December 5, 2013
Too much debt, not enough grass: The limits of Australia and New Zealand's dairy abundance
Debt financing, costly pasture land and a growing dependence on feed boost Oceana's dairy costs towards European and American levels.
By Eric J. BROOKS
An eFeedLink Hot Topic
For years, the global dairy industry has been dominated by Australia and New Zealand, which have leveraged their relatively low populations and large pasture land endowments into a combined world export market share exceeding 50%. Now however, a confluence of natural limitations and macroeconomic trends are eroding that cost advantage –and with it, the market share of Oceana's dairy exports.
This can be seen in the changing dairy market fortunes of the United States and Australia. According to USDA figures, in 2001, American shipments of butter, cheese, whole milk powder and non-fat dry milk powder amounted to only 20% of Australian exports of these dairy lines. By the late 2000s, American overtook Australia in these dairy exports and in 2013, the United States shipped 2.44 times more the volume of these dairy products than Australia.
Similarly, 2001 American exported 11% of the amount of butter, cheese, whole milk powder and non-fat dry milk that New Zealand did but by 2013, it was exporting nearly 36% of New Zealand's volume of these dairy commodities. Below we examine the natural causes and macroeconomic factors behind this ongoing reversal of dairy market fundamentals.
Pastureland becomes pricey
Traditionally, southern hemisphere dairy exporters relied on relatively inexpensive pastureland to sustain their dairy cattle. By comparison, northern hemisphere dairy exporters like America and Europe used a much higher proportion of costlier, commercial feed.
Essentially, pastureland dairy farming is considerably less intensive, has significantly lower dairy cow productivity and lower milk yields per hectare of land. By relying on pasture land, milk output fluctuates in response to seasons and weather conditions, irrespective of actual export demand.
Fortunately for Australia and New Zealand, all these drawbacks were more than strongly offset by pasture land's historically inconsequential cost relative to that of commercially procured feed. So long as cattle grazing land is already paid for and farmers have ample, unused acreage capable of supporting a demand-driven capacity expansion of dairy herds, pasture land is a far more cost effective means of producing milk than feed.
- Unfortunately, the above mentioned pre-conditions are increasingly not true in the southern hemisphere, particularly in New Zealand, which supplies 40% of world dairy exports. A Rabobank November 2013 report ("Agriculture in Focus: No longer low cost milk down under"), estimates that in 2002, northern hemisphere milk production costs were 50% higher than those of Australia and New Zealand.
Even in 2006, it estimates that the average farm gate milk production costs of the US Midwest and California were approximately 36% higher than the combined average of milk input costs in New Zealand and Australia's Victoria state. Australia and New Zealand also held an 80% cost advantage over Dutch dairy farms, which are among the most technologically advanced in Europe (but hamstrung by costly EU milk production quotas).
This can be seen in how feed makes up 60% to 65% of northern hemisphere dairy production costs but until recent times, accounted for 10% to 20% of southern hemisphere dairy production expenses –having said that, recent years have seen the proportion of Australian and New Zealand dairy costs accounted for by feed rise sharply .
As a result, by 2012, the average farm gate dairy unit production cost of milk from the American Midwest and California was only 14% higher than the average cost of milk produced by New Zealand and Australia's Victoria state. Oceana's cost advantage over milk from the Netherlands also narrowed, from 80% to around 40%.
In just ten years, more than half of the southern hemisphere's once large cost advantage has disappeared; nor is this a temporary condition caused by exceptional circumstances. The accompanying graphic makes clear that the past ten years has seen a trend for northern and southern hemisphere dairy production costs to converge. Moreover, there are powerful forces behind this trend which will see northern hemisphere dairy producers, particularly in America, continue to gain competitive advantage relative to their southern rivals.
Land, feed costs triple, productivity up by a third
Essentially, with Oceana reaching the limits of its pastureland availability, it began relying on feed inputs to boost dairy output just as the cost of corn and soy underwent a sharp, long-term, secular rise.
Although feed prices went up by roughly the same amount for Australian and New Zealand dairies and their northern hemisphere competitors, the proportion of feed used by Oceana's dairy farms tripled while those of northern dairy producers stayed constant. As a result, feed cost inflation boosted Australian and New Zealand dairy farm costs by up to three times more than those of their American and European rivals.
For example, Dairy New Zealand indicates that feed costs made up 10% of New Zealand farm expenses in 1991-92 but by 2011-12, this figure had risen to 24%. They most likely topped 28% in 2012-13, when a drought put much pastureland out of service and forced greater reliance on feed at a time when corn and soy were setting price records.
