(c) 2014, Bloomberg News.

(c) 2014, Bloomberg News.

LONDON Irish dairyman Pat McCormack figures it makes more sense to pay a 20,000-euro ($27,300) fine for producing too much milk than to pass up surging prices and an early start to a jump in European output.

The 36-year-old farmer expanded his herd to 80 cows from 60 two years ago and estimates milk production will exceed his European Union quota by 20 percent at 450,000 liters this year. While output limits imposed in 1984 won't end until April 2015, EU prices are 17 percent higher on average than a year earlier. Even with the fine, McCormack says he will be profitable and his herd will be ready with more supply when quotas are lifted.

"People have been gearing up since 2010," McCormack said by telephone from his farm in Greenane in County Tipperary, 184 kilometers (114 miles) southwest of Dublin. "Without a doubt, farmers have been increasing their herd sizes. There has been significant investment, both on-farm and processor investment."

Global dairy costs tracked by the United Nations more than doubled since early 2009 as demand surged in China and droughts limited supply from New Zealand and the United States. The end of quotas in the 28-nation EU, the world's top producer, will spark an output gain after 2015 of 6.6 percent to 162.3 million metric tons, Rabobank International said. Before 2013, production grew 2 percent since 2005, industry data show. Processors including Royal FrieslandCampina, Europe's biggest dairy cooperative by revenue, are expanding to handle the increase.

Farmers in the EU got 39.89 euro cents per 100 kilograms on average in December, up from 34.24 cents a year earlier, after reaching a record 40.55 cents in November, the Dutch Federation of Agriculture & Horticulture said. That's boosting costs for buyers including Danone, the world's biggest yogurt maker, and Nestle, the largest food company. More-expensive milk and cheese contributed to a 0.8 percent gain in euro-area consumer prices in January, data showed on Feb. 24.

Class III milk, used to make cheese, on the Chicago Mercantile Exchange reached an all-time high of $23.43 for 100 pounds on Jan. 31 and is up 20 percent since the end of 2013. The gain is more than 23 of the 24 commodities tracked by the Standard & Poor's GSCI Spot Index, which rose 2.4 percent this year.

Milk prices have surged after wet weather in the last two years cut supply from northwest Europe, while New Zealand, the top exporter, saw its first drop in milk-solid output in five years because of a drought in early 2013. California, the top U.S. producing state, is contending with "extreme" drought, according to the U.S. Drought Monitor, scorching pastures and reducing this year's dairy supply. At the same time, demand is rising in China, where imports of whole-milk powder jumped 14- fold since 2008, U.S. Department of Agriculture data show.

The rally in prices will fuel a 2.6 percent increase in EU output in the first six months of 2014 from the same period last year, even before the quotas end, Kevin Bellamy, a dairy analyst at Rabobank in Utrecht, Netherlands, said in a Dec. 19 report. The profit margins are large enough that some farmers will be better off over-producing and paying the fine, he said.

Eight countries are at risk of exceeding their output caps this year, including Germany, the Netherlands and Denmark, said Bart Van Belleghem, managing director of the Brussels-based European Association of Dairy Trade, known as Eucolait. Germany is the bloc's largest producer and top exporter of cheese, while the Netherlands and Denmark are the biggest shippers of whole- milk powder, the International Dairy Federation said.

Ireland will top its quota by 1.5 percent, with farmers who overproduce facing "super-levy fines" of about 28 euro cents per 100 kilograms, the country's Agriculture Ministry said Feb. 17. Ireland last exceeded its quota in the 12 months ended in March 2012, incurring 16 million euros in fines.

"Farmers in many countries in the EU that risk producing more than their quota are not slowing down their production, and they're doing so in full knowledge they will pay a super-levy fine," Van Belleghem said. "That could have an impact on the global supply and potentially on the development of prices."

Rabobank expects prices to decline later this year, before quotas are lifted, with Class III milk dropping to $17.88 by the fourth quarter. That's 23 percent less than futures for delivery this month in Chicago that closed Wednesday at $23.20. The contract for delivery in February 2015 traded at $17.45.

There will be no production shocks when quotas end next year as the EU boosts exports of milk, cheese and other dairy products, Herman Versteijlen, the acting deputy director general for agricultural markets, direct payments and economic analysis at the European Commission, said at a conference in Brussels Sept. 24. The bloc will be exporting 11.1 percent of its output by 2022, up from 10.1 percent last year, he said.

