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China’s demand for dairy continues to astonish; however, Chinese imports over the past nine months could be the result of declining milk supplies rather than rapidly expanding demand. No doubt, demand continues to grow in China, but the sharp rise in milk-solid imports is likely the result of a shortfall in domestic milk production, which is expected to continue through mid-2014.

China Graph

At the start of 2013, dairying regions in China suffered from persistent foot and mouth disease (FMD), which resulted in lower output per cow. In severe cases, entire herds were destroyed to prevent the spread of the disease. In 2008, melamine in Chinese-produced infant formulas killed six babies and sickened another 300,000. Since then China’s government has taken steps to provide a safe and growing supply of fresh milk to rebuild trust among consumers, recognizing the potential for growth in dairy demand and the risks caused by heavy reliance on imported milk and dairy products. China has tried to shift away from relying on small farms to provide most of its milk to obtaining its milk primarily from mid- to large-sized farms.

Furthermore, the efforts to modernize China’s dairy industry have been hampered by much-improved dairy margins throughout the world, which has tightened the supply of available cows for import. Last summer, China’s government encouraged smaller dairy farms to exit the business, fully expecting that the cows would be sold to new, larger dairy operations. Instead, exiting farms opted to send their cows to slaughter due to strong beef demand that had driven beef markets much higher.

All of these events drove China’s second-half 2013 milk production below 2012 levels, creating a vacuum for dairy solids. Since October, China has imported an average of more than 200 million pounds of whole milk powder (WMP) each month, with January and February posting the highest monthly WMP imports on record at 275 million and 212 million, respectively. Similarly, skim milk powder (SMP) imports surged in December. February 2014 SMP imports of 59 million pounds were 159% higher than the prior year but 13% less than January’s levels on a daily average basis.

With China pulling an increasing volume of dairy products off the world market to backfill lower domestic output, opportunities have been created throughout the world for U.S. dairy products exports. Despite historically high U.S. dairy product prices, U.S. exports continued to be brisk in February as millions of pounds of butter, cheese, milk, and whey powders moved overseas. The United States exported 79.7 million pounds of nonfat dry milk (NDM) and SMP in February, down only 5.9% vs. a year ago and 3.4% less than January on a daily average basis. U.S. cheese exports in February set a record for the month at 68.9 million pounds, up 44.5% vs. last year and 7.8% more than January. U.S. manufacturers also shipped a considerable amount of whey products overseas in February. Exports of whey protein concentrate (WPC), with less than 80% protein, were 20 million pounds or 37% higher than January and 8% more than a year ago. Whey exports surged to 42 million pounds, up 17% vs. last year and 15% higher than January levels.

U.S. exports are expected to be robust through Q1 2014; however, exporters are likely to face a headwind headed into Q2 as world prices decline and domestic prices are slow to react. Domestic dairy product prices will likely adjust lower given declining world prices or risk facing slowing exports and expanding stocks. That said, the U.S. milk supply is well-below trend for this time of year due to severe weather conditions east of the Rockies. Below-trend milk production could support prices for the near term. In addition, buyers have been maintaining minimum inventory levels for some time, which could lead to large buy-ins as prices begin to ease. This, too, could slow the price descent.