Coincidentally, the previous decade saw drought strike Australia repeatedly throughout most of the period when corn and soy began their multi-year rallies. As a result, Australian dairy farms were using 33% more feed grain per dairy cow in 2012 than in 2006. With feed costs roughly twice as high in 2012 than in 2006, that resulted in Australia's feed cost per liter of milk produced rising far more quickly than in the northern hemisphere, where feed's share of dairy inputs remained constant.
The proportionately stronger impact of rising feed costs on southern hemisphere dairy farms was further magnified by long-term currency market changes: Dairy products are traded internationally in US dollars and from 2002 to 2012, the Australian and New Zealand currencies rose by 90% and 70% respectively against the greenback.
This combination of southern hemisphere droughts, Oceana's rising production costs, a falling US dollar and America's chronic dairy surplus have given the latter an increased share of world dairy exports in recent years, and this trend looks set to continue. Although the resumption of normal climate conditions have restored most of Australian and New Zealand pastures to their former productivity, market conditions have changed but the quantity of pastureland does not. This factor, more than any other, is undermining the southern hemisphere's dairy competitiveness.
It means that to meet strongly rising Asian demand and take advantage of record high export dairy prices when pasture was out of season or during drought, Australian and New Zealand dairy farmers were forced over the short-term, to buy considerably more feed than before.
Over the long-term, to accommodate a decade of unexpectedly strong dairy export expansion, Australian and New Zealand dairy farms were forced to acquire additional pastureland. Occurring at a time of easy credit policies and a worldwide trend of rising farmland prices, the cost of buying additional pastureland in southern Australian and New Zealand tripled. From US$4,000/hectare in 2002, Australian dairy pastureland rose to approximately US$12,000/hectare by 2012. New Zealand pastureland rose by even more, from US$7,500/hectare in 2002 to over US$25,000 in 2012.
Financing the pastureland purchases required for additional milk production profoundly boosted the debt levels and interest costs of Australian and New Zealand dairy farmers. Rabobank concluded that as a result, "productivity, in terms of feed produced per hectare [and milk produced per cow] has increased, but this has been well outpaced by land prices." In all, the average debt per liter of milk produced rose by approximately 82% from 2002 to 2012.
On one hand, Rabobank estimated that as of 2012, debt interest cost American dairy farmers approximately US 2 cents/liter while their counterparts in New Zealand and Australia pay over US 8 cents/liter and US 5 cents/liter respectively.
On the other hand, whereas the last decade saw farm debt levels double and the cost of land and feed both triple, Rabobank reports that dairy cow productivity only rose by 19% and 30% in Australia and New Zealand respectively. With feed and financing expenses pushing up overall production costs far more than in Oceana than in America or Europe, the former lost competitiveness.
In addition, strong export demand and record prices for livestock products such as mutton, wool and beef mean that for the first time, Australia and New Zealand's dairy farms must compete with other livestock lines for pastureland. –That is a profoundly game changing development, as competition for pastureland from other livestock lines mirrors the situation that forced US and EU dairy farms to move their cattle to a mostly feed-based diet.
Rising interest rates = no going back to the old model
Cornered between a need to boost output and take advantage of Asia's growing dairy demand on one side, and the prohibitive, debt-addled cost of additional pastureland on the other, Australian and New Zealand farmers are choosing a middle road: They are bringing into production as much additional pastureland as they can afford. Demand above what pastureland can supply and peak period production are increasingly dependent on commercially sourced feed. Rabobank concluded that, "Production systems in this region are now moving towards a hybrid model and are adapting at least some of the practices employed by those in intensive or feedlot milk production businesses."
It is also clear that going back to entirely pastureland production system is not economically viable: With interest costs per liter of milk produced up 82% in ten years, there is not much scope for New Zealand's farmers to further expand their pastureland holdings.
But even with pastureland purchases tapering off and feed being substituted in place of grass, their debt financing situation could get a lot worse: Alarming as it is, this rise in Australian and New Zealand dairy farm indebtedness actually occurred during an extended period of super-low interest rates. Whereas New Zealand's benchmark T-bill interest rate was 8.2% in 1992, by 2012, by the late 2000s, it fell below 3% and currently sits near 2.8%.
Most of this debt is based on floating interest rates and it is commonly known that over the next few years, global interest rates have nowhere to go but straight up. Australia and New Zealand's interest payments per liter of milk produced are already 100% to 200% higher than those of American dairy farms.
Under such macroeconomic circumstances, new pastureland acquisitions can leave a balance sheet precariously overleveraged in the face of falling dairy prices and rising costs –something which an inevitable rise in world interest rates and EU dairy production liberalization make for a highly probably occurrence. –But while pastureland investments in capacity expansion are inflexible and financially dangerous, feed purchases are a variable cost that can be quickly reduced in response to a drop in export demand.
