December 7, 2015
A pause in China's dairy sector recovery
High feed costs, low milk prices and odd WMP market behavior extinguishes a three year dairy market boom. A strong recovery is around the corner, but not for imports.
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Following a half-decade of booming growth, China's dairy industry once more finds itself stuck in a period of flat prospects. At first, a combination of rising consumer incomes, simulative government subsidies and fading memories of post-2008 dairy food safety scandals had put the industry on the path to solid recovery.
For three years from the start of 2011 through the end of 2013, fluid milk production grew at a USDA estimated 4.8% to 6.2% annual rates. Output finally exceeding its previous 2008 high in 2013. With domestic production replacing dairy powder imports and a consolidated industry nimbly ramping up demand, it seemed as if fluid milk production would sustain rapid growth comparable to that of its mid-2000s peak. The USDA initially forecast to rise 4.9% in 2014 and another 4.0% in 2015 –but it was not to be.
Because of the country's government regulated, high-cost feed market, China's dairy sector faces unusually high and inflexible production expenses. When the global dairy market crash deflated domestic prices, farm gate milk prices fell by 12% to 16% lower than a year earlier, putting producers in a net loss position.  –Unfortunately, these negative profit margins occurred just as three years of 5.5% annual growth coincided with the worst recessionary conditions since China liberalized its economy three decades ago.
Thus, after rising 5.6% in 2014, 2015 saw human fluid milk consumption stayed flat at 15.15 million tonnes –when it was originally forecast to increase by 3.9%. Fluid milk used by food processors decelerated even more dramatically. After rising by 11.1% in 2014 to 23.975 million tonnes, this year saw it rise 2.2%, to 24.51 million tonnes. Overall fluid milk demand went from increasing 8.9% in 2014 to a near flat 0.08% increase in 2015.
In late 2014 and H1 2015, with consumer demand falling much faster than fluid milk production, huge, unusable milk inventories accumulated. With production running at a net loss, large producers curtailed output and attempted to run down existing stocks. Already officially encouraged to quit the sector, widening loss margins motivated smaller dairy farms to exit the industry earlier than was anticipated.
Consequently, rather than rising the initially forecasted 4.9%, 2014's production fell back 1.3%, from 38.75 million tonnes to 38.25 million. 2015's projected 4.0% rise in fluid milk output turned into a flat, 0% production increase.  For 2016, both milk output and demand for it will only rise a mere 2%, which is a slow rate usually seen in mature countries, not China.
Milk dried into WMP > Imported WMP turned into milk
Fluid milk production's dramatic fall-off was also an odd side-effect of the world dairy market crash: In particular, a 40% drop in New Zealand dairy import prices was further magnified by the New Zealand dollar's 20% devaluation. As a result, producers found it more profitable to turn large, existing stockpiles of imported whole milk powder (WMP) into fresh milk than to produce it from domestic dairy cows.
Consequently, while fluid milk production levelled off, by the end of 2016, WMP output will have risen 11.1% over two years. By comparison, fluid milk production will have risen just 2% over this same time.
On one hand, the USDA estimates that 20% of retail milk found in shops and supermarkets during 2015 was made from reconstituted WMP. –On the other hand, to prevent unsellable domestic milk from going stale (thereby leading to even higher net losses), a rising proportion of domestic milk was converted into WMP. It was this attempt to minimize losses on domestic fluid milk production that kept China's WMP inventories unusually high –and made the world dairy market crash much steeper than it otherwise would have been.
According to the USDA demand statistics, 20% of WMP is reconstituted into fresh milk, 37% is used in infant formula, 32% in dairy beverages, and 10% in ice cream, yogurt or dairy beverages. Going forward, it expects a high proportion of WMP to continue being reconstituted into milk even after milk producing returns become profitable.
According to the USDA, demand for WMP, "will continue to… be supported by the urbanization process." This is because, "Milk production is located in the northern part of the country while the majority of consumers are located in east and south China. Cold chain networks are not well-developed, making reconstituted [WMP-based] milk a practical choice to meet the demand of Chinese consumers, especially outside major cities."
