Connections between China's recovering dairy sector and a transformed world market
By Eric J. Brooks
While the last few years have seen China's dairy farms recover from the melamine contamination crisis of the late 2000s, economic conditions have also worked to stall the sector's progress. In the early part of this decade, fluid milk output rose rapidly. Increasing at a 6.2% annual rate from 2010 through 2014 inclusive, milk output nearly kept pace with demand for fluid milk, which rose at a 6.4% annual rate through these five years.
Moreover, the pace of China's milk production increases also accelerated in the first half of the decade. Based on USDA statistics, the country's milk production increased by an average of 4.7% from 2010 through 2012 inclusive, but yearly output rose by approximately 6.7% annually from 2012 through 2012 through 2014 inclusive.
Unfortunately, both China's economy and consumer demand levelled off shortly after demand growth accelerated, creating a massive oversupply situation by mid-2014. This tipped both China's dairy market and that of the entire world into sharp deflationary downturn.
From RMB4.24/kg (US$0.66/kg) in Q1 2014, farmgate milk prices plunged 20% in local currency terms to RMB3.40/kg (US$0.55/kg) by mid-2015 and only averaged RMB3.50/kg in the first quarter of 2016. Although consolidation and falling corn prices lowered unit production costs, revenue per litre still remained nearly 18% below its level two years earlier.
It goes without saying that despite their losses, China's dairy producers got off easy compared to dairy exporters, which saw both the volume of their top dairy exports to China and their prices fall by 30% to 50%.
Nevertheless, China's dairy price deflation was made worse by bloated WMP inventories. They tripled from their usual 60 to 130 tonne range in the five years up to 2012 to 300 tonnes in 2014 and a whopping 350 tonnes last year. Huge dairy powder surpluses impacted farmgate milk prices in China more than they would in other countries. According to the USDA, “milk prices are also constrained by the mass stockpiling of whole milk powder
[WMP], as Chinese dairy processors use whole milk powder to produce reconstituted milk.”
On one hand, because of sharply lower prices, total fluid milk demand avoided an outright drop. On the other hand, especially before late 2015 when the government deregulation lowered feed costs, low farmgate milk prices made smaller dairy farms suffer large net loss margins, causing fluid milk output volumes to flatten out.
At 39,050 tonnes, 2015 output only inched up 0.6%, which exceeded 0.2% total demand growth. With supply overtaking demand, imports dropped slower than consumption. This bloated dairy product inventories, thereby inducing deflation.
This year, with fluid milk production rising 1% and total demand from consumers and dairy processors rising 2.2%, supply is more closely balanced with demand. This should firm up prices, improve returns and stimulate fluid milk output by early next year. While this is good news for domestic dairy producers, dairy exporters will not partake of China's dairy sector prosperity in the manner they have grown accustomed to since 2008.
For foreign suppliers, the downturn in China's dairy import needs is bound to be longer lasting than was originally anticipated for several reasons. First, the last seven years of extraordinary Chinese dairy import growth were due to domestic farmers' inability to boost production for several years following 2008's melamine contamination crisis.
With the industry fully recovered and fully consolidated, there is no reason why fluid milk production cannot keep pace with demand in the manner that it did in the two decades prior to the 2008 crisis. That means that dairy import volumes may grow by up to 5% annually the way they did prior to the 2008 crisis but not at the 10% to 30% rates that were the norm up to 2014.
Second, the downturn in dairy imports initially occurred in response to rising domestic milk output in 2013 and 2014, which made the country less dependent on imports. The past year, however, has seen a recessionary economic conditions produce a far more extraordinary drop in demand, at least over the medium term.
This unanticipated nature of this protracted decline in China's dairy import requirements can be seen in the attached graphs for WMP imports and inventories: 2015 import volumes fell by 64%, to 310,000 tonnes from 670,000 a year earlier, or at a projected 370,000 tonnes for 2016, remain 45% below their peak 2014 volume.
Third, our inventory graph shows that from 2008 (when the melamine contamination crisis and similar food safety incidents began) through 2013 (when milk quality problems abated), actual Chinese WMP closing inventories matched or came very close to preliminary USDA projections. Since 2013, however, actual closing inventories have come in much higher than initial estimates.
