January 13, 2017
Shifting gears in China's stagnant dairy sector: Momentum shifts from dairy powders to fluid milk imports

An eFeedLink Hot Topic 
  • Low farmgate milk prices, poor returns are causing milk production to slump, with much demand met from reconstituting WMP
  • With WMP stocks running down to nil levels, milk prices should firm up, with returns, production rising more strongly from 2018 onwards
  • Fluid milk imports for consumer consumption now exceed combined import volume of WMP and SMP. Will become even more important in the future
  • The running down of WMP stocks could spark a new dairy price cycle later this year but with foreign WMP at near parity with Chinese supplies, growth will be limited
Nearly a decade after the melamine scandal, China's dairy sector continues to be defined by uncertain returns and turmoil. The country's hunger for commodities that powered the dairy boom may have long fallen off but new market trends are taking their place.
Once again, a much-heralded resumption of the dairy industry growth China once took for granted has been aborted. After peaking at a USDA estimated 39.05 million tonnes in 2015, milk output fell a steep 4.5% to 37.3 million tonnes in 2016.
With 2017 output expected to total 36.5 million tonnes, the 6.5% two-year drop will leave milk production at its lowest level since 2013. If one excludes other ruminants, cow's milk production suffered an even steeper 6.8% fall, from 37.5 million tonnes in 2015 to a USDA projected 35.0 million tonnes this year.
Stagnant milk production is a symptom of depressed milk making returns. During 2016 and into early 2017, fluid milk stayed near RMB3.50/kg (US$0.50/kg), nearly 18% below its secular peak of above RMB4.25/kg in early 2014. This caused over half of Chinese dairy farms to suffer net losses, with many of the smaller ones closing, the latter being the continuation of a trend that started four years ago.
Indeed, the echoing aftershocks of the 2008 melamine scandal can be seen in dairy cow inventories. From 2000 through 2008, they rose 166%, from 4.60 million head to 12.25 million. In the eight years since the scandal however, they increased a much smaller 14.2%.
The problem has been made worse by the last two years of depressed dairy farming returns. Peaking at 15.6 million head in early 2016, large losses, skyrocketing fluid milk imports and the exit of small farms from the industry boosted culling rates.
Consequently, dairy cattle inventories plunged 10.3% and entered 2017 at 14.0 million head, their lowest level since 2012. Milk production fell by considerably less than dairy cattle inventories because producers are find it cheaper and more profitable to supply fluid milk demand from reconstituted WMP than from feeding and milking dairy cows.
The reliance on WMP to meet local milk demand can be seen in its inventory levels. From a bloated 350,000 tonnes in 2015, they fell to 150,000 tonnes in 2016 and the USDA expects them to total nearly zero by the end of 2017 –which could in turn spark a world dairy market revival.
Despite all its troubles, the Chinese dairy market's deflated state has concealed a new, very strong trend: Explosive growth in fluid milk imports. Simply put, after the melamine contamination crisis of 2008 and several dozen subsequent scandals, China's consumers perceive imported milk as being safer, though food processors clearly prefer less expensive domestic supplies.
Based on USDA figures, from 2007 (the year before the melamine crisis occurred) through 2017 inclusive, fluid milk imports will have risen a whopping 22,400%. Most of this growth only occurred after 2011. That is because several dozen new milk safety scandals in the three years after the original melamine incident made Chinese consumers 'throw in the towel' and give up on the idea that their domestic milk supply would ever be safe enough to drink.
From a mere 4,000 tonnes in 2007 and 41,000 tonnes in 2011, fluid milk imports skyrocketed to 460,000 tonnes by 2015, 650,000 tonnes in 2016. In 2017, they are on track to rise another 38.5%, to 900,000 tonnes. More double digit import growth and volumes well in excess of a million tonnes are forecast through the end of the decade.
More telling, consumers' fluid milk consumption only increased 119,000 tonnes from 2007 through 2017 inclusive (it would have risen much more had it not been for food safety concerns). Over this same decade, imported fluid milk consumed has risen by 896,000 tonnes.
