Shocks versus structural change is the big dairy question

Right now, the focus of almost every New Zealand dairy farmer is on survival. It is a time when cash is king.

In the short run, it is all about turning cash inputs into milk. There can be no argument that this means using all available grass, but it also means not having hungry cows. Each farmer will find his or her way of achieving this. It may be through decreased stock numbers or it may be through appropriate supplementation to match feed deficits. In times like these, it is more important to travel the chosen path efficiently rather than to jump wildly from one path to the other.

Despite the focus on survival, it is also a good time to be thinking strategically. At the industry level, have we got it right?  In regard to what we are currently experiencing, how much of it is from one-off shocks and how much is due to structural change within global markets.

Short-term shocks eventually resolve themselves, as long as the industry is operating from a position of fundamental strength. But to the extent that the global situation reflects global structural change, then simply continuing as we have always done will not be good enough.

Our traditional strength in New Zealand has been low-cost seasonal production linked to long-life commodity products. For much of last century, our strategic positioning was based around butter. More recently, and particularly for the last 15 years, our strength has been allied to powder    production.

The traditional New Zealand model has focused on cost-efficient production behind the farm gate. We have been willing to bear the consequent loss of processing cost efficiency arising from seasonal production and hence low utilisation of processing plant capacity.  As long as our focus was commodities which have relatively low capital costs, and as long as commodity production was profitable, then it all made lots of sense.

So what has changed in the last two years?

Everyone knows that dairy prices have crashed. What is less well understood, at least in New Zealand, is that milk powders have fared worse than other products.

In the case of skim milk powder (SMP), the surplus is in part a by-product of increased global demand for butter.  As a consequence, the Europeans have put about 250,000 tonnes of SMP into store (public and private), with more still pouring in. And thank goodness they have done so, or else SMP prices would have crashed much lower.

Here in New Zealand, we produce about 400,000 tonnes of SMP every year, which goes into the same markets as does European SMP. So in the short term, the European storage has been a blessing for every New Zealand famer.   My best estimate is that this storage of SMP is currently buttressing the overall payout to New Zealand farmers by about 30c per kg milksolids, although the precise numbers are debatable. Unfortunately, all of this European SMP will still have to come back on the market eventually.

In the case of whole milk powder (WMP), there has been a decrease in demand for internationally traded product.  This is in part because China is producing more WMP itself, and China now exceeds New Zealand in terms of overall WMP production. It is also because the oil-producing countries cannot afford to buy as much as previously. So prices have crashed, despite New Zealand in particular having reduced its own production of WMP.

This decline in New Zealand WMP production has occurred because Fonterra, within the constraints of its processing capacity, has been preferentially channelling more milk into cheese and butter.

Right now, there are some early signs that global prices for the non-powder prices are rising. Six months ago, the spot price for non-contracted milk in the Netherlands was 13 euros per 100 kg of milk, now it is 26 euros. In Italy the price dropped to 22 euros per 100 kg; now it is 27 euros.

These current prices in Europe are still below the cost of production for most European farmers, but they are above the marginal cost of production. So unless a farmer decides to give up dairying altogether, the logical response is to produce to capacity.

European farmers are getting farm-gate prices for their milk about 35% higher than what New Zealand farmers are getting. So how is this happening? The answer is a combination of a better product mix combined with lower processing costs from non-seasonal production.  In addition, New Zealand and Australian products have been selling at a discount to European products on international markets.

One thing that cannot be used to explain these price differences is European subsidies. This is because European subsidies, with minor exceptions, are decoupled from milk prices.

The key outlier to the European story is Ireland. Like us, they are seasonal producers, with an export focus, and increasingly powder-dependant.  It is not co-incidental that Irish farm gate prices are considerably lower than elsewhere in Europe.

Some commentators appear to have been getting ahead of themselves in stating that European milk production increases are essentially over, and that supply and demand will soon come back into balance. Comprehensive European production statistics, currently available through to the end of April, show daily production for April more than 4% higher than March.

Eu milk production to April 2016

European comparisons with 2014 and 2015 can be misleading because of ‘one-off’ factors leading up to and subsequent to quota removal. Accordingly, I place more weight on comparisons with 2013, the last year of some stability. On that basis, European production continues to track at about 10% above 2013 and that can only mean continuing surpluses.

Within Europe, focusing on any particular country is particularly misleading. Ireland, the UK and some other parts of Northern Europe have stabilised production but this has also been influenced by a late spring. But the Netherlands, Poland and Italy have been steaming ahead at higher production levels.  And those increases appear to be structural.

