This article was first published in the July 2010 edition of the Australian Dairyfarmer Magazine
A common theme in discussions with our dairyfarmer clients is the incredible volatility that the industry has seen in farmgate milk price and raw material costs in the past three seasons. The questions that keep coming up are "Why can't we achieve a stable price?" and "... is this here to stay?". In this article Dr Hauser discusses the volatility question further.
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The milk price history for south-east Australia shows that the extreme volatility of the past three years is unusual but not unprecedented. The good news (historically at least) is that the extreme events seems to be a once in a decade event. The bad news is that the export dairy market, and almost all other commodity markets, are characterised by volatility and these periodic peaks and rapid falls are a common problem for both buyers and sellers.
Dairy commodities and currency - the two main drivers
In south-east Australia the most important drivers of farmgate milk price are the value of dairy commodities on the export market - the major products being cheddar cheese, butter, butteroil, skim and wholemilk powder, and whey powder. It is true that a significant percentage of Australia's dairy products are sold domestically (about 55%) but a large part of this is still commodity ingredients tied reasonably closely to the export price. There is no escape from this - there is a massive dairy factory on our doorstep in New Zealand that has free access to Australian markets. Trying to move domestic commodity prices too far above international price benchmarks is inviting New Zealand to take advantage of a price premium and export more product across the Tasman.
International, freely traded, dairy commodity markets are highly competitive with New Zealand, the European Union (EU) and Australia holding the lion share of supply. Global demand and the competition between these nations for supply has been the major driver of Oceania commodity prices.
The United States and South America are important sources of global product but have less influence on price movements. Arguably however it is the ramp up of US milk production and exports during 2007 / 2008 that caused the rapid and dramatic fall in price in the second half of 2008.
The US dollar and the Euro are the important currencies for export commodity trade but for an Australian farmer it is the net price in Australian dollars that really matters. Unfortunately (for dairyfarmers) there is only a loose connection between dairy commodity prices and the US dollar, Australian dollar, and Euro exchange rates. This means that two very complex and independent issues overlay each other and exaggerate the volatility in farmgate price.
Xcheque.com publishes an index for south-east Australia that takes account of movements in commodity price and exchange rates. The south-east Australian Milk Price Index (SAMPI) is a guide to the monthly movement in commodities and exchange rates, the effect that has on the revenue of major ingredient processors, and the estimated effect on farmgate milk price. The SAMPI for the past 16 years is shown on the farmgate milk price chart (see Figure 1 above). Estimation of final milk price from the SAMPI is a more complex issue but it is easy to see that there is a strong correlation. The rise in the SAMPI in the past 6 months is part explanation for the current level of optimism over 2010/11 milk prices.
The chart below shows of the impact on milk price of changes in currency movement and commodity prices in the past 16 years. The coloured bars show the positive or negative effects of each component relative to the prior year. The line overlaying this shows the net change in the final milk price. Note that this chart is our best estimate for south-east Australia and there will be significant variation between processors.
The data shows that in the past 6 years currency movement has had a secondary effect on milk price. The major issue has been commodity pricing and other internal business effects. That is probably true in most years although our analysis suggests that currency hedging issues played a major part in the dramatic price drop during the 2008/09 season.
The impact of global financial and production events
The GFC had a particularly dire effect on commodity market prices and milk price. It would be a comfort to think that this was a once in a generation event but we don't think that is the case. There have been two such events in 10 years. The post 9/11 fall in global confidence and world share markets had a similar effect.
In our view the problem is not that these were 'unprecedented events' that can't be predicted. It is the rapid and unsustainable rise before this that triggers the dramatic fall. When markets are pushed quickly to high levels, as occurred in both 2000/01 and 2007/08, it does appear that the backlash is particularly nasty. During the price fall there was an overshoot to low prices in both cases before the market recovered to a point closer to the long term price trend.
A part of the reason why the rises and falls in dairy commodity markets are so dramatic is that the volume of international dairy trade is a very small percentage of total world milk production (outside of closed markets like the EU). International trade that Australia and New Zealand have access to is roughly 7% of world production. If global demand or supply moves by 1%, a relatively small number by any standards, the product shortage or surplus equates to 14% of free global trade. It is extremely difficult to buffer this level of variation through stock movements and certainly Australia and New Zealand processors do not have the financial resources or storage capacity to do so.
