Make hay while the sun shines, is a saying well known to many New Zealanders; unfortunately the dairy industry is caught in a supply and demand storm.
The Dairy industry has been suffering from depressed milk prices since the boom of 2013/2014 when a kg of milk solids (kgMS) was selling for $8.40, with a 10 cent dividend. There are a number of factors that have led to the fall in dairy prices; these include political events, geographic factors, and trade.
Political events that have led to a fall in the price of milk include Russia’s ban on imported dairy products from the EU, US, Australia, Canada and Norway, essentially reducing world demand. Russia was the second largest importer of dairy products after China, equating to 3 billion litres per year before trade restrictions. Although Russia’s main dairy import is Cheese, of which 90% is made-up from banned countries, excluding raw milk or milk powder, the effect from banning value added dairy products is that producers either scale back production to meet demand, or focus on exporting to other markets. It would appear that most are choosing the latter option.
The second Political factor leading to falling dairy prices is the European Union (EU) removing milk quotas to help farmers compete with international rivals supplying fast-growing markets in Asia and Africa. The quota system was initiated after subsidised milk production consistently outstripped demand, such that from 1984 member states that produced too much milk were fined. The EU is the largest milk producer in the world, producing 151.5 million tonnes of Dairy, Milk and Fluid for the 2014 year, an increase of 4.6% on the prior year. Following the EU is India, the United States and China. For the 2015 year, overall milk production in the EU is expected to increase at a decreasing rate, growth of less than 1%, which is in-line with other producing countries; and to provide perspective from a NZ standpoint, we experienced growth in milk production in 2014 of 7%, falling to an expected 1.7% for the 2015 year. The current trend is for milk producing counties to continue increasing production, but at a decreasing rate.
Statistics from the United States Department of Agriculture (USDA) show forecast growth in EU milk production of less than 1% for 2015, low compared to a 4.6% expansion in production for 2013/2014. It’s fair to expect the EU to continue expanding production over the long term, but we’re unlikely to see another year of 4% growth in the short term. The EU quota was an effective production constraint with an unfortunate secondary effect, limited investment in milk production and processing capacity. Consequently, I would expect European milk production to increase in the medium term, as investment in infrastructure provides the means for European farmers to produce and process greater volumes of milk. The impact arising from increasing EU production will be downward pressure on the international price of milk.
New Zealand is the largest producer of whole milk powder (WMP) in the world, having produced 1.5m tonnes in 2014; however, New Zealand is only the 7th largest producer of milk in the world, having produced 21.7m tonnes of milk in 2014. New Zealand’s milk production is exceeded by the EU, USA, India, China, Brazil, and Russia. The USDA reports that four of the largest producers of milk (India, US, China, Brazil) are expected to increase production in the 2015/2016 season by approximately 3.5%. Although a reasonable portion of the increase in milk production is expected to meet domestic demand, exports from major exporters are expected to increase on average by 1%. Fonterra Chairman John Wilson stated that world demand for milk is increasing at about 2% per year, positive news when exports are expected to increase by only 1%.
The United States operates an intensive dairy farming model, utilising barns to house and feed cows, rather than New Zealand’s less intensive pasture fed system. The significant upside on using the barn system relates to the ability to milk all year round, however, this comes at the cost of supplying expensive bought-in feed to maintain milk production throughout winter. The US benefits from feed inputs that are sold at a significant discount to NZ, due to US production subsidies. American farm subsidies are expensive, harvesting $20 billion a year from US taxpayers’ pockets. Most of the money goes to farmers producing staple commodities such as corn and soya beans in states such as Iowa. Fonterra remains wary of the ability for US dairy farmers to affect world supply in the short term due to their intensive farming practices. US dairy exports increased 6% to $7.11Bn for 2014, averaging 15% of domestic milk production. New Zealand dairy farmers are competing against international dairy producers with artificially low input costs, and government support. Although we might find comfort in believing that the international dairy market is a free market, and every producer is treated equally, such a notion can only be regarded as folly. To quote George Orwell’s Animal Farm, “All animals are equal, but some are more equal than others”.