With its economy mired in recession, 2016 saw fluid milk consumption fall 760,000 tonnes, from 15.36 to 14.60 million tonnes –but milk imports jumped 190,000 tonnes or 41% to 650,000 tonnes. This year, a 100,000 tonne, 0.7% rise in consumption to 14.7 million tonnes will be dwarfed by a 250,000 tonne rise in fluid milk imports.
In 2016, for the first time ever, imports of milk exceeded those of WMP plus SMP combined. Moreover, with the New Zealand dollar's devaluation followed by that of the Euro, imported milk's low price undercuts domestic supplies, giving strong growth momentum over the medium term.
The dairy market crash, Euro's fall and EU's dairy market liberalization all occurred within 1.5 years of each other and gave the continent's UHT milk a strong competitive advantage. Based on China customs data, this has given the EU a 63% share of Chinese fluid milk imports, followed by New Zealand's 18.4%, Australia's 10.5%, with other countries accounting for the remaining 8%.
Fluid milk aside, New Zealand continues to dominate dairy powder lines, supplying 62% of China's SMP imports and 90% of its WMP imports respectively.
With respect to WMP, with much of it being turned into fluid milk, consumption has exceeded USDA estimates by 100,000 tonnes in each of the last two years. 2017's 1.9% WMP consumption growth, while weak by Chinese standards, is still defying a strong undercurrent of recessionary macroeconomic conditions.
The substitution of reconstituted WMP in place of real fluid milk initially pushed production above expectations. In 2015 for example, the USDA forecast 1.30 million tonnes but the actual quantity produced was 1.61 million. Since then, with dairy cow numbers falling WMP output fell to 1.38 million tonnes in 2016. This year, with inventories falling to near zero levels, they will try to get as much WMP as possible out of the existing, diminished dairy herd, which will amount to 1.4 million tonnes.
With this year's WMP consumption forecast for 2.1 million tonnes, demand will be met by rebounding imports. Though well below their 670,000 tonne peak set in 2014, WMP imports are forecast to rise by 25%, from 360,000 tonnes in 2016 to 450,000 tonnes this year.
With closing inventories set to close out 2017 at somewhere between 0 and 50,000 tonnes, the import requirement may be adjusted to maintain safe minimal stock levels. Another factor favoring a longterm resumption of WMP import growth is the scheduled start of WMP production in newly built, Chinese owned dairy facilities in Australia and New Zealand. They were constructed with exporting to China in mind.
Milk formula will account for 35% of WMP consumption, with reconstituted milk (28%), dairy beverages (20%), bakery products (10%) and yogurt (7%) accounting for the rest.
With respect to SMP, with official Chinese regulations discouraging its manufacture, 2017's production (40,000 tonnes), consumption (220,000 tonnes) and imports (220,000) tonnes are forecast to stay unchanged from 2016 levels. Although milk beverages were expected to result in demand growth, the USDA reports that alongside recessionary economic conditions, "beverage consumption has been decreasing due to lack of new and innovative products."
While New Zealand (62%) held on to its share of WMP imports, the US (8%) and Australian (9%) shares have been significantly reduced thanks to a sure in European SMP shipments, which now account for 21% of imports.
Going forward, there are three aspects to Chinese dairy market forecasts. First, with the ability to produce mass quantities of milk from dwindling WMP inventories exhausted, the balance between fluid milk supplies and demand has tightened in recent months, and will continue doing so. This should bring about a recovery in farmgate milk prices and profits, making larger dairy production increases possible from 2018 onwards.
Second, while WMP stocks are dwindling rapidly, the competitive price advantage of exporters is rapidly eroding. According to Rabobank's Q4 Dairy Quarterly, from an approximate 35% price advantage at the start of H2 2016, it almost costs as much to import WMP as it does to produce it in China. This implies that while its dairy demand for milk powders is turning upwards China will not resume the massive dairy powder import growth that was seen circa 2010-15.
The market is splitting into two sections. Food processors account for a majority of overall dairy demand. It seeks the cheapest possible supplies from any source. As smaller but lucrative consumer segment is willing to pay for imported higher quality fluid milk for personal domestic consumption. From the 2020s onward, the latter will make China's UHT milk imports as important a part of the world dairy market as commodity powders were a decade earlier.

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