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July 23, 2017

Analyzing New Zealand's resurgent dairy recovery

Rebounding farm gate prices, high demand for milk and fatty dairy goods result in a shifting export portfolio.


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Suddenly, it's once again a good time to be a New Zealand dairy farmer. Helped along by a return to good pastureland conditions, an ongoing recovery in world dairy prices is boosting New Zealand's milk production above initial expectations.

This prompted Fonterra, the country's leading dairy processer to boost its farmgate milk solids price two consecutive times. First to NZ$6.15/kg (US$4.30/kg) for 2016-17 and an estimated US$6.50/kg (not including dividend) for the 2017-18 season. Other processors followed Fonterra's lead and the current milk solids price of approximately NZ$6.60/kg (US$4.75/kg) is the highest in four years.

Granted, this is lower than the peak price of NZ$8.40/kg (US$6.88/kg) during 2013-14 or the NZ$6.98/kg (US$5.73/kg) average farmgate milk solids price of the 2010-14 boom years. Even so, it is a huge 67% improvement over the NZ$3.90/kg (US$2.53/kg) Fonterra offered dairy farmers year and a half ago, when the world dairy market was hitting rock bottom.

Moreover, judging by past behavior, the new market upturn still has two good years left in it: In constant 2017 dollars, based on Dairy Australia data, since 1996, farmgate milk solid prices have peaked at an average of NZ$7.67/kg (US$5.45/kg) and bottomed out at an average value of NZ$5.02/kg (US$3.56/kg).

Having recovered from a recent market bottom of NZ$4.30/kg (US$2.80/kg) to an average of NZ$6.60/kg (US$4.75/kg) across major producers, farmgate milk solid prices look poised to rise by at least another 15% before the current market cycle levels out. Profits-wise, pre-tax earnings have risen from a -NZ$1.31/kg (-US$0.85/kg) loss two years ago to a net profit margin of NZ$1.20/kg (US$0.86/kg) today.

With earnings usually peaking in the NZ$1.40/kg to NZ$1.80/kg range, profitability is rising and looks set to continue doing so. Consequently, so long as producers do not encounter unusually bad weather or a disruption in world dairy demand, the incentive to produce milk at current or higher profit levels should remain in place for at least another two years.

Supported by rising returns, instead of falling from 5.056 million head at the start of 2015 to 4.9 million at the start of 2017 as initially projected, the number of dairy cattle bottomed out at 5.0 million. Rising profitability will result in the dairy herd expanding approximately 3% to around 5.15 million head by the close of this year.

With higher prices restoring the incentive to boost production, the USDA's 2017's fluid New Zealand milk output estimate has been revised upwards from 21.70 million tonnes to 21.904 million tonnes. That roughly equals 2014's record output and on current momentum, has a good chance of exceeding it.

While production of all dairy commodities is expected to increase 3.2% in tandem with the rise in milk output, the production portfolio is following strong, new trends in export demand. Mainly, a shift away from commodity dairy powders and towards fluid milk or products with exceptionally high fat or protein content.

On one hand, from a peak price of US$4,290/tonne in 2013, WMP sold for 45% less at US$2,361/tonne in 2016. SMP fared even worse, falling 53% from US$4,149/tonne in 2013 to US$1,967/tonne last year.

On the other hand, butter rose 43%, from an average just under US$4,000/tonne in the year before the dairy market crash to approximately US$5,750/tonne today. Similarly, after falling below $2,600/tonne one year after the dairy market crash, cheese now sells for around US$4,250/tonne, roughly the same price it did at the top of the dairy market boom.

With 95% of dairy production exported, New Zealand's dairy output portfolio is adapting to these new price realities. On one hand, 2017 exports of WMP are rising a mere 0.9% while those of SMP are falling a whopping 8%. Once growth drivers, from 2014 through 2017 inclusive, WMP exports will have declined 4.7% while those of SMP are a mere 6.5% higher.

On the other hand, from 2014 through 2017 inclusive, shipments of cheese(+23.7%), whey(+40.6%), milk protein concentrates(+35.1%), whey(+60.%), fluid milk(+101%) and infant formula (+126%) have risen far more aggressively than was anticipated. Along with fluid milk, high demand for fatty or concentrated protein dairy goods more than compensated for the levelling out of once booming dairy powder exports.

Supported by booming exports of traditional fatty dairy goods, milk and protein concentrates, New Zealand's 3.38 million tonnes of total 2017 dairy export volumes will exceed their 2014 market crash bottom of 3.043 million tonnes by 11.1%. With demand for dairy powders tapering off and for most other product lines increasing, New Zealand's overall dairy production is recovering: After bottoming out at 3.038 million tonnes in 2016, total dairy goods output will rise 3.2%, totaling 3.135 million tonnes in 2016.

