March 11, 2016

America's consolidation driven dairy renaissance



An eFeedLink Hot Topic
  • Large dairy producers are leveraging their rising market power to extract better terms from processors 
  • Consolidation's falling unit costs has made feed-based US dairy exports competitive with their pasture-based rivals  
  • Vertical integration at home, rising export market shares overseas, are the wave of the future 
  • Rising competitive pressure may induce a restructuring of Australia and New Zealand's dairy sectors

From traditional, family run farms of several dozen animals, America's dairy sector is undergoing a metamorphosis into large-scale, feed-driven operations, many of which own more than 1,000 cattle. This ongoing consolidation process, while painful for small producers, successfully reinvented the industry in a manner that has shaken up the world dairy market.


Based on USDA data, a thirty-six year, 1,600% increase in the amount of milk produced per dairy farming operation coincided with a simultaneous 90% fall in the number of American dairy farms. Moreover, according to a recent Rabobank report authored by senior dairy analyst Thomas Bailey, (Industry Note #536, Feb. 2016, "Economies of Scale Driving Consolidation in the US Dairy Industry"), despite being underway for three decades, the pace of consolidation accelerated over the last decade.


It states that, "the number of dairy operations in the US fell at a compound annual growth rate (CAGR) of 4.7% from 1970 to 2005" -but then notes how from 2005 through 2015, the number of dairy farms fell at an even steeper 5.9% annual rate. Interestingly, while the total number of dairy farms fell sharply, "Operations with over 2,000 head [of dairy cattle] grew at a CAGR of 10% between 2002 and 2012."


While this has been very painful for small farms with fewer than 500 cattle, it has helped boost America's dairy industry competitiveness versus established world market suppliers. From slightly over 100 tonnes per farm in 1970, the quantity of milk produced per US dairy producer rose to 350 tonnes by the early 1990s, 640 tonnes by 2000, 1,000 tonnes by 2010 and over 1,600 tonnes today. It is not coincidental that the largest increases in quantity of milk produced per dairy farm and exports occurred after the mid-1990s.


The accompanying graph clearly shows milk production per farm accelerating from the mid-1990s onwards. This was also when US dairy exports started growing faster than their New Zealand and Australian competitors, eventually overtaking Australia's market share during the late 2000s.

It was in retrospect, a very timely export surge too, as it successfully counterbalanced falling per capita fluid milk consumption: USDA statistics show the proportion of fluid milk processed into dairy powders rising from 52% in 1970 to 64% by 2000 and an estimated 72% this year.


While it partly reflected flat domestic consumption, America's dairy export surge would not have been possible if ongoing consolidation had not boosted output per cow alongside scale productivity. Dairy cattle inventories dropped 25.6%, from 12.1 million head in 1970 to a bottom of 9.0 million in 2005.


Over the same fluid milk output rose 51.2%, from 53.1 million tonnes to 80.3 million tonnes in 2005 and to a USDA estimated 96.35 million tonnes this year. This means that in 1970, the average milk produced per cow was 4,100 litres and by 2015, this had risen to 9,830 litres. New Zealand dairy cattle's milk productivity is approximately half this level, Australia's at slightly over two-thirds of this figure.


Moreover, the American dairy sector's economic incentive to consolidate and innovate is underpinned by a slew of comparative advantages. Scale economies make the unit operating costs of farms with over 1,000 head 25% to 35% lower than those of their smaller rivals. According to USDA data, as of 2014, unit operating costs amount to US$25/cwt for farms with 50 or fewer dairy cattle, US$22/cwt for operators with 200 to 500 head, but only US$16/cwt at farms with over 1,000 dairy cows.


This large difference in unit costs arises from the fact that large dairy farms can spread the cost of expensive dairy equipment over a wide production base. They also purchase such equipment in sufficiently large quantities to get volume discounts. They subsequently re-sell their used equipment to smaller operators before they have suffered a full depreciation loss.


According to the USDA, the dairy sector has capital equipment costs approximately 150% higher than that of other livestock lines. This implies that large differences in capital costs will accelerate the dairy sector's consolidation more than it would that of other protein lines. Moreover, these statistics do not even measure the advantage that well capitalized dairy integrators have in minimizing the risk of feed cost inflation or dairy price crashes through their access to futures markets.


Alongside a significantly lower cost base, large dairy farms have the market leverage to demand higher unit prices for their milk than smaller producers. Moreover, there are several factors behind the rising market power which enables large scale milk suppliers to force dairy processors to pay them a higher price for the same quantity of milk.


First, with US dairy processing capacity significantly exceeding domestic milk production, large dairy farms wield the market power to pick and choose which dairy processors gets their business. Thus, paying a price premium for the milk of such a large supplier is a means of ensuring they do not give their business to a rival processor.


