[ This post was first published in the Fairfax New Zealand Sunday Star Times on 29 june 2014.]
The next two months will be crucial for the coming year’s dairy payouts. Normally, it is not until Christmas that predictions have any reliability, but this year it will be different. If global dairy prices are going to reverse the declines of the last four months, then we will see the evidence of that very soon, perhaps within weeks. Otherwise we are in for a tough year.
At this stage I remain optimistic. The key factor is the extent to which the Chinese milk companies buy New Zealand milk powder.
The story is murky, but it looks as if the Chinese companies built up inventories at the end of 2013. This was a response to getting got caught out by the New Zealand drought at the start of 2013, which led to a shortage of product. They did not want to get caught again. However, New Zealand production in the autumn of 2014 was spectacular, and the market has taken a while to digest the increased product volumes. Inventories will now be getting back to normal and the Chinese milk companies will need to once again build up their purchases.
If I am wrong, then it will indeed be a difficult year. At current exchange rates, the current milk powder price of about $US3650 per tonne will not support a payout to farmers above $6 per kg of fat plus protein. Given that Fonterra is currently predicting $7, then they too are obviously optimistic that things will turn around.
Chinese internal production seems stubbornly stuck at no more than about 35 billion litres of milk per annum whereas demand is now of the order of 50 billion litres. Also, internal milk prices in China are sufficiently high that it is more profitable to buy milk powder from New Zealand than to buy the milk fresh in China. That would be the case as long as the milk powder price is less than about $US6000 per tonne. For a lot of dairy products, the dried milk powder is directly substitutable with local fresh product, so there are very real incentives for the Chinese buyers to buy more powder.
Production is now starting to ramp up in Europe as farmers get ready for the removal of quotas in April 2015. Also, milk production is increasing in the United States whereas consumption there is actually lagging. So there will definitely be more milk coming onto the export market. However, neither the Europeans nor the Americans are well set up to produce whole milk powder. So my expectation is that for the next year or so whole milk powder will remain the product of preference whereas cheese and butter may both struggle.
This likely imbalance between milk powder prices and other dairy products will lead to continuing challenges for Fonterra in working out how much they will pay farmers. The much vaunted milk pricing formula, about which Fonterra spoke so glowingly when they set it up less than two years ago, is in tatters. Just as this year, my expectation is that Fonterra will decide to cast the formula aside and pay less. From Fonterra’s perspective, it makes good business sense to do so, but it does mean that sharemilkers in particular are once again likely to be paid less than what the approved formula says they should be getting. As with this year, the prime beneficiaries will be the non-farmer investors. Once the election is over, the Government and Fonterra will need to sit down and work out again the fundamental rules of farm gate milk pricing.
Looking out beyond next year, I expect to see major instability affecting European dairy farmers as they adjust to a free milk market. European prices will drift back to world prices as the bigger farmers continue to expand, and the small producers will structure out of the industry. In the short term there is no doubt that European production will increase, but the long term outcomes are harder to predict. It will not be a happy time for small scale European dairy farmers, and they will be marching in the streets.
In America, where more milk is now consumed as cheese than as fresh product, the industry will also continue to restructure towards mega farms with 5000 to 10,000 cows. Overall American production will increase as the Americans assume the mantle from New Zealand as the world’s largest dairy product exporter.
Assuming that China continues economic growth at around 7% per annum, or even if Chinese growth slips back to 5%, then all should still be well for New Zealand in the long term. But there could be some rocky periods of price volatility along the way. Those who have either high debt or high cost of production will need to tread carefully.