IT'S easy to be distracted by the bad news in the dairy industry, but the fundamentals are good, writes CHRIS PHILLIPS

They say every cloud has a silver lining.

However, at times like these, it can be hard to see through the fog created by a barrage of gloomy news headlines to get a proper handle on where the world dairy market is at, and where it's heading.

Volcanoes in Iceland, oil slicks in the US and debt crises and austerity programs in Greece and (maybe) other parts of the European Union add to the sense of uncertainty about where the world is headed.

While some of these factors may affect world dairy trade in the year ahead, commercially, the dairy market outlook is firm.

After a rough start last year, the world dairy market stabilised and began to slowly recover mid-year.

A major risk to world market recovery last year was the use of export subsidies by the EU and US as they sought to rebalance their own internal markets and manage their growing government stockpiles.

Today, fortunately, these risks have receded.

The EU has removed its export subsidies and is unlikely to reintroduce them any time soon.

The US is not using its DEIP subsidy program to any extent.

The EU does still hold significant stocks of skim milk powder, but, to date, it has been able to quarantine them from the market and limit their effect on prices.

In this environment, the fundamental supply and demand drivers of dairy markets have returned to centre stage.

And the news is positive.

After a downturn last year, demand for all major dairy products has recovered, particularly for butterfat and whole milk powder.

China has played a dual role here - first as a major importer of WMP and, secondly, through the spillover effect of its strong economy on confidence in other developing markets.

This has helped the other long-term drivers of increased dairy demand - income growth, rising population and pressure on arable land - to reassert their positive influence.

The dairy supply equation has also improved.

Commercial stocks have been wound down (both across major exporters and large international buyers).

A slow start to the European spring, financial pressures on segments of the US industry and the impact of drier weather on milk supplies out of India and New Zealand all suggest a tighter supply outlook up to next year.

The improved market balance has seen world prices recover sharply.

WMP and butter prices are now back near their pre-GFC peaks, though cheese and SMP still lag.

The outlook suggests world prices can maintain their recent gains.

As always with dairy, there are some wildcards that may come into play.

Europe's debt issues will keep pressure on the euro.

This, in turn, will have a dampening effect on international prices.

Japan's slow economy will limit import demand, while cheese imports will face added pressure from expanded local production.

An expanded price gap between dairy ingredients and some vegetable-based substitutes could encourage a shift away from dairy if world economic conditions slow.

The silver lining in all this is that the fundamentals of world dairy remain very sound.

Coupled with a resilient local market here in Australia, this suggests a positive outlook for 2010-11 and the continuation in the recent recovery in southern Australian farm gate prices for milk.