The author is director of dairy services at Informa Economics, Eagan, Minn.

Sensitivity analysis is about asking "What if" scenarios. It involves the study of how uncertainty in the output of a mathematical model can be apportioned to uncertainty in the inputs to the model.

Some dairy-related examples of "What if" questions include: What will happen to milk prices if Chinese dairy consumption is higher than forecast next year? What if there is another drought in New Zealand next season? What if global economic growth slows more than expected?

Through sensitivity analysis we can get an idea of the potential risks to the forecast and gain a better understanding of which variables play the biggest role in dairy prices.

Begin with a starting point
Before we talk about plugging in alternative inputs, we need a baseline forecast to work from. The drought in New Zealand in early 2013, along with cool and wet springs in many parts of the U.S. and the EU-27, limited milk supplies during the first and second quarters.

The tight supply has pushed up milk prices globally. Average farm gate milk prices in Europe are expected to reach a record high for calendar year 2013. Fonterra's projected milk price for dairy farmers in New Zealand is up 18.6 percent from the opening projection last season.

U.S. milk prices have not been as strong as Europe or Oceania due to weak domestic demand, but with feed costs trending sharply lower, farm level margins look very profitable for the third and fourth quarters of 2013. The high milk prices and profitable margins will drive an expansion in milk production across all of the major exporting countries during the second half of 2013 and early 2014.

Economic growth fuels dairy
The surge in milk production will be needed. Between a slight uptick in global economic growth and lower dairy prices, we expect global imports to be up 5 percent in 2014. Growing population and income are the long-run drivers for global dairy demand, and our models suggest that for every 1 percent growth in real GDP across the major importing countries, we can expect dairy imports to rise 1.2 percent in 2014.

Using real GDP growth projections from the International Monetary Fund's (IMF) World Economic Outlook report puts economic growth (weighted by milk imports) up 5.1 percent in 2014. So income growth alone would suggest a 6.1 percent rise in global imports.

However, even with strong production growth across all the major exporters, the supply of exportable milk is only forecast up 5 percent. We're looking at a mild shortage for 2014 and prices will need to be relatively high to slow demand growth.

Our baseline forecast calls for mild rationing with an equilibrium price of $18.50 per cwt., basis Oceania. That translates back to a $17 to $17.50 per cwt. Class III or Class IV price in the U.S. Most of the expansion in milk production expected over the next 18 months is anticipated to happen in late 2013 and early 2014, so we expect prices to fall below $17.25 in the fourth quarter of 2013 and the first half of 2014, but be above $17.25 the second half of the year.

It's unlikely that we have perfectly predicted the whole host of variables including production, imports, exports, domestic consumption, inventory change, feed costs, exchange rates, population growth, real GDP growth and dairy prices for the dozens of countries for which we run models. To account for this situation, we can plug in different possible inputs and see how sensitive our baseline forecast of $17.25 per cwt. of milk is to changes in the fundamentals.

The China factor
China is now the largest importer of dairy products in the world, absorbing about 13.4 percent of global exports in 2012. China's projected per capita milk equivalent consumption is 80.6 pounds per person in 2014.

If consumption comes in at 81.6 pounds, 1 pound higher than forecast and they import that milk, it would boost global demand by 1.37 billion pounds and push the milk price up $1.20 per cwt. if global supply is held constant. However, prices would only rise 80 cents per cwt. if the higher global milk price spurs production growth.

New Zealand is either the largest or second-largest exporter of dairy products (behind the EU-27), depending on which year you examine. Milk production in New Zealand is based primarily on pasture, so variations in weather and pasture growth flow through to their dairy exports on a nearly one-to-one basis. A severe drought in March and April of 2013 will put their production down about 4 percent for calendar year 2013.

Assuming normal weather, we expect to see production rise 4.2 percent for calendar year 2014. If they suffered another drought and milk production was up just 1.1 percent instead of the predicted 4.2 percent, it would reduce global supply by 2.75 billion pounds of milk. If we hold supply steady from other countries, a second year of drought would drive the global price up $2.40 per cwt., but only $1.15 per cwt. if we allow production to expand in other countries in response to the higher milk prices.

IMF projections for global GDP growth have been shifting lower over the past 24 months. What if economic growth in 2014 is 1 percent lower than currently forecast? If we hold supply steady, the equilibrium price would drop $2.50 per cwt. If we allow production to fall in response to the lower price, the equilibrium price would only be down about $1 per cwt.

In the analysis above we've just looked at one change to the outlook, but if you combine two bullish or bearish changes together, the price changes can be very dramatic. If Chinese milk equivalent imports were 1 pound greater than expected on a per capita basis, and New Zealand experienced another drought in this upcoming season, it would propel a $3.40 per cwt. gain in the milk price from baseline if we hold production constant in the other exporters. Meanwhile, it would yield a $1.95 price jump if production is allowed to expand in other countries in reaction to the higher milk prices.

The milk price, and more importantly the margin outlook, for U.S. dairy farmers is pretty good for 2014. The current baseline forecast puts the average Class III/Class IV price at about $17.25 per cwt. With corn futures now trading into the $4 to $5 per bushel range, most dairy farmers should be profitable. However, it only takes minor changes in global demand, supply or economic conditions to quickly add or subtract a dollar from the milk price forecast.

This article appears on page 589 of the September 10, 2013 issue of Hoard's Dairyman.