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Rabobank Quarterly


21 March 2012

Rabobank Dairy QuarterlyRabobank Dairy Quarterly

The opening months of 2012 saw international dairy prices fall between 3% to 8% across the complex, extending the run of gradual price softening to a year.

Rabobank

  • Unusually good weather across most regions exacerbated the impact of high farmgate milk prices, driving supply growth too fast for battered western consumers to soak up, even with support from solid international demand.
  • Q2 is likely to see further downward pressure on world prices. Expected declines in farmgate prices will come too late to slow production growth much through the Northern Hemisphere spring. And demand will remain compromised by weak underlying economic conditions and only modest price relief for consumers.
  • Fundamentals should begin to rebalance as we progress through 2H, though there is a risk of only weak price support at that stage given the prospect of significant stock accumulation in coming months if we have a strong Northern Hemisphere supply peak.

Prices

The opening months of 2012 saw the gradual softening of international dairy prices extend to almost a year. By mid-March prices were down on opening year levels by 3% to 8% across the complex in USD terms.

The US dollar rose 2% on a broad index basis over the same period, contributing marginally to downward pressure.

Dairy Commodity Prices Fob Oceania, 2003-2012

Supply growth gathered further momentum through the early months of the year. Farmers responded to attractive farmgate prices, while favourable weather conditions in almost all regions boosted feed growth and cow yields. Ongoing quota expansions in the EU provided further room to move, while Argentine farmers continue to take advantage of reduced government intervention. Production in the ‘Big 7’ export regions climbed 3.2% above prior year levels in the three months to January as a result—with strong contributions from all, bar Brazil.

By contrast, the demand picture remained weak through Q1. Consumption in key western markets appeared at best stagnant, reflecting low employment growth, falling real incomes, rising fuel prices and high retail pricing of dairy. Export markets held up better, with China entering the market to buy significant quantities after a six-month layoff, and strong support from buyers in South East Asia, the Middle East, Mexico and North Africa.

But increased international buying proved insufficient to soak up the rising surplus produced in export regions. More milk was processed into storable commodities, stocks started to rise in some export regions and dairy commodity prices were forced downwards. Downward price pressure was felt unevenly, with US wholesale markets taking a disproportionate beating (see below).

As we move forward, market signal lags will impede the ability of the international dairy market to rebalance quickly.

Current commodity pricing suggests that farmers in many regions will face 10%-15% reductions in milk prices, but these will come too late to impact supply much until the back half of the year. Similarly, consumers will see only moderate price relief in the near term.

Such inherent lags bring the prospect of further price pressure on the international market through Q2 in the absence of weather related supply disruptions or an economic environment that exceeds expectations.

Supply side

EU

  • EU supply momentum continued to build in early 2012, with milk production up 2.7% in January before a brief cold snap trimmed growth in February.
  • EU milk prices remained extremely high early in the year, supported in part by a 10% depreciation in the EUR/USD exchange rate in the nine months to January.
  • With only a handful of countries at risk of overshooting the continually expanding quota, farmers continued to respond to attractive returns ensured by high milk pricing and slightly lower feed prices.
  • Internal EU appetite for additional product remained weak in the face of rising unemployment, falling real incomes, extreme uncertainty and high retail pricing.
  • Much of the supply expansion found its way onto world markets, with exports up 16% YOY in MEQ terms through the fourth quarter. SMP shipments leapt 69%.
  • Butter was harder to shift offshore, and with NZ electing to use its quota to sell butter into the EU in recent months, PSA butter stocks rose to 11,000 tonnes just days after the programme opened.
  • Ample supply availability and declining wholesale prices have started to impact milk prices in recent months, though they remain profitable. In March, the FrieslandCampina guaranteed milk price was set at EUR 34.25, a 4% step down from February.
  • Rabobank expects further reductions in EU farmgate milk prices in coming months, as recent (and anticipated) market falls are passed back to the farmgate.
  • These will largely arrive too late to impact milk production through the crucial spring flush, with a solid 1.7% milk supply growth forecast for the EU for H1.
  • However, with intervention stocks now largely sold off, fresh supply will no longer be materially supplemented with stock sales through Q2.
  • Local dairy consumption may improve somewhat as retail prices also fall back in coming months, but any improvement will be limited given the weakness of underlying economic fundamentals.
  • A solid spring flush and weak local demand brings the prospect of a large increase in exportable milk volumes through Q2.
  • While export growth is achievable, it is unlikely to soak up all of the additional surplus, with considerable potential for a significant stock build in the EU in coming months.

