The rising cost of dairy products seems to be the darkest cloud on the horizons of a growing number of the world’s largest food producers.

It’s results season and in recent weeks, multinationals on both sides of the Atlantic have warned that the spiralling cost of milk and milk powder will weigh on profits in the coming months.

Cadbury Schweppes, Groupe Danone, Hershey and Kraft Foods are among the companies that have issued a note of caution on the dairy landscape. None more so than Cadbury, the world’s largest confectioner, who warned that dairy costs alone would add GBP20m (US$40.1m) to its bill during the second half of this year.

But what’s causing the price of milk to rise? In short there are two critical factors – a falling global supply of milk, coupled with booming demand in key markets, including China.

A drought in Australia, which accounts for over a tenth of global milk production, has had arguably the most significant impact on supply. Reform of the EU milk sector, with the phasing out of subsidies for milk exports, has also been a key factor. When the EU announced the end of subsidies back in June, Arla Foods, one of the continent’s largest dairy firms, immediately announced it was increasing the prices it charges for its products.

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Meanwhile, as with most current macro-economic trends, China is having an increasingly central role. While the global supply of milk is falling, demand from China is booming. The Chinese government, for instance, is looking to introduce milk as a compulsory part of school meals. As a consequence, demand in China is putting more pressure on global milk prices, just as supply issues are kicking in.

One would expect Nestlé, the world’s largest food company, to also have grave concerns at rising dairy costs. For the Swiss food giant, skimmed milk powder represents its most costly raw material, approaching 20% of its total combined raw material and packaging costs.

Nestlé is releasing its first-half results next week (15 August) and so declined to outline its current views on dairy prices when contacted by just-food today (9 August). However, when the company unveiled its first-quarter numbers in April, it hinted that its dairy costs would rise by CHF1.5bn (US$1.3bn) during 2007. That kind of figure suggests Nestlé will join its peers in being hard hit by the pressure in the dairy sector; however, some in the analyst community believe that, despite Nestlé’s dependence on dairy, the company should be able to more successfully ride out the storm than others.

With companies understandably loathe to pass on rising input costs to consumers, securing your raw materials on fixed-price contracts is one way of keeping selling prices stable. James Amoroso, an analyst at Swiss broker Helvea, points to Numico, the Dutch baby food and nutrition group, as an example of a company that has used fixed contracts to alleviate the pressure of a rising dairy bill.

And while Nestlé has not gone public with how its dairy contracts are structured, Amoroso suggests one should assume the company has followed a similar path to Numico. “For Nestle, [milk] is an even more strategic raw material, so we can assume that it has fixed price contracts,” Amoroso tells just-food.

Amoroso suggests that historically, the likes of confectionery giants Cadbury and Hershey would not have placed the same importance on milk and milk powder as they would have on materials like cocoa and cocoa butter, ingredients that they would have hedged against or covered with fixed-price contracts. Milk prices, particularly in the EU, have historically been pretty stable, Amoroso ventures.

“Chocolate manufacturers are more likely to be watching the price of cocoa and cocoa butter and hedge against those,” Amoroso says. He adds that the recent volatility in the price of milk and milk powder has left “the likes of Hershey and Cadbury with their pants down”.

Passing the costs on to consumers could be a remedy to protect profits but it is something of a gamble, both in emerging markets and the more mature markets of the West. Kraft, for instance, has looked to increase prices on its cheese products to protect margins in North America, in the face of rising commodity costs but has found increasing sales volumes to be tough. Earlier this month, Danone CEO Franck Riboud also warned that the French group will increase prices on its fresh dairy products.

However, juggling the need to increase prices and maintaining share is a tough task. And, what’s more, the signals emanating from the boardrooms of most of the world’s top food producers suggest that the problems caused by the rising dairy costs will be around for a while yet.