Keith Woodford says that dairy volatility is still with us, and there is lots of uncertainty over the coming months

By Keith Woodford*

Fonterra’s recent upgraded estimate of $6 per kg milksolids (fat plus protein) for the 2016/7 milk price has been welcomed by everyone in the industry. Given that it is only six months since Fonterra’s initial for this season of $4.25, the current estimate should also remind us of the impossibility of predicting milk prices with any accuracy.  

This level of inaccuracy is typical of the last three years, where Fonterra’s initial estimates compared to the final price were out by $1.40 in 2014, $2.60 in 2015 and $1.35 in 2016.

Currently, we are about halfway through the milk season in terms of production, and most companies will have sold about half of their total seasonal production. With some forward selling, they may even be ahead of this.  It is about this stage of the season that I bring in my price-range estimate to about $1.80 (i.e. plus or minus 90c around a mid-point).

This year I see more downside risk than upside risk relative to Fonterra’s current estimate, so I think the final price could be anywhere between about $5 and $6.80. Come the start of January, I will bring my estimate of the likely price range down from $1.80 to about $1.30. I may also shift the mid-point.

Early in the season, it was ASB who led with the most optimistic forecasts, initially at $6.50 and then $6. They will be pleased at their forecasting skill based on current prices. However, to present a convincing argument that their success (to date) has been skill-based rather than reliant on a considerable element of luck, they would need to show they had predicted the horrible North Island spring.

Hindsight is wonderful, and it tells us there have been three key drivers for the current buoyant markets. The most important driver has been reducing supply, first from Australia, then from Europe, and now New Zealand.

The second driver has been increased demand for WMP at the GDT auctions from China. Most of this is not yet showing up in either New Zealand’s export statistics or China’s import statistics. It will not be until the December New Zealand export stats and the January China import stats that this will show up.  Anything arriving in China before January will stay in bond so as to get tariff free entry at that time.

The third driver has been increased demand for butter, especially in the USA.  This is because the dairy industry has successfully convinced a considerable number of Americans (and also some Kiwis) that butter should no longer be considered a health demon. That message is less than consistent with the messaging from many health groups including the Harvard School of Public Health, but it is perception that counts.

Despite the current dairy upturn, there is lots of uncertainty for the rest of this season. The fundamentals remain weak.

European production for September – the last available month – was down 3% on the previous year, but European farmers are now starting to see the same price upturn as in New Zealand.

Although European farmers are currently receiving on average only 28.3 euro cents per litre (containing 7.55% milksolids), European farmers know that the current market prices even for commodities will support a farm gate price of about 33 euro cents. This is what the European models show. The current price is due to lagged responses. Indeed, the spot price in both Italy and the Netherlands is around 42 euro cents, which equates to around $NZ8 per kg milksolids.

Unless a European farmer plans to get totally out of dairying, then the current price signals are now sufficient to encourage more production. It will take several months for this to start flowing through.

International dairy commodity buyers are closely watching New Zealand production.  Fonterra has sent out strong messages that production is down, and has focused its messaging around the Waikato situation. The overall New Zealand situation is less dramatic, but NZ production (all companies) was down 6.1% for October and 3.1% for the overall season to that date.

It is clear that particularly over the last two months it has been Chinese buyers who have been bidding up the price of whole milk powder (WMP). Without that support, the price of WMP would be much lower.

Trying to tease out the likely buying behaviours from China over the next few months is very challenging. The big Chinese dairy marketing companies are also large-scale producers and processors of milk, and they are struggling right now with their own economics of production.   

Simple economics tells us that at current prices for Chinese raw milk at the farm gate (about 3.3RMB per litre), then it makes sense for Chinese companies to purchase WMP from New Zealand rather than to manufacture it themselves. However, the economics of reconstituting New Zealand WMP into UHT milk, which is a common use of the New Zealand product, no longer stack up relative to using Chinese raw milk for that purpose.  

Unfortunately, simple economics cannot tell the whole story. If more imports of New Zealand milk powder lead to the price of Chinese raw milk dropping even further, then both business and social dislocation in China is inevitable. And that is not consistent with China’s desire for social harmony. There are undoubtedly complex forces at work.

Turning to a New Zealand perspective, we know that the global demand for WMP is weak with the exception of China. Accordingly, we can say with some confidence that the WMP market, which underpins farm prices in New Zealand, will be in big difficulty again if the Chinese hold back on purchasing in the new year.

Another wild card is the effect of European Commission selling down its stocks of skim milk powder (SMP). These stocks are currently at over 400,000 tonnes.  

Until recently, there was quiet confidence that Europe would hang on to its SMP stocks and then eventually sell them for animal feed. But the European Commission has now said that is not the way it is going to happen. In December, they will start releasing stocks using a tender system, with 22,150 tonnes available in the first month to test the market.

American milk production is also on the rise, with September production up 2.5% over the same month of the preceding year. With feed and energy prices low, the market messages to American farmers remain to either increase production or get out of the industry. There will be an ongoing loss from the industry of small-scale family farms, while many of the industrial farms will continue to push production.  It is called economics of size.

Given all of the uncertainties, and when talking to farmers, I am focusing on the projected advance payments plus top-ups through to June, rather than the final payout. Fonterra is proposing that by 20 June 2017  it will have paid farmers $4.70 for milk produced in the four peak months of September to December, and $5.21 for milk produced in the shoulder months of June to August and Jan to April.  That is as far as I can see.

In the case of Synlait, they too are predicting a $6 payout, but with $4.65 paid by the end of June.

Residual payments will flow through in the months thereafter, but the size of them is in the lap of the gods.

As for next season (2017/18), that is totally unknown.  However, evidence from the past is that a rapid price spike such as has recently been occurring tends to not last more than one year. In 2007/8, the milk price rose from 3.87 to $ 7.59, then dropped back to $4.75 the next year. In 2014 it rose from $5.84 to $8.40, and then dropped the next year to $4.40.  The exception was 2009/10 through to 2011/12 when the price stayed above $6 for three consecutive years

For those who are risk averse, the 2017/18 production can currently be locked in by selling a futures contract at $6.22. But farmers wanting to play that game must not only learn the rules of the game; they must also set up a facility with their bank to cover any margin calls. That facility needs to continue through to final settlement at September 2018.

For those who are tempted to use futures, they should never forget that it is a strategy to minimise risk not to maximise profit. It can greatly reduce the risks associated with a poor price, but it also reduces the jackpot if the physical price goes very high. It is all about trading-off an opportunity that will be foregone in return for risk avoided. It is no use feeling cheated if prices do subsequently rise. Similarly, for those who choose not to use futures, then if it is no use, if the price of the physical product drops, to then bemoan the foregone opportunity to lock-in a price.  

*Keith Woodford is an independent consultant who holds honorary positions as Professor of Agri-Food Systems at Lincoln University and Senior Research Fellow at the Contemporary China Research Centre at Victoria University.  His articles are archived at http://keithwoodford.wordpress.com