Peter Redward points out that for Fonterra to achieve its latest farm gate payout expectation, either a significant decline in the value of the NZD and/or a sharp rise in prices is needed

Peter Redward points out that for Fonterra to achieve its latest farm gate payout expectation, either a significant decline in the value of the NZD and/or a sharp rise in prices is needed

By Peter Redward*

On 27 August, Fonterra’s shareholders’ council reaffirmed its farm gate payout expectation of NZD 6/kgMS.

The shareholders council acknowledged difficult market conditions, stressing to farmers that they need to “continue exercising caution with their farming business budgets” but that “current market views supported by our own forecasting indicate commodity prices improving later this year or early in 2015” with the decision to maintain the current farm gate milk price expectation reflecting “the longer-term outlook for dairy.”

Its hard to over-state the importance of dairy product prices to our economy with movements in dairy product prices mattering enormously for both the NZD and short-term interest rates via their impact on both our balance of payments and net national income.

For instance, we estimate that a NZD 1/kgMS rise/fall in prices raises/lowers farmer income by NZD 1.6 bln (0.7% of GDP).

In order to assess the credibility of Fonterra’s farm gate milk price expectation, we have constructed a simple cash flow forecasting model.

We then conduct scenario analysis around potential movements in the NZD exchange rate and auction prices over the GDT platform. The milk price is essentially derived from the revenue of the ‘Reference Commodity Products’ – comprising WMP, SMP, BMP, butter and AMF – less associated costs, divided by the amount of milk supplied.

Our exercise confirms Fonterra’s payout of NZD 8.40/kgMS in 2013/14 but there remains considerable downside risk for 2014/15.

It is worth mentioning that “prices primarily reflect US dollar prices achieved by Fonterra on the twice-monthly GlobalDairyTrade (GDT) trading platform, converted into New Zealand dollars at Fonterra’s actual average monthly foreign exchange-conversion rate.”

The central assumptions of our projections are that milk collection will increase by 10% from the 2013/14 season’s 1,584kgMS – which is perhaps a little optimistic – the conversion yield remains fixed and it is distributed over the Reference Commodity Products at the same proportions as past seasons.

Besides that, the three main categories of expenses:

1) lactose purchases (volume),

2) cash costs, and:

3) capital costs,

are determined as a multiple of milk collection.

However, we do not have a reliable lactose price series, which has led us to use the latest available GDT price, which is then converted into NZD at the appropriate rate in the respective scenarios. Our model yields a baseline payout of NZD 8.40/kgMS for 2013/14, in line with Fonterra’s guidance.

In our first scenario, we assume the average GDT price and NZD exchange rate on a season-to-date basis. As the season progresses, this scenario will slowly converge towards the final payout. Under this scenario, we derive a milk price estimate of NZD 5.11/kgMS, some 14.8% below Fonterra’s guidance.

Based on this scenario, farm gate income will fall by some NZD 4.37 bln (1.9% of GDP); and that’s under the assumption of a 10% lift in milk solid production.

While the 2014/15 season is still in its infancy, we are concerned that recent prices in the GDT auction have fallen well below their season average and consequently, our first scenario may be over-stating farm gate returns. Hence, in the second scenario, we assume a combination of the aforementioned season-to-date average and the current level of the GDT and NZD, weighted by the corresponding time period.

This scenario produces a milk price estimate of NZD 4.53/kgMS, some 24.5% below Fonterra’s estimate, emphasising the severity of the recent plunge in prices on the GDT platform.

A fall in milk prices of this magnitude would lower farm gate income by NZD 5.4 bln (2.3% of GDP).

Our third scenario assumes that prices on the GDT platform remain unchanged and the NZD remains at current levels for an entire season. This scenario highlights the full severity of the decline in dairy product prices and is consistent with a milk price estimate of just NZD 4.34/kgMS and a decline in farm gate income of NZD 5.7 bln (2.5% of GDP).

Finally, we conduct a sensitivity analysis, producing a matrix of potential milk prices based on season average movements in both the NZD and GDT prices. This table highlights the potentially devastating impact of the recent 40% plunge in dairy prices on the GDT platform and the still-strong NZD.

In order for Fonterra to achieve its farm gate payout expectation, we need to see either a significant decline in the value of the NZD and/or a sharp rise in prices on the GDT platform.

While this cannot be ruled out, experience tells us that forecasts of commodity prices are fraught with disappointment.

