August 3, 2015
Dairy market apocalypse
Stakeholders ask for trading to be suspended but the worst may be yet to come.
An eFeedLink Hot Topic
The world dairy market is officially in a panic: Early 2015's price rally has given way to a new round of mid-year deflation. Since their bear market rally peak in February, Global Dairy Trade Index's overall price level fell 46% by mid-August -and a whopping 20% in from mid to late July.

At the time of publication, New Zealand dairy executives and academics were calling for GDT's bi-weekly auction to be suspended.  The problem is that stopping trading will not change the oversupply situation at hand. As our report below implies, with production in America and especially the EU still overproducing, what the market needs more than ever is a strong price signal to curtail production -something we see happening by the fourth quarter.

On the positive side, lower prices are finally being interpreted as market signals to produce less, causing the USDA to slash its American and New Zealand fluid milk production forecasts by 2%. Among major exporters, only Australia's output forecast stayed constant, as improved pasture grazing conditions boosted dairy cattle productivity enough to offset the impact of higher than expected culling rates.

On the negative side, the worst part of the demand downturn may yet come. Even so however, some product lines and regions are faring far better than others. The divergence in market performance can be seen in powder lines, where the USDA expects world whole milk powder (WMP) exports to fall by 8% in 2015; but skim milk powder (SMP) and cheese exports to rise 5%.

Even though EU milk prices have fallen below a level where they can cover dairy cow input costs, the cross-continent herd expansion that had been undertaken prior to April's market liberalization means that EU milk output will remain constant, with a tendency to rise later in the year.

Moreover, this rise in output is putting EU producers in a paradoxical position. While European exports are clearly taking market share from traditional suppliers like America and New Zealand, their domestic situation is another matter. Shortly after the European dairy market was liberalized in the early second quarter, the EU announced that it would be extending its price support for SMP and butter.
SMP's nasty China surprise
Through September 30th, the EU will be mopping up excess supplies, purchasing SMP and butter at US$1,851/tonne and US$2,417/tonne respectively. With Australia and New Zealand now selling SMP for a whopping 23% less at US$1,419/tonne and butter for 5% less, the EU will have difficulty exporting its way out of butter and dairy powder overproduction -especially given the New Zealand dollar's ongoing, steep devaluation.

Up to now, New Zealand has taken the brunt of the SMP's market adjustment, with its output falling 3.8% from 2014's 400,000 tonnes to 385,000 tonnes this year, the worst may be over for it. For EU producers who have not responded to market signals, the worst could just be starting.

Partly due to April's market liberalization, partly due to new production capacity in France and Germany, EU SMP output is expected to rise 5%. Moreover, the EU's price floor not only encourages overproduction but ensures that supplies will remain too expensive to be exported. As a result, instead of falling 8% from 1.543 million tonnes as the USDA initially forecasted, EU SMP output is now projected to rise 5%, to 1.62 million tonnes.

The good news is that up to now, EU SMP exports to Thailand, Philippines and Vietnam have offset the downturn in Chinese demand. So much so that EU SMP exports are now projected to rise by 8%, thanks in part to the Euro's lower value.

The bad news is that even with Southeast Asian demand taking off, Europe's overpriced, and subsidy-bloated SMP output is about to collide into an unmovable wall: If its 2015 forecast comes true, EU SMP output will have jumped 74% in three years. Given the continent's slow, incremental demand growth, this extra output made its way to the world market at a time when world prices and import growth started declining from its peak growth phase.

For example, China's SMP consumption jumped 61% in three years, from 186,000 tonnes in 2011 to 300,000 tonnes in 2014. Its SMP imports jumped even faster, nearly doubling from 130,000 tonnes in 2011 to 253,000 tonnes in 2014. The USDA initially expected China's SMP consumption to ride the back of low prices and jump to 360,000 tonnes in 2015 -with imports supplying 310,000 tonnes of this amount.

Instead, it had to scale back its Chinese SMP consumption estimate to 249,000 tonnes -a whopping 17% year-on-year drop in production. Similarly, China's 2015 SMP imports, which were initially expected to total 310,000 tonnes, where sharply revised back to 200,000 tonnes, a whopping 53,000 tonne, 26.5% year-on-year decline. Moreover, due to the ferocity of China's economic downturn and its expected 8% rise in domestic SMP output, even these Chinese dim SMP import estimates may turn out to be too optimistic.

Granted, New Zealand, which relied on China's market more than any other exporter, has taken the brunt of this downturn in Chinese demand. Nevertheless, there appears to be a growing imbalance between European production, which has been liberalized (while enjoying official price support), and falling Chinese demand. It may put SMP prices in the tank for some time to come.

