Westpac economists say drought might cost economy nothing because Fonterra has 'cornered' the powdered milk market, driving prices up

Westpac economists say drought might cost economy nothing because Fonterra has 'cornered' the powdered milk market, driving prices up

Westpac economists say the severe drought might ultimately cost the economy nothing because of the way Fonterra has been able to drive up prices in the whole milk powder market.

In a paper titled 'Drought, Chinese Mums and the Price of Milk' , the economists say the drought has revealed Fonterra's "market power" and the way it has "gradually cornered" the fast growing Chinese whole milk powder market.

"In eight short weeks, world whole milk powder prices have surged to record levels. In the four auctions to April 2, whole milk powder prices shot skyward, rising 62%. This is largely a consequence of drought in New Zealand," the economists say.

"...Incredibly, the net cost to the economy of the drought could be close to zero. World dairy price increases could offset the costs of lost production due to drought."

The economists say they expect that what the drought and lower production has taken out of dairy farm incomes, the higher prices "have put straight back in".

"The higher revenue for New Zealand Inc. is enough to cover higher dairy farm costs such higher feed costs and the transport of stock."

The economists have estimated the net financial effect of drought on the dairy farming sector. It is is based on Westpac's latest estimate of Fonterra’s total payout (before retentions for a fully shared-up farmer) of $6.60/kg compared to the bank's $6.00/kg estimate prior to the drought. The economists also assume a five percentage point drop in production growth due to the drought from their estimates for production prior to the drought, and increased farm costs of between NZ$200m and NZ$400m.

What they get is: A gain on the milk price of NZ$1.01 billion, a loss on production of NZ$510 million, increased costs of NZ$200 million-NZ$400 million, leaving a net financial effect of between plus-NZ$100 million and plus-NZ$300 million. They say, however, that results will "differ widely" between farms and between the North and South Islands, with those in the South doing much better.

The economists say the drought has affected the meat sector, much as expected. However, they think the net negative cost to the meat sector is unlikely to offset the positive impact in the dairy sector.

They estimate the drought will have an overall negative impact of about 0.6% on gdp figures this year, with most of the negative impact coming in the June and September quarters.

In explaining exactly what has happened with milk prices, the economists say that over the past five years, Chinese demand for whole milk powder has increased by over 600,000 metric tons or the equivalent of annual EU production.

"In annual terms, demand has grown by 11%. New Zealand has met most of this demand."

Chinese demand for dairy products and New Zealand production were now "very much intertwined".

"Chinese demand is still growing at a rapid pace, so when dairy production in New Zealand dives the effects are immediate. With no other producers able to fill the gap, one thing has to give – prices.

"And Chinese Mums insist on baby formula made with foreign milk powder (the majority of which is from New Zealand), no matter what the price. In these current whole milk powder market conditions, Fonterra effectively has market pricing power."

The economists say the conditions that made this situation possible have been brewing since 2007 or longer.

"Firms that have market power can reduce the supply of the good or service that they produce, pushing up the price by more than the fall in supply – so that their revenue increases."

The economists say the best historical examples of this kind of market power were Saudi Arabia in the world oil market and de Beers in the market for diamonds. Both Saudi Arabia and de Beers, while not having full control over their markets, were large enough players in the traded part of their respective markets to be able to adjust their supply and influence the market price. When the price was high they could increase supply, and vice versa when the price was low.

"Fonterra now shares similar market power, particularly, in the short run. This is precisely what has happened in the whole milk powder market, albeit it took an act of nature for these conditions to surface."

China had said to the world “we want milk”, and New Zealand had said “sure thing”, the economists say.

"This is a victory for smart policy and smart business. New Zealand’s free trade agreement with China has helped. But the main victory is that the price signal has been heard loud and clear by New Zealand farmers, and they have responded by producing more milk."

Fonterra had "done its bit" by getting supplies to China efficiently in a form that works for the Chinese market. For example, manufacturers there can easily transform the powder into baby formula for Chinese Mums.

