"It's Not What You Make, It's What You Keep"

By: Dan Basse, President, AgResource Company

"It's the economy, stupid" was the popular phrase in American politics widely used during Bill Clinton's successful bid for the U.S. presidency against George H.W. Bush. Then-President Bush was thought to be a shoo-in to recapture the White House, but Americans turned out en masse and voted with their pocketbooks to elect the first U.S. Democratic president since Jimmy Carter back in the late 1970s. What analogies do the 1992 U.S. presidential election have for 2012 U.S. dairy producers - "It's still the economy, stupid!"

Today, economics have become far more important to U.S. agriculture valuations in a world where excessive debt/banking concern reigns amid a lack of political leadership. The instability of the European Union financial markets and the fear of default of European Union member debt have caused extreme ag market anxiety as the memories of the 2008 U.S. sub-prime loan crisis are still fresh. End users of U.S. grain and dairy products are staying very close, both unwilling to extend themselves amid such an uncertain future.

The inability of the U.S. congressional "super committee" to agree on $1.2 trillion of U.S. budget cuts in late November will likely cause an extension of the current U.S. farm bill. This means U.S. dairy farmers should be preparing for at least another year of managing their own milk margin. And, with the U.S. budget deficit rising to an unprecedented $17 trillion in 2013, the budgetary pressures on U.S. ag programs will be severe during the upcoming farm bill debate.

Beyond the 2012 presidential election, U.S. economic austerity will be rudely applied. And following the recent rising financing costs of Europe, the financial markets will be more acutely focused on U.S. politicians and their plan to dramatically curtail the U.S. budget deficit. Unsettling would be any rise in U.S. debt financing costs amid investor avoidance.

Rising milk prices helped repair U.S. dairy farmer balance sheets in 2011 with Wisconsin producers especially benefiting from favorable summer weather and enlarged harvests (see Graph 1). The graphic reflects that U.S. dairy producers were able to post some much needed balance sheet gains from March onward. The key 2012 unknown is whether this milk profit fortune will continue.

In recent years, it was the management of feed costs that has proven to be the arduous task of U.S. dairy producers as corn and protein meal costs soared. The competition for cash corn supplies by the fast growing U.S. ethanol industry has been unrelenting. The U.S. ethanol industry now consumes 42 percent of the 2011 U.S. corn harvest or just over 5 billion bushels, which has shifted the price skew of U.S. cash corn basis upwards.

U.S. dairy producers were hoping the December 2011 expiration of the U.S. ethanol blenders' credit of $0.45/gallon would produce feed cost relief. However, the U.S. is now exporting seven percent of its ethanol production to an unlikely source - Brazil. The rising price of world sugar will cause Brazil to import over 1 billion liters of U.S. ethanol in 2012, thereby preventing any sharp decline in U.S. ethanol corn consumption. It's the price/profit relationships of sugar, corn and crude oil that will have to be closely followed by the U.S. livestock industry.

The good news for dairy producers is U.S. unleaded gasoline consumption has peaked and expanding domestic ethanol demand will be slow. The days of heady U.S. ethanol growth have passed as the U.S. ethanol industry has reached a mature stage. Future ethanol crop year growth will be less than 150 million bushels. U.S. feed costs have already started to relax and, short of a dire central U.S. drought in 2012, this trend is likely to persist. Dairy farmer margin focus should turn to milk price management.

In 2011, the U.S. exported just under 14 percent of its dairy production - a record high (see Graph 2). It's the export of dairy products that allowed milk prices to recover and for the U.S. dairy industry to enjoy its best profitability since 2007. U.S. whole milk powder exports to China were particularly robust during the first half of 2011. U.S. cheese and butter stocks declined, and processing margins soared.

However, if the European debt crisis were to worsen or spread, it would have a chilling impact on Asian dairy product demand as European banks are critical in the finance of world dairy/ag trade.

And there are clear signs China's economic growth is slowing along with other countries in the Asian corridor. Rising Asian caloric intake has been a hallmark of the five-year bull market in U.S. agriculture. Any diminishment of U.S. dairy export demand would have a noticeable negative impact on forward milk prices as U.S. per capita fluid milk demand continues to slowly fade. This is a reason why CME milk futures contracts are trading at a discount to current spot cash bids.

In the absence of a new 2012 farm bill, U.S. dairy producers are encouraged to be protective of any positive milk margins until there is clarity in the European Union and Asian economic landscape.

Ever increasing world demand for U.S. dairy products is far from assured. World economic headwinds abound and political fighting within Washington will not be tolerated by the financial markets beyond the 2012 election. Clarity on U.S. debt reduction, jobs and tax policy are at the forefront.

"It's the economy, stupid!" Washington did not pay attention back in 1992 which produced a new administration and a change in political parties. But, the risks are much larger in 2012 amid our $14 trillion in U.S. debt. In this new global dairy market landscape, economic uncertainty will produce heightened milk market volatility with limited forward price visibility. Amid retreating feed costs, producers need to make sure to lock in profitable milk margins for at least 50 percent of 2012 estimated production. In uncertain times, protecting margin has always been the best advice.

Posted December 2011