With this week’s east coast low, the drought may be over but a new milk price drought seems set to linger, with some analysts even calling the downturn a “long term significant reset of dairy economics across the globe“.
I asked Rabobank senior analyst Michael Harvey for the bank’s take on what has caused prices to fall and what it will take to restore farmer fortunes. I’m grateful for his explanation below.
Uncertainties have surfaced about the true shape of the global market and its medium-term proposition. Are there factors at play that will continue to plague the market and do we need to reset our interpretation?
This is where Rabobank can provide some independent insights. There have been some changes to the market which I will explore and this commodity crunch is what Rabobank defines as a super-cyclical caused by a number of events leading to a perfect storm:
• The ‘floor’ price in the global market is weaker, and lower
• The EU has removed a structural handbrake on milk supply – the rate of growth in Europe has surprised even us, and was the main reason we missed our original expectations for a price recovery!
• There is a downshift in the speed of growth in the Chinese economy (and with it the world economy)
• The slowdown of Chinese dairy demand growth (this occurred before the crash in prices)
• The reduction in the prices of key commodities (and expectation that they will probably be lower in the medium term that we expected) which impacts feed prices
• The end of the Chinese corn price support scheme
• The failure of states in the Middle East
Political impacts on pricing
When gauging the global price floor, you need to look at intervention pricing systems. A few years ago the United States industry removed its intervention system and replaced it with a margin protection program. The floor is already weaker because of this.
The EU still operates a public intervention system and its wholesale market is weak enough right now that product is moving into intervention stores quickly. The price in Europe is set in Euro per tonne. Shifts in currencies have seen the intervention fall US$500/tonne when converted to US dollars which means the global floor price is not only weaker but lower.
A removal of a 30-year milk quota system is no doubt structural adjustment. It was always going to lead to an uncomfortable period for the global market. However, global markets have simply been overwhelmed by the sheer volumes. A slowdown in Europe milk supply will be the biggest factor to help correct the ship.
In the first year without quotas, the EU produced 153 billion litres of milk in total. This was just shy of 4% more than the same corresponding period (or in other terms 5.5 billion litres). That’s a lot of extra milk.
The growth in milk supply growth across Europe has not been uniform. Twelve of the 28 EU members had 2% or less growth and the Dutch and Irish sectors have been responsible for 45% of the growth.
But the signs of a slowdown in overall EU milk production growth are emerging. It will take a few more months yet but, by late 2016, this growth should grind to a halt. Rapidly falling milk prices and poor weather will be key to supply correction.
Other factors will also be at play. For example, in the Netherlands the introduction of ‘phosphate rights’ will force Dutch dairy farmers to reduce herds. The pressure won’t kick in until next year when new rules are enforced but there will be a need to reduce herds.
The good news
Rabobank is confident the global market will turn around and this is within sight. There will be other supporting factors helping to rebalance the global market including:
• Global supply growth outside of Europe – major exporters of dairy (Australia included) have seen lower farmgate prices and milk supply growth slow. But stocks do exist and need to be run down
• Sluggish dairy demand – macro headwinds and weak consumer confidence linger in many economies; but are now being offset by retail price relief and increased dairy promotion
• China’s well-documented ‘rebalance’ – China buyers have mostly worked through excess stocks and are likely to increase import volumes over the course of 2016
• Oil prices – a recent rally signals the end of the global surplus. Oil prices will increase again – but remember this is a good thing (for dairy importers) and bad thing for dairy (production costs)
• The cost of production for many dairy producers is lower right now due to cheap feed costs and a period of low fertilizer and interest rates
What about Russia – one of world’s largest importers of dairy? Russia’s trade ban is coming up for a two-year anniversary with no immediate end in sight. But Russia will eventually end the embargo.
Questions remain as to Russia’s long-term role in global markets. European cheese exporters may be cautious in rushing back in to this market. Meanwhile, Russia continues to build alternative supply chains – the success of this strategy is yet to be proven successful. Also, the collapse of the Russian economy means dairy demand and consumer purchasing power is weak irrespective of the trade ban.
Global pricing will get substantially better in the medium term
In Rabobank’s opinion there has not been any major shift in the medium-term fundamentals. The global market will present good opportunities to deliver profitable returns for Australia’s dairy sector – with the right export strategies. Here is our logic:
• Demand growth is still expanding the quickest across the developing world, including Asia
• These economies are net importers of dairy; and self-sufficiency will continue to be challenging going forward
• The cost of producing in many of these regions is expensive. The case in point resides in China where the cost of producing good quality milk can be as high twice as expensive as in Australia. So there is an incentive to buy imported milk
• Consumers in these markets also trust and prefer imported products which strengthens the trade opportunities
• Australia and New Zealand will simply not supply all the milk these market needs. This means the global market needs more milk from Europe and the US in the medium term
• Dairy producers in Europe and the US are structurally higher cost producers of milk than Australia.
• Current global prices are not sustainable for any dairy producers anywhere in the world and simply need to improve.
Better times do still lay ahead. Weak global market conditions are at the core of the current problem but by early 2017 the global market will be in better balance. However, the market will remain volatile and under current pricing models dairy producers will continue to absorb this risk.
Hopefully trust along the supply chain can be restored, as the viability and sustainability of the sector remains healthy beyond the current crisis.