"The only other producing regions capable of competing with New Zealand in world dairy markets have missed the Chinese boat. Shoddy European farm policy has meant authorities there have been too pre-occupied protecting their own patch (and incomes) for European farmers, while US policy has led farmers there to focus on their domestic market at the expense of exports," the economists say.

The Westpac economists expect that any future droughts will have a similar impact.

"New Zealand will continue to dominate whole milk powder exports, while Chinese demand growth will continue to outpace supply. Moreover, we don’t think that competing producers have their act sorted, and that it will take them several years at least for them to do so."

Overall, this evidence suggested that New Zealand’s terms of trade will stay higher, and trend higher over the next several years versus what was known prior to the drought, the economists say.

"A higher terms of trade means higher incomes for the economy in general. Moreover, higher New Zealand Inc. income over the next several years will be reflected in a higher exchange rate, which will boost New Zealand households’ purchasing power and thus increase their living standards. On the flip-side, a higher exchange rate will hamper non-agricultural exports.

"...And so it seems that drought has shown us that market power and Chinese Mums have a lot to do with the price of milk."

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

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Great news for farmers and NZ in general, shows how smart Fonterra have been over the last decade or so. Should give us a few years at least of higher prosperity at least, although other producers may catch up eventually.

Peering from the window of my Financial Hub, surrounded by pastures green, I couldn't help but think what the world needs now are cows sweet cows, no, not just for some, but for everyone.
I'm just so so glad their not chickens out there, I'd probably have to find and count the yet born.....and that wouldn't be good for anybody.

We don't think Fonterra has cornered the market.
We think the comparison to de beers or oil is poor.
We think exports to China are to a degree at the indulgence of China. NZ is not the only locale China is looking to source dairy. Price variation like this will only encourage more so
We think the impact of the bilateral trade agreement has been understated and note that the Australians are well on the road to obtaining the same.
We suggest the analysis of infant powder in China market is lacking, especially the activities on Corp/Big ag groups.
Even if payout were to reach the $6.60 before retentions, this mark is still well below a farmgate price of $7 that many converted at....

What a load of codswallop. The north island is rooted. If you doubled the payout it is still rooted. The payout is below average, the beef and lamb schedule is below average. There is no silage and baleage left to feed stock through winter.
"ultimately cost the economy nothing" what planet are these idiots on?

Farmers are killing capital stock, good dairy cows, beef cows, ewes are going to the works right now. They can not be fed. Go back to school Mr Economist, preferably redo your biology and maths classes. You need live animals and feed to make the produce. Zero times a large number is still zero.

Couldn't wait till Friday.

A truck driver amused himself by running over economists as they walked down the side of the road. Every time he saw an economist walking along the road, he would swerve to hit him. There would be a loud "thud", and then he would swerve back on the road.

As the truck driver drove along one day, he saw a priest hitch hiking, ...he pulled over and asked the priest, "Where are you going, Father?"

The priest said he was on his way to his church up the road.

"I'll give you a lift."

The priest climbed into the passenger seat and the truck driver continued down the road. Suddenly, the truck driver saw an economist walking down the road and instinctively swerved to hit him. At the last minute, he remembered he had a priest in the truck and swerved back onto the road. Even though he knew he missed the economist, he still heard a loud "thud." Unsure of where the noise came from, he glanced in his mirrors. When he didn't see anything, he turned to the priest and said, "I'm sorry, Father. I almost hit an economist."

The priest replied, "That's OK, I got him with the door."

Those economists obviously haven't heard about Ireland
"There is a 5-7% milk production increase predicted for this year and if that increase is going to be repeated year on year the Irish will indeed be on course to increase production by 50%. http://www.fwi.co.uk/articles/20/02/2013/137733/39irish-expansion-plans-...
Irish dairy farmers are getting more heifers on the ground as they prepare to boost production after the abolition of milk quotas in 2015.
It maybe several years before they can increase it by 50% but there are other regions who ramp up dairy pretty quickly when the prices goes over $3500/t.  USA is but one example.  Head in the clouds thinking from Westpac.

