, but not to the same extent in all locales.  On an state-by-state basis, dairymen in the West faced significantly worse financial pain than did those in the Midwest and East.  Looking forward, the prevailing 2010 national margin over feed index suggests production could climb just when many prognosticators are forecasting milk production to decline.  Data would also seem to suggest that improved profit potential in the West opens the door to a more rapid rebound in production than many expect.

Eyes on the Far East: As Goes China… 

In most commodities if not all, China has been the story, or a big part of the story for some time.  That circumstance continues with China’s reigning in of their economy by tightening lending, raising interest rates, and raising capital requirements.  Where China’s appetite for all commodities – including whey and whole milk powder – had been keeping many markets afloat, tighter credit in China has many markets reeling.  This is not to say that the China story has ended; conventional wisdom seems to hold that China is merely on pause.  And, where the US consumer has been on pause for some time, signs of stirring are coming to the fore, most notably in the restaurant space with surveys showing consumers planning to spend a bit more in the future and operators feeling better about their prospects. 

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Friday's editions of The Wall Street Journal feature a lengthy news story about the falling value of the US Dollar as well as a pointed editorial about the dangers of devaluation. A few snippets from the news story:

The dollar fell to a 14-month low against other currencies Thursday, intensifying a trend that the Obama administration has publicly suggested it opposes -- but which it appears prepared to tolerate quietly.

Many of America's trading partners, however, are pushing the other way. In Asia, traders said central banks in South Korea, Taiwan, the Philippines, Thailand, Indonesia and Hong Kong again intervened to slow the dollar's fall against their currencies.

Asian officials fear that the dollar's fall could crimp their export-driven economies. "The [Thai] baht has appreciated a little too rapidly compared with our fundamentals," said Suchada Kirakul, assistant governor of the Bank of Thailand.

In Europe, where the strength of the euro is clouding prospects for export growth, the president of the European Central Bank, Jean-Claude Trichet, said Thursday that the stated U.S. "'strong-dollar policy' is extremely important in the present circumstances."

The dollar, down 11.9% against a basket of currencies since President Barack Obama took office, fell an additional 0.7% Thursday. The yen ended the day at 88.48 per dollar, the lowest level since December 2008. In early trading Friday in Asia, the dollar inched up after Federal Reserve Chairman Ben Bernanke reiterated that once the recovery takes hold, the U.S. will need to raise interest rates. He didn't give any timeframe for the action.

From the editorial:

For many in the Washington establishment, alas, the falling dollar is considered a virtue. They believe it will help U.S. exports and therefore reduce the trade deficit and bring back manufacturing jobs. But as David Malpass argued on these pages yesterday, capital flows dwarf trade flows as a source of wealth creation. The only way to build wealth and create more high-paying jobs over time is through the productivity gains that come from greater investment and innovation. As the dollar falls and capital flees the U.S. for other countries, those global competitors reap its benefits and become more productive and relatively more prosperous.The more immediate danger—in the coming months—would be if the fall of the dollar becomes a rout. This could cause a spike in commodity prices, such as oil, that are traded in dollars and jeopardize the nascent economic recovery. But even if there is no dollar panic, the volatility of currency markets is distorting investment decisions and creating more economic uncertainty. It could also lead to a round of competitive devaluations, as other nations try to placate their own domestic export constituencies.Washington may not care to notice, but the sell-off in the dollar is a daily global vote on U.S. economic policy. It is not a vote of confidence.

This is not the first time the Journal has cautioned about the perils of a weak US Dollar. But the editorial page's tone has sharpened.

Two things come to mind... First, it should not be ignored that, often times, trends are often peaking when they receive intense/broad coverage in the popular press. There is an old saying among market professionals along the lines of "once it hits the front pages, it is over..." Indeed, we are reminded of a cover story in The Economist last spring -- replete with a apocalyptic Dollar demise graphic -- that corresponded fairly closely with the Dollar making its lows (lows that have not yet been taken out). Second, for all that, a continued trend toward Dollar weakness is likely to translate to commodity market strength -- and while the effects on dairy may not be as profound or direct as with, say, crude oil, dairy probably won't be excluded.