Global demand for dairy products is expected to be met by China; however, this point-of-view seems rather optimistic and narrow-minded when China’s GDP growth, as reported by the World Bank, is expected to cool from 7.7% in 2014 to 7.1% in 2015, leading to an expected decline in the volume of WMP imported by China. New Zealand is the largest producer and exporter of WMP, with a significant reliance on China’s demand, previously assumed to be insatiable. To provide perspective on our reliance on China, in 2013 90% of NZ’s WMP exports were destined for China. As China works through its reserves of WMP, estimated at 400,000 tonnes as at July 2014, we should see Chinese demand return to the market, leading to a slight recovery in the price of WMP, which in-turn ought to trickle down to increase the international price of milk. However, prices will only rise if international demand exceeds supply, with Fonterra increasing WMP production capacity across New Zealand, its arguable as to whether the required level of demand will return to the market in the short term.
India is the second largest producer of milk in the world, forecasted to produce 146.5m tonnes of milk in 2015. India’s milk production has been expanding over the past 5 years, experiencing growth of 4.5% in 2013/2014 and forecast growth of 4% for 2014/2015, as reported by the USDA. The increase in production has been driven by increasing demand for dairy products, with approximately 70% of dairy consumed as raw milk. The Indian National Dairy Development Board (NDDB) is operating a programme to increase milk production in-line with expected growth in demand of 180m tonnes by 2021-2022, financed by The World Bank. Indian milk production is currently growing at 4%, while growth in domestic consumption is estimated to be upwards of 5% each year. The growing gap between production and consumption is the primary reason behind the NDDB running a programme to increase dairy production, and the likelihood of Indian dairy exports being a threat to the world price of milk in the short-term is expected to be low.
Fonterra’s 2013/2014 actual milk pay-out was $8.40 per kgMS along with a dividend of 10 cents, for a total cash pay-out of $8.50. However, positive dairy sentiment was dashed when the forecast pay-out for the 2014/2015 season was announced on 30th April 2015 to be between $4.70 to $4.80, and more recently adjusted down to $4.50 per kgMS. In essence, the pay-out has halved when compared to the prior season, and with prices this low there’s good reason to cry over spilt milk. NZ farmers are in a cash-burn situation, and the ability to make cream from the crop is being quickly diminished.
In the 2014/2015 season farmers were fortunate to budget on receiving a retrospective milk payment based on a higher final 2013/2014 season milk price. However, farmers won’t have that luxury in the 2015/2016 season, as the forecast price is being repetitively lowered, in contrast to the 2013/2014 season where the final price exceeded interim forecasts. The retrospective payment has been instrumental in carrying farmers through the next season; with some farmers expected to end the 2014/2015 season in a financial deficit. Many farmers will be starting the 2015/2016 season in a financial deficit, and with no income until their advance payment in August, it might be worth calling the bank manager to setup an additional line of credit, if you haven’t already.
Per discussions with local farm advisors, there is consensus that for the 2015/16 season dairy farmers across North Canterbury will be tightening their belts. The average farm milks 650 cows, with operating costs at $4.20 per kgMS, and an average debt servicing cost of $1-$1.20 per kgMS. For the average farmer, if the 2014/2015 Fonterra forecast milk price of $4.50 per kgMS is carried into the 2015/2016 season, income will be less than the cost of operating, raising questions regarding the potential for farmers to cut costs further to manage cash flow. Lean operations and a transfer of fixed costs to variable are valid options, however, for operations that are already operating on a lean model, where is the fat to cut?
