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.

August and September Class III futures were hot out of the gate yesterday as summer heat grips much of the country, even the Upper Midwest which has been insulated from extreme heat for the past few years. High humidity levels have bumped up heat indices in many major cities in the heart of the country, but even in major milk producing areas like Central Valley California, Washington, Idaho, Arizona, New Mexico & Texas, temperatures are expected to remain well above average for at least the next seven to10 days.

CME spot cheese and butter continue to be on the rise with cheese sellers nowhere to be found or in the case of butter, above the current market. CME spot blocks continue to set 2010 highs and with yesterday’s $1.5250 settlement, barrel cheese can also stake that claim. CME spot butter rose ½ penny to set a 5 ½ year high, taking out the 2008 high of $1.77 set on Oct 13, 2008 and now the highest butter price seen since Dec 8, 2004, when butter prices were at $2.00/lb.

At the end of the futures trading session, August and September futures both closed near their intra-day highs.  However, as traders see this latest rally as mostly weather-driven, those front two month futures are enduring the vast majority of the daily trading volume and are leading to a more inverted market curve. The Oct-Dec futures average managed to gain an average of eight cents and the Jan-Dec 2011 average remained unchanged.  We expect spot cheese to make a run to at least $1.60 in the near future and for the near-term futures rally to continue.

As the Class III market truly inverts for the first time since 2008, it is important for us to explain the nature of different hedgers and how they use this market to lock in profit. There are two basics that everyone should know:  Processors and end-users constitute the vast majority of buyers in the dairy marketplace and farmers, either on their own or through their cooperatives make up a good chunk of the sellers in this market.   

However, when the market is in a “bearish” trend, meaning cheese prices are below average and deferred futures months carry a significant premium to the spot market, a new seller emerges:  the inventory hedger. If a trader, distributor, or anyone that buys and sells cheese can purchase at a given price and then immediately lock in 15-20 cents of profit to sell 60-90 days in the future, a heavy cost-of-carry futures market allows this business model to function profitably. For the past 18 months, this strategy has worked like a charm for this type of industry player. But when a market becomes inverted like we’ve seen develop over the past few weeks, this natural seller in the marketplace disappears and that business model ceases to exist.  Also, for at least the near-term, end-users that had the ability to physically buy cheese and store it for future use as their primary method of hedging have to look elsewhere to lock in costs:  the futures market.

Export numbers were released yesterday and those numbers continue to impress.  In particular, May 2010 cheddar cheese and total cheese exports were at their all-time highs, even above 2008 levels for any given month.   Trend lines look strong for all commodities and with Oceania struggling with their production late in the season, the U.S. has been able to ship product overseas in large numbers this year so far.  This is a strong sign for the U.S. dairy industry as the international partnerships forged back in 2007-2008 are paying dividends in 2010 and likely beyond.

Corn prices got a push to the upside yesterday on strong wheat prices and talk of the material drought in Russia.  There is also a short-term technical push to challenge the 200-day moving average on corn (December at $4.02). While the drought in Russia is causing some damage to crops, Russian agriculture ministry maintained that Russian farmers are harvesting about 2.9 million hectares of land, which is 214,300 hectares more than a year ago. Moreover, several news sources quoted the Russian Ag Minister, Yelena Skrynnik, as saying, “Even if the drought reduces the grain harvest, we will be able to fully meet domestic demand and maintain our export potential”. Only time will tell.

U.S. weather models show that temps in the U.S. may be higher than normal over the next two weeks, getting enough moisture to the crop does not appear to be a problem.  China too is seeing much needed rains over the past few days.  The question then becomes will China have a hefty crop or a small crop requiring U.S. exports to shore up demand?  For now we expect a firm opening in corn and a volatile weather trade. And we expect that prices over the coming weeks will be driven more by supply, than demand.

http://www.cmegroup.com/daily_bulletin/Section04_Agricultural_Soft_AltInvestment_Futures_2010134.pdf

7/14  Class III Futures:   Volume:  968  Open Interest (OI) Change:  +257  Total OI:  27,017

7/14  Class III Options:   Est. Put Volume:  257   Total OI:  19,095   Est. Call Volume:  116  Total OI:  17,825

7/14  Spot Markets:   Block Cheese $1.55 (UP 1),  Barrel Cheese $1.5250 (UP 1),  Butter $1.7750 (UP  1/2),  NFDM: A $1.2175 (UP 1/2),  X $1.2250 (DOWN 1/2)

7/14  Other Dairy Futures Volume:   Butter:  52  Dry Whey:  2   NFDM: 24    Class IV:  3   Cheese:  2

7/14 Individual Cheese Futures Prices, Change, Volume & Open Interest
Jul           $1.456     UNCH                Vol:    0                    OI Change:  UNCH
Aug         $1.588     UP .013               Vol:    2                   OI Change:  UP 1
Sep         $1.604     UNCH                 Vol:    0                   OI Change:  UNCH
Oct          $1.60        UNCH                Vol:    0                    OI Change:  UNCH
Nov         $1.572      UP .002              Vol:   0                     OI Change:  UNCH
Dec         $1.57        UNCH                 Vol:    0                    OI Change:  UNCH

7/14 Individual Class III Futures Prices, Change, Volume & Open Interest
Jul           $13.73     UNCH               Vol:  29                   OI Change:     UP 5
Aug         $14.96     UP 22                 Vol:  455                 OI Change:     UP 135
Sep         $15.13      UP 13                  Vol:  210                 OI Change:     UP 18
Oct          $14.97     UP 7                    Vol:  92                  OI Change:      UP 5
Nov         $14.80     UP 5                    Vol:  26                 OI Change:      UP 7
Dec         $14.64     UP 1                     Vol:  33                 OI Change:     UP 7
Aug-Dec 2010 Avg:  $14.92                                       UP 0.12/cwt
Jan-Dec 2011 Avg:  $14.56                                         NO CHANGE

Source:   FCStone/Downes-O'Neill