[This post was first published in the Fairfax NZ Sunday Star Times on 5 October 2014]
This last week I have been analysing the opportunities for the Australian dairy industry arising from an FTA (free trade agreement) with China. The FTA is still being negotiated, but the chances of an agreement in the coming months are good. A key insight has been that Australia will then have a clear competitive advantage relative to New Zealand in relation to fast moving consumer goods such as UHT milk, ice cream, soft cheeses and dairy desserts.
It all comes down to issues of seasonality. New Zealand is the only developed country in the world where the dairy industry is predominantly seasonal. [A correction and apology to my Irish friends. Ireland has a dairy industry, about one quarter the size of the New Zealand industry which is also predominantly seasonal. They focus on butter, hard cheeses and other products which have long shelf lives.]
Nearly all New Zealand dairy farmers calve the cows in spring. This is to get alignment between the seasonal feed supply and feed demand curves. Milk production reaches a peak in October, then declines until the cows are dried off in May. In winter time, almost all the processing facilities are closed, with just enough milk produced to supply the local New Zealand population with fresh products.
It is this seasonality, and the consequent alignment of feed supply and demand, that is the dominant reason why our on-farm production costs are lower than most other developed countries. Under the New Zealand system, it is the cows that go and collect the feed from the pastures rather than the humans. Hay, silage and concentrates make up only a small part of the overall feed.
The problem is that there are two downsides to this system.
The first problem is that our processing costs are higher than elsewhere in the world. A typical New Zealand milk processing plant only operates at about 50% capacity when averaged out over the whole year. Other countries achieve close to 90%. This greatly affects the efficiency of capital.
With whole milk powder, we can partly compensate with a scale of operation that no-one else can match. But for other products, our seasonal production leaves us with a cost structure much higher than our competitors. As we move further down the value adding path, and processing costs become a major part of overall costs, this issue is increasingly important.
The second downside of seasonality is that for perishable products such as yoghurt and soft cheeses it leaves us completely out of the market. Even for long life UHT (ultra heat treated) milk, with a shelf life of at least six months, the supply chain logistics of managing expiry date issues become complex.
The advocates of value-add strategies seldom recognise the implications of matching an all-year-round supply of consumer product to our current production systems.
Basically, we have two options. We can continue to focus on low cost seasonal production systems and the efficient production of commodities. Or we can shift to higher cost systems of production with half the cows calving in spring and the remainder in autumn. The cows don’t mind calving in autumn, as long as they are given enough feed.
Our competitors deal with this problem by keeping the cows in barns for much or all of the year. With an ad lib supply of feed, and no need to spend energy harvesting pasture mouthful by mouthful, the cows produce about twice as much milk as New Zealand cows. Although the feed costs are higher, so is the conversion rate of feed to milk.
The Achilles heel of these systems in the past has been the high cost of labour. Our competitors in other parts of the world are now dealing with this in different ways.
In the US, the hourly pay rates of pay earned by the predominantly Latino labour are less than in New Zealand. On the large mega farms, which is where the expansion is occurring, there is also very high efficiency of capital. Cows are often milked three times per day and the milking parlour operates close to 24 hours per day using two or three shifts of labour.
In Northern Europe, things are playing out rather differently. The smaller farms are rapidly moving to robot milking. Although expensive, the economics are sufficiently strong that in the Scandinavian countries some 50% of farmers now use robots. Holland and Germany are also heading in that direction.
In Australia, nature has itself solved the seasonality problem. In the dairy areas the pastures grow well in winter. A combination of autumn and spring calving makes sense even without winter price premiums.
On Fonterra’s China farms, the cows are fully housed with ad lib feed supplied. Once again, there is no impediment to all-year-round supply of milk.
This leaves New Zealand with some big issues to wrestle with. There are two ways we can go. We can continue with efficient production of commodities based on seasonal production. Alternatively, we can compete in the supermarkets of China with the Germans, Americans and Australians. But some of that production will have to come from autumn calving cows. This second alternative won’t come cheaply.