Huge Uncertainty over Dairy Prices

Currently (July 15) , Fonterra has a predicted milk price of $5.50 per kg milksolids for the 2012/13 season. The smaller dairy companies are quoting similar estimates.  However, my contention is that these prices have such huge uncertainty around them that they are of no value for planning purposes.  The reality is that the payout could easily be a dollar less, or it could just as easily be a dollar more. [See updates at bottom of post.] 

Since the start of May, the Fonterra auction prices for whole milk powder, which is the most important of New Zealand’s dairy product, have averaged about $US2800 per tonne. Based on an average exchange rate of  $NZ1 = $US0.78 over this period, this converts to about $NZ3600 per tonne.  However, farmers in New Zealand get paid on milksolids, and each  kg of milksolids produces about 1.7 kg of milk powder plus about 0.1 kg of anhydrous milk fat (AMF) (selling during this period for about $2850 per tonne).  So the gross value of a kg milksolids has been about $NZ6.50. Dairy company costs then have to be deducted from this. In broad terms, these are between $2.20 and $2.70 per kg milksolids, depending on the company and the method of calculation. 

What this tells us is that recent product prices have, at best, only been sufficient to support a payout price of about $NZ4.30. 

Each auction is for less than 2% of total annual production, and there are 24 auctions per year. But non-auction prices are closely linked to the auction prices.   This means that the price has already been determined for close to 20% of the 2012/13 production.

So how is it that the companies are still predicting a payout of $5.50 or thereabouts? The answer is that the industry is confident of a turnaround in prices as the season progresses. The big uncertainty is when that will  occur.   It will need to occur before the end of the 2012 calendar year to have a large impact on the overall price for the 2012/13 season, which runs through to the end of May.

It is well recognised that the current downturn  in international prices is linked to rapid expansion of supply. In the Southern Hemisphere this has been caused by great weather conditions. In the Northern Hemisphere it has been driven by farmers responding to the high product prices of the last two years. 

What we don’t know is how quickly Northern Hemisphere farmers, and particularly those in the United States, will now respond to the lower product prices.  Until a month ago (mid June), I thought the response would be both delayed and small, but the current drought affecting the American Midwest could change that in a big way.  Between mid June and mid July the futures market for corn during the forthcoming year has risen from  $5.20 to $7.40 per bushel and some are predicting a price of $10.   (A bushel of corn is approximately 25.5kg.)

In New Zealand, with the weather apparently turning from La Nina to El Nino, it is unlikely that our production will increase markedly this coming season. However, in Australia the dams are full for the coming year.

On the demand side, the big question relates to China. In the last two months there have been two new well-publicised milk quality scares in China, one relating  to Yili (mercury content) and the other to Bright Dairies (detergent water in the milk). These will  have further reinforced Chinese perceptions about the unreliability of their local product.  China is now by far our most important milk powder market, with current sales of about 500,000 tonnes per annum.

The other big uncertainty is what will happen to the New Zealand dollar. For the last few months it has remained stubbornly high despite declines in almost all of our commodity prices. I now think it may stay high as a side effect of the Canterbury earthquakes.  So far, only about $10 billion of earthquake funds have been paid out by insurers, and there is another $20 billion or so still to be paid. Most of this comes from overseas re-insurers and has a direct effect on the exchange rate.  

The Chinese problems, the Midwest drought, and the shift away from La Nina conditions, all reinforce the chance that dairy prices will  increase as the months go by. Once overseas buyers are convinced that prices are going to rise, then they will start building inventory. This inventory building will in itself lift prices. 

In the meantime, the key word is ‘caution’.

Keith Woodford
15 July 2012

Update of 2 August.
Since first posted 18 days ago there have been two further dairy product auctions (http:globaldairytrade.info).  On 18 July prices dropped 0.9 % and then on 1  August (actually 2 August in the NZ time zone) they rose by 3.5%.  These latest prices are still  below the average ‘season to date’ prices that I used in the earlier version of this post. Also, the exchange rate has drifted higher to about $US0.81 which makes the conversion to NZ dollars even worse.  So there is no comfort yet in what we are seeing.   At best, for a company relying mainly on milk powder,  these latest two auctions would have supported a milk payout of about $3.80 per kg milksolids.

