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Keith Woodford says shocks can resolve themselves if there is underlying strength. But our underlying position on WMP is no longer a strength and that needs to change fast

Rural News
Keith Woodford says shocks can resolve themselves if there is underlying strength. But our underlying position on WMP is no longer a strength and that needs to change fast

By Keith Woodford*

Right now, the focus of almost every New Zealand dairy farmer is on survival. It is a time when cash is king.

In the short run, it is all about turning cash inputs into milk. There can be no argument that this means using all available grass, but it also means not having hungry cows. Each farmer will find his or her way of achieving this. It may be through decreased stock numbers or it may be through appropriate supplementation to match feed deficits. In times like these, it is more important to travel the chosen path efficiently rather than to jump wildly from one path to the other.

Despite the focus on survival, it is also a good time to be thinking strategically. At the industry level, have we got it right?  In regard to what we are currently experiencing, how much of it is from one-off shocks and how much is due to structural change within global markets.

Short-term shocks eventually resolve themselves, as long as the industry is operating from a position of fundamental strength. But to the extent that the global situation reflects global structural change, then simply continuing as we have always done will not be good enough.

Our traditional strength in New Zealand has been low-cost seasonal production linked to long-life commodity products. For much of last century, our strategic positioning was based around butter. More recently, and particularly for the last 15 years, our strength has been allied to powder production.   

The traditional New Zealand model has focused on cost-efficient production behind the farm gate. We have been willing to bear the consequent loss of processing cost efficiency arising from seasonal production and hence low utilisation of processing plant capacity.  As long as our focus was commodities which have relatively low capital costs, and as long as commodity production was profitable, then it all made lots of sense.

So what has changed in the last two years? 

Everyone knows that dairy prices have crashed. What is less well understood, at least in New Zealand, is that milk powders have fared worse than other products.

In the case of skim milk powder (SMP), the surplus is in part a by-product of increased global demand for butter.  As a consequence, the Europeans have put about 250,000 tonnes of SMP into store (public and private), with more still pouring in. And thank goodness they have done so, or else SMP prices would have crashed much lower.

Here in New Zealand, we produce about 400,000 tonnes of SMP every year, which goes into the same markets as does European SMP. So in the short term, the European storage has been a blessing for every New Zealand famer. My best estimate is that this storage of SMP is currently buttressing the overall payout to New Zealand farmers by about 30c per kg milksolids, although the precise numbers are debatable. Unfortunately, all of this European SMP will still have to come back on the market eventually.

In the case of whole milk powder (WMP), there has been a decrease in demand for internationally traded product.  This is in part because China is producing more WMP itself, and China now exceeds New Zealand in terms of overall WMP production. It is also because the oil-producing countries cannot afford to buy as much as previously. So prices have crashed, despite New Zealand in particular having reduced its own production of WMP.

This decline in New Zealand WMP production has occurred because Fonterra, within the constraints of its processing capacity, has been preferentially channelling more milk into cheese and butter.

Right now, there are some early signs that global prices for the non-powder prices are rising. Six months ago, the spot price for non-contracted milk in the Netherlands was 13 euros per 100 kg of milk, now it is 26 euros. In Italy the price dropped to 22 euros per 100 kg; now it is 27 euros.

These current prices in Europe are still below the cost of production for most European farmers, but they are above the marginal cost of production. So unless a farmer decides to give up dairying altogether, the logical response is to produce to capacity.  

European farmers are getting farm-gate prices for their milk about 35% higher than what New Zealand farmers are getting. So how is this happening? The answer is a combination of a better product mix combined with lower processing costs from non-seasonal production. In addition, New Zealand and Australian products have been selling at a discount to European products on international markets.

One thing that cannot be used to explain these price differences is European subsidies. This is because European subsidies, with minor exceptions, are decoupled from milk prices.

The key outlier to the European story is Ireland. Like us, they are seasonal producers, with an export focus, and increasingly powder-dependant. It is not co-incidental that Irish farm gate prices are considerably lower than elsewhere in Europe.

Some commentators appear to have been getting ahead of themselves in stating that European milk production increases are essentially over, and that supply and demand will soon come back into balance. Comprehensive European production statistics, currently available through to the end of April, show daily production for April more than 4% higher than March.

Source: EU Milk Observatory

European comparisons with 2014 and 2015 can be misleading because of ‘one-off’ factors leading up to and subsequent to quota removal. Accordingly, I place more weight on comparisons with 2013, the last year of some stability. On that basis, European production continues to track at about 10% above 2013 and that can only mean continuing surpluses.

