April 2, 2014
Deflation, stabilisation and an El Niño wild card: China makes -and breaks- the world dairy market
China's import binge overwhelms explosive supply growth to sustain prices amid falling feed costs. Supply-side increases peter out amid slackening demand and a problematic weather forecast.
by Eric J. BROOKS
A eFeedLink Hot Topic
By any measure, it has been a very good year for the global dairy market. In the first quarter of 2013, after rising strongly for over a year, a widely anticipated, an early year price crash was averted by plunging Chinese fluid milk production.
Chinese demand exceeds export boom
Strong beef import demand, high beef cattle prices and government incentives to encourage dairy sector consolidation motivated countless small-scale Chinese farmers to sell their entire cattle herds to meat slaughterhouses. The resulting reduction in China's dairy cattle numbers has led to a sharp, 18 month drop in China's fluid milk production.
According to a report by Rabobank's RaboAgriFinance division, ("Rabobank Dairy Quarterly -- Q1 2014") China's faltering domestic production fell 6% in 2013, forcing it to jack up milk powder imports just as Australia and New Zealand endured a nasty Q1 2013 drought. This kept prices stable at historically high levels throughout 2013 and into the first quarter of this year.
As a result, Oceana's H2 2013 rebound in dairy production and surging US dairy exports enjoyed high selling prices for their rising output. With feed costs falling 30% by the third quarter of 2013 and prices staying high, this has led to several fortunate quarters of rising output, high prices, falling production costs and exceptionally wide profit margins, particularly among US dairy producers. But all good things must come to an end and the market is showing signs of an impending crack at the critical April / May juncture of its yearly price cycle.
China takes all, countries sit out shortage
The entire world dairy market boom was predicated on Chinese imports, which increased even as exporter's output soared and other countries scaled back purchases in the face of high prices. For example, Algeria is the world's second largest importer of whole milk powder (WMP) and fifth largest importer of skim milk powder (SMP). According to Rabobank, "Algeria slashed purchases in 2013 from the market in the face of exceptionally high prices."
Rabobank's report explained, "The volume of product available on the international market rose in Q4 2013 11% year-on-year…However, another surge in Chinese buying saw more than the entire supply increase soaked up by China, with the rest of the market left with less to go around." Along with Algeria, Russia, Venezuela, several nations in Southeast Asia, the Middle East and North Africa (MENA) opted to stop importing dairy products, at one time or another in the latter half of 2013. In some cases, this caused, "instances of empty shelves of UHT in some regions and rampant inflation at the retail level."
In such a situation, the moment Chinese import demand falters, so does the market -and it did. By mid-January, China's raw milk prices fell for the first time in twenty months. Within a few weeks, the deflation spread from China's fluid milk market to those for processed dairy powders. Less than a month later, China's domestic dairy deflation spread to the world market, such that Global Dairy Trade's (GDT's) mid February auction, its overall price index fell 1.2%.
Thereafter, the pace of accelerated, with GDT's overall index falling 4.0% in early March, 5.2% in mid-March and a whopping 8.9% in early April. The latter was the index's largest fall in 20 months. Even so, the deflationary trend was concentrated in milk powder lines where China is a world leading importer.
On one hand, WMP, butter milk powder (BMP) and SMP, the dairy lines most sensitive to Chinese import demand lead early April's price plunge, falling 11.0%, 15.0% and 9.6% respectively.
On the other hand, product lines dependent on western dairy consumption suffered far less. While the overall index fell 8.9% in early April, GDT's Cheddar cheese's index fell only 3.5% while rennet casein's price defied the overall trend, rising 5.5%.
First, it must be noted that even though a slowdown in Chinese import volumes was the market shake up's primary catalyst, there are also other circumstance unique to the situation. The lack of Chinese buying interest occurred in the six weeks after January 31st's Chinese Lunar New Year, which is usually followed by a sharp, six week consumption drop in all of China's protein lines.
Second, prior to the cyclical post Chinese New Year slowdown, their dairy import sourcing had actually accelerated at the turn of the year. There is reason to believe that it may do so again over the medium term: Rabobank's report and those of other analysts are forecasting a marginal drop in China's fluid milk output in the first half of 2014, followed by a modest production recovery of comparable magnitude in the second half of this year.
