In search of Australia's dairy sweetspot

In the previous two articles I have written about the value of flat milk supply to processors and “the market”. The articles also showed how milk pricing mechanisms have been used to pull southeast Australian milk towards a flatter milk supply curve. In this third article of the series I’ll take a look at the topic from the farmer’s perspective – what are the cost / benefit implications for a farmer who chooses to flatten their milk supply.

To write this article I have enlisted the support of Neil Lane – a dairy farmer consultant and member of the Intelact farm advisory group (www.intelact.com). Neil’s clients include some of the more profitable and successful farmers in southeast Australia and he is well respected for his theoretical and practical understanding of dairy farm economics and management.

Neil and I agonised for some time on how to approach this question. If you talk to 600 dairy farmers you will find they manage 600 unique businesses. There is a huge variation of climate and land type across this wide brown land. Our dairy farmers have managed to squeeze themselves into all sorts of places you wouldn’t think possible. In addition, the market that consumes Australian milk has a split personality with half of the milk going to the domestic consumers and the other half being directed to commodity ingredients for export. Analysis of this complex soup probably requires methodologies used in the social sciences rather than cold hard economics. Nonetheless, we have come to a view, and did work out how to draw some lines on a chart, so here goes …

Start at the production system extremes

The easy starting point for this analysis is the two extremes of milk production systems. At one end we have a highly seasonal spring calving farm where the cows are dried off during winter - the typical New Zealand system. Farmers follow the pasture production curve taking advantage of the spring peak to cut silage and hay and eke out their feed supply over summer and winter. Australia’s fickle climate makes this quite a risky prospect and there is an ever reducing number of farms operating this system. They do however exist and it is possible to get quite good cost data for this type of farm.

At the other end of the spectrum is the Freestall Barn with a Total Mixed Ration (TMR). Cows and heifers are housed all year and all feed is purchased. There are only a few of these farms in Australia. They are however the system of choice in Europe, the USA and many other parts of the world. There is a mass of data on the cost of production overseas and it is not too difficult to translate that data back into an Australian context.

Table 1. Comparison of pasture and freestall barn / total milk ration systems (assuming the same milk solids production)

Table 1 shows the major operating and economic differences in the nature of these two systems. The pasture system has of course a much greater land requirement; more cows; and lower milk production / cow. The annual operating cycle is also very different with the TMR system requiring constant ongoing management of breeding.

Our analysis of the financial structure of the two systems shows that the primary difference is of course the cost of purchased feed. This is nil or a very low % of cost in a purely pasture based farm and the major variable cost in a TMR system. On our assessment the total of other variable costs is somewhat similar. Fertiliser and other land management expenses in the pasture system are balanced by higher labour maintenance and depreciation costs in the TMR system.

Offsetting the comparatively high feed cost of a TMR system is a lower capital cost. This is mainly because of the large investment in land for a pasture based farm. The increased building and equipment cost of a TMR system creates a different asset base but the total, including the value of livestock, is lower.

In an overall sense we believe the cost of milk production in a TMR system is somewhere between $1.00 and $2.00 / kg MS more than a pasture based farm. Our estimate of the cost of operating a typical Australian 300 cow pasture based farm is $5.00 - $6.00 / kg MS. This includes the cost of servicing debt plus a competitive return on investment for the owner. We estimate the equivalent cost of production in a TMR system to be $6.00 - $8.00 / kg MS.

We do of course put all sorts of disclaimers on the strict accuracy of these numbers but are quite sure that the magnitude of the cost is real. As a reference point, the estimated breakeven milk price in USA’s very large factory TMR farms is in the range $5.50 - $7.50 / kg MS (AU dollar basis). Again feed price is the main variable determining this price range. The cost of production in Europe appears to be even higher due to the smaller size of their farms and higher labour, energy and compliance costs. This however is offset to some extent by farm subsidies.

Peering into the murky middle ground

It would be tempting to draw straight lines between the cost of production on a purely pasture based farm and a TMR system. We believe however that the lines are not straight and that, up to a point, the cost of production does not move very much as farms transition from pasture and home-grown fodder through to more complex and intensive feed systems. Furthermore there does appear to be a reduction in cost and improvement in return given careful use and management of purchased feed in a low to average feed price environment.

Figure 1 represents our estimate of what the cost curve looks like across the full spectrum of supply patterns. The chart demonstrates our view that at average feed prices the cost of milk production per kg of milk solids is reduced by extending lactation and / or split calving. This effect appears to hold up to about 40 – 45% off peak milk production.

