January 25, 2016
Second bear market collapse portends another difficult year for dairy exporters
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  • Adjusted for inflation, dairy commodities are cheaper now than at any time since online trading began in the mid-2000s.
  • 2014 and 2015 price upturns are revealed to be classic 'bear market rallies'
  • China's recession coincided with unexpectedly high Australian, American and EU output, implying flat, soft prices throughout H1 2016
For the second time since the world dairy market crashed two years ago, prices rallied for one to two quarters before collapsing back to their bottom. The pattern was confirmed in recent Global Dairy Trade's (GDT's) bi-weekly auctions.
Having fallen from a secular peak of 1,482 in February 2014 to 566 in July 2016, the overall GDT index rallied to 837 by mid-October. This was due to tighter dairy supplies from Australia and New Zealand, anxiety over El Nino inducing dry pasture conditions in those countries, alongside aggressive buying by importers in Southeast Asia and the Middle East, who took advantage of low prices to restock their inventories.
Thereafter however, with Oceana's weather staying wet despite El Nino conditions, production did not suffer as much as expected.
In particular, Australia had a wet winter followed by a warm spring, which is ideal for boosting both pasture growth and dairy cattle productivity. Moreover, while El Nino did not lead to dry conditions in Oceana, it did increase Latin America's rainfall, leading to more exports from Brazil and Argentina.
Thereafter, H2 2015's restocking exercise of second tier buyers was not followed by a hoped-for return of aggressive Chinese buying. Thus, January 2016 saw prices down 16% in two months, with the GDT overall index at 708, approximately 52% below its 2014 secular peak, and 58% below its 2007 all-time high of 1,691.
The fact these are bear market rallies is revealed in the fact that even after the second mini-rally ended, the GDT index was lower than it was before the first such rally started.
The true depth of this market depression however, is revealed when we conservatively assume an average inflation rate of 2.5% over the last ten years. When the GDT index's value is discounted for such an annual inflation rate, we see how in constant dollars, its 2011 and 2013 and 2014 market peaks stood 25% to 30% below its 2007 all-time high. -And we also see how, when inflation is factored in, dairy products are actually cheaper today than at any time since online global dairy trading commenced
WMP's nominal, immaterial price drop was kept from being much steeper by many second tier buyers, who bought considerable quantities forward. The bad news is that their aggressive inventory restocking means that they will demand less in months to come. In effect, some of today's deflation was postponed to the next quarter.
Over the longer term, we see the market making adjustments that conform to the maxim, "the bigger they are, the harder they fall." Whole milk powder (WMP) and skim milk powder (SMP) that enjoyed exceptionally high demand during the 2006 to 2013 boom years, fell the hardest –down 56% and 62% respectively from their early 2014 peaks.
On the other hand, while their western consumer base never expanded by much during the long dairy boom, butter and cheese fell by just 33% and 42% from their respective secular highs.
Of course, during both rallies and bear markets, commodities overshoot their equilibrium points, with steeply falling commodities doing so by a greater margin.  Thus, it is not surprising that during last year's second bear market rally, WMP and SMP increased by 60% and 70% respectively -but from a lower starting base, thereby leaving them significantly further below their early 2014 peak than butter or cheese, which were partly stabilized by lackluster but steady demand from the west and wealthier East Asian countries like Japan.
Hence, even before early 2016's price weakness, late 2015's rally was due to forces, both market and environmental, that have mostly worked themselves out. On one hand, the market had hoped that the ongoing culling of Oceana's cattle, particularly in Australia, would dovetail with El Nino dryness to significantly curtail supply. But southern hemisphere weather, while not ideal, was not as arid as initially feared.
According to Rabobank's Q4 Dairy Quarterly, a 2.8%, post EU dairy market liberalization's supply 'surge' and dairy prices above the world average in the United States mean that, "Production growth has slowed considerably in export regions, but not enough to avoid a small increase in exportable surplus."
The report estimates that while August-October milk production was 3.7% lower in New Zealand, it was more than offset by quarterly increases in the EU (+2.8%), Australia (+1.1) and America (+0.5%). Coming at a time when global liquidity is drying up and China's recession is curtailing the number one importer's demand for milk by-products just as supplies unexpectedly increased.
Moreover, all this is the outcome of an unusually buoyant supply trend that has defied a 50% market crash. Ironically, dairy output briefly fell in 2013, when producers expected the downturn to hit –but prices stayed high.
When China continued aggressive importing for another year into early 2014, top seven dairy exporter's behaved as if the trend would last forever: During all of 2014 and through the end of 2015, top supplier's milk output defied the 50% market crash: Instead, collective milk production actually grew more rapidly during the dairy market depression years of 2014-15 than during the 2010-13 boom years.
We especially see this in H2 2015's bear market price rally: This upturn came after a nominal, Q1 2015 drop in top exporter's milk production. However, when their output resumed growing in H2 2015, no sooner did the news hit the market late in the year, prices again collapsed.
Going forward, Rabobank's report expects strong EU export margins, particularly for butter and cheese, to keep that continent's milk output growing. With EU output increases offsetting declines in America, Australia and New Zealand, top seven exporter's milk production is expected to merely level out, instead of fall sharply as was previously expected.
From a conservative point of view, this implies that dairy prices should stay depressed below 50% of their early 2014peak well into the middle of this year. It also means that even if output falls in the second half of the year, should recessionary economic conditions developing in China, Brazil and Southeast Asia worsen, a trend of low and falling prices can easily span the whole year and continue into 2017.

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