May 14 (Bloomberg) -- Milk prices worldwide are rising at the fastest rate ever and won't be falling anytime soon because of growing demand in China and Latin America and dwindling government supplies.

Dairy farmers have failed to keep pace with a 3 percent increase in annual milk consumption, according to Rabobank Groep in the Netherlands, the world's biggest agricultural lender. Reduced subsidies eliminated milk surpluses in Europe and slowed production growth in the U.S., government data show. The rally started last year after Australia reduced exports because of its worst drought in a century.

``Over the next several months we're going to see some pretty strong prices on all milk,'' said Larry Salathe, an economist and dairy expert at the U.S. Department of Agriculture in Washington. Production needed to bring prices down ``takes at least several months, usually a year to two years, to come.''

Skim-milk powder, the benchmark for world trade, has risen 60 percent in six months to a record $1.58 a pound May 4 on the Chicago Mercantile Exchange, 74 percent higher than the five- year average. During the first five months last year, prices fell 14 percent.

Fluid milk futures on the exchange advanced to a record $19.15 per 100 pounds on May 3 and have risen 63 percent in the past year. The commodity rose 0.7 percent today to $18.89.

Hershey Co., the biggest U.S. candy maker, and Dean Foods Co., the nation's largest milk processor, said this month that higher dairy costs will hinder profit growth. Domino's Pizza Inc. said it will spend more on cheese, which accounts for 30 percent of the cost of each pizza.

Feeding the Poor

Government aid officials say food programs for children in Indonesia, Mexico, the Philippines and Algeria are likely to be scaled back because of the rising costs. About 80 percent of the world's exported milk powder is sold to developing countries.

``Programs to feed the poor will face difficulties,'' said Merritt Cluff, an economist with the United Nations Food and Agriculture Organization in Rome, which monitors food security worldwide. ``They'll be able to buy less, or they'd have to buy alternative sources such as wheat, but prices for wheat and maize have also risen.''

Mexico, the top importer of U.S. dairy products and a buyer of almost $1.4 billion of foreign supply in 2005, cut purchases of milk powder by 28 percent last year and may buy less again this year because of higher prices, a U.S. Department of Agriculture report showed in November. Mexico already has capped tortilla prices to keep inflation in check.

Raghuveera Reddy, agriculture minister for Andhra Pradesh, an east Indian state of more than 75 million people, said rising milk costs ``will have an impact'' on the country's consumers.

Different This Time

This year's rally is different from increases in previous years because government surpluses are no longer available in dairy-producing countries such as the U.S., the largest exporter of milk powder, and the EU, the largest exporter of cheese.

U.S. inventories of butter, cheese and dry milk peaked at more than 2.7 billion pounds in 1983. The government that year spent $2.5 billion on surplus dairy products to support prices and farmer income. Today, the U.S. has no surplus after selling the 27 million pounds it held in 2005, USDA data show.

European warehouses, which had 200,000 tons of milk powder in 2003, are empty, according to Erhard Richarts, dairy expert with the Bonn-based market and price reporting agency ZMP. Skim milk powder exports from Europe fell to 84,000 tons last year from 194,000 tons in 2005, he said.

The European Union said in March that only ``residual quantities'' of butter are left in member countries after a sale of some 6,000 tons that month.

Demand Gains

The world consumes about 1.9 billion liters of milk a day, enough to fill five supertankers, based on estimates by Rabobank. The 14 percent jump in milk demand during the past seven years outpaced the 13 percent rise in oil use, according to estimates from the International Energy Agency in Paris.

The annual increase in consumption since 2001 was 13 billion liters of milk on average, or about what is produced each year by New Zealand. Milk exports have helped make New Zealand's currency the best performer against the U.S. dollar during the past year among the 16 most-active markets. Uruguay and the Netherlands also are benefiting from dairy sales.

``We will see some rationing in the months ahead because you can't make the cow make more milk,'' said Ken Bailey, an associate professor at Pennsylvania State University who studies dairy markets. ``Prices haven't hit their high,'' Bailey said today in an interview from State College Pennsylvania. ``We're going to hit the high right around October.''

Price Forecast

Peter Turk, a broker with Rice Dairy in Chicago, said fluid milk prices on the Chicago Mercantile Exchange may reach a record $22 in the second half of the year, up 16 percent from today's close.

``Milk production is growing but not at a pace that keeps up with global demand,'' Turk said.

While the 2.5 billion people in China and India are drinking more milk than ever, they still have a long way to go before catching the U.S. Per-capita demand in the U.S., buoyed by the ``Got Milk'' promotions begun in 1993 by the California Milk Advisory Board, averages 25 ounces a day, almost four times the amount in India and 19 times more than in China.