We note that just as a maiden over in a one-day cricket match raises the run-rate required for the second batting team, every GDT auction in which prices undershoot Fonterra’s projection, and every week that the NZD remains elevated, increases the difficulty Fonterra will have in achieving its milk price target.

The potentially massive negative consequences for New Zealand require no explanation.

Milk price sensitivity

Source: Bloomberg, Redward Associates


Peter Redward is the principal at Redward Associates. You can contact him here.

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So from that last scenario, each kgsMS that I put in the vat today is valued at $4.34 at today's prices yes? Half of last years value. Not sure if I should laugh or cry.
The value to GDP. Does that take into account the fact that the banks take the first bite out of income in the form of interest which then effectively locked away from the economy. So as payout drops the proportion of money put into the wider economy  drops.  If total farm gate income is $10b and banks claim $3b then $7b is left but if the total drops to $8b then only $5b is left. Or is it just a Friday and I don't want to go back out in the cold?

If your Kg of MS is used in producing WMP then its value today won't be over $4.50. That may raise questions about why Fonterra has maintained its payout forecast.
In the national context PREFU's small supposed OBEGAL surplus for 2014/15 is now a deficit. It probably always was (Treasury was working on a reduction in dairy export prices of only around 21%).
The drop in farm income is not the worst of it. There will be multiplier effects from that. The forecast 3.8% increase in GDP will not happen. Nor the increased tax take dependent on it.

It's maintaining the $6 vs $4.50  because otherwise the spendup in China is likely to see some dead or injured Fonterra area managers around the country....   (if $6 is breakeven for some operations, at $4.50 they've got nothing else to lose)

I got my sharemilking job (100 cows/20aside shed, no calving, winter milk) to pay for some deferred maintainence on a couple of rentals, so I could finish my comp sci degree.
  My boss made some mistakes, left me out of pocket 17k...been caught in sharemilker debt trap ever since.  IF I could have left I would have done so

Well done, I like to see this sort of macro sensitivity analysis:  most are confined to the micro picture of interest rate/milk solids produced/costs per/debt per.
Production increases don't depend solely on conversions (e,g, from sheep/beef or cropping).  They can also happen as e.g. barns/feedlot configurations become more common.  A significant effect of these configurations is that the 'milk curve' disappears:  production is essentially flat, year-round.  This may help the 10% lift assumption.
But, overall, it's going to be a tough season or two for heavily indebted outfits, especially if there's a tax liability overhang from the Glory Days....

is it a pull, or a push
the ecan chap worth a listen

Probably both but its not a game i'd want to be in just now.   Canterbury is going to be very difficult, eventually targets will have to be met.
 Who is going to want to house cows on a sub $6 payout.  Do farmers try and increase production with falling prices or cut costs, cut production?

The price will always determine whether or not they increase production. This is what i don't understand ,the government has come to our region promoting big irrigation schemes,  but current agricultural prices don't justify this. Economies that are based on speculation are castles made of sand.

Sometimes when prices fall the reflex is to try and increase production. Make more to make more, so to speak.
 The Ruataniwha scheme always was apoor one but I confess I'm not a supporter. It could make money if farmers didn't mind taking a big hit to their capital values.
 The HBRC is totaly out of touch with the realities of farming in such a high cost system. The risk is systemic failure.
 How much would you need to invest in farming to earn the $380k the CEO of the council earns?

Yes, it may take time for the reality of the lower payout to sink in. The marginal cost of producing the extra litre of milk at the new price will determine production levels.

Old habits are slow to die.

The marginal cost of producing the extra litre of milk at the new price will determine production levels.
"Will" is a bold statement to make. I agree that it should, but how many dairy farmers, farm consultants let alone bank managers would know what a dairy farm's marginal cost curve looked like?   

yeah ok, "should" might be a better word.

irrigation is "big business" and pays many reports.  With "experts" constantly being paid to blow ot air into the beehive about infinite demand (and pay-ability) in China - which is the news they want to hear - then getting Big Projects will stimulate economies ..  the important part of irrigation (1) It requires big machines, (2) It supports much higher denisty of operation (3) higher density of operation means company/investor ownership and thus employee-slaves paying taxes,  (4) investment opportunities in construction, agricultural and a GST skim for all the hardware and consumables needed to make a high density operation work.

I think the most important section is the last 30 seconds of the audio where it becomes apparent that the Minister for the Environment has little interest in ensuring that the limits in her own National Policy Statement on Fresh Water are enforced. 