Options on the table for getting through the expected cash burn situation include aggressive cost cutting, selling up to 50 cows per farm to maintain sufficient cash to meet outgoings, or scaling back production with a corresponding sell-down of Fonterra shares. Aggressive cost cutting requires a fine balance to ensure future performance is not inhibited by a short term operating decision. The majority of farmers won’t have the option to reduce workers, however, supplementary feed costs will likely be the victim. Supplementary feed costs are a significant input cost for farmers, and a reduction in supplementary feed with an increased focus on pasture management can free-up much needed cash for ongoing operations. A reduction in supplementary feed will adversely affect milk production; however the change in milk production is less than the proportional change in supplementary feed.
Selling cows is a valid option for larger herds, with beef prices offering a reasonable return. Low producing cows are a drag on the overall herd, and it’s a good time for farmers to start assessing their herds to maximise kgMS per cow. The average price per cow at the meat works is between $700 and $850, which provides a valuable option for farmers with a few underperforming cows.
Scaling back production by selling the underperforming cows and selling-down Fonterra shareholdings is an aggressive strategy to weather the storm, but it might be the strategy to keep you dry. A sell-down of lower producing cows will ultimately benefit overall herd production in the long-run and provide much needed cash in the short-term. The second part of the strategy is selling-down Fonterra shares, not the most attractive option when farmer traded shares are trading at their lowest price since listing. For farmers who are financial stable, with Fonterra Co-operative Group (FCG) shares at an all time low, now would seem like a golden opportunity to accumulate shares in preparation for increased future production. As the saying goes, “you buy a straw hat in winter”.
FCG share price movement over 3 years
The New Zealand dairy industry was restructured in 2001 following the introduction of the DIRA 2001, with the aim of boosting New Zealand’s competitiveness in world dairy markets. The restructure involved the New Zealand Co-operative Dairy Company and Kiwi Co-operative Dairies merging to become Fonterra. Fonterra was the focus of the DIRA, regulating the supply of milk Fonterra is required to accept, process, and how Fonterra manages rival milk processors. Following the restructure, export restrictions were gradually relaxed, and Fonterra emerged as a milk processor with an insatiable appetite for milk.
A recent development has been the Dairy Industry Restructuring Act 2012 (DIRA) Section 148A (1) requiring the Primary Industries Minister and Commerce Minister to produce a report on the level of competition in the NZ dairy industry, on the basis that one has not been requested earlier than the 1st of June 2015. The NZ dairy industry is regulated by the DIRA, which states that Fonterra must be an open co-operative that accepts (subject to limited exceptions) all milk supply offered by any dairy farmer in New Zealand who is willing to hold shares in Fonterra in proportion to their milk supply. Essentially, Fonterra is the supplier of default, absorbing ever increasing volumes of milk. The report will determine whether the NZ dairy market can be considered workably competitive, based on the following market share thresholds being met: Independent (non-Fonterra) processors have, directly or indirectly, collected 20 per cent or more of milk solids on, or from dairy farms in the North Island in a season; or 20 per cent or more of milk solids on, or from South Island dairy farms in a season. If the report finds that the NZ dairy industry is workably competitive, potential routes for deregulation will be addressed. The results of the report will be provided to Minister Nathan Guy, and he will have 90 days to respond.
Fonterra claims approximately 83% of NZ’s raw milk market, and in accordance with the DIRA, at least 80% of milk must be sourced from either the North or South Island, such that they are within the 80% threshold for either the North or South Island. Fonterra is the dominant player in the NZ dairy industry, and further regulation would not only hurt Fonterra farmers and shareholders, but remove them as the acceptor of excess supply. Independent industry players including: Synlait, Open Country, Westland Milk Products, and Tatua have been growing over the past 5 years on the back of growing milk production, but do they have the infrastructure to handle increased volumes of milk if regulation removes Fonterra as the default acceptor of milk?