Ironically, the decline in milk powder production would have been even steeper except for the need to take advantage of new market opportunities. For example, SMP production is only staying constant at 410,000 tonnes in order to produce enough butter to take advantage of high export demand for the latter.

In response to this new trend, once booming milk powder production has stayed constant. With WMP output staying on an undulating plateau slightly above 1.3 million tonnes and that of WMP near 410,000 tonnes, producers have used their limited milk supply increases to boost production of fattier or more protein rich dairy goods and for Asia Pacific importers, particularly UHT milk and infant formula.

This trend towards fatty products is a worldwide one. Everywhere from America to Australia, not only is whole milk back in fashion at the expense of skim milk, even fattier steak cuts are increasingly preferred over leaner ones.

Thus, China did not invent the trend away from dairy powders and towards high fat or high protein dairy goods. Moreover, it has plenty of help from Southeast Asia in boosting demand for products ranging from infant formula to the cheese used on fast food pizzas. Even so, China has played an undeniably large role in the ongoing shift in New Zealand's dairy export portfolio.

For example, China, which absorbed 48% of New Zealand's world leading WMP exports in 2013 only accounted for 29% in 2016. While New Zealand's USDA estimated 2017 WMP exports of 1.34 million tonnes exceed its 2013 dairy market peak volume by 4%, this is not the case with its shipments to China.

From a peak of 622,000 tonnes in 2013, WMP exports to China sank to 354,291 tonnes in 2015. Though they rebounded to 389,000 tonnes last year, China bought 38% less WMP from New Zealand in 2016 than it did three years earlier. On the other hand, from 2013 through 2016 SMP exports to Middle East and North African (MENA) nations boomed. In particular, WMP exports to Algeria jumped 409% from 32,000 tonnes to over 166,000 tonnes.

Over these same three years, large WMP export increases to Bangladesh(+90.7%), Vietnam(+62.6%), Saudi Arabia(+53.5%), Sri Lanka(+48.2%), Thailand(+34.5%) and the UAE(+26.3%) compensated for falling Chinese demand. While New Zealand SMP exports to China fell 37.5% or 222,000 tonnes from 2013 through 2016, WMP shipments to the rest of the world jumped 42.6%, from 669,000 tonnes to 954,000 tonnes.

Only by successfully diversifying its WMP exports into fast growing ASEAN and MENA nations did New Zealand keep its WMP shipments at 1.344 million tonnes in 2016. –Otherwise the loss of so much China business would have made for a steeper drop than the 5.6% decline from 2014's record 1.423 million tonnes of WMP exported. At 1.356 million tonnes, estimated 2017 WMP export volumes are rising for the first time since 2014 but they have a long way to go before sustained, solid growth beyond prior peak levels occurs.

We see a similar diversification away from China in New Zealand's SMP exports, which from 2013 through 2016 fell from 18.8% from 132,527 tonnes to 107,627 thousand tonnes. Over these same three years, SMP exports to the rest of the world rose 29.7%, from 259,442 tonnes to 336,430 tonnes. That was driven by large increases in SMP export volumes to Algeria (+239%), Vietnam(+84.8%), Thailand(+71.5%), Taiwan(+25%) and Philippines(+17.7%).

While Southeast Asia and the MENA region helped cushion the fall in dairy powder shipments to China, the latter also played a role in making liquid milk, infant formula and fatty milk products into booming new export lines. For example, from buying 5.4% of New Zealand's cheese exports in 2011 and 7.7% in 2013, China purchased 14.6% of them in 2016.

Shipments of cheese to China rose 282% over five years, from a mere 13,536 tonnes in 2011 to 21,367 tonnes in 2013 and 51,668 tonnes last year. Although Australia and Japan each import approximately 10,000 tonnes more cheese annually from New Zealand than China does, the latter is expected to overtake them within a few years.

In sum, New Zealand has emerged from the most brutal global dairy market recession in decades relatively unscathed. With enduring abundant rainfall, lower input costs and higher returns, New Zealand's output does not face the production constraints of nearby Australia. Nor does it have the high cost levels of a feed-based dairy farming found in Europe and America.

While China's dairy demand will not grow as quickly as before, new export frontiers are emerging, both in China itself and in neighboring Southeast Asia. This has helped diversify exports away from being too dependent on just one large importing nation. It also helped achieve greater balance between dairy powder exports and other product lines. All New Zealand needs to do is adjust its dairy export product profile to take advantage of these new growth opportunities.

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