Within Europe, focusing on any particular country is particularly misleading. Ireland, the UK and some other parts of Northern Europe have stabilised production but this has also been influenced by a late spring. But the Netherlands, Poland and Italy have been steaming ahead at higher production levels. And those increases appear to be structural.

I watch every Global Dairy trade auction carefully, but this next one on Wednesday morning 6 July New Zealand time, has the potential to be a real bellwether event. The volumes of WMP on offer will be up more than 50% from the last sale. Will the buyers from China be there?  If not, we are in trouble. It could go either way. With exchange rate having moved against us in recent weeks, it will need a price increase of about 10% to support the current proposed price of $4.25.

All of this short term stuff is about shocks and their echo effects. But it does help focus the mind on whether we have got it right. Further focusing of the mind comes from looking at what is happening in China, our biggest market.

To see the trends occurring in China it is helpful to go back a few years, with 2012 being a good starting point.  In that year – before the crazy boom starting in early 2013 and continuing through into 2014 – China imported 406,000 tonnes of WMP. In 2015 they imported 347,000 tonnes. In contrast, China’s imports of liquid milk increased five-fold in the same three-year period, and imports of infant formula doubled in this period. Currently, there is a modest but fragile increase in WMP for the first five months of 2016 (up 20%, led by high January imports, but not sustained thereafter), but this is easily outpaced by the ongoing rapid growth in infant formula and liquid milk imports. For the three months March to May, Chinese liquid milk imports, largely from Europe but with 15% of the market share from New Zealand, are running almost double that of last year.

Should New Zealand companies decide to move more strongly into to value-add products, then it will not be an easy journey. The reason for that is that New Zealand is at least eight years behind where it should be.  So there is lots of ‘catch up’ to do.  But there are some good signs of what is possible, such as Fonterra’s mozzarella factory at Clandeboye and the sliced cheese factory at Eltham. And several companies now have UHT plants.

Making ‘value-add’ work for New Zealand can only work if a proportion of farmers move to non-seasonal production. That requires a massive rework of farming systems and this can only be justified with guaranteed price premiums for off-season production.

So it is the processors that need to first provide the signals. It will then be up to each farmer to make his or her own choice as to how they want to proceed, based on whether the price premiums exceed the additional on-farm costs. Different farmers will choose different paths - seasonal production for long-life commodities, or non-seasonal production for value-add products.

In future articles I will have more to say about those seasonal premiums, the need to get those signals clear, and what it means for farming systems.


Keith Woodford is Professor of Agri-Food Systems (Honorary) at Lincoln University and a Senior Fellow (Honorary) of the NZ Contemporary China Research Centre. His archived writings are at http://keithwoodford.wordpress.com

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11 Comments

Fantastic read. In the case of value-added, branded products, I think that it is very tough across Asia with so much competition from Australia, Europe, North America and local. This appears to be the case in Vietnam where local brands have good share and distribution. As a consumer, the only real differentiation I can see to drive trial is through price discounting, which the NZ brands and brands with less market share appear to do. This is SEA and I guess that the opportunities might be better in countries such as India and Sri Lanka.

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can only be justified with guaranteed price premiums for off-season production.
Fonterra (and its predecessors) started off paying significant off season premiums, convincing farmers to become autumn calving then once the numbers were sufficient proceeded to wind the premiums back until they were below the added costs of production - knowing it wasn't that easy to change your production curve. It will need some serious trust rebuilding by the processors to convince farmers who have been burnt before.

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Fonterra missed the boat, went for the path of least resistance, volume. Now its in trouble awash with milk from all the dairy conversions, its created a real issue for itself, when it could have had a much better product mix and versatility. Big is not always best. Encouraged by a National govt, who largely don't have a clue about farming and just go off the hype

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And let us not forget the politically charged Australian situation.
Announcing the Oz new season price this week (given the weekend election) means few chessey smiles....

"From day one I would have been all over Murray Goulburn, insisting that they take responsibility for their errors and their abuse of their powers and that they use every mechanism available to them to keep that milk price higher," Mr Fitzgibbon said.

Chief among those mechanisms, Mr Fitzgibbon said, was for Murray Goulburn to pump the $42 million net profit announced on Tuesday into higher farm gate prices instead of paying it out as dividends.

http://m.smh.com.au/business/turnbull-pledges-to-meet-murray-goulburn-o…

And as other posters note dairy D is front and centre Oz bankers.
If only they had been right and their cashflow servicing using plug numbers NZ$5.75/$5.80 had been the benchmark fgmp.
Who were/where are the bright sparks now.
Jokes aside there was a time when banks and bankers took bad lending/bad cycle funding to heart - careers lost and all that.
Those days seem well past.

