Once again furrowed brows are starting to appear on the faces of Oceania dairy farmers.   Global recession looming; a strong Aussie / Kiwi Dollar; US production and exports increasing; NZ production well above last year; China WMP purchases falling off; Fonterra’s GDT going down, down, down. Despite the assurances of Fonterra and Murray Goulburn on forecast final milk prices, this doesn’t look like a recipe for a good year.

Are we seeing the start of an ongoing slide in dairy commodity prices? 2009 is not such a long time ago and a return to the industry price environment during that year does not bear thinking about.

This week I thought I would check up on the general state of the global dairy market and see if I can predict what is in store for the world in general, and Oceania farmers in particular.

Tracking global milk production trends

First let’s look at supply. The chart below shows our latest interpretation of milk production from the major global dairy traders – New Zealand, Europe, Australia, the USA, and Argentina. Many of you will be familiar with the seasonal standardisation techniques we have applied to milk production data. Here these methods have been applied to the global production totals.

In the production trend chart the orange line is the total monthly production of the five major dairy traders. It is extremely noisy data and difficult to get a handle on what is going on. For the most part this is reported as the % change from same month in the previous year – a quite useless statistic because the variation depends on whether the prior year result was high or low relative to the long term trend. The long term trend is also shown in the chart. This averages about 0.9% over the period from 2005 – 2011.

Correction for normal seasonal variation in global milk production takes much of the noise out of the data and we see a clearer pattern emerging. The seasonally adjusted trend line shows whether milk production is ahead of or behind expectations for any given month. A figure that is exactly on the long term trend line represents an underlying growth trend of 0.9%. This is also shown by the green line on the chart which measures the underlying growth rate (0.9%) plus or minus the monthly variation from this trend. This is a measure of the annual average milk production growth rate.

This is a rather complex analysis but the implications for the current milk production and price environment are reasonably obvious. The major global dairy traders have been growing production at an average underlying rate of 2.2% in the past 12 months. That represents an additional 7 billion litres of milk and that is a lot of milk in anyone’s language.

The table below shows our estimates of the contribution to growth from the major traders (in billions of litres). In absolute terms Europe has led the way adding just under half of the growth. This represents a production increase of about 2.7%. The US, NZ and Argentina make up most of the balance with year on year growth rates of 2.0%, 5.8%, and 8.6% respectively. Despite a return to good seasonal conditions, Australian dairy farmers are letting the team down and have pretty much gone to sleep.

 Commodity prices: the primary supply / demand indicator

A proper analysis these issues would look at the demand side next but quite frankly it is just too hard. In the interest of time and my sanity I’ll have to sidestep that mess of information and go straight to dairy commodity and milk prices.

The most responsive indicators of current dairy commodity prices are are WMP, butter, AMF and SMP (NFDM in the US). It is important to model the combined value of all the co-products in milk and so WMP is the best choice because it is close to the natural composition of milk. The exception here is the US market where WMP is a relatively minor product. In this case it is best to use a combination of NFDM and butter to give the equivalent composition of WMP. Cheese also plays an important part in all markets but the price response is generally slower than milk powder, butter and AMF.

The chart below shows the price trend for WMP in Oceania, Europe and the US. Also shown is the NFDM / butter couple in the US market. What you see here is something of an interesting international dance of price movement and response. By and large however there is a consistency of behaviour with Europe as top dog and the US NFDM/Butter market tracking at about $1,000 / tonne below this. Oceania is something of a tart at this party – smooching up to Europe when the market is strong and prices are firm and crossing back over to the level of the US at the first signs of market weakness. From a global perspective the periods of most serious concern are when the market is going soft and Oceania has product to sell … like right now.

Oceania, and particularly New Zealand, has nothing to hold its trousers up in a falling market. There is no financial or physical capacity to hold stock, no government subsidies, an inadequate domestic market to fall back on, and lots of customers with long memories. The processors down under know full well that it is not much fun being left in the middle of the dance floor, with no partner, and your trousers around your ankles.

Now are you still surprised that dairy commodity prices have gone down in the past few months???

The 7 billion litres of extra milk had to go somewhere and it looks very much like supply has yet again outstripped demand. The result is easy to see in the past 6 months of data (use the zoom feature for a better view of the recent data). It was something of a surprise to us that prices rose above $4,500 / tonne early this year. Global milk production was in a temporary lull and Oceania had sold out of product. That situation was soon corrected. When Fonterra and the other Oceania processors reopened for business dairy prices came tumbling down. Oceania WMP prices are back below $3,500 and Europe and the US are now following the market down. The current outlook in US NFDM and butter futures puts that market at A WMP equivalent of $3,400 by January 2012. That is about $300 / tonne lower than the current level of $3,700 tonne.

20:20 hindsight is all very well but the final question to ask here is whether the price and trend is predictable. To which I have to answer maybe. There is certainly no direct correlation in milk production trends. If anything milk production follows price which is to say: price follows demand and supply follows price. You can see that in the chart below which shows that a significant and sustained production response lags the price signal by 6 – 12 months. Short term seasonal effects and natural disasters aside, it takes a while to speed up and slow down global milk production.

