December 2, 2016

New Zealand's dairy fortunes slowly turn for the better: New products, more stable future earnings and a long climb back up

An eFeedLink Hot Topic
  • While weather and pastureland conditions improved, low farmgate milk prices, slumping exports caused an average loss of NZ$196,000 (US$143,000) per dairy farm
  • The tendency for traditional fatty commodities to perform better than dairy powders is carrying over into its third year
  • Fluid milk and branded dairy products are fast growing, emerging export lines
  • The huge downturn in milk powder export earnings is keeping milk production flat, making it impossible for the country to fully take advantage of high demand for fattier milk products
  • Improved farmgate revenues, rainy weather, low feed costs will restore farms back to marginal profitability in 2017
  • UHT milk, infant formula and cream are rising from 11% of export volumes this year to 30% by 2022
Although harsh conditions persist in New Zealand's dairy industry, with prices recovering and new product lines emerging the country's dairy cattle sector is finally seeing light at the end of the tunnel. Over the immediate term, H2 2016's drift into La Nina-like conditions brought about significantly improved rainfall and pastureland conditions. Moreover, not only are markets recovering but newer, less commodified and more stable product lines are emerging.
Coinciding with a USDA estimated 5.2% reduction in opening dairy cattle numbers over two years (from 5.17 million in 2015 to 4.95 million head at the start of 2017), this enabled farms to reduce commercial feed intake to minimal levels. Dairy New Zealand reports that use of imported palm
kernel extract, corn-based silage and other feed grains fell by 36%, 12%; and 27% respectively.
This had the effect of boosting milk production while minimizing cost. 2016's resulting 21.3 million tonne milk output, while 3% below 2014 peak levels, was 1.9% more than the 20.9 million tonnes that had been projected.
The bad news is that with farmgate milk prices bottoming out more than 50% below their market peak earlier this year, most farmers are deeply in the red. Dairy New Zealand estimates that for 2016, dairy farmers will have suffered an average net loss of -NZ$1.31/kg (-US$0.96/kg) on the milk solids they produced. With an average farm herd's annual milk solid output amounting to 157,000kg/year, the average New Zealand dairy farm will suffer a whopping 2016 net loss of NZ$196,000 (US$143,000).
Most of the country's farmers covered losses by taking on bank debt and naturally, some defaulted in the process. This has resulted in fewer farmers and a rising farm production scale. According to Dairy New Zealand, from 350 head at the turn of the decade, average dairy cattle herd size per farm rose to 390 by 2013 (before the market crashed) and is estimated at over 430 head for 2017.
Despite the industry's trouble's, thanks to new, emerging product lines, exports (which account for over 90% of output) did better than expected. While the volume dairy commodities that make up the bulk of earnings sagged, led by a 55% rise in fluid milk shipments, overall exports rose 4%, from 3.15 million tonnes in 2015 to 3.27 million in 2016.
Though they too are a minor share of its overall dairy trade, exports of butter, cheese and anhydrous milk fat (AMF) rose 4% to 6%, while whey exports rose by a tenth. Moreover, even though dairy powder losses more profitable product lines, market dynamics are slowly turning more favorable.
WMP exports came in below expectations, amounting to 1.315 million tonnes rather than the 1.36 million initially projected for 2016. This 4.7% less than the 1.38 million tonnes exported in 2015 and 7.6% below the 1.423 million tonnes of WMP shipped abroad during 2014, when the market cycle peaked and turned. Going forward, with much competition from EU producers, 2017 WMP exports will stay stagnant, falling another 0.8% to 1.305 million tonnes.
With almost all production exported, WMP output was also compromised, coming in at 1.325 million tonnes, significantly below 1.37 million tonnes initially expected. 2017 is expected to see slack output slumping further to 1.320 million tonnes. Moreover, while inventories are expected to close 2017 down 5% to 171,000 tonnes (from 180,000 at the start of the 2017), this is still far above the 100,000 to 150,000 tonne WMP inventory levels usually seen during the dairy export boom years.
There was however, good news on SMP exports, as they totaled in 430,000 tonnes rather than the 415,000 projected. The problem is that most New Zealand dairy powder earnings are accounted for by slumping WMP, whose shipments usually exceed those of SMP by a factor of three. Moreover, WMP has the lowest unit production costs of any New Zealand dairy product line. As exports shift from WMP to other dairy commodities, unit costs are higher and returns correspondingly lower.
Thus, even though SMP exports are about 10% above their pre-market crash peak, they are counterweighted by three factors: First, the fall in WMP exports outweighs the increase in SMP shipments. Second, even though SMP shipments have gone up by a tenth, with unit prices down by 35% to 50% below peak levels, earnings have fallen steeply over the past three years. Third, surging SMP export volumes from America, Australia and the EU is expected to cause 2017 SMP export volumes to slump back 10.5%, to 380,000 tonnes in 2017.
All this will wipe out any revenue gains from the slight increase in SMP market prices made over the past year. Hence, from an earnings perspective, dairy powders make up most New Zealand dairy exports and the news is not good: WMP shipments remain far below their peak volume and unit price.
While higher SMP volumes had partly offset their lower market price, with the amount exported forecast to fall 11% in 2017, they will drag earnings down by any amount that an improvement in WMP prices could have lifted them.

