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June 8, 2017

Six factors constraining Australia's dairy output

An eFeedLink Hot Topic
 •  Low returns, culling, poor feed input quality keeps milk output far below peak levels
 •  Farm gate revenues fall by a third while costs rise 25% in four years
 •  Shifting consumer preferences constrain the supply of high end dairy exports.
It was a better than expected year for Australia's dairy industry but the sector remains beset by many problems. After producing 9.80 million tonnes of fluid milk in 2015, El Nino-induced arid weather made for dry conditions in the first half of last year, particularly in Victoria and New South Wales, which account for most of the country's milk production.
It slashed fluid milk output 4.6%, to a USDA estimated 9.35 million tonnes in 2016, but it could have been worse: Thanks to a wetter than expected conditions in late 2016, production exceeded the 9.2 million tonnes initially forecast.
2017 began with highly favorable temperatures and healthy rains, bringing the new year off to a better-than-expected start. Even so, output is projected to fall to another 2.5%, to 9.1 million tonnes –but even this is an improvement from the 8.9 million tonnes forecast earlier in the year.
While favorable first and second quarter rainfall made for an improved forecast, this is a shadow of what Australia can produce. This year's projected 9.1 million tonnes is down 7% from the 9.80 million secular peak achieved two years ago and 21% below the 11.6 million tonnes achieved back in 2002. This is the smallest quantity of fluid milk produced by Australia since 1997.
Although arid El Nino conditions are anticipated in H2 2017, far more than drought holds back Australia's milk production. First, 2016's dry conditions coincided with a third consecutive year of low export prices following the 2014 market crash. Reflecting poor export prices, Q2 2016 saw leading dairy processor Murray Goulborn cut its farmgate milk solids price from A$6.00/kg (US$4.50/kg) to A$5.50/kg (US$4.13/kg).
In April of this year, Murray Goulburn again slashed its farmgate milk solids price, this time to A$4.70/kg (US$3.53/kg), warning that it would only rise to around A$5.20/kg-A$5.40/kg by the end of the 2017-18 financial year. This is a steep fall from a milk solids price of A$6.79/kg (US$4.92/kg) a few years ago, just before the world dairy entered its current depressed phase.
In an interview with Australian Broadcasting Corporation, Murray Goulburn CEO Ari Mervis cited the need to cut costs and recent closure of three dairy processing plants. He noted that, "Whole milk powder and particularly skim milk powder remain under their ten-year averages."
Second, while farmgate milk prices have fallen 31% over four years, John Hunt, a dairy farmer and spokesmen for the South Australia Dairy Farmers Association, states that production costs have risen 25% over this same time. This combination of 31% milk price deflation and 25% production cost inflation has devastated Australian dairy farming returns and milk output, particularly among smaller producers.
Third, even before the dairy market meltdown, the industry was already marked by huge earnings gap between large and small producers. The market downturn made matters worse. According to ABARES statistics, a 3.7% 'average' return on industry capital in the five years ending in 2015 masked wide industry disparities. Large farms enjoyed a 4.8% return and medium farms 2.5%. Small farms barely broke even, earning a 0.5% return.
This year, amid low post crash dairy prices and high debt burdens, ABARES expects large dairy farms to make a 1.5% return while both small and medium sized producers will suffer a 2.5% net loss. This reflects a 20% drop in average dairy farm cash revenue, from A$131,250 in 2015-16 to A$105,000 in 2016-17. As revenues plunge, the difference in unit costs between large scale and small-scale farms become a critical factor in their survival.
Fourth, to meet short term debt obligations, many smaller producers culled their herds and if they exited the industry, their entire herds. Consequently, from January 2016 through January 2017, 106,279 dairy cattle were culled, up 16% from the 91,620 head sold off in the previous year.
In 2017, for a second consecutive year, farmgate milk prices barely cover operating costs but India's recent ban on cattle slaughtering is pushing up world beef and cattle prices. Hence, the motivation to meet short-term financial obligations by culling dairy herds will remain strong this year.
Fifth, alongside having fewer dairy cattle for milk production, another constraint on output comes from falling cow productivity. To cut costs, many farms are reducing their feed grain rations and relying more on pastureland grazing.
The USDA notes this is occurring, "Despite comparatively low prices for supplementary feeds and is attributed to the cash flow problems and increased debt of many producers." It expects the substitution of pasture in place of higher quality feed to slash annual milk yields 3.4%, from 5.9tonnes/cow in 2016 to 5.7tonnes/cow this year.
Alongside directly reducing the quantity of milk available for processing, an increasing reliance on pasture-based feeding reduces milk's fat content. This reduces the quantity of value-added products such as cheese or butter can be made from the same quantity of milk feedstock. Dairy Australia reports the average fat content of milk has fallen from 4.39% in 2015 to an estimated 4.31% this year. Thus, to the 3.4% less milk produced per cow, each liter of its milk will contain 1.6% less fat (by volume) for turning into high value goods than it did two years ago.
Sixth, shifting consumer preferences is also constraining the supply of value-added products that can be produced for export. At 105 liters per capita, Australians are keeping their fluid milk consumption but shifting towards fattier, full cream varieties.
According to Dairy Australia, from 2014 through 2016 inclusive, total fluid milk consumption increased by only 2.5% or 34,000 tonnes, roughly in line with Australia's population growth. However, consumption of full cream milk increased 12.4%, from 567,000 tonnes to 637,000 tonnes.