At Xcheque we believe the answer to the direction of the dairy market can be found in the hip pockets of consumers and farmers. There appear to be limits to dairy sales growth and how far dairy prices can be pushed in the supermarket. There is also a very definite floor in farmgate milk prices, below which farmers will slow down production and choke off supply.

The limits on consumer price tolerance continue to be tested with WMP again moving above 4,500 US dollars and 3,000 euro for a brief period during 2011. Those price rises brought on another round of international news stories about price gouging and the spectre of food inflation. It does seem possible that those prices levels will at some stage be maintained but for the moment the comfortable trading range appears to be 3,500 – 4,000 US dollars or 2,500 – 2,800 euro.

On the other side of the dairy trade farmers have economic concerns of their own. They too start rattling the political cage when their margins are squeezed. More importantly they have control over milk production. Courtesy of the USDA’s wonderful data gathering service, the US market provides the best demonstration of this effect (see also these earlier articles ⁽¹⁾). The data shows that there is a distinct relationship between US milk production growth and dairy farmer’s margin above feed costs. US dairy farmers will increase production when offered a margin above feed cost of $10 / cwt and turn production down when margins fall back to $5 / cwt. In the face of rising feed costs the US market has struggled to come to terms with this issue. In the past 18 months US dairy commodity buyers have tried more than once to push dairy commodity and milk prices back down towards traditional levels. As a consequence supply growth has not kept up with demand and prices have had to rise.

Underlying buyer sentiment, and the recent fall in the value of international dairy commodities, has pushed the current value of US dairy commodity and milk futures back to a region that would translate into dairy farmer margins of $5 / cwt. Our prediction is that this is not sustainable and milk production growth will be again suppressed.

You can be certain that if US farmers are going to struggle with commodity and milk prices in the current range, then European farmers will also struggle – as will any global dairy producer that is reliant on grain as a feed source (such a China). The corollary of this is that the current level of international dairy commodity pricing is not sustainable while feed prices remain at current levels.

A word of caution is necessary here for those who may be excited or dismayed about an impending rise in international dairy prices. Prices do need to be higher to encourage milk production growth and increased exports from the critical regions of Europe and the US but that does not mean this will happen. While Oceania has product available, and needs to clear this product from its warehouses, we are unlikely to see any change. The turning point may occur when Oceania closes shop for the season and buyers have to turn back to the US and Europe for product. That will however depend on whether Europe and the US have overshot the supply side by too far. If the rate of global production growth is excessive then Europe and the US will also have surpluses to clear and that will depress prices for a longer period. We shouldn’t have too long to wait. Watch out for a turn in the GDT (and US futures) later this year or early in 2012. If prices don’t rise then we will know that production growth needs to drop back and wait for demand growth to catch up.

Oceania’s competitive advantage

Not so long ago I encouraged Oceania farmers to get on their bike and have a red hot go at competing in world markets ⁽²⁾. 9 months on I haven’t changed my view.

To understand how to draw a line between the prior analysis of global milk production and dairy commodity prices, and the value of dairy farming in Oceania, you need to understand the link between international commodity prices and farmgate milk price in Australia and New Zealand. This analysis is not a precise science but we have some very good historical data to guide us.

Our estimate of the current value of the international market is $5.00 - $5.50 / kg MS in Australia and $6.25 - $6.75 / kg MS in New Zealand. Murray Goulburn in Australia and Fonterra in New Zealand are predicting final prices at the upper end of these ranges. They appear to be well positioned to achieve their forecasts given the strength of the market in the early part of the season and the opportunities available to them in exchange rate hedging.

By historical standards the forecast milk price range for Oceania is in very positive territory and well over the cost of operation for an average farm. In other words, while the US, Europe and other grain based dairy producers are struggling under the weight of excessive feed prices, Oceania is having a day in the sun.

Based on recent milk production data it looks like New Zealand has taken up the challenge and opportunity of the global dairy market. Here in Australia the industry malaise continues. Perhaps that is because of a higher cost base and lower margin opportunity but more likely it is the result of mixed industry messages.  The supermarkets tell us that "milk prices are going down and staying down!". Add to this a fall in the GDT and a high Australian dollar and there is little reason for optimism. There are plenty of opportunities for investors in this big wide land other than the unreliable area of agriculture. That's not a view that I subscribe to and when I'm done here i'm off to take more of my fat lambs to market.

Until next time Xchequers and remember to keep the faith - for the most part farming is a necessity, not a luxury.

¹⁾   “US milk production – Shouting down the supply chain” Dr Jon Hauser, Xcheque.com, 1 April 2011
       “US milk production climbs back above the line” Dr Jon Hauser, Xcheque.com, 7 October 2011

²⁾  “Global milk production 7 - Global climate 1”, Dr Jon Hauser, Xcheque.com 21 February 2011