The following explanation was released with today's Fonterra interim Reports
In December 2013, the Board announced that it was maintaining the forecast Farmgate Milk Price at $8.30 per kgMS, which was 70 cents less than the price calculated under the Farmgate Milk Price Manual at that time.
In February 2014, the Board increased the forecast Farmgate Milk Price to $8.65 per kgMS. With the Farmgate Milk Price calculated under the Farmgate Milk Price Manual at $9.35 per kgMS, the 70 cent gap between the two prices remained.
Both the December and February decisions were made in the Co-operative’s best interests. It is not appropriate to forecast a Farmgate Milk Price that is higher than we can afford to pay and would require borrowing.
That is why the Fonterra Board exercised its discretion to pay a lower price than specified in the Farmgate Milk Price Manual when it is warranted.
That the Board chose to do this in the current Season does not foreshadow that it will do so in the future.
The calculation of the Farmgate Milk Price under the Farmgate Milk Price Manual is based on processing and manufacturing milk powder and related streams such as butter and anhydrous milk fat (AMF) – also called Reference Commodity Products.
The choice of reference product is deliberate. It is based on the fact that powders account for more than half the global trade in dairy products, that most new investment in new Zealand has been in milk powder related assets and that in the medium term the highest returns are expected to come from powders.
The calculation is also based on the production costs for a theoretical efficient manufacturer of Fonterra’s size and scale. This theoretical and efficient manufacturer model effectively sets up a highly competitive benchmark against which Fonterra measures its actual performance.
Using that methodology delivered a forecast $9.00 per kgMS Farmgate Milk Price in December, compared to the forecast $8.30 per kgMS by the Board.
Behind the 70 cent difference is the cost of higher than usual milk flows across a longer than usual peak and the significant divergence between the returns from Reference Commodity Products and returns on non-Reference Commodity Products such as cheese and casein.
Even with significant investments in driers in recent years, our fixed asset base, coupled with the longer peak and higher flows not only limited our options for processing milk into the highest returning products but did so over a longer than usual period. Our product mix returns reflect this reality.
During the first half of the Season, Fonterra was able to process around 75 per cent of milk flows into Reference Commodity Products but around 25 per cent was converted to non-Reference Commodity Products such as cheese and casein.
However, Reference Commodity Products prices during the period were significantly ahead of those for cheese, casein and other Non-Reference Commodity Products. In some cases the selling prices were lower than the cost of the milk used to produce them. As a result, we had the 70 cent gap between the current forecast Farmgate Milk Price and the price determined by the Farmgate Milk Price Manual.
While the price gap between Reference Commodity Products and Non-Reference Commodity Products has more recently narrowed, it is too late in the Season to make up for the large differential experienced earlier in the Season. As a result, the 70 cent gap currently remains.
The strength of the Farmgate Milk Price Manual is that it enables this high level of transparency, something which should give confidence to Farmer Shareholders, suppliers and Unit holders alike.
The underlying basis for the Farmgate Milk Price Manual remains sound in that milk powders, butter milk powder and AMF will support the highest sustainable Farmgate Milk Price in the medium-term.
That is why the vast majority of capital investment in new plants for the past decade has involved milk powder plants.
Work will continue to maximise our current milk powder plants’ efficiency while accelerating planned investments to expand capacity.
This strategy will, over time, reduce volatility in the earnings of our ingredients operations and help deliver the highest sustainable returns.
To give readers a sense of the total value of the 70c "gap", Fonterra reported it purchased 1,120 million kgMS in the first half of the 2013/14 season. That is 87.8% of all volumes for all New Zealand dairy companies, according to data from DCANZ. interest.co.nz estimates the full year Fonterra volumes to July 2014 will be about 1,770 million kgMS. Therefore Fonterra will have paid farmer suppliers about NZ$1.2 billion less than 'required' by the Farmgate Milk Price Manual.