ANZ economists say the deflationary impacts of lower dairy prices and the broad-based weakness in global commodity prices have shown up in a large drop in the cost of farm inputs

Economists from the country's largest dairy farm lender have welcomed drops in the cost of dairy farm inputs.

In their weekly Market Focus, ANZ's economists say one thing that has become more apparent in the dairy sector is the cost adjustment underway.

"The deflationary impacts of lower dairy prices and the broad-based weakness in global commodity prices have shown up in the cost of farm inputs in 2015/16. It fell 2.9% in 2015/16 – the largest fall seen in data going back to 2000/01," they say.

"This adjustment is welcome and necessary. We stand by our view that dairy prices are not only weak in a cyclical sense; there is structural adjustment going on too. Dairy prices (whole milk powder) are not going to average US$3,500 per tonne over the cycle going forward so forget about the payout averaging $6.50/kg MS; we think something closer to $6 is more likely. If incomes are down on average across the cycle then expenses need to be too."

The economists said that the cost adjustments, alongside other cuts in expenditure and farm management changes, were helping recalibrate cost bases.

"Time will tell how successful these adjustments prove to be and there is no way to sugar-coat the challenges.

"Our expectation is that the average break-even for a dairy farm will fall below $5/kg/MS from $5.25 now (it was $5.50 over a year ago). Prolonged tighter cost control and financial pressures will continue to have wider impacts on many rural communities and support businesses over the next 18 months nonetheless, particularly for cash-flow-dependent businesses. Many farmers have the ability to fall back on equity built up when land prices were rising. Cash-flow leveraged (dependent) businesses don’t tend to have the same luxury and this is the under-appreciated aspect as to where the pain will be focused."

The economists said price falls were occurring in some of the largest dairy expenditure categories.

"To be fair, it is being led by interest rates and fuel, which are of course part of a wider thematic. Both are down around 10% compared to a year ago. But prices are also softer for cultivation, harvest and purchase of animal feed (-5.1%); fertiliser, lime & seeds (-1.5%); weed & pest control (-0.8%); rent & hire (-0.2%) and even rates (-0.2%), which are all more sector-specific.

"Prices are often sticky on the downside; the fact they are falling in the current instance shows the sector is adapting. Together, these cost categories account for around 60% of total farm expenditure on the average dairy farm. Annual wage increases, at just 1.2%, were also the second-lowest in the 16 years of this data, with only 2009/10 recording a weaker outcome (+0.9%).

The economists said that some of these expenses looked set to rebound next season, especially fuel, but there will be more weakness to come for others.

"Indeed, grazing prices have only started re-rating in recent months. The general feed/grain market remains oversupplied, and many service providers are now feeling a more significant pinch and offering ‘specials’. Fertiliser prices are still under downward pressure. This specific pressure comes on top of the lack of wider inflationary pressures within the local and global economies more generally."

The economists believed Fonterra was "prudently" taking a conservative approach to pricing.

"Its $4.25/kg MS opening milk price forecast for 2016/17 looks to be modelled off current market pricing, as opposed to assuming any meaningful price recovery. This conservativeness is appropriate. The past two seasons have taught us that ongoing disappointment is not helpful for planning and budgeting considerations, nor farmer sentiment.

"While this means that farm cashflow in 2016/17 will be better than the last 12 months, it is only at the margin, and not enough to restore profitability for the sector. Based on these figures, we estimate that a fully-shared Fonterra farmer will receive $3.97/kg MS in 2015/16 and $4.40/kg MS in 2016/17."

The economists said until the milk price moves back above $5/kg MS (and higher dividend payments persist) – which they expect in the 2017/18 season – it’s going to be difficult for many farmers to generate profit/breakeven.

"We ultimately expect this season’s payout (2016/17) to end up in the $4.50-$5/kg MS range. This means negative cash-flow for the average dairy farm until early 2018. The cumulative impacts are the biggest concern."

The economists said from a medium-term perspective they were still optimistic.

"We certainly hold the sector in a higher regard than we do many of its global peers, which are pushing (in many cases quite vocally) for government support and subsidies. It has long been a feature in the likes of Europe, but has become more evident across the Tasman of late too. It highlights the political reality of dairying, but is only a Band-Aid answer to key structural and cyclical challenges.

"Interference with market forces will only lengthen the time required to bring the market back into balance.

"We prefer the New Zealand approach, which, while painful, will put the sector on a much more sustainable path over the longer term. It opens up a Pandora’s Box of problems if a sector goes looking for (and expects) government assistance when it gets into financial difficulty."