Milk Production Growth in Key Export Regions

US

  • US milk production continued on its upward tear in the opening months of the year. Production was up 3.4% in January YOY, led by California (up 6.6%).
  • Much of the growth was generated by improving yields. High milk prices and easing feed costs enabled producers to restore optimal feed rations and an exceptionally mild winter boosted cow comfort.
  • The herd has continued to expand, up 0.8% YOY in January, though the rate of growth has slowed from a few months prior, reflecting a relatively modest herd build ahead of Northern Hemisphere spring.
  • The unexpectedly strong spurt of milk growth through January and February has exacerbated excess supply in the US industry.
  • Domestic dairy sales are expanding, but only marginally. Decent growth in foodservice cheese sales has been largely offset by ongoing contractions in retail sales volumes of all major product lines, as consumers respond to real wage falls, rising gas prices and inflation in the dairy cabinet.
  • Exports, the destination for much of the growth in US milk supply in recent years, have started to lose steam in the face of a tight world market, with shipments down 3% YOY in the three months to January. The CWT export subsidy programme was extended from cheese to include butter from January.
  • A 21% rise in imports over the same period has added to domestic product supply.
  • Widening discounts for US cheese and powder have driven more severe local commodity price falls than those seen on the world market. In some regions capacity issues forced the production of less desired product lines and the US to some extent fell victim to the ‘last in first out’ nature of its traditional footprint in international trade.
  • US milk prices have fallen significantly as a result, and with feed prices staying high, unhedged producers in many regions now face negative returns.
  • Milk production growth is expected to slow somewhat in coming months as the ‘dividend’ of a mild winter passes, and farmers respond to a loss-making proposition. But history suggests the milk supply response will be lagged and modest. Rabobank expects US milk production to rise 1.9% in H1.
  • Amidst improving, but still challenging local economic conditions, such an expansion in milk production will generate another increase in exportable surplus.
  • Facing a well-supplied export market, this will likely see stocks build more than usual as we pass through spring.
  • In the absence of an unexpected fall in feed costs, producers are therefore likely to see margin pressure on farm into the early stages of H2 as the market cries out for a ‘slow down’.

New Zealand

  • Buoyed by exceptional growth conditions, farm expansions and high milk prices, New Zealand’s milk production has continued to outstrip prior year levels by a long way (up 9.4% in the three months to January).
  • Producers are enjoying a wet summer on the back of one of the best springs in many years. With soil moisture levels now at optimal levels in most regions, production prospects remain strong for the rest of the season.
  • Exports have been strong, with January shipments 26.5% higher than a year ago. Powder sales to China have been strong in recent months, although volumes to Russia are down. WMP continues to dominate growth.
  • Softer international dairy prices, coupled with the persistently strong New Zealand dollar, have placed downward pressure on farmgate milk prices. Commodity prices in NZD terms are now trading around 35% below the levels seen this time last year for WMP, with cheese down around 15%.
  • In response to softening commodity prices and a higher local currency, in mid-March Fonterra revised their farmgate milk price down to NZD6.35/kg MS.
  • The adjusted price remains highly profitable for most farmers and is unlikely to significantly impact supply over the balance of the season.
  • Rabobank expects milk supply to be up 4% for H1 2012, generating solid export growth and as some still unsold volumes.