At this time, the only country where rising SMP supplies are not blunting the bottom line appears to be the United States. Its expected 7% rise in SMP output from 0.995 to 1.06 million tonnes is comparable to Europe's 8% increase. -Except that in America's case, domestic SMP consumption is rising a proportionate 7.3%. Europe's SMP consumption is only increasing 2.3%, but its output is rising 3.5 times faster.

Moreover, in Mexico, America has near exclusive access to a fast growing and more economically stable market. In particular, with its domestic consumption rising 8% in 2015 to 285,000 tonnes, Mexican SMP imports which are sourced from the US, are up 11.3%, from 203,000 tonnes to 230,000.

With Mexico absorbing 67.5% of the 40,000 tonne increase in US exports, producers made sure that the rising US dollar would not hold them back in the rest of the world: According to industry reports, thanks to high domestic prices for butter (of which SMP is a by-product), American producers are using high domestic butter prices to subsidise their SMP exports to a competitive price level.
WMP in sorry condition
While the SMP market has its bright and dim geographies, this is not the case with whole milk powder (WMP), its primary supplier, New Zealand, or its main customer, China, which absorbed 61% of world imports in 2014.

China' domestic WMP output is rising a relatively anemic 1.9% or 25,000 tonnes to 1.375 million tonnes. Unfortunately, it inventories have jumped from 60,000 tonnes in 2012 to 154,000 tonnes at the start of this year. When low consumption caused these bloated inventories to not fall by much, China drastically slashed its WMP import volume. From 671,000 tonnes in 2014 and the expected 600,000 tonnes this year, the USDA now expects China to only import 400,000 tonnes of WMP in 2015, an exceptionally steep 40% less than a year earlier.

As is the case with the other estimates mentioned, this too was made prior to China's recent financial market crash -but it represents a drop in WMP imports equal to more than 20% of the world market. Although New Zealand did an admirable job of boosting exports to alternative markets such as Malaysia, the UAE and Algeria, they cannot completely offset such a huge downturn in Chinese demand. Consequently, New Zealand's H1 2015 exports to China are down 65% but its overall WMP shipments were down 7%. The realization China was not coming back to the market anytime soon came in mid-year and with it, SMP prices took another steep dive.
Cheese fundamentals finally give way
While the world market for cheese has suffered less than that for SMP and WMP, this has not been true of late: Cheese is more likely to be consumed in the west than SMP or WMP. Initially, strong demand in North Asia and China enabled the US, Europe and New Zealand to sustain cheese export growth, with the latter's shipments expected up 22% over 2014 levels for January through May of this year.

Unfortunately, Russia's ban was followed by its extension through to August 2016. The latter is also taking a toll on exporters, particularly European ones. As a result, from late June through early August, world cheese prices fell approximately 20%, more than any other dairy line.

Reflecting the fast export pace prior to Russia's ban, EU January through April cheese exports were 12% lower than in 2014, but thanks to rapid export growth in non-Russian markets, 2015 volumes are expected to fall to 700,000 tonnes, just 3% below last year's USDA estimated 721,600 tonnes. The large decline in shipments to Russia were in large part offset by higher exports to Switzerland, Japan, and most especially the United States.

Although American cheese imports are virtually flat at 120,000 tonnes (versus 122,000 tonnes in 2014), the source of these supplies is changing. With the Euro having fallen sharply against the US dollar, EU cheese exports to America are up 24%. This is due to an estimated 2.4%, fast-food led consumption increase. With US cheese production growing by 1.6%, market share has been grabbed by the EU from Australian and New Zealand exporters.

However, after mid-July's large drop in world dairy prices, New Zealand's own currency plunged. With only America poised to turn in above average consumption growth, there is no demand driver to compensate for the currency-driven cheapening of New Zealand's cheese, thereby implying further deflation.

Going forward, the overall market finds itself in a bind. While product lines consumed by wealthier countries are doing better than dairy powders previously sought after by developing nations, dairy cattle inventories have to keep falling before supply can be throttled back enough to meet demand. Consequently, as the accompanying graph shows, there is a persistent, widening gap between exportable dairy supplies and import demand. With both commodities and world liquidity in a marked downturn, world dairy consumption, particularly in China.

Although this implies that there could be a third deflationary round, at least feed costs also look to be fall by a proportionate amount. Still, even if loss margins stop widening, it is going to be a long road back to yesteryear's profitability.

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