The next big commodity boom - milk

The rising price of milk has seen UK shoppers paying 23% more for cream this year, whilst for Americans a gallon of the white stuff now costs more than a gallon of petrol. Eoin Gleeson picks two ways to profit.

The floods drenching the countryside in recent weeks have left many of Britain's cows struggling to keep their heads above water. But in truth, they have been living on borrowed time for a while. After years of surviving on the thinnest of profit margins, British farmers have lost their appetite for producing milk. Of the 28,000 dairy farmers in Britain in 1995, more than half have quit the business and 2,500 more are set to join them over the next two years.

But something is happening that might make farmers change their minds. Milk is rapidly becoming a valuable commodity. In the last six months, the price of skim-milk powder, the benchmark for world trade, has risen by more than 60%. UK shoppers have seen the price of cream tick up 23% in a year. The European Union recently scrapped export subsidies on milk products as rising prices rendered them unnecessary. Americans are finding that a gallon of milk is more expensive than a gallon of petrol. And it may not be long before a bottle of milk costs more than a bottle of wine, says Tom Bulford on Penny Sleuth.

So what has changed over the last ten years? Well, the Chinese have fallen in love with pizza, for a start. Twenty years ago, cheese was regarded with revulsion in China, says The Economist it was what gave Westerners their smelly breath. But much like the Japanese before them, as the urban middle class has grown richer, their diets have become Westernised. And the Chinese have taken to dairy products in a big way, filling their newly purchased refrigerators with yogurts, ice cream and cheese-topped pizzas. At the moment, the average Chinese person consumes about 24kg of milk a year, but that is expected to rise to 40kg each by 2020, say Leo Lewis and Suzy Jagger in The Times.

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Dairy prices have also been driven up by the rising cost of maintaining a herd of cattle. The price of corn, a staple in the diet of the dairy cow, has doubled this year as demand has risen for its use in the production of ethanol, an alternative to petrol. Meanwhile, the rising cost of land in New Zealand, one of the world's biggest dairy producers, has stifled the industry's efforts to expand. Global warming has also played its part. A drought in Australia, the worst in 100 years, has crippled its dairy industry, stripping more than a billion litres from Australia's milk production quota.

What we have with dairy is a classic case of rising demand meeting limited supply, says David Fuller on Fuller Money, just as we've seen with more traditional resources, such as base metals and oil. And supply is unlikely to be able to grow quickly enough to meet that demand any time soon. As New Jersey farmer Richard Byma tells The Times: "Last year, one of my cows would have fetched $2,000 at auction. Last week, I would have got $3,000. It would take years to build up a herd."

It won't become any easier. China's new-found appetite for milk is being repeated across the world, from the Middle East to Latin America. Dairy farmers suddenly have a lot more mouths to feed. And with a host of supply contracts with the likes of Tesco about to expire, it couldn't have come at a better time for milk producers in the UK. They are now in a much stronger position to renegotiate unfavourable terms that have seen them receive a flat, or dwindling, share of the proceeds from milk sales in recent years. We look at the stocks best placed to benefit from the milk boom below.

The two best bets in the sector

The Chinese consumer's appetite for milk products will grow by about 15% a year for the next three years, say Leo Lewis and Suzy Jagger in The Times. This in turn should should see American Dairy (NYSE:ADY) grow its share of the market. The company is a pure play on the Chinese dairy industry, producing milk powder for primary-school children in China, across its network of 25 provinces. American Dairy has also made the move into higher-margin products, such as yogurt and cheese. The company's shares trade on a forward p/e of nine for 2008 and Small Cap Investor rates it among its top-ten small-cap stocks for 2007.

One UK firm that will benefit from the power balance shifting in favour of dairy producers is Dairy Crest (DCG), says Tom Bulford on Penny Sleuth. It is Britain's biggest dairy products producer, owning cheese brands such as Cathedral City and butter products such as Clover. A series of acquisitions has established it as a dominant supplier in the market at a time when the terms of trade with retailers are being renegotiated. In 1995, retailers took 2p from the 43p cost of a litre of milk, with the rest split between farmer and dairy, but today retailers take 17p from the 51p per litre sale price. But with many deals set to end this year, Dairy Crest should be able to set better terms and increase revenues, says Bulford. Its shares trade on a forward p/e of 12.9 for 2008.

Eoin came to MoneyWeek in 2006 having graduated with a MLitt in economics from Trinity College, Dublin. He taught economic history for two years at Trinity, while researching a thesis on how herd behaviour destroys financial markets.