Ten years ago there was a general belief in the industry that dairy farmers would respond to low prices and low profitability by producing more milk. This is a sort of perverse defiance of the laws of supply and demand where the reverse is supposed to happen. The reality of this adage is that some farmers produced more milk, and others sold out or shut down the dairy. During the 1990’s the net effect of this was industry growth. Since 2002 the trend in Australia has been the other way - an ongoing decline in milk supply. This article is not however about the causes of declining production. It is about how to encourage milk supply and, despite the evidence to the contrary, that is exactly what has happened during the autumn and winter periods of production in the southeast. Last month I showed why milk processors want flat milk supply and the value it creates for them. This month I’ll demonstrate what they have done to encourage flat supply, and how farmers have responded.
A decade of production decline … but not every month
The trend in Australian milk production over the past decade is no more dramatic than in northern Victoria. Figure 1 shows monthly milk production since 1999 along with the underlying seasonally adjusted trend. What is quite remarkable about this data is that milk production in the lowest month of the year has not followed the overall trend. There has been a consistent and dramatic shift to a flatter production profile. Even the return to better seasonal conditions and cheaper water has not shaken this effect. Farmers have increased off peak milk production by just as much as the increase in peak milk. The data presented in the July newsletter showed that the supply curve of northern Victoria is now very similar in profile to the domestically focussed states of NSW, Qld, WA and SA.
It is important point to note here that the shift in seasonality is also evident in the dairy regions of Gippsland and the Western District (Figure 2). Farmers in those regions have progressively changed their production systems towards all year round milking and increased supply of harvested and purchased feed in autumn and winter. As a consequence, off peak milk supply has increased while peak milk has declined.
There is remarkable similarity between the two regions in terms of total milk supply, seasonality and the long term trend. Apart from the production setback caused by the 02/03 price / cost squeeze, there has been slow growth and a clear trend towards more off peak milk.
The fall in milk volume in northern Victoria is very clearly a consequence of a margin squeeze - falls in milk price and increases in the cost of water and grain. Northern Victorian farmers are particularly sensitive to this equation. In Gippsland and the Western District the farmers have little or no exposure to water cost but in many cases are sensitive to feed price increases. So why is it that farmers have held the line on production of autumn and winter milk which, in principle, is more expensive to produce? The answer lies in the shift in milk payments.
Seasonal pricing has long been a feature of Australian milk payment systems. There is an absolute need for off peak milk and a clear understanding by processors that they need to pay a premium for this supply. In the southeast these premiums have been progressively ramped up in the past decade. It has been private processors that have led these price rises. Companies such as National Foods, Parmalat and UDP paid for the off peak milk they needed while Burra Foods, Fonterra and others used off peak prices as a means of attracting supply. There is some debate about whether it was appropriate for Murray Goulburn to follow this trend but follow they have.
Figure 3 shows the monthly premiums paid by MG over the course of the past 15 years. Figure 4 shows the contribution of these premiums to the overall milk price for different seasonal supply curves. This represents a massive shift in the payment structure. Whereas 15 years ago seasonal incentives represented about 5% of the milk cheque, they now make up as much as 15%. Given that operating profit margins on dairy farms are typically less than 10% of the milk price, farmers who continue to follow the traditional seasonal pasture curve, and who dry off in winter, are forgoing a significant and important income opportunity.
It is no surprise to me that the overall contribution of off peak payments is roughly aligned with the value to processors. This can be seen in the analysis of a milk powder factory economics that was presented in last month’s newsletter. The modelling suggests that flat milk production provides a benefit to a powder factory of about $0.70 Kg MS when compared to a highly seasonal New Zealand type supply curve. The benefit will be higher for more complex and capital intensive operations such as cheese and UHT milk production. In the case of a co-operative such as Murray Goulburn, it is very appropriate to provide a price incentive for off peak milk that is equivalent to the value generated. This comes from cost savings per tonne of product from lower storage costs and better capital and overhead utilisation. There is also a marketing benefit in providing a more stable product supply to customers. The fact that MG have boosted their off peak premiums to the extent they have must be galling for the private processors. Not only have MG passed on all the benefit created by off peak milk supply, they have taken away the advantage that was available in competing for milk supply. Nice work MG.