This implies that once China's post Lunar New Year consumption pause ends, its import demand should resume growing for at least 1.5 to 2 quarters, at least until its own production recovery begins to rebuild domestic supplies.
Third, the Chinese are notoriously sharp traders. They are aware that April and May is the time when the world dairy market usually comes under the most price pressure. Hence, early April's exceptionally steep deflation might be due to Chinese traders deliberately sitting out of the market, in the hope of inducing further price falls. Of course, that also implies that by June, they should be back in the market, as they will need to restock inventories depleted during their post Lunar New Year rundown.
Going forward, close attention needs to be paid to China's domestic production trend. One must remember that "We remain convinced that frenetic Chinese buying has more to do with falling local milk production than a surge in end use consumption."
Beyond China however, there are other factors ensuring that once the initial price dive is over, any further declines into a market bottom should be a gentler, less volatile affair. Many countries who exited the world market during China's buying binge have seriously depleted inventories of WMP and SMP. Rabobank predicts that, "After 12 months of enforced dieting, importers in regions like Southeast Asia and MENA are expected to jump at any chance they get to procure more from the internationally traded market over the balance of 2014."
With store shelves empty of UHT milk cartons and fear of civil unrest growing, butter and yogurt, Algeria re-entered the world dairy market with a large tender in early March, just as the Chinese withdrew. With WMP and SMP prices down 15% to 20% from early March levels, you can expect other countries to follow Algeria's world market re-entry during the second quarter, giving prices enough support to ease the decline, and –all other things being equal- form a price floor.
Supply trend less predictable
Of course, you cannot assume that demand will politely taper off as conveniently predicted while export supplies stay constant in the above mentioned, "all things being equal" manner. In fact, whereas demand-side analysis is made simplistic by China's monolithic market dominance, world dairy's supply-side dynamics are made complicated by a host of competing countries and emergent weather wild cards.
Over the short term, the high prices, high export demand and falling feed costs in the latter half of 2013 caused the milk output of top 6 exporters (New Zealand, Australia, United States, Brazil, Argentina and the EU) to be 3.7% higher in the first two months of 2014 compared to the same period a year earlier. It was motivated by the fact their collective fourth quarter dairy exports were up 11% year-on-year.
US becoming a key exporter
Between filling the export supply gap left by Oceana's early 2013 drought, high dairy prices and falling feed costs, Rabobank estimates that US dairy farms' income exceeds their feed costs by a, "a staggering 120%, with the futures curve indicating a sustained period of positive margins for at least 12 months."
But a bitterly cold winter meant that while January's milk output increased by 4% in warmer California, the polar-vortex afflicted Midwest experienced a 2.4% from January 2013 volumes. That helped make for a nominal production increase of 1% from January 2013 levels. However, with weather conditions recovering, output will recover from its weather constrained 1% pace in H1 2013, to increase 3% in the latter half of the year, making for an overall 2014 output increase of 2.3%
Relative to production, America's export performance was more dynamic, as they were up from a year earlier by 43% in the fourth quarter of 2013 and 23% in January. Rabobank expects American dairy exports to meet the demand of many countries presently re-entering the world dairy market, and rise another 40% in the first half of 2014 from the levels of a year earlier.
However, a second half slackening of world dairy demand growth will coincide with depleted inventories. The latter will only be partly counterbalanced by domestic milk demand drop, which is wilting under a combination of (export-driven) high prices and the cutting of milk subsidies to America's poor. That means that while US dairy exports will help keep a lid on dairy prices in the first half of this year, from the late third quarter onwards, low inventories and supply constraints will limit their deflationary impact.
Nevertheless, with US dairy margins staying strong throughout the remainder of this year and the emerging El Niño weather system having less of an impact than in the southern hemisphere, any unexpected supply constraint would be more likely to be met by a US export surge than that of any other region.
America's growing role in the world dairy market should not be underestimated. It has overtaken New Zealand as in exports of non-fat dry milk powder (NFDM). With NFDM exports up 295% from 2000 levels, America now ships more of this dairy powder than Australia and New Zealand combined.