As the accompanying inventory graph shows, even with WMP imports plunging and dairy prices nose-diving, WMP closing stocks came in several hundred tonnes lower than initially projected in 2015. Even the closing inventory estimate for this year came in 90,000 tonnes higher than expected. And that is also the reason why the dairy import graph shows that WMP consumption greatly exceeds the sum of domestic production plus imports.
With far larger excess inventories accumulating than anyone anticipated, production and imports need to be kept below consumption for one or two years longer than initially predicted. This is one reason why the world dairy market slump may last up to five years.
At the same time, not all dairy product imports are downtrending. For example, its imports of cheese from New Zealand have nearly doubled over two years, from 21,367 tonnes in 2014 to 28,923 tonnes in 2015 and a projected 39,550 tonnes this year. While this partly reflects the New Zealand dollar's plunge and the substitution of cheese from that country with that of more expensive American or Australian supplies, overall cheese import volumes increased by over 50% in two years.
That is also why over the past two years, cheese has been selling at US$500/tonne premium to WMP. Analysts expected this large price gap between cheese and WMP to close by late 2015 but, instead, it has persisted right up to the time of this article's writing in mid-2016. While China's cheese imports are skyrocketing, a huge pile of unconsumed milk powder is preventing China from stepping up WMP imports.
This has boosted international cheese prices at the expense of a depressed WMP market. Moreover, alongside cheese, China's import demand for fatty or high protein fast food inputs such as whey and butter has also held up well.
Similarly, with demand for high quality UHT packaged milk booming, fluid milk imports jumped a whopping 4,525% in seven years, from 4,000 tonnes in 2006 to 185,000 tonnes in 2013. Thereafter, even with domestic dairy production recovering and demand growth tapering off, fluid milk imports defied the global dairy market crash, jumping 73% on-year to 320,000 tonnes in 2014.
In 2015, even with China's recession underway, fluid milk imports jumped 25%, to 400,000 tonnes. This year, the USDA expects fluid milk imports to jump yet another 18.8% to 475,000 tonnes. From 2006 through the end of 2016, China's fluid milk consumption will have grown 9.2% and its milk production by 19.5% --but milk imports have risen by 1,175% over these same ten years.
As a result, imported milk has risen from under 0.1% of milk consumed by the public in 2008 when the melamine contamination scandal broke out to 4.3% this year, with most sales accounted for by the country's most educated, higher income consumers. This points to a persistent, long-term marketing problem for China's dairy industry.
While dairy processors will use lower cost domestic milk as their primary production input, consumers apparently trust foreign milk over domestic supplies for their personal consumption, buying UHT packaged milk whenever they can afford to do so.
This brings us to our fourth point: Not only is the quantity of dairy products imported by China changing, so is its dairy import product's profile. In the first five years after 2008's melamine contamination incident, fluid milk production was unable to keep pace with the demands of food processors. This led to an aggressive expansion of milk powder imports.
On the one hand, since 2012, local milk production has roughly kept pace with the demand from food processors. Since 2014, this has made for below-trend milk powder import volumes and less long-term dependence on foreign supplies.
On the other hand, while food processors are happy to rely on cheaper, more plentiful domestic milk supplies, this is no longer true of China's dairy retail segment.
Consumers remain wary of Chinese milk's food safety and increasingly buy imported UHT milk. They are also increasingly likely to eat fast food containing cheese imported from countries such as New Zealand. The net effect of these changes is that milk powder imports are down and will grow more slowly, but imports of fluid milk and fatty products used in fast food such as cheese are rising faster than before. Nevertheless, because the volume of milk powder that is internationally traded greatly exceeds that of fluid milk or fattier dairy goods, China's overall dairy import growth will be far slower in the future than it was in the past.
On one hand, per capita dairy product consumption, though it has risen rapidly, still has at least 20 years of rapid, pent-up demand growth ahead of it. For example, while overall milk consumption (including both fluid milk and dairy products) has tripled over the last 15 years, at 33kg, it is still below the 100kg to 200kg common in most developed countries.
On the other hand, with rising dairy productivity and the recent deregulation of Chinese corn prices, the next decade will see China's milk production costs fall significantly closer to average world levels. Along with the recent fall in China's currency, that will make it less cost effective to import than before. When the economy recovers, for the first time in a decade, China's milk supply will be able to keep up with dairy demand. These changes imply that except for fluid milk or commodities used by the fast food sector, China's dairy market is poised to become much more self-sufficient than it was over past decade.
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