Rising global demand may soak up some increased supply from Europe in 2015, with prices of export products including milk powder remaining supported, Rabobank's Bellamy said. The price of cheese, which is consumed more in Europe and North America than in the growing Asian markets, may come under pressure after quotas end, he said.

China, the top consumer of whole-milk powder often used in baby formula, will import a record 650,000 tons in 2014, 21 percent more than last year, according to the USDA. Chinese imports surged since 2008, when six infants died after some companies were found to have sold formula tainted with the chemical melamine.

Demand also may increase longer term as China, the world's most-populous nation with 1.36 billion people, relaxes its one- child policy, and economic growth in developing countries is boosting incomes and demand for higher-protein diets, including meat and dairy products, Rabobank's Bellamy said. China's economy, the world's second largest, will expand by 7.5 percent this year, more than twice the 2.9 percent growth expected in the U.S. and more than six times the 1.1 percent rate of the EU, surveys of economists by Bloomberg showed.

Consumption of dairy products in developing countries will rise 2.2 percent a year through 2022, reflecting "robust income growth and growing affluence, increasing populations, further westernization of diets and greater access to refrigeration facilities," according to estimates from the UN and the Organization for Economic Cooperation and Development.

Demand is rising faster than world output, which will increase 1.8 percent annually over the next eight years, the OECD said. Global inventories of whole-milk powder will drop to a seven-year low in 2014, and stockpiles of butter and cheese will decline amid rising consumption, according to the USDA.

Speculators are betting on gains in Chicago milk futures, with money managers holding a net-long position of 760 contracts as of Feb. 18, the most-bullish since April, U.S. Commodity Futures Trading Commission data show. As recently as October, hedge funds were bearish.

Danone, which gets half its revenue in Europe, saw 2013 milk-price inflation at 10 percent that exceeded its forecasts, with costs in Russia up 30 percent, Chief Executive Officer Franck Riboud said on a Feb. 20 conference call. He said the Paris-based company expects profit margins to improve in the second half of 2014 as it increases prices to consumers.

Vevey, Switzerland-based Nestle, the maker of Carnation condensed milk and Haagen-Dazs ice cream, expects a stronger second half after a period of "very soft" pricing power and higher dairy costs, Chief Executive Officer Paul Bulcke said Feb. 13 on an earnings conference call.

EU milk production is set to accelerate after more than a decade of slow growth. From 2000 to 2012, annual output was between 149 million and 152 million tons, according to the International Dairy Federation's annual World Dairy Situation report. Over the same period, global output of cow's milk jumped 30 percent to 637.3 million tons in 2012, the Brussels-based group estimates.

The EU is a net-exporter of dairy products, and per capita consumption of liquid milk declined in the bloc from 2010 to 2012, at the same time demand jumped 43 percent in China to 15.9 kilograms per person, the Dairy Federation estimates.

The EU began phasing out quotas in 2009, raising production limits by about 1 percent annually through this season. The quota will be held steady for the next year at 154.6 million tons, before being removed April 1, 2015. Before quotas were introduced in the 1980s, a system of price guarantees for farmers encouraged overproduction because the EU commission bought up surplus supply, said Roger Waite, a spokesman for the Commission in Brussels.

Under the current system, each EU country has its own cap. While some major producers fulfill their limit, total output in the bloc has been under the overall EU quota since at least 1996 because countries in southern and eastern areas with fewer herds often produce well below their cap. Total EU output was 152.3 million tons in 2013 and will rise to 153.8 million this year before reaching 160.4 million by 2023, the commission said.

Lifting quotas will mean an increase of 10 million tons, according to Rabobank, while Eucolait's Van Belleghem estimated a smaller gain of 3 percent.

World dairy trade climbed 8 percent in 2012, according to the International Dairy Federation, and many of the expansion projects announced by European processors are for plants to make milk powder to be exported.

Countries like Ireland that have damp, moderate climates good for growing grass may have the most to benefit from the phase out of quotas, Bellamy said. Ireland's government has said it plans to increase milk production by 50 percent by 2020, according to the Agriculture Ministry. The country exports about 80 percent of its dairy production, according to the Irish Dairy Industries Association.

"If prices are good, the farmers do have the capacity to respond in an unfettered environment," said John Lancaster, a dairy analyst at INTL FCStone in Dublin. "People have been gearing up for the end of quotas, so there's latent capacity there to hit the ground running."

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