On the other hand, a previously mentioned trend towards a higher proportion of exports being fattier, more traditional dairy products is continuing, though with unexpectedly strong fluid milk exports too.
From 2015 through 2016, butter production has consistently come in nearly 5% above the 570,000 to 575,000 tonne range expected, totaling 600,000 tonnes in both of these years.  Not only did fats fall less in price in the current market crash, but demand was higher than expected too.
 After rising more than 10% from pre-dairy market crash levels, the USDA expected New Zealand butter exports to level out at 550,000 tonnes. Instead, 2016 saw them rise a surprising 4%, to 570,000 tonnes, with another 1% increase to just over 575,000 tonnes expected in 2017. With butter demand high and milk output rising more incrementally, the export momentum is causing butter inventories to fall 23.3%, from a USDA estimated 90,000 tonnes at the start of 2017 to 69,000 tonnes by the end of the year.
Similarly, cheese also came in above expectations: Rather than rising less than 1% as was expected, cheese shipments jumped 5.5%, from 2015's 327,000 tonnes (which itself exceeded expectations) to 345,000 tonnes in 2016. Production also responded to the higher export demand, with cheese production rising by 1.4% (to 360,000 tonnes) rather than falling by this amount (to 350,000 tonnes).
A major factor maintaining cheese output and exports up in the face of limited milk production and higher production cost is market behavior: From selling at an average discount of US$500/tonne before the dairy market crash, cheese has sold at premiums ranging from US$400/tonne to US$1,000 tonne in the years since the world dairy market crashed.
At the same time, the growing importance of branded fluid milk can be seen in its revised export statistics. Originally projected to rise a healthy 23.5% by the USDA, its fluid milk exports exceeded all analyst expectations. Instead, they have risen an estimated 52.1% to 260,000 tonnes in 2016, from 171,000 tonnes the previous year. Fluid milk exports have risen by 9.8% annually in the ten years since 2006, when they totaled 67,000 tonnes.
Moreover, the rate of expansion has picked up in recent years and is currently at its peak. For 2017, fluid milk shipments are expected to boom another 15.4% and total 300,000 tonnes. Over the longer term, liquid milk exports, though a small portion of output have jumped by a factor of 10, from 0.14% of fluid milk produced in 1995 to a USDA estimated 1.4% in 2017.
Nor is fluid milk the only branded, non-commodity product experiencing an export boom. At 55,000 tonnes, infant formula exports are more than double the level of two years ago.  According to the USDA, "Once the regulatory changes in the Chinese market are fully implemented and IMF [infant milk formula] producers in New Zealand are fully compliant, it is likely there will be further significant increases in total worldwide exports up to a level of 150,000 to 200,000 metric tonnes annually." Up already by a factor of ten in less than a decade, we can expect New Zealand's exports of infant milk formula, particularly to China, to triple by the middle of the next decade.
The only problem is the fact that milk powder revenues determine New Zealand fluid milk production more than exports of butter, cheese, fluid milk or infant formula. Thus, with SMP and WMP earnings firmly in the red, milk output was curtailed to the point that the country could not produce enough butter, cheese or AMP to take full advantage of the exporting opportunities available. That is also why even though world demand for fattier dairy products is holding up well, other countries will take advantage of the situation, as flat milk output will constrain New Zealand's 2017 output of butter and cheese.
The good news is that New Zealand-based Global Dairy Trade's overall price index –though still 40% below its market peak, rose by approximately a third over the past year and 50% above its secular 2015 low. In response, after plunging from NZ$8.40/kg in 2014 to below NZ$4.00/kg in early 2016, Fonterra's trend setting farmgate milk price rose to near US$4.80/kg in the fourth quarter and is expected to range in the NZ$5.25-75/kg range in 2017. To this can be added the fact that the past two harsh years have seen farmers make significant cuts to their dairy cattle herd overheads and non-pasture feed costs.
With the world dairy market finally showing signs of recovery, there will be a staunching of the huge losses suffered by New Zealand's dairy farmers over the past two years. From a Dairy New Zealand estimated peak profits on milk solids of NZ$1.80/kg, earnings plunged into a net loss position of NZ$1.40/kg in 2016. The new year should see a modest movement into the black and average milk solids earnings of up to NZ0.20/kg.
Hence, while dairy powder and traditional fatty product exports volumes will fall for a third straight year, this will be counterbalanced by fast rising fluid milk shipments. Moreover, for the first time since the dairy market crash occurred three years ago, lower dairy powder export volumes will be more than offset by significantly market prices, resulting in a net increase in earnings.
Moreover, with La Nina conditions promising above average precipitation throughout 2017, it would not be surprising if production of fluid milk and dairy commodities exceeds our conservative forecast. With both production and unit prices promising their most significant improvements, next year will be one of recovery and the start of a new industry market cycle.
The new market cycle will not see the price inflation or exponential export growth taken for granted in the 2010-14 dairy boom. On the other hand, with consumer purchased, branded goods such as fluid milk and infant formula making a rising proportion of New Zealand dairy exports, over the long run, its dairy farmers will enjoy higher value-added export earnings with considerably less profit volatility than they have experience over the last decade.
Thus, after three very harsh years, New Zealand's dairy farmers will finally see a light at the end of the tunnel in 2017. It will however, take a further, China-driven improvement in dairy market fundamentals to restore earnings back to normal levels; and that is at least one year away.

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