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The issue being when certain industry participant(s) have too greater influence and on the flow of ideas, then the collective intelligence drops

https://www.youtube.com/watch?v=XAGBBt9RNbc
its all good, esp 7:30

when you get the same ideas over and over again you get the echo chamber, where then the accuracy of decisions go down and collective wisdom is destroyed

think about having a lend...

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Fonterra Australia next season milk price. Higher than MG.

http://mobile.abc.net.au/news/2016-06-29/fonterra-slashes-milk-price/75…
Major milk processor Fonterra will slash the price it pay farmers next season to an average of $4.75 per kilogram of milk solids (kgms).

The figure is higher than rival Murray Goulburn, which is offering $4.31kgms, but below the opening prices of Bega Cheese at $5kgms and Warrnambool Cheese and Butter at $4.80kgms.

"Our forecast is based on the Australian dollar holding at around 74 cents to the US dollar and reflects the revenue we expect to earn on products produced using our manufacturing assets.

And earning a ?% return on capital (debt costs and equity and debt repayments).

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These updates need to be made available to Fonterra suppliers rather than keeping them in the dark so they can plan ahead and make their own informed decisions about payout rather than listening to the hype

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Does the industry have a HiPPO problem?

Ron Johnson exited JC Penney humbled, with a list of accomplishments that he certainly didn’t intend to leave as his legacy:
• The company burned through nearly $1 billion in 17 months, taking its cash balance from $1.8 billion to $930 million
• Revenue fell by 25 percent in 2012 for a loss of nearly $1 billion
• The company’s market capitalization fell by nearly 50 percent on Johnson’s watch

How does a leader initially hailed as the second-coming of Steve Jobs, ready to reinvent a 111-year-old staid retailer, crash and burn in such dramatic fashion? If JC Penney’s board members had studied Amazon more closely, they might have discovered the answer. Leaders like Johnson have a special name at Amazon: they’re called HiPPOs, which stands for “highest paid person’s opinion.” HiPPOs are leaders who are so self-assured that they need neither other’s ideas nor data to affirm the correctness of their instinctual beliefs. Relying on their experience and smarts, they are quick to shoot down contradictory positions and dismissive of underling’s input.

Arriving with a $52 million package, Johnson was certainly the highest paid person at JC Penney. Fueled by the board’s affirmation of his credentials, the stock shot up nearly $1 billion shortly after his appointment was announced. But in the midst of the positive hype, Johnson didn’t show much restraint in his disdain for the competence of JCP’s personnel or the company’s culture. According to one report, he required the then-marketing Vice President to go through each customer mailing publicly in an exercise designed to show the foolishness of the company’s prior communication and promotion strategy.

When making changes, Johnson trusted his gut rather than the data in front of him. Although he was reportedly shown focus group results clearly indicating consumer’s strong preference for discounts, Johnson pressed ahead with his changes, mandating a fixed pricing matrix for all merchants to follow. The ensuing confusion and consumer defections were at the heart of the company’s 25 percent sales drop.

But Johnson didn’t stop there - he not only ignored existing data, but he was also convinced he didn’t need new information to validate the righteousness of his strategy. Although encouraged by the company’s retail veterans to do so, Johnson decided not to test any of his changes because Apple had never tested when growing its store network. Experimentation in a small number of stores is common practice in retail before nationwide roll-outs. Had Johnson been interested, surely experiments would have provided an early warning that his strategy wasn’t sitting well with customers.

Once execution of the company’s new direction was underway, Johnson did reportedly ask frequently “is it working?” It’s not surprising that few had the courage to speak up and give Johnson an unvarnished dose of reality. The former CEO liked to tell employees that there were two kinds of people - skeptics and believers. At Apple, Johnson said, there were only believers and he expected the same at JCP. It’s not hard to imagine employees hearing that message loud and clear - speak up and you’ll be labeled as a resister. At a time when the company was slashing the headquarters payroll and downsized in total by nearly 17,000 people, Johnson’s dogmatic approach didn’t exactly encourage open discourse.

To be fair, transforming a large company is hard work that requires vision, conviction in one’s beliefs and perseverance. Typical of HiPPOs, Johnson over-indexed in all these traits, seeming to believe that he could will a transformation across hundreds of stores and thousands of employees to happen based on his brainpower and grit. His ultimate downfall was his disinterest and inability to listen to others, whether in the form of customer data or employee feedback.

Amazon, by contrast, has fostered a culture of experimentation in which leaders at all levels are encouraged to test ideas in the marketplace and then let data - not senior leadership opinions - guide implementation.

What happens when a HiPPO runs a company? JCP shareholders know the pain all too well.

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A CEO shouldn't need to be paid so much, the passion for the company should be a reward in itself

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