When supply is short buyers start to get desperate and push prices beyond sustainable levels. The reverse is true when supply is in excess. Processors compete fiercely to clear stocks and generate the cash they need to pay farmers, employees and other creditors. Eventually sanity prevails and the market settles back to a manageable level.
EU and US market intervention
When dealing with this sensitive but important topic it is important to distinguish between the two major aspects of EU and US government intervention in dairy commodity markets.
Purchase of surplus stock is the process whereby the government takes surplus product off the market and funds its storage for sale at a later date. In the context of the recent financial crisis this action by the EU and US was a particularly important and desirable thing for them to do. At the time it was of huge benefit to all dairyfarmers - including those Australian and New Zealand. It reduced the amount of stock that was being released onto world markets, slowed down the fall in price, and probably reduced the depth and length of the period of low pricing.
This so-called 'intervention stock' cannot be held forever and must be sold at a later date. The US has already cleared its stock - doing so during the recovery of the market in the first half of this year. The EU built a much larger stockpile and they are only now bringing it back onto the market. This is timely in the case of butter stock (the price is currently high) but the skim milk powder is a problem and market prices are falling in anticipation of the stock release.
Subsidy of export sales is the practice of paying processors compensation for the difference between domestic market prices and sales at a lower export price. This might be called 'dumping' but under current world trade agreements the EU and US are allowed to subsidise a certain volume of product in any given year. Needless to say this practice is not good for the Australian and New Zealand farmgate milk price.
Figure 3 gives an indication of the effect of the subsidies in terms of SE Australian farmgate milk price. This is somewhat speculative because failure to subsidise would have dragged down EU market prices. The reality is somewhere in the middle but the chart does give some idea of the magnitude of the effect.
The good news is that current World Trade Organisation (WTO) agreements, and indications of future EU dairy policy, will see an ongoing reduction or elimination of export subsidies. This should result in a general increase in the Australian and New Zealand farmgate milk price. It is a more difficult question as to whether this will reduce commodity and milk price volatility. We think not if the trend in US domestic milk price is any guide (see the Xcheque website charts and data section for more information on this).
While local climate conditions can have a dramatic effect on farm costs and income, the impact on farmgate milk price is not normally significant. Variation in Australian milk production has relatively little influence on international market prices and currency exchange rates. The past year may be something of an exception to this because of the rapid and significant production drop in south-east Australia. The shortage of supply from Australia has driven prices quickly back to a level that sits above EU market prices, a very unusual situation.
We have mainly focused here on south-east Australia where export markets are the primary driver of milk price and the associated volatility. It is a fair question as to why milk price in NSW, Queensland and WA should follow that of south-east Australia. The simple answer to this is that a price difference will be justified only to the extent of the transport cost. This means that prices in NSW and Queensland in particular should follow the Victorian price up and down. Local supply and demand effects, plus the transfer of much of the milk supply from co-operative to private processors, makes the pricing equation more complex. It is possible that pricing will stabilise in these areas but our prediction is that will be at the expense of relatively fixed volume contracts or effectively a private quota system. Suppliers will not be free to respond to financial challenges with an increase (or decrease) production without the support of their processor and an underpinning contract.
Volatility here to stay
This article has provided a background to the drivers of the south-east Australian farmgate milk price and the reasons for the recent volatility. Will this volatility continue? For us the bottom line is, unfortunately, an emphatic yes.
We are optimistic about a general rise in milk price in the next 3-5 years but see no end to the problem of volatility.
The primary reason for this is that Australia (and New Zealand) sit on the fringes of overall global milk supply. We trade in the same space that Europe and the US trade their domestic surpluses. We can't control their internal supply / demand balances, let alone that of other nations such as our key markets in Asia.
In addition our currency exchange rate bears little or no relationship to movements in dairy markets. The Australian currency seems to be forever destined to follow the vagaries of international commodity and financial markets.
The good news is that there is no doubt that the cost of dairy production in Australia is highly competitive on world markets. The extent to which the EU and US have needed to subsidise exports is clear evidence of this. As the EU and US move closer to reduction of dairy export subsidies, there is a real opportunity for growth and improved dairy farm profitability in Australia.
The volatility of the milk price means that this is not without significant risk. Control of debt and operating costs is a key to long term profitability, as is the need for continuous improvement. Farmers need to use wisely the cash that becomes available in boom periods to buffer themselves against the inevitable downturns in income.