By Joe Schmit
THE SPOT MARKET
Cheese prices rallied significantly into the end of October following seasonal trends. Blocks rallied to $1.90/lb. during the first week of November, surpassing the summer highs. The rally into peak holiday demand season seems reasonable, as fresh supplies become hard to procure but the underlying fundamental landscape remains quite bearish. Milk production was up 2.3% with significantly more cows entering the milking herd. Excess milk found its way into the cheese vat causing inventories continue to build. Cheese inventories stand at a bulging 36.7 days usage, up 2.5 days from last year, which represents the highest days usage stock since at least 1999 (as far back as data extends). The latest import/export report showed that U.S. exports were up 3.7% from the previous year but most of the increase came from whey exports rather than cheese.
While the U.S. works through its supply issues, the rest of the world may have turned a corner. The latest GDT report showed that winning bids increased by 11.4% with WMP and SMP making new highs for the year. Reductions in milk supply due to herd reductions over the course of the past year have been amplified by a persistent rainy spring in the Southern hemisphere. New Zealand milk production has plummeted during their peak milking season. Asian buyers seem to be caught in a state of denial with shrinking inventories while the low prices that they’ve grown accustomed to appear to be in the rearview mirror. Milk production in Europe has also started to contract. The latest data shows that economic decisions made by European producers this summer have led to a 3% drop in milk supply this fall.
THE FUTURES MARKET
The futures and options market have been characterized by large volumes and high volatility. When futures were near their low, the November 1550 calls traded over 1,000 times. The futures market rallied over $1.50 and most of the shorts appear to have been rolled into December strikes. Late last week, we saw one trader covering short straddles in November while initiating new short straddles in December. This short straddle calendar roll was executed entirely electronically and was of note because a strategy this complex normally takes place on the trading floor. The January-March 1500 straddle traded several hundred times only to come unwound a week later at a seven figure loss. The option trade has been fast and furious the past month as traders adjust to rapidly changing market conditions.
Change in basis has been the feature in the futures market. Near the low, futures held a $.50/lb. premium to cash equivalents. Cash cheese then rallied to what equates to a $4.00/lb. Class III increase. Futures, however, only rallied $1.50/lb., leaving the December contract a full $2.00/lb. discount one week prior to pricing. Traders simply don’t believe this rally and are unwilling to initiate long positions at these inflated levels. Cash and futures will ultimately converge as is the nature of the contract.
As traders, we are taught to respect the seasonal trends while understanding that the fundamentals will ultimately prevail. The market is currently adjusting to holiday demand. Blocks have reached new highs for the year and look poised to test the gap left at $1.9425/lb. last November. Once the buying frenzy passes, it seems reasonable to conclude that the cheese market may feel a bit heavy. Anecdotal reports suggest that excess product is currently being pushed back on manufacturers as end users fear building inventories at current elevated levels. Seasonally, cheese values decrease into early December. Inventory reports suggest that the cheese market is oversupplied although fresh product remains scarce. With the seasonals and the fundamentals aligned, it’s not difficult to understand why the futures market holds such a substantial discount. The market is likely due for a correction. That correction, however, could be an opportunity to establish a long term bullish bias based of the global supply situation once the calendar turns to 2017.