Chinese Demand

Chinese consumers, who drink an average of 1.3 ounces of milk a day, will increase demand by as much as 15 percent annually for the next three years, said Mark Voorbergen, a dairy analyst at Rabobank. India's gains will range from 3 percent for milk to 7 percent for processed dairy products, he said.

``We're expecting to see the highest growth in dairy consumption in China because the Chinese government has started sponsoring school milk programs,'' said Rabobank's Voorbergen. ``That means there are now generations of Chinese children growing up who drink a cup of milk every day. This is something completely new, as the Chinese are not traditional dairy consumers.''

Rising milk prices have increased interest among investors. Tod McElroy, who helps manage $2 billion at Hunter Hall International Ltd. in Sydney, is spending $20 million to make dairies out of cattle ranches in Uruguay.

``The supply is coming under pressure cost-wise, and then you've got this big increase in demand,'' he said.

Growing Crops

Milk production also may drop because the cost of corn, the primary source of livestock feed, has advanced 55 percent in the past year to $3.6925 a bushel on the Chicago Board of Trade. Rising demand for grain-based ethanol has increased the price of corn feed and may prevent dairy farmers from expanding their cow herds, agricultural analysts say.

``Producers are a still a little scared of the high feed costs,'' said Joel Karlin, commodity sales coordinator for Western Milling in Goshen, California.

Feed accounts for half the cost of producing 100 pounds of milk in the U.S. The value of a pound of milk was equal to 2.54 pounds of dairy feed in April, up from 2.48 a year earlier, the USDA said. The ratio needs to be at 3 pounds for several months before milk producers will expand herds, Karlin said.

Manufacturers Suffer

Milk output in the top 20 producing countries rose 1.7 percent to an estimated 425.1 million metric tons in 2006, while consumption of fluid milk rose 1.9 percent to 170.4 million, the USDA estimated in December. Output was forecast to rise 2.1 percent to 434 million tons as consumption may gain 3.1 percent to 175.7 million, USDA said.

``It's a straight supply-demand equation,'' said Craig Norgate, who used to run Auckland-based Fonterra Cooperative Group, the world's largest dairy exporter. ``The population is in Asia and Africa, and the places that can supply the food aren't.''

Manufacturers are suffering from higher dairy costs. Dean Foods on May 3 said earnings this year will be at the low end of its forecasts as raw milk rises faster than retail prices. Shares of the Dallas-based company plunged the most since September 2004.

``Milk prices should actually go higher before settling down,'' Prudential Equity Group analyst John McMillin said in a May 3 report.

Cheese Prices

Domino's Pizza of Ann Arbor, Michigan, has already budgeted for higher prices this year for cheese.

``We are horrible at predicting cheese prices and we are not going to start,'' Chairman David Brandon said on a May 2 conference call, when asked for his outlook.

Domino's has paid prices ranging from 99 cents to $2.60 a pound in the past eight years, he said. Benchmark U.S. mozzarella prices were $2 a pound in April, up 6.5 percent from a year earlier, Department of Agriculture data show.

Hershey lowered its annual profit forecast on May 10 because of rising prices for the milk used in chocolate, saying growth may be as low as 4 percent, less than half an earlier projection. Vevey, Switzerland-based Nestle SA said last month it will increase the price of some dairy products by more than 10 percent this year because of higher milk costs.

Milk prices at U.S. stores averaged $3.32 a gallon in April, up 2.9 percent from a year earlier, USDA data show. Retail costs are likely to go higher, after the government last week raised its month-old forecasts for record wholesale prices. Retail milk prices in the U.K. rose 15 percent in the past year to 2.30 pounds ($5.56) in April for a gallon, according to the U.K. Dairy Association.

Farm Prices

Prices on the farm will jump 34 percent this year to a record $17.30 per 100 pounds on average from $12.90 in 2006, up from a $15.80 forecast in April, the USDA said May 11. The previous record was $16.13 in 2004. Milk will rise next year to $17.50, the agency said in its first forecast for 2008.

Farmers are also earning less as retailers seek to limit price increases. In the U.K., some 3,000 of the nation's 18,000 dairy producers may leave the industry in the next two years, according to the Royal Association of British Dairy Farmers and the National Farmers Union.

Even producers have been caught off guard by the market's strength.

``Prices are probably at their peak now,'' said Henry van der Heyden, chairman of Fonterra in New Zealand. ``But if you'd asked me that 10 months ago I would have probably said the same.''

To contact the reporters on this story: Gavin Evans in Wellington at gavinevans@bloomberg.net; Danielle Rossingh in London at drossingh@bloomberg.net.

Last Updated: May 14, 2007 16:52 EDT