The future of the dairy revival may be in the hands of US farmers, National Australia Bank has said in a report warning that price falls look more likely than a continuation of the market rebound.

The European stocks of butter and skimmed milk powder built up this year through intervention buying, to protect the region's farmer from the slump in global prices up to July, posed little threat to the market.

"While these stocks have yet to be cleared, they are relatively modest by historical standards and not expected to significantly affect pricing," NAB economist Mark Walton, said.

The combined European Union and US skimmed milk powder stocks were, at about 370,000 tonnes, less than half levels reached six years ago.

'Genuine risk'

Instead, the pressure point for prices may be the response by US farmers to a recovery which has lifted dairy prices, in US dollar terms, by 70% over the last six months to significantly above levels before the 2007 price spike.

"There is also a genuine risk of a supply response in the wake of the upswing in prices, most likely by US dairy producers," Mr Walton said.

While America's diary farmers had, through culls, cut milk production by 1% this year, the first decline since 2001, the price revival coupled with soft markets for grains used as livestock feed signalled that they would be back in profit in the first half of next year.

"If this occurs, it is likely to result in a rebuild of dairy cow numbers, and hence a lift in production," Mr Walton said.

He added that, with the New Year set to bring a seasonal uptick in northern hemisphere milk production too, "the risks ahead [for prices] are much more heavily weighted to the downside".

Lowest since 1995-96

In Australia, milk production was set to fall to a 14-year low of 8.9bn litres in 2009-10 after declining at a rate of 5% in the first four months of the marketing year.

The industry had been badly hit by drought as well as high fodder prices, until the 2008-09 crop price slide, while the strengthening Australian dollar has eroded the benefits to farmers from the global dairy recovery.

However, improved rains and lower feed grains would provide farmers with "some relief".

"Looking beyond 2009-10, a steady improvement farmgate prices and lower production costs are likely to lead to improved profitability in the dairy industry," Mr Walton said.

"Reflecting this, Australian dairy production is forecast to stabilise over the medium term."