Figure 1. Estimated cost of production vs factory capacity utilisation and % off peak milk

The reason for this fall in production cost is a reduced capital cost per kg MS, or in other words, more milk is produced from the same asset base. The “sweet spot” appears to be somewhere in the vicinity of 40% off peak milk. Beyond this point the capital cost / kg MS tends to flatten out. As the system trends towards TMR feeding grain in the milking shed and simple feed pad arrangements become inadequate. More complicated and expensive feeding infrastructure is required, offsetting the reductions in land and livestock costs. Our view on the capital cost trend is shown in Figure 2.

Figure 2. Estimated capital cost vs factory capacity utilisation and % off peak milk

The second reason why the cost of production starts rising beyond the sweet spot is that it becomes necessary to purchase more expensive fodder and feed concentrates. This is to compensate for the loss of the nutritional benefits of pasture as a feed base. Labour costs also start rising as calving shifts towards an all year round operation and it becomes necessary to feed out more and manage manure on feed pads and other lot feeding systems.

It is important to note again that there will not be a cost reduction when purchased feed prices are high. What does high mean? The feed price spikes of 03/04 and 07/08 were definitely a problem. If current futures prices carry through to the 12/13 harvest then 2013 might be another high price year. That will be another bad coincidence of events for dairy farmers with weak export dairy commodity prices driving 12/13 milk prices down.

What is this telling us?

In this series of articles I have attempted to demonstrate the tension between the consumer and processor desire for a flat milk profile, their willingness to drive this trend with offpeak milk premiums, and the cost to farmers of flattening their milk production profile. The major conclusions to be drawn from this examination are as follows:

• There is no doubt that the market wants a flat milk production profile. People consume milk products on a more or less uniform basis all year round.
• Generation of peak milk surpluses increases the processing cost dairy products. Factories need to be bigger to handle the peak milk flow and factory resources are wasted when they lie idle in the offpeak season. There is also a storage, handling and working capital cost associated with taking product into inventory.
• Over the past decade all southeast Australian processors have progressively increased price premiums for offpeak milk. The payment premium for a flat milk production profile stands at about $0.60 kg / MS when compared with a highly seasonal milk production curve.
• Southeast Australian farmers have responded by significantly increasing offpeak milk production. The peak – trough production ratio in Victoria has moved from 4:1 to about 1.7:1 with offpeak milk increasing from 32% to 40% of the annual supply.
• Examination of the cost of milk production suggests that there are significant gains to be made by southeast Australian farmers if they increase their offpeak milk production up to about 40%. This transition is not without risk but there can be a dual benefit in higher milk prices and a lower, or at least stable, cost of production.
• As farmers flatten their curve further the value opportunity deteriorates sharply. For those farmers that do choose to move away from predominantly seasonal pasture based dairying systems the available milk price premiums are inadequate to compensate for the cost increase and feed price risk associated with flat milk production.

The future of feed price - September 2012

In the 12 years since deregulation of the Australian dairy industry has been undertaking a very complex economic experiment. The outcome this experiment has been a huge transition in the ownership and focus of processing assets, farm production systems, milk payment systems, farm cost and revenue.

In the absence of government regulation, or a coordinated whole of industry commercial approach (AKA Fonterra New Zealand), the export growth engine has been pulling one way and the domestic market price stability and price premiums pulling in the other. Outside of the southeast of Australia most farmers and processors have simply given up on export and ingredient markets. Milk supply has contracted back to something closer to local requirements. Meanwhile the traditional pasture based farmers of southeast Australia have spent this time tinkering with their production systems to take advantage of offpeak payment premiums. The increase in premiums has largely been driven by inadequate industry returns, contraction of supply and competitive pressure from domestically focused processors. Farmers have also been pursuing opportunities to reduce cost by increasing offpeak milk production and thereby improving the cost efficiency of asset and overhead utilisation. There appear to be gains to be made from this but they come with an associated risk – volatility of feed price is added to an already unstable economic equation.

As I suggested earlier, the economic experiment conducted on the Australian dairy industry has resulted a split personality - export ingredients vs domestic consumers. Dairy farmers have been caught in the middle and are uncertain who they can rely on. In the opinion of this analyst, if Dr Jekyll was one half of this split personality, then Mr Hyde would be demands of the domestic processors and their customers for a flat milk supply. With those demands comes the expectation that seasonal milk surpluses are “Someone else’s problem”.

It would be disastrous for Australian farmers to ignore the cost advantages inherent in pasture based milk production systems and head further towards the TMR systems of Europe and the USA. Nobody would be the winner. Not the consumer - milk prices would be higher. Not the processors – export and domestic market opportunities would be choked off by higher costs of production and competition from New Zealand and elsewhere. Not the farmer – the dairy industry would continue to contract and there would be massive displacement of farmers who don’t have access to domestic market milk contracts. Don’t go there Australia - this would be the classic lose - lose - lose scenario.