Editor’s note: This market commentary is provided by  Dave Kurzawski and Eric Meyer, risk-management consultants with FC Stone/Downes-O’Neill, Chicago, Ill.

Class III futures dropped back on Friday in what appeared to be a profit-taking session to close out the week. Chicago Mercantile Exchange Spot Block cheese managed to set a new 2010 high for the second straight trading session with a 0.75-cent gain, but the fact that both blocks and barrels finally found a seller with a lone trade in both markets had traders running for cover.

We view Friday’s futures trading activity as a correction and expect cheese prices to continue to carry its momentum to the upside this week. The industry has seen this all before a few times in 2010; a CME spot rally up to $1.50 and within a few days prices quickly retreat into the $1.30s. Here’s why we believe this rally is a bit different from the ones earlier in the year:
 
First, the summer heat has had some impact on milk production throughout the country. While the Northeast has taken the biggest punishment over the past couple of weeks, the 10-day forecast for much of the country is anywhere between the mid-80 degrees F up to the mid-90 degrees F, humidity levels in the Midwest are on the rise and this will continue to impact milk component levels in a negative way.  

Moreover, we are approaching the time of year that milk production is seasonally at its low point and milk product demand tends to be at its highest over the next four to six weeks. Inventories of dairy products seasonally decline during the third quarter and end-users tend to begin their hedging programs around this time as well, keeping a relative floor underneath futures prices. While historically high cheese inventories might keep the price of cheese from getting too out of control this summer, a run to at least the low $1.60s seems realistic.  
 
Open interest rose as prices corrected downward Friday, leading some to believe that the rally is over as more traders added to their positions. However, due to strong volume throughout 2011 Class III months and second half 2011 as well as an up-tick in cheese and dry whey futures trading volume lead us to believe that the volume over the past week has been commercial buying in nature.
 
In June, Class III futures only managed to have three 1,000-plus contract trading sessions. So far in July, six of the first seven trading sessions have been over 1,000 contracts — even with the new competition of cheese futures contracts, which incidentally did not show as large of a drop in prices as Class III had on Friday. While still in its infancy, we will begin looking at the rise and fall of cheese futures in relation to Class III to see if there is a correlation with the longer term price direction of the spot market. We expect a busier third quarter as commercial buyers get a head-start at locking in prices for the fourth quarter and into 2011.
 
We like the idea of end-users taking advantage of a market that does not have a lot of premium built into the deferred months. Currently, the highest price on the futures board over the next 18 months is at $1.60. End-users should consider locking up a portion of their usage into next year with the “budget-friendly” futures price curve.   
 
CME spot butter prices finished higher on Friday and futures were mixed but on strong volume in the August contract, up nearly 0.25 cents. Spot butter prices also just a penny away from breaking above the 2008 high of $1.77, trading there only a single day in December 2008. In order to find the next highest butter price, one has to look back to December 2004 when prices were last over $2. Commentary from the weekly USDA reports as well as anecdotal reports across the country is that both butter and cream remain tight. We have to look back to 1998 to find CME stocks lower than where they are currently during this time of year.
 
In international dairy news, two years after a national health scare over melamine-tainted milk products rocked China’s dairy industry, inspectors in western China’s Qinghai Province have seized 76 tons of dairy ingredients laced with the same industrial chemical, the state-run Xinhua news agency reported Friday. 
 
Meanwhile, corn traded mixed overnight as the momentum of the quarterly grain stocks numbers, and last week’s supply/demand numbers, loses momentum to continued ideal growing weather. Corn market bulls will need fresh bullish news to catapult prices over the $4 per bushel level for any protracted period of time.

We suspect a market correction of between 20 and 30 cents per bushel in the short term. If you have any corn that needs to be sold for 2010, we recommend selling the balance. We also recommend selling a portion of your corn production for 2011. Buyers of corn ought to wait patiently on the sidelines for now.

http://www.cmegroup.com/daily_bulletin/Section04_Agricultural_Soft_AltInvestment_Futures_2010131.pdf

7/9  Class III Futures:   Volume:  1049  Open Interest (OI) Change:  +310  Total OI:  26,586
7/9  Class III Options:   Est. Put Volume:  160   Total OI:  18,958   Est. Call Volume:  230  Total OI:  17,505
7/9  Spot Markets:   Block Cheese $1.5275 (UP 3/4),  Barrel Cheese $1.50 (UNCH),  Butter $1.7625 (UP 1 1/4),  NFDM: A $1.21 (UNCH),  X $1.23  (UNCH)
7/9  Other Dairy Futures Volume:   Butter:  75   Dry Whey:  13   NFDM: 6    Class IV:  0   CHEESE:  25

7/9 Individual Cheese Futures Prices, Change, Volume & Open Interest
Jul           $1.432    UNCH                  Vol:    0                      OI Change:  UNCH
Aug         $1.56       DOWN .006        Vol:    0                     OI Change:  UNCH
Sep         $1.593     DOWN .002        Vol:    0                     OI Change:  UNCH
Oct          $1.60       DOWN .006        Vol:   0                     OI Change:  UNCH
Nov         $1.569     UNCH                  Vol:   0                     OI Change:  UNCH
Dec         $1.568     UNCH                 Vol:   0                      OI Change:  UNCH

7/9 Individual Class III Futures Prices, Change, Volume & Open Interest
Jul           $13.64    UP 8                     Vol:  183                 OI Change:    DOWN 27
Aug         $14.53     DOWN 13            Vol:  233               OI Change:     UP 46
Sep         $14.82    DOWN 18             Vol:  105                OI Change:     UP 28
Oct          $14.84    DOWN 16            Vol:  88                  OI Change:     UP 15
Nov         $14.70    DOWN 3              Vol:  59                  OI Change:      UP 30
Dec         $14.57    DOWN 13             Vol:  67                  OI Change:      UP 54
Aug-Dec 2010 Avg:  $14.69                                        DOWN 0.13/cwt
Jan-Dec 2011 Avg:  $14.55                                          DOWN 0.02/cwt

Source:   FCStone/Downes-O'Neill