Dairy prices have downside risk

Whenever I write about the dairy price outlook, the key messages are about volatility and unpredictability. Nevertheless, right now the risks are weighted to the downside.

There is considerable nervousness within the export trade about the next GDT auction in early November.   The auction acts as a barometer for the overall market.

This next auction will either confirm or reverse an emerging trend where buyers have been purchasing for immediate needs, but then quietly stepping back to the sidelines in regard to later deliveries. 

The problem is that when buyers think prices are going to fall, they then step back and their collective action actually causes prices to fall. Conversely, when they collectively decide there is an emerging shortage, then their collective ‘rush to buy’ does indeed raise prices.

A key reason that buyer sentiment has changed is that production is increasing again in Europe.  The buyers think they can see plenty of product coming forth in the next few months.

The last two to three years have been a crazy ride for European dairy farmers. When production quotas were removed back in April 215, then production soared. Then, when prices dropped in response to the increased production, farmers sold some of their animals and production declined. Then. with farm gate prices rising steadily again this year as market prices rebounded, farmers have decided once again to increase production.

By the start of August, European production was setting new records. Given the lags between decisions and outcomes, this expansion looks likely to continue in the next few months.

The specific situation varies between European countries. Poland, Italy and Ireland have been leading the recent charge.  Germany and the Netherlands are showing muted responses.  British and French production is still lagging.

In the USA, dairy production continues to increase each year. This year it is up by 1.6 percent. Right now, the apparently never-ending American increase in consumption of cheese is struggling to outweigh the ongoing decline in fresh milk consumption. So, more product is available for export.

The underlying message of USA dairying is an ongoing story of big farms getting bigger and small farms going out of business. Total cow numbers are close to static, but per cow production continues to climb. Productivity increases are fuelled both by increasing corn yields keeping costs down, and more productive cows that produce more than twice the milk of an average New Zealand cow.

The reason that Europe and the USA are so important in the dairy world is that between them they produce 250 billion litres of milk each year. This is about 12 times the New Zealand production.

Both Australian and Argentinian production is showing signs of recovery after a disastrous 2016.   New Zealand is the only big producer that is not producing more this year.

So, if prices in the market place are to hold, then someone needs to step up with increased demand. But who will that be?

As always, China is the hardest market to read. Their recent buying interest has focused on product that will be on the water by 31 December, and which can be logged into the new year’s tariff-free quota which opens on January 1. No one else appears to be putting their hand up for big deliveries in early 2018.

The last 12 months have seen a unique combination of prices, with fat products at record prices and protein prices very low. The current relativities between fat and protein have not been seen for at least 25 years.

Butter reached its peak of $US6000 and above in August and September, but now is slipping rapidly. Sales for delivery in 2018 are closer to $US5000, and still searching for firm ground.

At the record prices that we were seeing, it was inevitable that the food processing industry would re-evaluate its enthusiasm for butter and anhydrous milk fat (AMF). The financial difference between milk fat and the alternative vegetable oils selling at under $1000 per tonne became too much to ignore.

Manufacturers are always reluctant to make unnecessary changes to their ingredient mix, and so there are lags in the system. This acts in both directions.  Once they do decide to move away from dairy fats to vegetable oils, they are equally reluctant to move back unless dairy fats drop by a very large amount.

Skim milk powder (SMP) has been struggling for more than two years. The Europeans have 380,000 tonnes in store, all owned publicly by the European Community.  New Zealand SMP sold below $US1800 per tonne at the last auction. There is no joy with these prices.

The whole milk powder (WMP) market has stayed in more healthy territory, hovering around $US3000, per tonne, but only held up by short-term demand for product into China.

An emerging risk for WMP is what is known in the trade as ‘fat-filled milk powder’. This is code for milk powder which has had the dairy fat removed and vegetable fats added. Many of the big dairy companies including Fonterra sell this commodity product, but they keep the trade below the radar of the general public.  Indeed, very few farmers at Fonterra or elsewhere even know that this trade exists.

Fat-filled milk is often loosely described as fake milk, and that can be a fair description.  But in terms of nutritional quality it is not necessarily inferior. It may even have a superior ratio of unsaturated to saturated fat. It is sold mainly to developing countries.

The fat-filled trade would still exist without any direct involvement of the dairy companies. This is because there are plenty of independent supply chain intermediaries who can buy SMP, add in vegetable fat, and then sell the synthetic product.  The only gripe that I have is the lack of transparency as to what is happening.

One thing for sure, is that the combination of cheap SMP plus cheap vegetable oils, together with high dairy-fat prices, has created big margins to be exploited with fat-filled product.

My key message in all of this is that the farmgate milk price pathway for the rest of this dairy season is full of uncertainty.  There is nothing new in that. However, there has been a developing perspective in New Zealand over the last year that perhaps some of the dairy volatility of recent years might now be behind us. It is not that simple.

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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