Could there be a line of units for sale :)

Or Henry perhaps they are talking the NZD back up. Whatever their reason, its unbelievable bullcrap.

Belle, here is something that got signed off by bank for publication. We see this bank is probably the 3rd or 4th largest investors in dairy and ag.
The problem being if this line of "thinking" widely held in the bank.

Hey maybe the bank truly sees nothing wrong with debt levels, incomes, book value of assets v production/earnings valuations.

Is TAF a Fonterra own goal?
Henry, given that we will be able to sell up to 25% of our shares, what's your view on the $475m of shares being sold in to the shareholders fund, likely to happen, Granted there will be some who will sell, but like last time, I haven't yet found anyone that says they are going to this time round either.

CO, yes same here. Thinking seems to be the share is part of the farm, and why move to be an unshared supplier.
Think of it this wasy: 300,000 kgs, *25%, * 7.20 = $540,000 gross. its not enough to pay the overdraft (for the keen borrowers they are half + owned by the bank anyway). It doesn't make a big enough difference... So for no pressing need for cash why sell.
The down side is that the share price moves down, say to $4.50, for the farmer, so what, the farm business to supply fonterra (land + shares) are still "worth" the same, and you are inside the tent.....
Could be different if you are changing processor, buts thats few...
The other issue like posted to Donker this morning. Its the Gross Div Yield 2.168%: Fonterra units. The Farm shares show Gross Div Yield 2.162%:
We don't see how the institutional folk can stay happy (by March of June they will have booked the IPO pop/bonus share gain and be hungry for more), sure index may mean some mandates need to hold, but we can't see the dividend going up, nor can we see any announcement of business build that would see share value to appreciate (i.e. something extra good on the brands/foodserve side). They have already used the bonus share trick....
Will the unit holders now appreciate that the GDT price rise is about farmgate price, not dividend? If anything the brand side has been caught short of expected manufactured product volume so if anything is to give, in theory it should be dividend to units (too many red faces for that we think).
Maybe the exe's big bet is infant powder to China.... These things need capex, and some capex from retained earnings, otherwise the project gets promised again to someone new....

Well, it has taken a while for "economists" to work this out. All's fine whilst China is buying their comodity fat but along the way our nation has effectively been taken hostage by the Fontera monopoly via its' political lackeys. The other-side risk is: what happens if the Chinee stop, say they discover Brazilian Soy or have another revolution for example and we are faced with bailing out Fontera?

Or they confused the co-op with global commodities trading houses like glencore, cargill, vitol, trafigura etc. These guys show return on equity of 20% - 30%.

But maybe not.
The analysis talks nothing of the industry profits. Fonterra makes little retained profits as farmgate meant to get it all.
Farmers are making poor return on assets = usually below loan interest % rates for equity.

Reason no profit commentary by bankers was that they didn't need to, as they already know. All profits collected by them as interest charges on loans embedded in fabric.. offered via credit manufacture process....

We think these guys are having a lend...

We think these guys are having a lend...

Mist, you are right. This looks a PR disaster as the Tier 1 media are picking up the Bank's words and saying:
The bank said Fonterra had gradually "cornered" the fast-growing Chinese whole milk powder market and that the drought had revealed its market power.
Thinking about it overnight, this is terrible, its a complete own-goal by Westpac. And to think that Fonterra would be a large part Westpac's NZ's world. Its in the news cycle, so can't be undone.... unless some action such as you describe is undertaken to show that the Bank truly did not intend to have such acqusation stand....
And the GDT price stayed about the same last night:
The GDT-TWI Price Index rose 0.6 per cent compared to the last sale two weeks ago, on higher volume and (fewer bidders) - (i.e. the market is working as intended in the face of a generation scale drought etc. etc )...
The total volume of dairy products sold at the latest auction rose to 15,019 tonnes from a two-year low of 13,912 tonnes two weeks ago.
There were 80 winning bidders over 13 rounds. There were 158 participating bidders out of a total number of qualified bidders of 797.
DH: could you extract a comment from Fonterra and Ministry of Foreign Affairs and Trade (re market cornering and market power)..... please.