No longer are the days when those concerned with the price fluctuations of butterfat were given an ultimatum: deal with a 40,000-pound, physically delivered butter contract or deal with nothing at all.

After years in the making, a trim 20,000-pound, cash-settled butter contract has not only emerged, but done quite well in during its first full month of trading at the Chicago Mercantile Exchange. And that is good news for butterfat and cream buyers and sellers as we look towards 2006.

Most futures contracts, especially those of the agricultural variety, experience liquidity issues in their infancy. The CME’s new cash-settled butter contract has quieted even the cynics with a good mix of buy and sell interest from the start. Volume for the new contract totaled 448 contracts in October versus 555 contracts traded by its 40,000-pound sibling. While this may not add up to half of the old butter contract traded in terms of pounds, it represents that a void is being filled.

Members of the industry who found the physically delivered butter contract impractical to meet their cream or butterfat hedging needs now have a tool. The contract trades 12 consecutive months, is settled to the monthly NASS butter price and participants will never “make” or “take” delivery of physical butter. It’s ideal for the hedger who whose bottom line is sensitive to the price of butterfat, but wants nothing to do with butter.

Now that we have the tools, what do we do with them? If you’re like most, expectations are for lower butter prices next year. Dairy producers, who finished one of the best years to date in 2004, are throwing substantial resources at making more milk and they’re doing an exceptional job. Milk production has risen 3.16 percent year to date with little indication of slowing. Butter production has followed suit.

The year-to-date numbers from January to August 2005 show domestic butter production has grown by a robust 7.8 percent as compared to 2004, while demand has remained largely flat growing only 0.2 percent during the same time period. Cold storage numbers tell us we’re moving the product as inventories show a 7.1 percent drawdown. These numbers hardly add up until we consider that our butter imports plunged by a massive 49.1 percent in the same report. Even still, prices appear high.

If futures prices are based purely on supply and demand, we should expect prices to come down in 2006. However, futures prices also reflect premiums as anxious buyers are willing to pay more to get their price. This is true of butter prices as buyers a weary of waiting for $1.20 or $1.30 prices only to risk another run to $1.80 or higher.

Where does this leave you and your company? Market fundamentals will eventually take control of the market. Does that mean $1.05 butter for 2006? Not likely. But it means that prices should fall and you will have the cash-settled butter contract to control your butterfat price when the time is right. m

Dave Kurzawski is an account executive with Chicago-based commodities brokerage Downes-O’Neill LLC.