Colin, as someone who is involved with water quality on a catchment level, I see it differently to you.  Local communities are being given given as much opportunity as possible to come to their own solutions.  While this may take some time it is likely to deliver longer term benefit solutions taking in the whole communities priorities.  Government enfocement will be used as a 'last resort' - as it should be.
It was interesting that there were two 'water activists' interviewed on that programme.  Alison Dewes was interviewed as speaking about farmers but she is also the Fish and Game 'expert' at water hearings.
One of the points she said is now gaining traction in advice to farmers generally - don't be in a hurry to be the early adopters.  If you have worked hard to bring your leaching rates down and the RC brings in a blanket '30% reduction of N on every farm' you are going to be much harder hit than those farmers who are leaching heavily and only have to reduce 30%. So where the rules haven't yet being set, advice now is to wait and see.

Looks like I'm going to end up on the battle front -again- then.

My normal use of N is around manual addition of 8kg N per hectare per year. Stock rate 2.5 xbred.
So if the RC uses "scientific" methods such as 30% blanket reduction (with the farmer doing all the paperwork for free, of course)   then I suppose we're going to fight again.  yay science..

Aj, farming in  Northland is not for the faint hearted.  If Bayleys are invovled, there is a chance that it is the banks controlling the release of farms under financial stress.  You would want to be mortgage free if you buy in Northland. Ticks, grass pests and droughts are only some of the issues you face.

Perhaps these folk have identified a niche market that takes us all back to the idea of sustainable dairy farming. Watch the video to get an indication of the low input into their land with regards to fert and urea.
I have a small block of land, previously used for dairy farming by my Pop some 30 years back milking 60 odd cows. It's in need of a new cowshed!
The opportunity is there to sell and purchase a larger dairy operation milking 150-200 cows. The main reason is for lifestyle choice. I've worked out I'd need to borrow in the vicinity of a cool million. Anything below a $5 payout would mean I'd be eating the grass myself...
Like most people during the boom period, banks loaned too aggressively and some farmers bought into it. There's been a few well known names in our area that have lost it all.
I seriously believe that banks would be getting nervous in Northland, the same occurred 2-3 years back in the southern Hawkes Bay and is probably still happening today. Forced mortgagee sales weren't uncommon.
Interesting times ahead.

How much does a litre of milk cost from these villagemilk people?

$2.50 per litre.
We've been purchasing ours from Arran farms for the same price using their 1 litre glass bottles. The only hassel for us, is the 15-20 minute drive out there. But we would argue the milk is worth it.

Hopefully this sales concept will not be killed by administration and "health"  regulations etc.
When I was young, it was normal for me to walk every evening into the next village to buy fresh lukewarm milk from the farmer,  never a problem healthwise, just the reverse, I think this   raw full fat milk enabled us to survive  the hungeryears (Europe) in the 40's and early 50's.
Nowadays: milk just from the supermarket, despite the fact I am surrounded by dairy farms. 

Who was the 'blogger fixer' for the supermarkets in 'Dirty Politics"? I have lent my book out so can't check.
My bet is the supermarkets are closely watching this villagemilk development and will quietly influence events so it is FUBR.
Maybe the big two supermarkets will send a carefully coded message to villagemilk that being an uncompetitive niche player is fine but try being competitive and the response will be total extermination by fair means or foul.

Interestingly enough, Village milk sells their milk direct to the customer through Italian made dispensers. stick in your card, press a button and hey presto, you've got quality raw milk.
I agree that the "big guns" will be doing everything in their power to limit the choice of consumers buying raw milk. The MPI are reviewing this process in 2016.
There has been plenty of scientific evidence suggesting the scare-mongering of raw milk is unfounded. However, their is always risk involved particularly when the milk is supplied from < 30 cows. 
You should check this guy out...
Same deal, milking a few cows, currently writing up a 7000 word report to pass his selling of milk to Joe Public.
Some supermarkets in Europe actually sell raw milk from the shelves and many supply raw milk for Cheese (fromage).

Administration and health regulations - MPI is already well into the process:
Not that they have predetermined anything:
Since then MPI has done a scientific assessment of the risks associated with drinking raw milk. The study showed that although on-farm practices could reduce the risk of illness from drinking raw milk, there are no hygiene practices that guarantee raw milk would be free of pathogens.

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