Black Thursday for Dairy and Fonterra – but eventually the sun will rise again

Thursday 16 July was surely a black day for dairy and Fonterra. Not only did prices on the Global dairy trade auction prices drop to a record low, but Fonterra announced it was cutting 523 positions.

It was also a black day for New Zealand, as commentators and exchange rate speculators started to realise that the downturn was going to affect the whole economy. The exchange rate dropped close to 3% that day.

Regional New Zealand has seen the downturn coming for some time, but in the main cities the realisation is only starting to dawn.

Suddenly our newspapers and the airwaves are full of commentary. Some of it is good and some of it is way offline.

First the bad news. There is no sign that we are at the bottom of the dairy slump.
I am expecting more bad news with the next auction at the start of August. Futures prices have dropped by several hundred dollars in the last few days, and although that is not a sure sign, it is indicative that auction prices will also drop.

At the last auction (Thursday 16 June New Zealand time), not only did overall prices drop by a further 10.7%, and even more at 13.1% for whole milk powder, but Fonterra failed to sell all of the product on offer. At the next auction, and subsequent auctions, there will be a lot more product on offer as new season production ramps up.

In this current environment, the Fonterra end of season forecast price is largely irrelevant. No-one knows where things will be nine months from now. The key numbers are the advance payments that Fonterra will pay for milk produced through to the end of December.

As I write this on 21 July, Fonterra’s advance price is $4.17 for August, and $3.66 for September to December, to be paid on the 20th of the following month. But the latest auction prices are not enough to cover this. So I am expecting an announcement from Fonterra in the coming days that these prices will drop.

The latest auction prices will struggle to support a final payout of even $3 per kg milksolids. That is not a prediction about the forthcoming season. It is simply a statement of fact about the dire outcome of the last auction.

One of the uncertainties in the current environment is the effect of foreign exchange hedging policy. When exchange rates are dropping, it is a time when all companies wish they were not hedged. My estimate is that over the coming months Fonterra may still be hedged against the US dollar at about 70c whereas the spot price is in the mid 60s.

In the current environment, with both global prices and the exchange rate dropping, there is a real risk that dairy companies will find themselves over exposed to exchange rate hedging. If dairy companies have hedged more foreign exchange than they now find themselves earning, then they not only take a loss on their earnings relative to the spot price, but they also become accidental speculators on additional amounts of US dollars. This is what happened to Westland Dairy Company in 2009, with disastrous results for their payout that year.

Currently, there is no good news coming out of Europe. Overall EU production figures are only available up to the end of April, but early data from both the UK and Germany suggests volumes relative to 2014 are still climbing through to June. European farmers are losing lots of money, but they are still covering their variable costs, so production has not declined.

For the last two years I have been predicting that 2015 would be the year when French and German dairy farmers would riot through the streets of the big cities, and I still expect to see that happen. It is simply not possible to remove production quotas as the Europeans have done without there being major turmoil.

Although I foresaw likely European turmoil from quota removal, neither I nor anyone else predicted the way events would evolve in the Ukraine and the subsequent shutting of the Russian market. Without that, there was always a chance that increasing Chinese demand would counter-balance the European turmoil. But alas, it is working out very differently.
Global Dairy Trade does not publish where the buyers come from for its recent sales. However, Fonterra will of course know. Without this, it could not organise the logistics of supply.

Indeed Fonterra CEO Theo Spiering was quoted by Fran O’Sullivan in the NZ Herald on 8 May as saying that “China was again more than 50 per cent of globally traded volumes [on the Global Dairy Trade auction]”.

This tells us that it is wrong to focus just on China as the predominant cause of the current problems. Much of the problem is that the rest of the world is not buying what it usually buys.

There are complex reasons why the rest of the world is buying less. But lower international oil prices are having an important effect on the oil producing countries, and that is where a considerable amount of our product has gone in recent years.

In the long run, I remain very confident that China will come to the rescue and that our dairy industry will flourish. In that context, I reject the notion from Labour’s Grant Robertson and others that New Zealand is over-exposed to the dairy industry. I also reject the widely expressed notion that we are over exposed to China. Quite simply, without China and without dairy, then New Zealand would indeed be in long term trouble.

However, I also believe that the Government is currently under-estimating the short term implications to the whole economy of this current downturn. Regional New Zealand in particular is going to be hard hit, but it will flow from there to the main cities.

A lot will depend on what happens to the exchange rate. I am inclined to the view that it will go lower, but just like dairy prices, no-one really knows. I have been watching bank predictions for 15 years as to where it might be heading, and the reality is that one might as well toss a coin.

Indeed there is good economic theory, called price expectation theory, that tells us that current exchange rate, with minor adjustments for interest rate differentials between countries, is the best estimate of future exchange rates. Of course the exchange rates will change, but the current price represents the current market consensus where those who think it will increase balance those who think it will decrease.

In all of this, the key reason that I remain so confident about the long term for our dairy industry is that China currently produces more than 1 million tonnes of milk powder each year itself. There is absolutely no way this can be cost competitive with milk powder imported from New Zealand.

As of last week, typical dairy farmers in China were receiving about 3.4 yuan per litre of milk. This equates to about $NZ11 to $12 per kg milksolids (depending on the components). At this price these farmers are still making big losses. Yet when converted into milk powder this has a cost of about $US6000 per tonne which is way above the global price even during the 2013 boom.

Industry restructuring within China is already occurring and it will continue. But industry restructuring always takes time. In the case of China, there are very important social issues that have to be dealt with. In the meantime, Chinese processors have to purchase local milk – which in some cases they then pour down the drain – when they would much prefer to purchase New Zealand milk powder.

The urbanisation of China is ongoing. Just this month China has announced plans to link Beijing with neighbouring Hebei Province to make a mega urban development of 130 million people. Let there be no doubt, the opportunities for New Zealand are huge.

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.
This entry was posted in Agribusiness, China, Dairy, Fonterra. Bookmark the permalink.

7 Responses to Black Thursday for Dairy and Fonterra – but eventually the sun will rise again

  1. Appreciate your analyses, Keith.
    How do you view the 100,000 cow dairy the Chinese are building for export to Russia?

  2. Henry Filth says:

    What proportion of dairy is sold at auction, and what proportion is sold via long-term, fixed-price contracts?

    • Keith Woodford says:

      I would need to check the spreadsheet to get the precise figures. But in broad terms about 35% is now sold by auction.
      Fonterra has very few long term fixed price contracts. What happens is that Fonterra knows many months in advance who will by buying much of the non-auction product through long term relationships). But the price will still be determined off the auction price at the time of delivery (or thereabouts). Accordingly, the auction price is very much the price that drives the vast majority of sales.

  3. John Martin says:

    P B Cows, and clever Chinese. They can’t grow their own feed so get it from the neighbour. Russia can’t buy milk from us, so they get it from the neighbour. (perhaps that should be written the other way around). The milk will not be very nutritious – poor feed, unhappy cows, and the heat of the sterilisation process eliminating many what nutrients remain. Lovely industrial exercise though, will have kept some engineers very happy.

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