Secondly, Bailey adds that, "Processors tend to prefer large suppliers, as they simplify the logistical chain associated with the collection of milk." Transporting a very large truckload of milk from one large dairy farm is more cost-efficient than hauling the same quantity of milk from numerous small producers over several vehicles. To keep a large dairy farm's business, the processing plant operator then gives back either part or all of the transport cost savings in the form of a proportionately higher unit price for a large producer's milk.


Third, because large producers can afford expensive investments in everything from rapid milk cooling systems to RFID-based feed traceability and herd tracking chips, their milk commands a higher price by being of higher quality and having lower bacterial counts.


Consequently, whereas scale economies always reduce production costs, for America's dairy farms, they also significantly boost unit revenues. With scale economies pulling costs and revenues in opposite directions, the accompanying graph shows that dairy farms with over 1,000 head enjoyed profit margins 35% larger than operators with 200 to 500 head of cattle.


With the market power of large dairy farms increasing not just versus their smaller rivals but also relative upstream dairy processors, some producers are taking steps towards vertical integration with the latter. According to Bailey, giving large milk producers premium prices for their milk is no longer enough: Producers are now, "Asking for things like a voice in the direction of the company processing their milk."


With both market power and value shifting from dairy processors to large milk producers, vertical integration represents the consolidation trend's next logical step, but carries with it risks. On one hand, this would allow large milk producers to boost retail dairy prices and keep a larger proportion of overall profits for themselves. On the other hand, unlike dairy commodities, milk processing returns have not increased over the past fifteen years.


Given dairy processing's think profit margins, the incentive to vertically integrate is one of achieving market power, rather than revenues. This implies that while US dairy consolidation will continue, for now, early steps towards vertical integration will be limited to joint investments, joint operational management or large integrators acquiring seats on their dairy processor's executive boards.


Despite its huge impact on small farms and dairy processors, the competitive threat from America's dairy sector consolidation is being felt far beyond its borders: Traditionally, pastureland-based dairy exporters have had a huge enjoyed huge cost advantages. However, after three decades of consolidation, this is no longer the case with America's feed-based dairy sector.


China's dairy demand is outgrowing Australian and New Zealand's traditional low cost, pastureland production base. Top southern hemisphere producers are becoming increasingly dependent on feed to boost milk output, but have very little experience with this dairy business model. America, by comparison, has spent four decades fine-tuning the art of non-pastureland dairy production to a much lower cost base. This was particularly true in Australia's case, where a decade long drought forced it to rely on feed to a much greater extent than New Zealand.

As the accompanying graph shows, with Australia and New Zealand becoming increasingly dependent on feed, several US states are close to closing milk production cost gap between themselves and these two leading exporters. As a result, from 2000 through 2015, Australia's total exports of WMP, SMP, butter and cheese fell 38% and those of New Zealand increased 123%. US exports of these same dairy commodities jumped 340% over this same period.


Although consolidation's supply-side changes dovetailed with an export boom, it was the industry's restructuring that made its expanding world market footprint possible. As of January this year, America exports 36% of its whey output, 50% of its SMP production and 74% of the lactose it produces. By making American competitive enough to export key dairy commodities, consolidation enabled the industry to transcend the stagnation of its domestic market. 


In 2006, the USDA projected that America's dairy cattle herd, then at 9.10 million head, would by 2016 contract to 8.74 million. -Instead, it increased by 3% or 270,000, to 9.32 million head at the start of this year. With world dairy exports expected to rise at a 5% annual rate from 2017 onwards, it projects America's dairy cattle herd staying constant at 9.3 million head through 2020, then rising to nearly 10 million by 2025.


Flat dairy cattle herds through to 2020 reflects how during this post dairy market crash period of slow growth, productivity increases will be sufficient to meet rising domestic and export demand. Already 40% and 90% more productive than their respective Australian and New Zealand rivals, the USDA projects milk production per American dairy cow is projected to rise another 22.5%, from 9,800 litres in 2015 to 12,000 litres by 2025.


While the large gap between US cow productivity and that of its Australian and New Zealand competitors matters less today, time is on side of American dairy producers. Once world dairy demand resumes outracing supply, Australian and New Zealand producers will become increasingly dependent on feed inputs to meet growing Asian demand. Over time, this will enable American dairy producers to increasingly leverage their large competitive advantage in feed-based dairy production.


Consequently, the only way Australia and New Zealand will be able to keep pace is if they restructure the way they produce milk and consolidate their own dairy production models. It may be a decade away in the future, but the competitive impact of America's dairy restructuring will eventually force a re-invention of Down Under's own industry model.

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