One final note is that I have used Murray Goulburn’s milk pricing in this analysis because it is relatively public and transparent, and because MG suppliers represent such a large proportion of the Victorian industry. In addition MG create the benchmark price for the industry and everybody else dances around this price. The important point in this regard is that other processors will set a precedent in pricing to attract supply but it is MG’s pricing that sets the overall industry trends. MG members have shifted their production curves in response to the price offered by MG and as result Victorian supply has shifted along with it.
What do I care about Victoria?
Outside of the southeast of Australia relatively flat milk production has been pretty much the norm. There have been a variety of pricing methodologies applied to achieve this - in some cases this has been via seasonal price incentives, in others monthly supply quotas have ensured there is sufficient milk when needed and not too much when grass and feed is cheap. For the most part private processors have again lead the more extreme pricing systems. Co-operatives on the other hand have taken a softer approach “encouraging” flat milk supply rather than imposing punitive price arrangements.
In a business that is reliant on the fresh domestic market more of a gentle seasonal pricing policy will result in an internal cost and value cross-subsidy. The cost of managing peak surpluses is absorbed and averaged back against the value of core products and markets. The value of a more relaxed pricing method is that it provides room for a wider variety of production systems and more milk. Farmers that want to produce milk in a more seasonal profile can do so - albeit at a slightly lower milk price than their neighbours.
The purchase of DFMC’s processing assets by National Foods and the demise of Challenge Dairy in WA has of course changed all that. On the east coast the dreaded T2 milk price and regional pricing has made some farms completely uneconomic. The more extreme outcome has been that supply contracts have not been renewed. That has also happened in WA where there are also where the private processors will simply not pick up any milk in excess of the suppliers quota.
Some would say that cross subsidy of milk cost and value is death by a thousand cuts - inevitably the underlying economics will drive the outcome. The counter argument is that there is strength in diversity and the additional milk pool provides: flexibility; opportunity to develop new markets; and a buffer against climate and input cost shocks. The argument is however moot. The private processors are by-and-large running a more ruthless pricing policy and the likely consequence is that monthly milk production will be forced onto the supply line that they require.
If you don’t farm in southeast Australia a more subtle and disturbing consequence of the current situation is that the current price / supply situation has just about completely choked off the opportunity for growth. Real growth will come from products like cheese, powder, UHT milk, yoghurt milk and other products with a medium to long shelf life. In principle the flat milk profile does provide an attractive basis for the fresh product manufacture. We are however now at a point that off peak milk supply in NSW and Qld is just about exactly matched to the fresh milk demand. In WA there is a shortage in some months. Against the background of supply history, pricing, and the opportunity in Victoria, it would be a brave processor that built a factory of any scale in those regions. In WA the government and local industry has tried hard to encourage an investor on the basis of “build it and they will come”. It is a romantic notion but it is not a reality.
In this chart (Fig. 5) peak milk is volume delivered between August and January and off peak March to July. Southeast Australia (Victoria and Tasmania) has given up peak milk volume but there is an increased supply of off peak milk. Off peak supply declined in the other states through to 2008 but since then the volume has held.
The bottom line
The conclusion from the analysis presented here is very clear. If processors want more milk at a particular time of year they need to pay for it. And when they do pay the price … farmers will respond. The laws of supply and demand have been vindicated. This seems like a simple equation but there is however an underlying twist in the supply response of dairy farmers. Supply is not simply about milk price. It is the margin and profitability of their businesses that matters and that is a complex and unstable equation.
In the next article of this series I will enlist some expert assistance to look at the relationships between the milk supply curve and production cost. What is required to unlock that precious offpeak milk and what are the hidden costs and benefits for farmers.