(I note that Synlait CEO John Penno has pointed out to his milk suppliers, at about the same time in July that I was suggesting $4.30 per kg milksolids as an optimistic estimate of what current international prices would support, that his estimate based on  prices to date was only $4.15. So we are essentially singing the same song.)

The message coming out of the United States is still somewhat fuzzy. Some areas have had good rains but most of the Midwest, which is the grain bowl, remains in drought. Corn prices have now risen further to sit at about $8 per bushel on the futures market for December 2012. But for December 2013 they are only $6.30.  Northern Hemisphere dairy farmers are grizzling big time at the moment, but the extent to which they will actually drop production remains to be seen.

It is still far too early in the season to be panicing here in New Zealand. I always say that it is December before payout estimates have any accuracy for planning purposes. But there is also absolutely nothing in the figures so far to suggest that the hoped for turn around is upon us.

Update of 4 August
On 2 August (coincidentally just a few hours after my last update) Westland Dairy Co-operative reduced their expected payout for 2012/13 by 70c per kgMS to within a new  range of $5.00 – $5.40.  CEO Rod Quinn has emphasised the uncertainties. Unlike Fonterra, Westland does not separate its payout into a milk payment and a dividend.  (All Westland farmers hold shares valued at $1.50 per kg MS, with there being no capital gain on these shares.)  Between-company comparisons are always fraught with difficulties given that the comparisons are not exactly like-for-like. But all other things being equal, one would expect the Westland payout to be somewhat above Synlait’s or Open Country’s milk price (where farmers own no shares) and also above  Fonterra’s milk price, and close to Fonterra’s milk price plus dividend.

It is now a reasonable expectation that Fonterra will also reduce its estimate following the next Board meeting (probably in late August) given the increasing need to communicate the ongoing uncertainty to its members.

Update of 16 August
Today’s Global Dairy Trade Auction (actually dated 15 August using UTC/GMT) has produced a headline increase of 7.8%. This is good news indeed, but immediately in the media we are seeing some over exuberance.  The whole milk powder (WMP) price of $US2870 per tonne  combined with a current US/NZ exchange rate of 0.807 will still, at best support a milk price payout to farmers of about $NZ4.25.  The alternative combination of skim milk powder (SMP) plus anhydrous milk fat (AMF) could  support a somewhat higher payout of around $4.60.  So although prices are moving in the right direction, I still expect Fonterra to revise downwards their current season (2012/13) estimate  at their forthcoming Board meeting (presumably later this month).

We now have a three-week gap until the next Global Dairy Trade auction. It will be interesting to see how Fonterra manages the quantities at that auction, both in terms of the total volume and the spread between supply contracts. It appears as if so far Fonterra has only been putting significant quantities into the September and October supply contracts.  Unfortunately there is a three month data withhold as to the quantities for each contract period, so the only way to work out what is happening in terms of individual monthly supply contract volumes is to see how the weighted average price compares to the separate prices for different contracts, and to make some ‘educated guesses’ from that.)

Update of 31 August
As expected, Fonterra dropped their 2012/13 estimate earlier this week. The milk price estimate dropped 25c to $5.25 per kg milksolids, and the dividend before retentions by 5c to 40-50 cents per share.  Synlait are still holding their prediction to $5.50 per kg milksolids. but have advised their farmers that current prices will only support a price of about $4.30.

Meanwhile, milk production in the United States for July is up 0.7% over the same month last year, but is tracking downward from the highs of earlier in the year.  Good rains in much of the American Midwest over the last week have eased the drought somewhat, but for much of the corn crop it will have come too late. The futures price for corn is still sitting around $8 per bushel for December 2012 (where it has been sitting for some four weeks now), dropping to $6.50 for December 2013. However, these rains have been in time to still influence soybean yields at the 2012 harvest. 

The next Global Dairy Trade auction is September 5.

 **********************

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About Keith Woodford

Keith Woodford is an independent consultant, based in New Zealand, who works internationally on agri-food systems and rural development projects. He holds honorary positions as Professor of Agri-Food Systems at Lincoln University, New Zealand, and as Senior Research Fellow at the Contemporary China Research Centre at Victoria University, Wellington.
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