by Dave Kurzawski

Whoever says one year can't make a difference has not looked at the cash-settled butter futures market lately. Born at the Chicago Mercantile Exchange (CME) on September 19, 2005, the long-awaited, 20,000-pound, cash-settled sibling of the 40,000-pound physically delivered contract has proven to be a blessing for those dairy professionals whose bottom-line is sensitive to the price of butter.
On November 8, 2005, the 40,000-pound physically delivered contract had an open interest of 613 contracts, or 24.5 million pounds of butter. At the same time, our newborn cash-settled contract had an open interest of 416, or just over 8.3 million pounds. Although the new contracts showed strength out of the gate, the bulk of the business remained in the thin, physically delivered futures market. That's all changed.
One year later, the lion's share of butter-futures trading is done with the trim 20,000-pound contract. As of this writing, open interest in the cash-settled butter futures market registered at 2,552 contracts, or slightly more than 51 million pounds of butter. Weighed against the elder contract that posted an open-interest number of 112 contracts or 4.48 million pounds, the difference is staggering.
So where did all of this new interest come from? From the new contract itself.
The need to hedge butter or cream price risk was a perennial issue for most companies. But until last September, the only tool available was less than attractive primarily because there was the possibility of taking delivery of 40,000 pounds of butter. That's a big pill to swallow if your business doesn't actually need the butter.
Now that we have a proven tool, our eyes turn to what the market fundamentals say about the future price of butter. For the cream buyer, 2006 has been a delightful year. Butter prices, by and large, have remained under $1.30 due in no small part to hefty inventories; not since 2003 have monthly butter storage numbers been higher. Add to that a 6.8 percent growth in production over the course of the year and the prospect of a barn-burning market rally doesn't appear so ominous. Furthermore, with the recent spike in nonfat dry milk prices, the conclusion is often made that more milk will find its way into butter/powder plants and away from cheese or fluid plants in the next 3 to 6 months. All good reasons to dismiss $2 butter prices in 2007. Or are they?
Right now, replacement heifers are at record highs and milk production hasn't shown any marked declines to worry about. The argument can be made, however, that the U.S. supply of milk may be in jeopardy in 2007. When we examine the price of grains, the milk-feed ratio and potential changes in government policy, milk for butter production may not be as easy to come by as it appears.
Since early September, corn prices at the Chicago Board of Trade rallied over $1 per bushel, proving that milk is not the only commodity that can experience contra-seasonal price moves. That will further compromise an already lackluster milk-to-feed ratio, a benchmark for profitability. In 2005, the milk-to-feed ratio averaged 3.23. That means that on average, a dairy producer could buy 3.23 pounds of feed for every 1 pound of milk sold. So far in 2006, the milk-to-feed ratio has averaged 2.58. A ratio of 2.50 or lower is typically enough to prompt cow culling.
An increase in operating costs, plus an anticipated policy change on the make allowance that would lower raw milk prices, would further squeeze dairy farm operators. Should the USDA revamp the Class III pricing formula, producers could lose an additional 40 cents on the milk price. While the need for pricing changes is evident, the long-term effect will likely be less milk. It is the short-term economic equivalent of kicking a man when he's down.
So, as the price of nonfat dry milk catches your attention and the talk turns to resurrecting a whey futures contract, remember that the horizon for butterfat prices is not so clear, and our new cash-settled butter contract is, for all purposes, not so much a baby anymore.
Dave Kurzawski is an account executive with Chicago-based commodities brokerage Downes-O'Neill LLC.