The farmer-owned co-operative’s Farmgate Milk Price (FGMP) is not just a mechanism to determine milk cheques. It is used to measure the earnings performance of Fonterra’s business units and acts as a benchmark for both setting the price of milk sold to the co-op by non-shared suppliers and the milk supplied to third party processors under Dairy Industry Restructuring Act (DIRA) regulations (see the next page for more about DIRA).
Most of Fonterra’s competitors benchmark against the FGMP for their own milk prices rather than establishing independent milk prices. That’s because there’s not enough depth in the NZ market to establish a milk price independent of the price paid by Fonterra.
In the absence of a market price, Fonterra established an alternative mechanism to determine FGMP, which is set out in its annually revised FGMP Manual.
The building block approach
Fonterra adopted a “building block” approach to determining FGMP (Table 1), broken down into four elements:
1. Identifying the boundaries of a notional FGMP Commodity Business
2. Calculating the commodity revenue of that business – the FGMP Revenue
3. Calculating recoverable costs of that business – FGMP Cash Costs
4. Calculating a capital recovery amount for that business – FGMP Capital Costs.
Farmgate Milk Price Commodity Business
The notional boundaries of the FGMP Commodity Business needed to make it possible to benchmark performance to competitors.
International markets for milk powder and cream products are the deepest and most transparent, relative to other product streams such as cheese and casein and their respective by-products, and so, in theory, more viable for benchmarking.
Also, when the methodology was established, it was assumed Fonterra’s efficient near-term competition for NZ milk would be from new entrants who would construct milk powder plants.
The mechanism developed to define those boundaries revolved around a specified basket of “Reference Commodity Products” – whole milk powder (WMP) and skim milk powder (SMP) and their by-products butter, anhydrous milkfat (AMF) and buttermilk powder (BMP). Combined, these products account for about 70% of Fonterra’s total production.
This enabled the simplifying assumption that all milk collected would be converted into one of four combinations of the Reference Commodity Products – WMP or SMP, butter or AMF, and BMP.
The mix that is used is the one that aligns most closely with Fonterra’s actual product mix.
The Farmgate Milk Price Revenue
The Reference Commodity Products form the foundation for determining FGMP Revenue.
Based on the assumption that all milk collected is converted into those five reference products and is sold to external customers at the NZ wharf (Free Alongside Ship, FAS according to Incoterms 2010), the revenue is calculated with the prices (in US dollars) for those products mainly based on the twice-monthly GlobalDairyTrade auctions (see Figure 2).
This is then converted to NZ dollars at Fonterra’s actual average monthly foreign exchange conversion rate.
Figure 3 – Changes in Fonterra’s Farmgate Milk Price
The Board indicated the co-op would have had to borrow funds to meet the price calculated under the FGMP Manual, a step they were not willing to take.
What is DIRA?
The Dairy Industry Restructuring Act 2001 (DIRA) enabled the formation of Fonterra through the merger of Kiwi Co-operative Dairies, the NZ Dairy Group, and the NZ Dairy Board.
The legislation was required because Fonterra would collect 96% of all milk supplied by NZ dairy farmers after forming, becoming the country’s largest dairy company and holding a dominant market position. The regulation aimed to maintain a contestable and efficient dairying environment in NZ in the face of this dominant position.
DIRA locks in free entry and exit from Fonterra by requiring the company to remain an open co-operative, and accept nearly all milk supply offered providing the farmers make capital contributions in proportion to their milk supply.
The original Act specified the co-op shares were issued and redeemed under a fair value system.
In 2012 an amendment was passed to facilitate trading among farmers (TAF) which includes both the Fonterra Shareholders’ Market and the Fonterra Shareholders’ Fund.
The 2012 amendment also set outconditions for milk price governance, public disclosure of information with respect to Fonterra’s milk price setting, and introduced a milk price monitoring-oversight regime.
Initially the DIRA compelled Fonterra to make up to 600 million litres of raw milk available to independent processors at either a mutually agreed price or a regulated price.
Because of the 2012 amendment, from 2013 Fonterra had to make up to 5% of their raw milk supply available to independent processors. The legislation also put in a time limit of three seasons for compulsory supply to “large” independent processors – defined as those sourcing more than 30 million litres of raw milk from farmers directly. A monthly quantity limit based on the seasonal supply curve was also introduced.
So many letters…
AMF – anhydrous milkfat
BMP – buttermilk powder
DIRA – Dairy Industry Restructuring Act (see shaded box)
FGMP – Farmgate Milk Price
GDT – GlobalDairyTrade; an auction platform for internationally traded commodity dairy products with twice-monthly events.
GMP – Fonterra’s Guaranteed Milk Price facility (see sidebar)
SMP – skim milk powder
WACC – weighted average cost of capital; the weighted average of the expected cost of equity and the expected cost of debt.
WMP – whole milk powder
Guaranteed Milk Price
First tried out in the 2013-14 season, Fonterra’s Guaranteed Milk Price (GMP) was rolled out this season with 60 million kg milksolids (MS) of locked-in milk price available – 40m kg MS in the June tranche and 20m kg MS in the December round.
This season the June GMP was $7/kg MS. The offering was undersubscribed, with 26m kg MS locked in of the available 40m kg MS. In early December Fonterra’s forecast milk price dropped to $4.70/kg MS but at the time of writing the application period for the December GMP was still open and the final price had not been settled.
In the June application round, farmers could apply for between 10% and 75% of their estimated 2014-15 milk production while in the December round that drops to between 10% and 35% of estimated production.
Farmers who can’t supply the amount of milk they have committed to, who choose to intentionally reduce their guaranteed supply, are potentially liable to pay compensation to Fonterra. There is a conditional opportunity to reduce the supply commitment for 10 days immediately following a Fonterra announcement revising forecast Farmgate Milk Price (FGMP), which would incur a fee.
To deal with oversubscription, a range of prices is offered at equal fixed increments at and below the May-December forecast FGMP. The size of those increments depend on the forecast FGMP – if it is greater than $8/kg MS, the increments would be 20 cents; between $5 and $8, the increments would be 10 cents; and if the forecast FGMP is less than $5, the increments would be 5 cents. The farmer specifies the quantity of milksolids they would supply at each price point see table. For each round the GMP would be the highest price at which the quantity of milksolids in the respective quantity ranges – 35-40m kg MS for June and 15-20m kg MS for December – would be reached. If the quantity ranges at even the lowest price point were exceeded there would be a pro-rata allocation process to accommodate applicants.
If this pro-rata process reduces the application to below the 10% estimated annual production threshold for GMP, it would become ineligible.
Any premium, discount, or adjustment – including specialty milk, winter milk and capacity adjustment – would happen as set out in the standard terms and conditions of supply.
If the final FGMP exceeds the June or December GMP value, the farmer is paid at the GMP rate for the contracted amount of milksolids, foregoing the extra revenue.
