• Fonterra reduced its forecast Farmgate Milk Price for the 2015 season from $5.30/kgMS to $4.70/kgMS – downside risk remains.
  • The new forecast price is 33% lower than the opening season forecast and down 44% from last season's record.
  • There was no change to the estimated dividend range of 25-35 cents per share, however the Board will update at the half year result (March 2015).
  • This equates to a decrease of circa NZ$6.2 billion in terms of dairy cash income compared to last year's record season.
  • Possible impact on New Zealand GDP could be in the region of 1.4%.

The GlobalDairyTrade (GDT) Price Index's last auction struck an average winning price half of that achieved during the February 2014 peak. Subsequently Fonterra have been forced to downgrade their forecast 2015 Farmgate Milk Price to $4.7/kgMS.

GDT Price Index

GDT Price Index

Figure 1, Source: Nikko AM NZ, GDT historic data

Some explanatory factors include:

  • Strong domestic production growth – Fonterra forecasted 2% growth for the current season yet the run rate has been +5%.
  • Strong global production growth from major exporters, namely the EU and US.
  • Lower feed costs in the northern hemisphere aiding farm profitability and production incentives.
  • Inventory build-up in China as last season's record imports led to greater than expected surpluses.
  • Recovery in Chinese domestic production with 2014 generating 1.4% growth (year-on-year).
  • Middle East conflicts distorting demand side markets.
  • Lower oil price potentially impacting large dairy importers, namely Venezuela, Algeria and Iran.
  • The Russian trade ban on Australia, Canada, EU, Norway and US has significant implications. The EU and US are major global dairy exporters and Russia is the second largest importer. This supply has found its way on to the wider market. Longer-term this carries the potential for EU producers to shift their product mix toward direct substitutes for New Zealand products (i.e. away from cheese towards milk powders).

The peak of dairy prices the previous season was driven by domestic supply side issues impacting China and Russia. The world's two largest dairy importers (combined 25%) lifted their import requirements and bid up prices, illustrated by figure 2 below.

Import requirements and bid up prices

Figure 2, Source: Fonterra

However, last season's tailwind drivers have become this season's headwinds. Figure 3 presents Fonterra's estimates for China and Russia's import growth.

Fonterra's estimates for China and Russia's import growth

Figure 3, Source: Fonterra

Implications

The impact of the forecast Farmgate Milk Price will likely reduce dairy cash incomes by circa NZ$6.2 billion, equating to 2.8% of GDP in terms of pure income loss. However, it is important to note that the full amount is not expected to translate into a direct economic impact. Economists are expecting the impact on GDP to be circa 1.4%.

Given the average New Zealand dairy farm's break-even is circa $5.50kg/MS, the current forecast implies the average farm will be making a loss, which would be just the second time since the 1998 season. Consequently, we can expect a period of cost control and pressure on discretionary spending from the sector and this may weigh on rural land prices.

Whilst one season of low prices is manageable, a multi-year slump in the GDT Price Index could become problematic, with wider economic implications such as negatively impacting the New Zealand dollar and potential easing of the Reserve Bank of New Zealand's Official Cash Rate. It is of concern that the GDT has still not stabilised. Year to date prices point to a Farmgate Milk Price closer to $4.40kg/MS implying a significant expected recovery has been built into Fonterra's forecast.

Summary

Supply-side shocks and market distortions have created a degree of uncertainty over the short to medium-term outlook for the New Zealand dairy industry. Notwithstanding these immediate issues, the longer-term trajectory remains in place. Rising Asian incomes and an emerging middle-class with westernised diets supports increased demand for safe, high-quality dairy products. In addition New Zealand's geographic proximity, counter-cyclical supply and preferential market access bodes well for the future.

2014 Season

Last year's 2014 season provided New Zealand's farmer base with a record Farmgate Milk Price of $8.4/kgMS, up 44% from the prior year. The key dynamic driving these elevated dairy prices derived from China and Russia.

The supply-side in China has been impacted by the exit of many smaller farm owners (profitability issues), a step up in quality standards and persistent animal disease resulting in lower milk production 2014. This created disequilibrium as supply tightened while the nation's aggregate demand for milk products continued to grow. This led to the 2013 season entailing a 36% increase in China's imports of dairy products. The observed price tension created a direct benefit to New Zealand as evidenced by January and February 2014 representing their highest monthly imports on record, coinciding with the peak in the GDT Price Index.

Russia is the second largest global dairy importer behind China. However Russia's increasing import requirements had a less direct impact on New Zealand, as their major import product is cheese (63% of total), a product less relevant to New Zealand compared to milk powders. Nevertheless this aided New Zealand price tension by attracting the increasing European production, with Russia representing the EU's largest dairy export market.

New Zealand Dairy Industry

New Zealand is the world's largest exporter of dairy commodities representing one third of international dairy trade each year, exporting to over 150 countries with key destination markets being China, US, Japan and the EU. In absolute terms, New Zealand produces a modest 2.5% of total world milk production but exports 95% of the milk produce. Consequently, as the country's top merchandise export earner (one quarter of all merchandise exports) the industry is of fundamental importance to the New Zealand economy.

Fonterra Co-operative Group (Fonterra) represents the key operator in the industry collecting circa 87% of New Zealand's milk production. Pre the 2001 season, dairy farmers received payment from the New Zealand Dairy Board through a system of payouts via dairy companies. However the Dairy Industry Restructuring Act 2001 enabled the largest dairy companies; Kiwi Co-operative Dairy Company and New Zealand Dairy Group to merge with the Dairy Board to form Fonterra.

The Farmgate Milk Price refers to the base amount to be paid by Fonterra to farmers for the milk supplied in a season ending 31 May. While an aggregate amount, it is usually quoted as a New Zealand dollar figure per kilogram of milk solids (kgMS). In terms of Fonterra's financial statements, it is the cost of New Zealand sourced milk sold. The Farmgate Milk Price is determined by the outcome of GlobalDairyTrade (GDT), a bi-weekly online auction platform for internationally traded dairy products. While being a subsidiary of Fonterra, GDT operates separately and independently with audited separation protocols in place.