Dairy farmers that supply Fonterra are required to hold 1 Fonterra share (FCG) for 1 kgMS produced, determined by a 3 year rolling average of a farm’s production. This 3 year rolling average is determined with reference to 2 dates, the “Measurement date” and the “Compliance date”. Fonterra states, “The shareholding requirement for Farmer Shareholders is determined on the Measurement Date, being the first day of a Season (currently 1 June) and advised to farmers. It is tested on the Compliance Date, which will be set by the Board and will be not less than six months following the Measurement Date. It is currently intended to be on or after 1 December.” What this means, is that if farmers intend to lower production for the coming 2015/2016 season, they will have to sell their cows and/or sell-down their Fonterra shareholding before the 1st of June. The number of shares farmers will be able to sell, will equal the prior adjusted rolling three year average production less the adjusted rolling three year average based on lower production for the coming season. Failure to sell-down Fonterra shares prior to the 1st of June will result in Farmers being required to hold their shareholding throughout the 2015/2016 season until the 1st of December.
Wilson Consultancy Agricultural Consultant, Will Wilson commented in the KPMG Field Notes 6th of May edition, stating, “around $2 billion in additional working capital will now be needed by farm businesses to fund operations for the 2015/16 season due to Fonterra’s 20 cent milk price downgrade.” These figures appear extreme, but they are very much a reality, when the average North Canterbury farm milking 650 cows is expected to be facing a $360,000 loss for the 2015/2016 season. Prudent seasoned dairy farmers budgeting on a historically low pay-out will be well prepared for the forecasted milk price, however new entrants to dairy farming (entered within the last 5 years) will be forced to aggressively manage cash flow to make it through low prices. To provide perspective on debt levels, the Reserve Bank, in its six-monthly Financial Stability report, said 11 percent of farm debt was held by farmers with both negative cash flow and elevated loan-to-value ratios, and if low global milk prices continue financial stress in the sector could rise rapidly.
Looking forward to the 2015/2016 season, we can expect the price of milk to increase under the following scenario, Russia’s 1 year ban on imported dairy products is lifted in August, The EU’s growth in milk production tracks domestic demand, The US doesn’t experience another year of cheap supplementary feed, and China works through their WMP stockpile and their demand comes back to the market. It’s unlikely these events will occur concurrently, and it’s reasonable to predict that the price of a kgMS will remain low for the coming season. Australian Banks have started forecasting the 2015/2016 season opening price, with ANZ forecasting a price between $5 and $5.25, and ASB expecting the price to open at $5.70. On the 19th of May, ANZ Bank Rural Economist, Con Williams, stated that he expected Fonterra to issue a prediction of $5 to $5.25 per kilogram of milk solids for the new season. These forecasts are extremely early, and there are a large number of factors at play before the 2015/2016 season. The reality of the situation is that prices are likely to remain under pressure in the short to medium term and there is every chance ANZ and ASB will lower their forecasts.
Although milk prices are low, low interest rates continue to support demand for farmland, based on the notion that in the long run China will increase their demand for dairy products, and dairy prices will adjust upwards to meet supply. As at the 7th of May, the median dairy farm price in NZ had increased by 31% to $45,000 per hectare, reflecting continued demand for dairy farms at an historically low milk price. As the price of dairy farms continues to rise, the returns to farmers are being transferred from continuing operations to capital gains. As mentioned previously, with the average farmer expecting operating plus financing costs to exceed income, there’s still a business in making a loss. Reliance on capital gains will only exacerbate the issue of making a sustainable return from dairy farms, and will eventually price farmers out of the market. The effect of this change will likely be an increase in the concentration of dairy farms owned by corporates, with a greater focus on lean operations and expanding production. Although individuals may find themselves priced out of the market, the relentless pursuit of profits by companies will likely accelerate milk production and add fuel to the fire of an already oversupplied market.
To conclude, the international dairy market is in a supply glut, and it’s unlikely that sufficient demand will come to the market to relieve the stress that lacklustre demand is having on the world price of milk. Russia has shown no sign of mending relations with the Ukraine or the West, which leads us to assume that the ban on imported dairy will be rolled-over for another 12 months, latest estimates regarding China’s forecast GDP growth indicate a cooling economy, and global milk production continues to grow. The land of milk and honey is awash with milk amid a hive of activity; its likely milk prices will remain under pressure in the short to medium term.