Market commentary by DairyCo's Huw Thomas

With milk production peaking on 11 May at about 37.4m litres (2.3m litres, or 5.7% down on the three-year average) there were some hopes that production would fall off more slowly than in previous years and perhaps catch up with last year's daily levels.

While this has not yet happened, there are signs the rate of decline in production is slowing. At the beginning of June daily production was 1.5m litres a day lower than last year, but this deficit reduced to 0.6m litres a day by 20 June.

Whether daily milk production matches last year's level or not, it is already looking likely that milk production in the current milk year will show a further fall, with most industry commentators predicting a total production figure for the year of about 13bn litres. Milk supplies are tight, as demonstrated by the recent UDF auction, which saw prices rise for the second month running to 25.86p/litre for one month contracts and 26.22p/litre for three-month contracts - both higher than this time last year.

A combination of low milk availability and a weak sterling has kept UK commodity prices high and in some cases has helped them increase, as processors secure higher returns from their customers.

In Europe, prices for most dairy commodities are also increasing following earlier falls. Despite some individual countries reporting large increases in production in the first quarter of 2008, across all 27 member states the uplift is reported as a modest 1.5% year-on-year. Much of this uplift has been manufactured into butter and SMP. The amount of butter being offered for Private Storage Aid (PSA) is currently 40% more than last year which has raised some concerns about how the market will react from mid-August when this butter becomes available for sale.

However, European importers of butter from New Zealand are suggesting that imports will be about 25,000t down on last year as high world prices, coupled with the European import tariff, make other markets more attractive for New Zealand exporters. This should reduce the need for unsubsidised exports from the EU and will help prevent EU butter prices falling to world levels - currently a fall of about 10%.

The only major exporter of dairy products reporting an increase in milk production is the USA. Estimates for May 2008 put milk production 3.4% higher than in May 2007 - no doubt helped by a 1.5% increase in the number of cows in the national herd. However, whether these year-on-year increases can be sustained is likely to depend heavily on what happens to feed prices. Partly due to bad weather, this year's corn harvest is predicted to be 7% down on last year this has helped push the price of corn to more than 50% above last year's levels.

All these factors suggest commodity prices, and hence milk prices, should remain firm for the summer. In the longer term, greater price stability for European farmers could come about through using the proposed European milk futures markets. The existence of futures markets offers dairy farmers the opportunity to manage risk by selling all or part of their milk forward. These mechanisms should also provide milk buyers with the opportunity to offer farmers the option of a guaranteed price for a fixed period, without exposing themselves to excessive risk. This in-turn would provide farmers with a more predictable cash-flow, particularly useful if planning an expansion in an industry that is increasingly exposed to the volatile world markets.