The Market For Cheese Has Changed in 2020

While Americans may not drink nearly as much milk as they once did, they have never eaten more cheese. According to the USDA, the United States produced 13.1 billion pounds of cheese in 2019, a new record.  Forty percent, or 5.2 billion pounds, was of American cheese types with Cheddar making up the bulk at 28 percent, or 3.7 billion pounds, of total U.S. cheese production in 2019.

Cheddar is priced as either 40-pound blocks or 500-pound barrels. While both are classified as cheddar, they are used to make different products. Block cheddar is used to make "natural" products like sliced, shredded, or chunked cheese for retail and food service. Barrel is used to make "processed" products like nacho cheese sauce. Because of the different end-products that are produced and the differences in the underlying demand for those products, they end up being priced differently.

Since blocks and barrels are priced separately, there is a spread between them. Historically, that spread has averaged $0.02-0.05 with blocks at a premium to barrels. Due to changes in consumer preferences, consumption of processed cheese has declined, which has contributed to extreme volatility in the spread.

Dairy Futures

Prior to 2020, dairy futures markets consisted of six cash-settled contracts at CME that allowed market participants to manage the risks associated with milk and the component products that are produced from that milk, such as cheese.

CME Cash-Settled Cheese futures and options contracts, or CSC, settle to the monthly weighted average price for American Cheddar cheese as reported by the USDA. This price includes both 40-pound blocks and 500-pound barrels. The stable historical relationship between block and barrel prices allowed for the CSC contract to grow into a successful hedging tool since its launch in 2010.

However, beginning in 2017, the spread relationship between block and barrel prices started to become unstable. By the fall of 2019 the spread had widened to a record of $0.43 (blocks over barrels) in September before falling $0.67 to -$0.24 (blocks under barrels) in November.

Pizza Power

American cheddar and mozzarella together account for almost two-thirds of all U.S. cheese production.  Block cheddar cheese represents less than a quarter of all cheese production, but its price is much more significant as roughly 75% of all fresh cheese sold to consumers is priced relative to it. That is particularly important as it relates to one of America's favorite foods: pizza.  Americans consume about 30 pounds of cheese per year, and pizza is among the top ways they eat it.

With increasing volatility in the price spread between block and barrel chesses, the hedge effectiveness of the CSC contract began to change for managers facing price risk for fresh cheese.  As a result, CSC volume and open interest began to decline making it obvious in 2019 that a new tool was needed for the fresh cheese business.

Block Cheese

CME Group launched Block Cheese futures and options contracts, or BLK, on January 13, 2020. It trades alongside the other cheese offering, CSC. Prior to launch, the fear among some market participants was that the new Block Cheese product would take away liquidity from CSC, not trade at all, or both. Since the CSC contract can be used in conjunction with the BLK contract to hedge barrel exposure, it was important for both products to grow together.

BLK futures and options have been successful so far with active daily trade combined with underlying growth in the CSC contract. In just over four months of trading, BLK futures and options have grown to just under 4,500 contracts of combined open interest with average daily volume of 74 contracts.

This means large cheese consumers, like pizza companies, are finding value in this evolution of the cheese market. They no longer have to worry about the block and barrel spread as they now have a hedge tool for the price of the cheese used to make your favorite pie, which helps keep costs down.  While America continues to produce record amounts of cheese, it's a welcome sign of improved price discovery.

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