In working out the long term positioning for the New Zealand dairy industry, we have to ask ourselves four big questions:
• What will happen in China?
• What will happen to oil prices?
• What will happen in America?
• What will happen in Europe?
In this article I will focus on Europe.
The need to shed some myths
To understand the fundamental changes that are occurring in European dairy, we need to first shed some myths. Dominant among these myths is that the European industry only survives because of subsidies.
The reality is that Europe has been competing on world markets, free of export subsidies, for the best part of ten years. The reason that everyone signed-off on elimination of export subsidies at the WTO in December 2015, which both Fonterra and DCANZ (Dairy Companies of Australia and New Zealand) got excited about in their press releases, was that the agreement was simply ratifying existing behaviours.
The counter perspective is that European agriculture still has large internal subsidies. It is true that some European countries, particularly the poorer ones, do still have subsidies that are linked to production. For dairy, these subsidies total about 0.8 billion euro, which sounds a lot. But it only averages out at about NZ 11c per kg milksolids. In the greater scheme of things it’s trivial. In any case, these subsidies do not apply in the major European exporting countries with the exception of France.
In addition, Europe does still protect its internal markets with tariff protection, but that is not going to change. Quite simply, as a matter of food security and regional security, the EU will never allow itself to become dependent on outside countries for basic foods. And we in New Zealand have zero influence to change that.
There is also a range of decoupled support mechanisms related to environmental management. Increasing or decreasing milk production has no effect on these payments. Indeed farms can stop producing milk at all and these payments remain unchanged. And they are totally compliant with WTO rules.
So our industry leaders can hammer away as long as we like at the Europeans, but in reality it is grandstanding for our own New Zealand audience.
Alignment with international prices
Despite the tariff protections, European farm gate dairy prices are now becoming aligned to international prices. In the new Europe, with no production quotas, and with the industry having to itself market surplus production, it is inevitable that this alignment occurs.
The major caveat on European prices being aligned to international prices is that there are lags in the system, which we are seeing right now. It takes a while for current international prices to work their way through to the farm gate, and the same lags can happen when international prices rebound. Also, the so-called international prices as measured by the GDT auctions are only for basic commodities.
The European producers, just like New Zealand’s Tatua Dairy Co-operative, have protection from some of the wild GDT swings. This is through their reliance on value-add products. Also, apart from Ireland, all European dairy systems are 12-month-a-year production systems. These 12 month production systems can lead to higher production costs, but they also lead to lower processing costs through better utilisation of processing infrastructure. This then feeds back into higher farm-gate prices.
The straitjacket of quotas
Until April of 2015, the European dairy industry was in a straitjacket as a consequence of production quotas. The legislation behind those quotas goes back to the 1980s. In those days, the European system administered through the Common Agricultural program (CAP) provided large production subsidies for domestic reasons. But this led to over-production. It also led to the so-called butter mountains, which could only be sold through export subsidies.
That European subsidy system was gradually whittled away during the 1990s and the early years of the 20th century for the simple reason that it was too expensive for the EU budget to maintain. During this time, the EU was getting ready for the eventual elimination of quotas.
Ironically, the last three months of production quotas through to April 2015 actually saw a reduction in production as producers, having got themselves organised for the new world, had to put the brakes on to stay within their old annual quotas. But then in April the lid came off.
Unleashing the entrepreneurship
For much of 2015, our New Zealand industry leaders effectively under-reported what was occurring in Europe. The reason was that they chose to report whole- year to whole-year increases, rather than focusing on the specific month comparisons since the quotas were released.
To illustrate this point, if calendar 2015 is compared to calendar 2014 then European production only increased by 2.5%. But in the months from April to December, European production increased by 4% relative to the preceding year. And in December 2015, European production was 6% above December the previous year.
As long as January to March 2015 figures were included, then the message as to where the story was heading was misleading.
There is no doubt that many European farmers are going to experience huge pain. They already are. This is what happens when entrepreneurial forces are unleashed after being held back so long. Those of us with long memories know something about that in New Zealand.
Currently, the Europeans are producing as much cheese, butter, infant formula and cream as they can, with cheese being more important than liquid milk. The Europeans are also selling increasing quantities of UHT and infant formula to China. With both products, they are out-marketing New Zealand.
Chinese infant formula statistics for 2015 show European countries with 78% market share of imported product, compared to New Zealand at 8%. Holland is Number 1 (at 34% market share and rapidly increasing), Ireland is Number 2 (at 15% and also rapidly increasing), whereas New Zealand’s market share keeps drifting down with each new set of statistics.
The Europeans would like to decrease their production of skim milk powder (SMP), but with butter and cream being profitable, they keep producing the SMP as a by-product. However, the European production of whole milk powder (WMP) has been drifting down in response to low prices.
Amongst the general gloom, and given the ban on European cheese imports by the Russians, it is remarkable how well cheese prices have held up until recently. The Europeans have had good success with exports to the USA and Japan as replacements markets, and overall their cheese exports are almost unchanged from 2014. But in recent weeks the international price of cheese has been going pear-shaped. Ouch! The European pain is about to get worse.
The Europeans have been putting limited quantities of SMP into what are called intervention stocks. This is a form of temporary price support and is somewhat like Fonterra’s actions during the 2008/9 price crash. At the end of January 2016, there were about 50,000 tonnes of SMP in public intervention store, but it looks as if stocks have been climbing rapidly since then. The intervention quantities could reach a new limit of 218,000 tonnes over coming months. The main benefit of the SMP intervention is a smoothing of commodity prices.
These intervention stocks, by buttressing international prices, reduce the short-term pain for New Zealand farmers as well as the Europeans. But eventually, the SMP has to be sold, and that will slow the SMP price recovery.
What will happen now?
My current thinking is that the European production surge relative to last year is about to peak right now on a same-month to same-month comparison. From April, growth on a same-month to same-month basis may even stop. However, feed prices are low and so there are no guarantees.
Regardless of what happens in the short term, there is a good chance that in the longer term European production will further increase, as some farms grow and others get out of dairy completely.
For this longer term, the Europeans, with the possible exception of Ireland, are not going to try and compete with New Zealand with WMP. Europeans regard WMP as an outlet for product with no other immediate use. And they know that, in low-priced volatile commodity markets for long-life products, they lack competitive advantage relative to New Zealand.
One good example is the Arla Co-operative which now has more than 10,000 farmers in seven countries. Their aim is to increase production by 20% in the next four years, with all of this going into consumer products, and much of this heading to Asia.
I also note that Danone, whose brands include Karicare in New Zealand, has ambitions to process more European milk, and is currently building an infant formula plant in Holland at a cost of about 240 million euros. No doubt that product will be aimed at China and other Asian markets.
A remaining puzzle is whether Poland will step up to the mark. There is no doubt that Poland could become a major milk producer. Latest statistics show that milk production there is up 3.6% since quotas came off, but it could be some time before they really get their act together.
Implications for New Zealand
The full implications for New Zealand is a story for another day, and has to be tied in to what is happening with China, USA, and oil. But the big picture is that Europe has commenced a journey of radical reform. In future, there will be less European dairy farms but they will be bigger. And Europe is here to stay as a major exporter of consumer dairy products onto global markets.