I recently had a series of discussions with a potential investor in the Australian dairy industry. My task was to explain how milk is produced on a seasonal basis and the monthly price paid during the year. The investor was keen to keep their new factory running at 100% capacity, and they wanted the same price for milk throughout the year, and ideally that cheap Australian spring milk price that they keep hearing about.
You will all be familiar with this story, and probably get reminded about the issue every time you see the price of the dreaded T2 milk in your statements. It is interesting topic and deserves further examination of the underlying issues.
Australian milk supply curves
The starting point is a controversial statement:
It’s not the market’s job to consume milk as and when the farmer produces it. It’s the farmer’s job to produce milk when the market needs it.
It will be no surprise to suggest that there is very little seasonality in milk consumption and on that basis the “market”, consumers and processors, would consider the ideal milk production system to be a constant monthly supply. That is achieved in many parts of the world via feedlot milking systems and calving all year round.
Flat milk production is not a reality in Australia. The conventional wisdom is that this would be a poor economic choice for a farm system in most dairy regions, and particularly on the pasture based, export oriented dairy farms of the southeast. Figure 1 shows the monthly supply curves for the more seasonal areas in southeast Australia and the general trend for the other regions.
From the processors’ point of view, the important number from this chart is the volume of milk that is in excess of the lowest production month. Table 1 shows the current data and the change in seasonality since 1999 / 2000. For Victoria and Tasmania there has been a significant reduction in seasonality. The change in the other regions is not as significant although although it is somewhat surprising that NSW has become more seasonal.
Table 1. Peak milk surplus
|Peak Surplus %|
* Regional data not available for NSW in 99 / 00
This table shows the % of milk produced in excess of a base of flat production. The base flat production = the lowest production month x 12. The peak surplus = Total production - the flat production base.
Australian dairy farmers and milk processors deal with the seasonal milk surplus by diverting milk to cheese, powder and butter production. This seems like a perfectly acceptable option from a farmer’s perspective and indeed there are significant quantities of cheese and milk powder, and butter consumed domestically. Using Dairy Australia and ABARES data, Xcheque’s estimate of milk consumption in Australia is about 254 litres / person / year (see Figure 2). Of this 138 litres or 54% needs a fresh flat milk supply. The balance of 116 litres is consumed as cheese and milk powder (butter production is associated with skim milk powder).
At the current population size and level of consumer demand, the balance of requirements for domestic fresh milk will be met by the supply curves in most Australian regions. Only Western Australia is short of fresh milk for the domestic market in a few months of the year. In that region the problem has more to do with declining milk production and increasing population than the intrinsic seasonality of supply.
So what is the fuss about? There is plenty of fresh milk available and a good percentage of the market demand is in the storage products of cheese, powder and butter. The answer lies in the complex economic equation of factory operations - the balance of market value and the operating costs of: milk supply, capital investment, overheads, storage, and working capital for stock. To examine the seasonality question further I found an idle moment and put together the financial analysis for a milk powder and butter factory.
My model factory is capable of processing 40 million litres of milk per month. That equates to about 9 tonnes per hour of whole milk powder. It is not large by New Zealand standards but it is big for Australia. We haven’t seen an investment in a drier of this scale for over 10 years.
To get to the heart of the matter (from a farmer’s perspective) I have calculated the break-even milk price for factory operation under various milk supply scenarios. At this price all costs are covered including bank loans. This break-even price would not satisfy a private commercial investor but it goes close to the price a co-operative might pay. What is important here is not the absolute milk price but the difference in the amount that can be paid for the different supply curves.
Figure 3 shows what happens as the seasonality of supply moves from 55% capacity utilisation (a typical New Zealand supply curve) to completely flat production and 100% capacity utilisation. The break-even price for milk increases by $0.70 / Kg MS or just over 5 cpl across this range. The increased value derives in approximately equal proportions from better utilisation of capital (finance and investment costs) and overheads (fixed operating expenses such as salaries, maintenance, sales and administration).
I need a spare week or two to run the same analysis for a cheese factory but my expectation is that the milk price effect will be even more acute. The fixed capital, operating and storage costs of cheese production are higher than milk powder which means lower profitability from under-utilised capacity. Given the high degree of seasonality in New Zealand milk supply, it is no surprise that they have favoured powder production over cheese.
There are a wealth of other outcomes that arise from this analysis including the impact of a decade of reducing milk supply and increased supply competition in southeast Australia. The ingredient factories have struggled to get the milk they need to keep their factories operating and, as a consequence, their cost efficiency has deteriorated. Offsetting this has been a trend towards flatter milk production and competition for supply. On balance (in my opinion) the farmgate milk price has suffered. The jury is still out but that malaise may be addressed by a recent round of Victorian factory closures and dairy company staff redundancies.
The take home message
The market wants the same volume of milk every day – except of course at Easter and Xmas when you should give your cows a few days off.
It is a simple fact of economics that in all dairy markets and ingredient operations, milk is worth more if you can supply the factory on a flat monthly basis, and it is worth a lot less if you can’t. Managing large seasonal surpluses of milk is not cheap or easy and it is no fun at all if you don’t own the ingredient factory that you need to balance supply. A surplus milk trade at reasonable prices might be possible if there is factory capacity available, and the processors are a little bit hungry to fill that capacity. When processing capacity is full (or is shut down because of low supply volumes) then the price of traded milk surpluses will tumble dramatically.
The supply curve story is not done here but I have run out of time and space. In my next article I will take a look at how supply competition, plus the economics of market value and factory cost, have shaped milk price systems and the seasonality of milk supply. In the third article of this series I will head into the much more dangerous territory of farm economics - what is the cost and consequences of flat milk production for farmers.