Australia

  • Australian milk supply has pushed further ahead of prior year levels in recent months as farmers respond to high milk prices, an attractive milk–to-feed margin and ample availability of irrigation water.
  • National production was up 5.6% YOY through January, with strong gains in Tasmania and Victoria.
  • Despite ongoing uncertainty surrounding the macroeconomic environment, domestic dairy consumption has been positive. The latest data shows domestic consumption volumes have lifted for all the key dairy categories, albeit only marginally for cheese.
  • The latest data shows that the recent improvement in supply has yet to hit the world market, with export volumes still down 2.3% YOY in the three months to January.
  • Australian exporters continue to confront a strong Australian dollar. The AUD continues to hover well above parity against the United States dollar with minimal relief in sight. Coupled with softer commodity prices in USD terms farmgate prices have been revised down in the Southern region.
  • Australia’s production season will continue to wind down in the coming months but is still expected to track above year ago levels, supported by ongoing profitability and access to ample feed supplies. Flooding in February in Northern Victoria and Southern New South Wales will have limited impacts on total milk flows.
  • Higher milk production should be reflected in export volumes through the remaining months of the season.

Argentina

  • Argentina closed 2011 much as it started, with milk supply up 11% in Q4. Even more impressively, production was up another 13% in January 2012 (a 30% rise in just 2 years), buoyed by an attractive milk-to-feed price ratio and readily available feed that offset any impacts of a bone-dry start to the year. Growth is likely to have been trimmed by excessive rain through February.
  • Domestic consumption was strong, despite high retail pricing.
  • Milk supply growth has freed up plenty of product for export, with January shipments up 19% YOY (MEQ).
  • Rabobank expects YOY supply growth to slow through Q2, due to higher year ago comparables, recent weather disruption and the difficulty of repeating last year’s yield gains.
  • Many processors are now embarking on expansions to deal with looming capacity constraints.
  • But all industry participants face an increasing challenge of eroding competitiveness ensured by high local cost inflation and the removal of several key subsidies (particularly energy).
  • Nonetheless, supply growth will still free up additional product for export through Q2, though volumes will be limited given the seasonal decline in local milk season.

Brazil

  • Brazil was the only export region to see a contraction in milk supply through the early stages of 2012.
  • Milk prices are high by world standards and were pushed up further in February as supply waned.
  • However feed prices are also high, crimping margins for dairy farms. Low livestock prices have also encouraged higher slaughter rates at cow-calf operations, which are primarily beef businesses but commonly milk cows also.
  • Production was also impacted by drought in the south in the beginning of the year, while excessive rains in some southeastern regions affected milk transport.
  • In January, milk supply remained 1% below last year.
  • Falling supply, a strong Brazilian currency and still buoyant domestic demand, generated strong demand for imports, which rose 38% in January YOY.
  • As we enter Q2, feed prices may well fall with the arrival of the Brazilian corn and soybean crop. This may set the stage for a rise in the use of concentrate, which could then minimise the traditional seasonal reduction in output.
  • While economic growth is slowing, there remains room for local sales expansion; with production in seasonal decline now, Brazilian companies will remain highly active importers through Q2.

Demand side

The global economy provided little support for dairy in the opening months of the year. Having declined 0.3% in Q4, the EU economy is widely tipped to have continued a mild contraction in Q1, as austerity programmes and uncertainty undermined confidence and spending and drove unemployment higher still. The US economy did better, with decent employment evident, though real wages are slipping. Economies continued to fare better in emerging regions. However, trade impacts and local monetary policy tightening saw momentum slow in many of these countries, including China and Brazil.

Dairy consumers saw some price relief. Retail prices for dairy continued to drift downwards through Q1 in many regions. But these came from a high starting base and price cuts were notably absent in key developing markets including much of Asia.