Consequently, when combined with the expectation of rising interest rates, Oceana's high farm land costs and correspondingly high dairy debt levels discourage further investment in pastureland. This is motivating Australian and New Zealand farmers to meet export demand growth through financially safer –but more expensive– feed driven dairy production. All this implies that the proportion of dairy cattle inputs accounted for by commercially bought feed will rise further, and with it, Oceana's dairy production costs relative to those of the United States and Europe.
Ironically, the fact that New Zealand continues to use more pastureland will also work against it over the short-term: Because they continue to use much more feed than their southern hemisphere counterparts, the near 50% fall in feed crop prices will cut the unit costs of American and EU dairy producers more than that of their Australian and New Zealand rivals.
In the medium to long-term, the postponed (but inevitable rise) in world interest rates could make Oceana's high interest costs per liter of milk produced double or triple within a few years. That could put many Australian and New Zealand famers out of business and accelerate a restructuring towards an integrated, feed-driven, intensive dairy production found in the America's Midwest. Under such macroeconomic circumstances, it will become increasingly impossible to expand dairy farm pastureland holdings. The upshot of this is that with an increasing proportion of Oceana dairy inputs coming from feed rather than forage, production costs will continue to converge towards northern hemisphere levels.
Consequently, the feed-intensive dairy farming model commonly found in Europe and America is on the rise, and with it, Oceana's milk making cost base. In sum, Australia and New Zealand are gradually moving closer to the American dairy model, which uses significantly more pastureland than European countries but far less than traditional southern hemisphere milk producers.
Much higher labour costs than US
But there is more to Oceana's dairy cost inflation than just pastureland constraints, rising interest rates or a growing reliance on more expensive feed.
Both the expansion of dairy production and the increasing reliance on commercially bought feed is making Australian and New Zealand dairy production more labour intensive, and this too is unfortunate: Due to Australia and New Zealand's high urbanisation rates, and low number of immigrants, dairy farm labour is hard to come by and getting increasingly expensive. In Australia, this problem is compounded by the fact that such a high proportion of the rural labour force has been lured to its fast growing energy and mining sectors, whose own wages have skyrocketed.
This pushed up labour costs to the point that Australian and New Zealand dairy farm wages are approximately 100% and 20% higher respectively than those paid by American dairy farmers. Moreover, with America enjoying a steady stream of Hispanic immigrants from rural farm areas and Australia and New Zealand tightening their own immigration regulations, America's advantage in dairy wage costs appears destined to widen, and be augmented by a slowly falling US dollar.
Nor is there much chance of Australia or New Zealand's upcoming market share loss becoming South America's gain rather than North America's. Rising by a factor of 6 in ten years, Brazil's pastureland costs have increased twice as rapidly as those of New Zealand, and its interest rates have already risen higher than those of either Australia or New Zealand. Moreover, Brazil's currency has appreciated as much against the US dollar as much as the Australian and New Zealand dollar, and its farm labour costs are rising faster than those of any other dairy producer.
Rising interest rates + EU liberalization -a perfect storm?
Finally, up to now, this article has mostly compared the supply fundamentals and export performance of Oceana's dairy producers to those of the United States, as Europe has a significantly higher cost base than the former. Nevertheless, alongside the southern hemisphere's pastureland, wage and debt financing related cost pressures, the northern hemisphere is throwing one more competitive factor into the world dairy industry.
Aside from the EU's higher reliance on feed inputs and slightly lower dairy cow productivity, that continent's dairy farmers are rendered uncompetitive by strict dairy market quotas. Not only do European milk production quotas keep that continent's prices artificially high but cost of buying such quotas boosts EU milk production costs to well above American levels.
That will no longer be the case from 2015 onwards, when the EU abolishes all milk production quotas. That will have the effect of profoundly lowering EU dairy production costs while allowing supplies to expand to levels dictated by the market, rather than by bureaucrats.
There is a significant possibility that rising EU milk production and falling EU dairy prices could coincide with higher interest rates and Australia and New Zealand's production costs rising. That could accelerate a trend already underway: as this article's last chart clearly shows, US dairy exports as a percentage of combined Australian and New Zealand shipments have gone from 10% to 15% in the early 2000s to over 31% in 2013, and are destined to gain even more market share over the next few years.
As Ocean moves beyond a pure pastureland based production model, Australia and New Zealand dairy prices will converge with those of America with a falling US dollar giving further weight to this inevitable trend. Although Oceana will probably continue to use a slightly lower portion of commercial feed in its dairy cattle rations, that cost advantage will probably be offset by higher US dairy cow productivity
Consequently, a raft of short-term, medium-term and long run factors that imply that Oceana's dominant dairy industry will be giving up some market share to its American and European competitors.
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