Unfortunately, with domestic milk being turned into WMP faster than imported WMP could be turned into reconstituted milk jumped 131%, from 130,000 tonnes in 2014 to 300,000 tonnes in 2015.

With WMP accumulating faster than it could be turned into milk, imports crashed 48%, from 617,000 tonnes in 2013 350,000 tonnes in 2015. By comparison, even as of mid-2014, the USDA was expecting China to import 600,000 tonnes of WMP in 2015. This drastic, 367,000 tonne plunge in China's expected milk powder import volume completely upset the world market expectations, and led to the current international dairy market depression.
EU UHT pushes out domestic supplies
Alongside reconstituted WMP, another fast growing source of fresh fluid milk was UHT supplies from Europe. The EU's April 2015 deregulation of its dairy sector led to large exportable surpluses. With early 2015's Euro devaluation further discounting the cost of European dairy products, the EU accounted for 65% of 2015 UHT milk imports, with New Zealand (16%) and Australia (14%) accounting for most of the rest.
On one hand, though it accounted for just 2.5% of retail consumer milk demand, at 380,000 tonnes, 2015's UHT milk import volumes grew by 8.5% -and it was usually sold a at a price premium. On the other hand, due to its lingering bad reputation from a succession of food safety scandals, domestically produced fresh milk was often discounted far more than the actual fall in farmgate prices.
SMP imports track demand fall
But more than just fluid milk or WMP are finding that Chinese dairy market fundamentals changing. With China's milk being relatively low in protein, imports have always been cheaper and accounted for over 80% of consumption –with an even higher proportion in the domestic infant formula industry, where local SMP's reputation remains scarred by 2008's finding of melamine in Sanlu brand formula.
Even so, after growing at 15% to 30% rates for most years since 2000 (and for every year since 2008),  skim milk powder (SMP) consumption dived 18.9%, from 302,000 tonnes in 2014 to a USDA estimated 245,000 tonnes in 2015. This is its steepest consumption decline since a 19%, melamine-driven consumption drop in the late 2000s.
Accounting for such a large portion of total SMP supplies, imports fell with consumption, down 20.9%, from 253,000 tonnes in 2014 to 200,000 tonnes this year. Along with the impact of recessionary conditions on consumer demand, SMP consumption suffered a blow when China announced new regulations on the production of domestic infant formula. Although designed to increase consumer confidence in the safety of local products, it forced suppliers to curtail production.
As a result, rising SMP demand from makers of yogurt and lactobacillus beverages is being offset by lower domestic infant formula output. For 2016, this will lead to a nominal 2%, 5,000 tonne rise in consumption to 250,000 tonnes. Constrained by the high proportion of fluid being turned into WMP, SMP output will fall 11% to 40,000 tonnes, from 45,000 tonnes in 2015. With consumption rising 5,000 tonnes and domestic output falling by 5,000 tonnes, the resulting 10,000 tonnes supply gap will be filled by a 5% rise in 2016's SMP imports, to 210,000 tonnes.
The good news is that with China cutting its official corn price by 10% to 15%, production costs will fall over the next few months. With surplus dairy stocks being run down, lower costs and an impending farmgate milk price recovery will restore profitability.
By the end of 2016, WMP inventories, which peaked at 300,000 tonnes at the start of 2015, will be down to 89,000 tonnes –their lowest level since the heady dairy boom years from 2010 to 2013. Moreover, while WMP inventories are falling, with milk production margins rising, the motivation to turn raw milk into WMP will also decline
The bad news (for exporters) is that production growth will accelerate faster than demand for milk powders recovers. While China will never be completely self-sufficient in dairy products, the exceptional post-melamine scandal years are over: Within a few years, dairy imports will re-touch their 2014 peak but even so, their volumes will not grow at the heady, double digit rates taken for granted at the turn of the decade.

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