The strength of global dairy markets has put a smile on the face of Oceania dairy farmers ... but not for long. In the tradition of the normal farmer mindset we can already hear calls of anguish over a weak US dollar. This week I thought it was worthwhile taking a quick look at the impact of exchange rate movements and a weak US economy on dairy industry values in Australia and New Zealand.

The Fonterra Auction has put dairy commodity values on the front page in the past couple of years (well in New Zealand at least). We now get to take the temperature of the industry every couple of weeks. It is all very exciting but in reality the numbers are meaningless to most people. Who really understands how the wholemilk powder price translates into the all important industry reference point - farmgate milk price? Conversion of WMP commodity price to milk price is hard enough. The overlay of the US dollar exchange rate makes this calculation a dark art.

A few weeks ago I wrote about the Fonterra payout forecast for 10/11 and noted that the financial wizards in the back room appear to have worked some magic through forward currency hedging ("Magic in the air - Has Fonterra pulled a rabbit out of a hedge?" Dr Jon Hauser, Xcheque.com September 15, 2010). As we progress further into the season the value of a forward hedge is becoming even more evident. In AUD / NZD terms, dairy commodity prices need to continue to rise if they are to offset the ongoing decline in the US dollar.

Here at Xcheque.com we measure the value of the Oceania market in the form of two indices:

SAMPI - Southeast Australian Milk Price Indicator ($AU / kg MS)

NZMPI - New Zealand Milk Price Indicator ($NZ / kg MS)

These indices convert the value of export dairy commodities, plus the prevailing exchange rate, into an equivalent milk price. There is not a direct relationship between these indicators and the final farmgate price but there is a strong correlation.

In the charts below we have plotted the SAMPI and the NZMPI from June 2009 to October 2010.  June 09 was pretty much the bottom of the dairy market following the GFC decline in 08/09. Alongside these plots are the $US exchange rate and the value of the SAMPI and NZMPI at the exchange rate of June 2009. These charts show the extent to which the rise in exchange rate has offset the value of dairy commodity price increases.

On the face of it the loss in value due to the weak US dollar looks like $0.50 - $1.00 / kg MS. It looks like a big number but frankly I dont subcribe to the view that this effect is real.

Australia and New Zealand supply 50% of commodity dairy trade in freely available markets. Europe takes up most of the balance. The larger and more valuable market opportunity for dairy products is in Asia and the Middle East. The US has a role to play in these markets but they do not set the day to day price. Buyers and sellers think first about what the prevailing price means in their own currency and then convert this to US dollars - this being a common currency of convenience.

The argument is therefore that as the US dollar weakens Europe and Oceania simply increase commodity prices (in US dollars) to compensate.  My long held view is that you should first look to the dairy commodity price in Europe (in euros), adjust for the the subsidy effect, take off a little bit more, correct for the currency exchange rate, and you then have the Oceania price.

Yes the US dollar exchange rate is an important issue, and make no mistake, there are big gains to be had in Australia and New Zealand if you can hedge forward against a rising local currency.  There is also a risk that you will lose in this currency trade. The core business is selling dairy products and you need to do this at the highest possible price - in the local currency (if you are a buyer you want the lowest possible price in your local currency).

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And now having built this house of cards I'm going to turn the fan on it. 

If you have followed these blogs over time you will know that I do believe that the US has a significant effect on world dairy prices. Here are just a few reasons why:

• China's currency is pegged to US dollars. Their capacity to pay on export markets (and in fact their entire economy) is affected by the strength of the US economy and the US dollar.
• A weaker US dollar and high dairy prices makes export markets attractive to US processors
• The US has the capacity to turn on additional dairy production very quickly. They can easily add a couple of billion litres to international supply within 12 months.

So on the one hand I don't believe that dairy commodity prices, and the effective value in Oceania, have been adversely affected by the strengthening of AUD and NZ currencies against the US dollar in 2010. Indeed if you read my blog of a few weeks ago I think it is possible that New Zealand dairy farmers at least will enjoy a windfall gain from a rising local currency.

On the other hand a weak US dollar and attractive international prices are a real risk to dairy commodity prices in 2011. As we did in 2007, Europe and Oceania are again inviting the US to the international dairy trade party. It won't be fun, they are very good at low cost large scale production.

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