On the other hand, consumption of reduced fat and low-fat milk fell 11.9%, from 469,000 tonnes to 413,000 tonnes.
Nor is the rising popularity of milk fat limited to that for full cream milk. Reflecting a move away from vegetable oil consumption, butter consumption jumped 79%, from 58,000 tonnes in 2000 to an estimated 104,000 tonnes this year. Australia's population only increased by 26% over this same time.
With 30% of Australian milk consumed directly by consumers amid skyrocketing butter consumption, rising demand for these products is constraining the supply of fat that can be made into exportable value-added commodities. The shortage has been dealt in two ways.
First, as butter offers a lower return than cheese, we find that producers produced less of the former to increase the supply of milk fat available for producing the latter. From 2014 through this year inclusive, butter output will have fallen 10.4%, from 125,000 tonnes to 112,000. –By comparison, even though Australia will produce 6.2% less milk and nearly 10% less milk fat than it did in 2014, it will make 330,000 tonnes of cheese, 3.1% or 10,000 tonnes more than it did three years ago.
Second, because exports offer higher returns than domestic sales, when there was insufficient supply, cheaper imports were imported so that higher value-added dairy goods could continue to be exported. This of course, negatively impacted Australia's dairy trade flows in a number of ways.
On one hand, 2017 will see total dairy exports rise for fourth consecutive year from the lows of the 2010 to 2013 drought years. At a USDA estimated 715,000 tonnes, total exports of butter (45,000 tonnes), cheese (170,000), WMP (70,000 tonnes), SMP (180,000 tonnes) and fluid milk (250,000 tonnes) will have risen 33% from their 2013 low of 538,000 tonnes.
On the other hand, this is still 22% less than the over 870,000 tonnes of these dairy commodities exported back in the early 2000s, when the world dairy market was much smaller than it is today. With the country producing 21% less milk than 15 years ago, amid constant domestic demand, Australia cannot help but export less dairy goods than it did back then. 
–In fact, where it not for burgeoning Chinese demand for its fluid milk, Australia's export volume of butter, cheese, WMP and SMP is not only 41% lower than 787,000 tonnes exported in 2002; it is also 5.9% lower than the 494,000 tonnes of these commodities it exported in 2012 –when it was just starting to come out of the worst of its multi-year drought.
While its exports of traditional dairy commodities are a fraction of their previous volume, the world dairy market is several million tonnes larger than today than it was then. Hence, Australia lost much market share to New Zealand, the EU and especially America. The latter went from exporting less than 200,000 tonnes of these five dairy products fifteen years ago to exporting over a million tonnes –and 42% more than Australia does– in the early 2010s.
Faced with a shortage of milk to produce exportable dairy goods, Australia has been strategic about what it produces, imports and exports. Faced with a scarcity of milk fat and higher returns on cheese, butter exports have fallen a whopping 68%, from a peak of 223,000 tonnes in 2000 to a USDA estimated 45,000 tonnes this year.
Moreover, with 104,000 tonnes of domestic butter consumption nearly equaling 112,000 tonnes of output, it was profitable to import 25,000 tonnes of cheaper foreign butter, as it freed up a similar quantity of higher value domestic butter for export. As a result, net butter exports are now immaterial, having plunged from 129,000 tonnes in 2000 to 25,000 tonnes today.
Cheese exports fared better, falling a far smaller 24%, from a peak of 223,000 tonnes in 2002 to an estimated 170,000 tonnes this year. As mentioned earlier, that was partly achieved by sacrificing the production and export of butter for that of cheese, which generates higher earnings.
Even so, in the seventeen years since 2000, cheese consumption rose 27% or 54,0000 tonnes (to 254,000 tonnes) while output fell 11.5%, from 373,000 tonnes to 330,000 tonnes. Despite falling milk production, that is 10% or 10,000 tonnes more than the quantity imported in 2016.
Unfortunately, with production now exceeding domestic consumption by only 76,000 tonnes, the 170,000 tonnes of exports was only achieved by boosting imports from 38,000 tonnes in 2000 to 110,000 tonnes this year.
Aside from fluid milk exports, the only bright spot in Australian dairy trade fundamentals is SMP, which is not affected by its shortfall of milk fat. At 180,000 tonnes, 2017's SMP exports are projected to be 9.8% higher than in 2014, when the dairy crash hit. Even here, it has difficulty competing against a surge of low cost European SMP, which has flooded its East Asian markets after the EU liberalized its dairy market in 2014.
Sadly, Australian dairy shipments have fallen over two decades when their world market prospects have never been better: EU exports of milk, cheese, butter, WMP and SMP in 2017 will be approximately a million tonnes higher than they were in 2000, while those of New Zealand will have increased by nearly 1.8 million tonnes. America's world market performance was even more impressive: Its dairy exports jumped an impressive 351%, from 225,000 tonnes in 2000 to a USDA estimated 1.015 million tonnes this year.
Having lost its number three dairy exporter position to the United States after 2010, Australia's net dairy exports are falling even faster. Unless Although the US has a feed based dairy sector, operating costs are comparable to those of Australia but their profitability and scale economies are much larger. By comparison, Australia's dairy production is constrained by low returns.
The implication is clear: Unless Australian dairy farming returns improve, it could become a net importer of goods such as butter and cheese. A restructuring of the industry or new government policies are required before milk production becomes profitable enough to justify its expansion.

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