[This post was first published in the New Zealand Sunday Star Times on 15 December 2013]
China is seriously short of milk. Although Chinese consumer demand for dairy products is increasing, the local supply is at best static. This is despite rapidly increasing prices paid to local farmers.
Currently, there are shortages of milk in Chinese supermarkets. In just the last two weeks, Chinese supermarket prices have moved another 8%, and imported UHT (ultra heat-treated) milk is now selling for well over $NZ3 per litre.
It is these same economic forces that are causing milk powder in New Zealand to sell for the remarkable price of $US5000 per tonne. The big question is whether this is a short-term bubble or are we really seeing a long-term transformation of markets
Most commentators in New Zealand are describing the current high prices as short-term, and predicting that milk powder prices will drop early next year. This is based on the assumption that other countries, and in particular the USA, will rapidly increase production. However, the predicted outcome of a price decline may underestimate the power of what is occurring in China.
My own prediction is that, despite some inevitable volatility, strong milk prices are likely to continue for a number of years. This is because the challenges that the Chinese industry faces are so profound. The only caveat is that there are no more food safety scares of one type of another. And that is a very important caveat.
The melamine scandal of 2008 has led to major changes in the Chinese industry. Some 300,000 babies became sick as a result of that scandal, which was caused by endemic corruption within Chinese milk supply systems. The Chinese Government now believes that food safety can only be guaranteed by the creation of large-scale farms and large-scale processing factories, where quality is systemised and managers are held accountable.
The problem is that setting up and running large-scale dairy farms with 3000 to 5000 cows requires a new set of skills which are not well embedded in the Chinese dairy industry. Some companies are apparently making a success of it, and that includes Fonterra which has several of these large farms in China. However, some other firms appear to be challenged by the demands of getting the system right.
There are additional forces leading to the decline of the traditional Chinese dairy sector. There is a critical shortage of labour in traditional agriculture, with ongoing urbanisation at the rate of about 12 million people per year. That is like a new city the size of Christchurch being built every ten days, or a city the size of Hamilton being added every five days. It is the young people who are shifting to the cities, and there are now very few people under the age of 45 back in the villages.
Chinese small-scale dairy farmers receive about NZ60c per litre which is much higher than in many parts of the world. However, large farming companies are receiving a lot more at about $NZ1 per litre at farm gate, and in some cases even more. For reasons relating to both genetics and feed, this milk is low in fat and protein. Accordingly, when converted to a New Zealand type payout based on what we call ‘milksolids’ (the protein plus fat), the $1 per litre equates to more than $15 per kg milksolids. This is approaching double what New Zealand farmers get paid even in this current high-priced year. The reality is that China will always be a high cost producer.
Statistics from China Customs show that growth in dairy imports is continuing unabated. In the ten months through to the end of October, China imported 618,000 tonnes of milk powder of which 79% came from New Zealand. The October imports were more than double the tonnage of the previous October.
New Zealand is fortunate that no other countries are currently set up to produce the quantities that China wants. It will take time for other countries to produce the large-scale dryers which underpin the Fonterra-style efficiency in this commodity business.
During the same ten month period, China also imported 147 million litres of fresh UHT milk of which only 17 % came from New Zealand. For this fresh milk New Zealand does have lots of competitors, with Germany being the most important source at 40% of total imports. Quite simply, New Zealand has been slow to latch on to opportunities for UHT milk, and is only now building significant UHT processing capacity. New Zealand has also been slow to latch on to selling branded milk powder, instead selling the product wholesale in 25kg bags.
I can only see one potential cloud on the horizon. For quite some years I have been advocating New Zealand should be converting its herds away from the mutant A1 form of beta-casein to the original A2 type. The mainstream industry has chosen to ignore the health issues surrounding A1 beta-casein and instead has pushed the line that it is a non- issue. Despite this, some of the Synlait producers are now specialist A2 producers and receive a premium for their product. In Australia, A2 milk is by value the largest industry brand (i.e. a brand not owned by a supermarket), and sells at a premium of over 100% over the supermarket-owned brands. In New Zealand, the A1 versus A2 issue has largely slipped below the horizon, but at some time it will emerge again as a threat to the mainstream industry.
Disclosure: Keith Woodford consults as an independent adviser to A2 Corporation.