Coming off a warm, pasture-friendly winter allowed fourth quarter both EU output and exports to climb 4% over Q3 2013 levels. Despite expected on-year output expansion of 4% in the first half of 2014, Rabobank expects the EU's 20% rise in dairy prices, lack of economic growth and slackening export demand to limit the output and export increases to 1% in the second half of this year. That makes the EU a neutral influence on the world dairy market.
While America and the EU's impact on the world dairy supplies are neutral to somewhat deflationary, Oceana's dairy supply picture is more problematic. Superficially, New Zealand's 13% rise in January 2014 dairy output looks good, except that it is merely a recovery from the previous year's drought shriveled performance. With dairy exports in the three months ending in January up 7% from a year earlier, H2 2013's resumption of rainy weather allowed New Zealand to take advantage of China's booming dairy demand, though not in the way the United States was able to do so.
A cloud over Oceana's supply forecast
At a USDA estimated 19.7 million tonnes, 2013's milk output was identical 4.3% lower than 2012's pre-drought record. This year's estimated 20.6 million tonnes milk production is no higher than it was in 2012, even though world demand has grown strongly over the last two years.
Two factors outside New Zealand's control are working against the country's fluid milk output meeting these forecasts. A serious drought has gotten this year's dairy production off to a poor start, as February's rainfall on the country's North Island was 50% below normal.
By coincidence, northern New Zealand's farms have ample feed supplies at this time, giving them more flexibility in a drought than they had during the previous year dry spell. However, if the forecasted El Niño -driven southwest Pacific Ocean cooling occurs, it could bring drought and upset all these export forecasts.
A similar, more long-term cloud also shadows Australia's supplies, which endured far worse drought conditions than New Zealand in many parts of the country. According to the USDA, 2013's 9.57 million tonne fluid milk output was 2.2% below 2012's total. It was also 14.6% below 2000' record of 11.2 million tonnes. Similarly, 2014's 9.88 million tonnes will be 11% below the 2000 output record.
In a year of ferocious demand growth, drought put Australia's dairy exports in the three months to December 10% below the previous year's levels. Although exports of SMP, WMP, butter and cheese were all down, the only bright spot were WMP exports, were a large inventory overhang and falling Australian dollar resulted in a 12% jump in exports in the last quarter of 2013.
Although falling feed costs and strong dairy prices encouraged both Australian and New Zealand farmers to expand herds and production, USDA forecasts for modest production growth may not materialize if the widely anticipated El Niño weather phenomena occurs: It usually does every three to five years, and the last one occurred in 2009.
The only southern hemisphere bright spots are Brazil and Argentina, as they usually have greater rainfall and fluid milk production during El Niño years. But as they account for a much smaller share of the world export market than Australia and New Zealand, any increase in Latin American supplies will not be sufficient to counterbalance Oceana's more pessimistic (and problematic) supply forecast.
Deflation, market stability + El Niño's ghost
Hence, on the whole, high returns and aggressive milk production growth and ideal pasture growing conditions in all exporting regions (except Australia) during late 2013 is giving way to a cloudier supply-side picture.
With its high dairy returns gradually falling and domestic market facing slack demand, America's 2%+ supply side growth is now constrained by depleting inventories. Despite the expected pick up in output in the second half of this year, it will be unable to sustain double digit increases in export volumes seen in 2013 and during the early first quarter.
Oceana would be hard pressed to exceed the EU's own slack 1% to 2% growth and, if the El Niño weather pattern forms, may see output actually fall. With Argentina's government refusing to issue dairy export permits in March, Latin America's smaller contribution to the world market will not see it contribute more in the way of net exports this year.
Consequently, we can expect China to take advantage of the traditional second quarter world dairy supply surge and re-enter the market alongside major importers from Southeast Asian and the MENA region once prices have bottomed out. That will create a temporary, post-dairy crash market floor in the middle of the second quarter.
In the third quarter, fewer supplies will come on the world dairy market than during April and May. By that time however, we can also recovering Chinese dairy output to begin trimming that country's appetite for dairy imports for the remainder of the year, making room for other buyers to enter the market without causing inflation -unless of course, an El Niño of sufficient severity to cause drought in Australia and New Zealand materializes in the latter half of this year.
In all, the tempering of Chinese import demand will be balanced by a second half slowdown in dairy export expansion, with El Niño acting as a wild card that is capable of upsetting this stable forecast in an inflationary direction.
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