In the face of weak economics and expensive pricing, sales volume growth remained elusive in key western markets. In the US, retail sales volumes of milk, cheese, frozen pizzas and even yoghurt contracted in the opening months of 2012—though foodservice cheese sales are faring better. In Germany, household consumption of all products fell in the three months to January in year-on-year terms, except cheese, which was stagnant. Companies generally reported flat sales across the EU.

Stronger economic fundamentals continued to support better growth in many emerging markets, including China, Malaysia and Vietnam—particularly in infant formula.

Strong appetites for more dairy in emerging markets helped sustain brisk international trade. Exports from key surplus regions rose 7% in Q4 YOY—pushing trade to 38% above the levels seen just three years ago in the same period. After six months of light purchasing (in both seasonal and YOY terms), China bought vigorously in December and January. This reflects the clearing of previous excess local inventories, solid local demand and attractive pricing offshore compared to locally. Mexico sucked in enormous quantities of milk powder in the face of a drought in Northern production regions. Solid support came from South East Asia and the Middle East, more than offsetting poor Russian demand (where local supply improved).

Recent months have seen economic risks dissipate, and the prospects for growth improve. In particular, the injection of liquidity into EU financial markets and orderly Greek default on bonds has removed near term risks of an EU implosion.

However, we are still looking at very modest expansion of the global economy through Q2. In the west, employment and real income growth will remain limited and sentiment is likely to remain weak. Emerging regions will remain buoyed by domestic market conditions though constrained by weak trade business, with China in particular entering a slower growth environment. And rising oil prices pose a significant risk to growth.

Consumers will see further price declines at retail level as Q2 progresses, but stickiness ensures that price relief may be greater as we push into 2H.

The health of demand for internationally traded dairy products will be crucial to sustaining good commercial disappearance through coming months.

Rabobank expects another strong quarter from importers in Q2. Despite some deceleration, domestic demand growth in emerging regions remains adequate to generate increased requirements for imported milk given ongoing challenges with boosting local milk production. Recent price falls will further increase the appeal of imported product against what remain very high local product pricing.

But with strong demand from emerging markets offset in part from weakness in the OECD markets (that still account for around 40% of global consumption), global market demand growth will remain compromised for some months to come.

Outlook

Rabobank expectations

  • The slim chance of the global dairy market being able to avoid a downward price bias through Q1 disappeared with the exceptionally mild Northern Hemisphere winter, ensuring that milk production, already buoyed by high milk prices, raced ahead of generally weak demand requirements.
  • The market will continue to struggle to balance at current pricing levels through Q2.
  • Outside the US, farmers in most regions have yet to see a significant decline in their milk prices, with any adjustment now too late to significantly rein in supply growth through the Northern Hemisphere spring.
  • Consumption in key export regions will remain weak, with some dairy price relief offset by poor economic growth and rising fuel costs, ushering in another quarter of significant growth in exportable surpluses.
  • While a further expansion in import demand is expected to soak up much of this, leftovers will exert further modest downward pressure on world prices.
  • Fundamentals should rebalance as we progress through 2H, though there is a risk of only weak price support at that stage given the prospect of significant stock accumulation in coming months if we have a strong Northern Hemisphere supply peak.
  • Factors that would lead to a better or worse outlook than expected are addressed below.

Upside influences

  • Weather related disruptions in the Northern Hemisphere through the spring peak could reduce expected surpluses.
  • A further spike in feed prices would pose substantial additional pressure on the US producers and further slow supply growth.
  • Venezuela (a major dairy importer) may boost purchases for local programmes ahead of October elections.

Downside influences

  • Disruption of oil supply from the Middle East looks alarmingly possible and would generate an oil price spike that could snuff out the global economic recovery.
  • A re-escalation of the EU economic crises still looms as a possibility, though the near-term prospects of this have fallen in recent weeks.
  • Favourable weather conditions through the Northern Hemisphere spring peak will exacerbate surplus production.

March 2012

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