I watch every Global Dairy trade auction carefully, but this next one on Wednesday morning 6 July New Zealand time, has the potential to be a real bellwether event. The volumes of WMP on offer will be up more than 50% from the last sale. Will the buyers from China be there?  If not, we are in trouble. It could go either way.  With exchange rate having moved against us in recent weeks, it will need a price increase of about 10% to support the current proposed price of $4.25.

All of this short term stuff is about shocks and their echo effects. But it does help focus the mind on whether we have got it right.  Further focusing of the mind comes from looking at what is happening in China, our biggest market.

To see the trends occurring in China it is helpful to go back a few years, with 2012 being a good starting point.  In that year – before the crazy boom starting in early 2013 and continuing through into 2014 – China imported 406,000 tonnes of WMP. In 2015 they imported 347,000 tonnes. In contrast, China’s imports of liquid milk increased five-fold in the same three-year period, and imports of infant formula doubled in this period.  Currently, there is a modest but fragile increase in WMP for the first five months of 2016 (up 20%, led by high January imports, but not sustained thereafter), but this is easily outpaced by the ongoing rapid growth in infant formula and liquid milk imports.   For the three months March to May, Chinese liquid milk imports, largely from Europe but with 15% of the market share from New Zealand, are running almost double that of last year.

Should New Zealand companies decide to move more strongly into to value-add products, then it will not be an easy journey.  The reason for that is that New Zealand is at least eight years behind where it should be.  So there is lots of ‘catch up’ to do.  But there are some good signs of what is possible, such as Fonterra’s mozzarella factory at Clandeboye and the sliced cheese factory at Eltham. And several companies now have UHT plants.

Making ‘value-add’ work for New Zealand can only work if a proportion of farmers move to non-seasonal production.   That requires a massive rework of farming systems and this can only be justified with guaranteed price premiums for off-season production.

So it is the processors that need to first provide the signals. It will then be up to each farmer to make his or her own choice as to how they want to proceed, based on whether the price premiums exceed the additional on-farm costs.  Different farmers will choose different paths – seasonal production for long-life commodities, or non-seasonal production for value-add products.

In future articles I will have more to say about those seasonal premiums, the need to get those signals clear, and what it means for farming systems.

 

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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.
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8 Responses to Shocks versus structural change is the big dairy question

  1. I’ve been meaning for some time to leave a comment saying just how valuable your commentary on the dairy industry is. There is nothing I’ve found, in the public eye, that is remotely as good.

    Thanks

    • Keith Woodford says:

      Thank you Michael.
      It is always nice to be appreciated.
      I see some interesting articles for me to delve into at your own site.
      Keith

  2. Matthew Grierson says:

    What Fonterra and NZ primary produce suppliers are looking at is no different what many other companies have had ask themselves over their existences; specifically, is this temporary, or is it a long term trend?
    If it is long term, then action must be taken.
    The first company that comes to mind for an example if 3M – started as Minnesota Mining and Metals. The markets moved, the opportunities were elsewhere and they moved with them.
    I would imagine as China’s wealth increases, so will their demand for value added products increase – with the resulting decline in the raw product.
    From this distance, it doesn’t look to me like it is a glitch in the market.
    I’m believe Fonterra should be quickly moving to meet the market.

    • Keith Woodford says:

      Matthew
      I agree
      The challenge is the amount of time it takes for a large ocean liner to change direction; and in relation to Fonterra, the capital required to make the shift. There will still be demand for WMP, but having so many eggs in the one basket is indeed a high risk strategy.
      Keith

  3. Instead of making large changes to farm infrastructure could we get enough winter milk to keep processors going viably through winter if four or five farms combined their empty cows on one farm to be milked and then sold to the works at a high schedule later? Presently there is a lot of (admittedly low per-cow but perhaps collectively significant) production going to the works at a low schedule before winter.

    • Keith Woodford says:

      James,
      One of the issues with late lactation milk is that it has its own distinctive composition and also tends to be high in somatic cell count. It’s OK when just a small part of a larger volume, but processors would not want a predominant supply of late lactation milk.

      Also, the issue is not just getting milk in the winter months, but of evening out the supply across the shoulder months of the year to give an even 12 month supply. In NZ, milk production peaks in late October, and processing facilities have to be built to meet this peak. Production then tails off quickly from about New Year.
      Keith

  4. Pingback: Rural round-up | Homepaddock

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