If milk prices fall, in theory milk supply should also fall, but in practice it is not that simple.
Dairy commodity markets have been oversupplied for at least the past 12 months as indicated by the prolonged period in which dairy commodity prices have trended down. The signal to reduce milk supply was dispatched only slowly in many parts of the world, and areas that did receive the signal early didn’t react to low prices because of the farming systems being operated.
Dairy markets in different parts of the world are not perfectly connected. Trade tariffs, farm subsidies, and a lack of quality data mean markets don’t operate efficiently. For example, in the second half of 2014 dairy markets in the United States were trading at record levels while elsewhere dairy commodity prices had fallen significantly. This meant the signal that the world had too much milk did not get conveyed to US dairy farmers until at least six months after New Zealand farmers received that signal.
The direct link between Fonterra’s milk price and GlobalDairyTrade prices means NZ farmers receive global price signals faster than farmers in other parts of the world. NZ also lacks a domestic market to cushion movements so any change in the global market is reflected in the farmgate milk price. However, even in NZ the farmgate price signals are not perfect. The seasonal milk price system where a single price is paid across a full season’s production clouds the price signal compared with a system that allows prices to be set for a shorter time, such as monthly prices.
The speed at which farmers will react to a change in price signal depends on whether they consider it to be a short-term change in the market or a longer term change, as well as the type of farming system they operate. Farming systems can broadly be classified as intensive systems where cows are housed, and extensive pasture-based systems. There are many variations but basically more intensive systems can react more quickly to changes in milk and feed prices simply by increasing or decreasing feed rations. In a pasture-based system an increase in milk supply would require a corresponding increase in the area of land being used for dairying, unless a more intensive system is adopted. In pasture-based systems most costs are fixed rather than variable, so in the short-term they are slow to respond to price changes.
Despite farmgate prices in NZ virtually halving from last season to this season there has been very little change in milk supply that can be directly attributed to the change in expected income levels. Most of the slowdown in production in the later part of the 2014-15 season can be attributed to regional droughts. In the short term weather dictates how much milk will be produced in NZ, not milk prices.
European farmers are often insulated from what is happening in the global markets but in this downturn farmgate milk prices in Europe were quick to fall. This was because Europe is refocusing on global markets as they move into the post-milk quota environment. But the ban imposed by Russia, the European Union’s largest market for dairy products, on dairy imports was the main reason why milk prices in Europe dropped so quickly.
The expected surge in EU milk supply post-quota is now being curtailed by low milk prices. But we will still see growth from efficient dairy farmers who can make a profit at today’s prices. Over the longer term, the removal of milk quotas in Europe is likely to lower average costs of production as production moves away from inefficient regions to more efficient regions. In the short term there will be some growth in milk supply as the transition occurs. The removal of quotas will distort short-term market signals because farmers have placed a vote of confidence in the longer-term viability of the industry.
The dairy markets will work more efficiently if factors that distort market signals such as trade barriers and subsidies were removed or reduced. Until this happens NZ farmers will continue to bear the brunt of the market during periods of downturn and enjoy the spoils when milk is in short supply. Therefore it is vital that businesses are structured in a way which can cope with price volatility.
