As with almost anything in dairy the answer is multi-faceted in that there is no one answer. Instead it is a combination of a number of different factors.
First, we have talked in the past of how the mantle of being one of the lowest-cost producers needs to be challenged. There has been an increasing intensity throughout NZ with fewer farmers falling into a System 1 category and more reliance placed on supplementary feed.
NZ's share of the palm kernel market has increased dramatically over the past 10 years, displacing existing demand from Europe.
Any increase in intensity of course pales in comparison to the mega-farms of California with herds numbering in the tens of thousands, which has increased the competitiveness in pricing of product produced in that part of the world.
The other component to increased costs is the purchase price of NZ land suitable for dairying (as well as increased conversion costs).
Prices have moved to such an extent that even at the record payout levels of a couple of season ago it was difficult to achieve a suitable return on investment.
The RBNZ governor had previously commented that, “it has become increasingly hard to try to rationalise prices paid for land using estimates of the future flow of income from the land”. A comment made all the more chilling when you realise that statement was made close to ten years ago.
It’s also worth revisiting a comparison of milk prices offshore, whereby a NZ milk price transposed into euros/100kg (EU Milk Composition) would equate to €21.43 (versus €29.75 for Friesland Campina).
With Dutch farmers receiving a third more for their milk it would seem unusual that they could then produce powders at a price that would be competitive with product from this part of the world.
Remembering it’s still very early days in this post-quota environment and producers are finding their way in terms of determining which markets they wish to gain strategic footholds in and with which products they wish to optimise.
Manufacturing infant formula for China is an obvious example but on the whole the easy wins have already been made, creating a brand and dealing with the tough and ever-changing regulatory environment is both expensive and not without its risk.
So the Europeans have been quite open in that they are using a cross subsidy from their consumer brands in order to support farmers to ensure they don’t have all their eggs in one basket when it comes to the assets they have on the ground.
Ahead of April 1 of this year there were a number of new dryers commissioned in the likes of Ireland and the Netherlands to produce SMP and WMP, that given the state of powder markets, would have gone nowhere near to returning the milk prices that farmers are currently enjoying (for want of a better word).
Though it’s not all doom and gloom and as we mentioned in our earlier publication we do believe we have visited the lows in WMP for this particular cycle and one of the reasons for this, is the ability to optimise going forward.
During peak season most plants are running at, or very close to, capacity producing whatever can move quickest through the plant, with little thought given to what the best return would be for a bucket of milk.
This downfall comes about from having to have the capacity in place to process all the milk on the peak day of each season (October 22 this year with ~87m litres) in what is a very steep curve, something that the likes of the European and certainly the American producers do not have to deal with to the same extent.
In the shoulder season there is a greater ability to make optimisation decisions that return the best outcome for the raw milk received.
With this season’s peak collection being down 3% and the overall season forecaste to be down 5% (though we think the risk remains to the downside to that figure) it will allow Fonterra to make decisions earlier in the season than what would have previously been the case.
Oceania commodity prices remain at the bottom of the pile when it comes to stream returns and so it’s likely that Fonterra will take any opportunity to produce almost anything at the expense of WMP or SMP.
As capacity frees up we may see milk diverted from the likes of Darfield and head 125km south to Clandeboye to take advantage of its increased mozzarella offering. Darfield 1 is a 16t/hr dryer that could process ~2.5m litres of milk a day.
Tankers (100-plus a day) are now more likely to head south from Ashburton (rather than north), destined for Temuka, to help satisfy the ever-increasing Southeast Asian demand for pizzas.
The recent free trade agreement with South Korea is only going to make these sort of decisions more attractive going forward.
Of course, producing non reference commodity products that are yielding better than reference commodity (AMF, butter, BMP, SMP and WMP) has the double benefit of increasing Ebit (and subsequently the dividend for fully shared farmers) and removing the supply of lower-returning streams.
• Mike McIntyre is head of derivatives at First NZ Capital Securities.
