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Rabobank Dairy Quarterly

18 September 2010

Dairy commodity prices fell through July and August before rallying again in September,  leaving butter and cheese prices unchanged for Q3 and powder prices down five per cent to 14 per cent.

Summary

Initial downward pressure was triggered by supply­side growth actual and anticipate and a softening of world demand, before buyer covering and strong Russian imports reversed sentimentlate in the quarter. Q4 is likely to bring ample supply availability, with a strong Southern Hemisphere season to follow the pronounced surge in EU and US exports through the middle of the year. But with the twin giant importers Russia and China expected to be extremely active, prices are likely to hold their ground in coming months.

Prices 

The US dollar prices of internationally traded dairy commodities fell consistently through July and August, before rallying somewhat in early September. Both phases were far more dramatic in the powder complex than in butter and cheese where prices remained fairly stable throughout the period. In early September, SMP and WMP closed 5 per cent and 14 per cent, respectively, shy of opening quarter levels, with butter and cheese more or less unchanged. With the US dollar itself largely stable (closing just 1.9 per cent down on opening quarter levels), recent shifts have been driven by dairy market fundamentals rather than currency shifts.

Figure 1: Dairy Commodity Prices for Oceania 

Note: Whey is fob west Europe 
Source: Rabobank, USDA 

The downward shift in prices through the opening two months of the quarter was driven by negative shifts on both sides of the market.  

As foreshadowed in our Q2 report, after an extended period of contraction, the supply tide started to come in again midway through Q2. Aggregate milk production returned to growth in the world’s key exportregions in May and was showing YOY growth of over three per cent by July. Weak local demand saw Northern Hemisphere milk supply growth directed to export markets. With EU intervention stocks also finally up for sale, prospects for buyers looked considerably improved.  

At the same time, the global economy appears to have softened. Also, with retail and ingredient prices high and rising, sales growth momentum slowed in some regions. Having covered their short­term needs, Indian buyers also disappeared from the market.  

The combination of improving supply and slower demand growth inevitably pushed prices down. The price rally of late August/early September appears to have had little to do with supply side developments in export regions. With a strong supply season for the Northern Hemisphere leading into an excellent startfor that of the Southern Hemisphere, export supply is expected to have been firm through Q3.    

More likely the answer lies on the demand side of the market. Anecdotal evidence suggests that buyers held off as long as they could to take advantage of falling prices and have now come back into the market with increased force. Inaddition, Russian import buying is reported to have surged as processors looked to cover their requirements in the wake of a savage recent drought.  

With export surpluses expected to expand again and import buyers on the prowl, trade volumes are likely to remain vigorous through Q4. The price at which that trade is conducted depends much on ongoing economic growth, the strength of the building New Zealand season and just how short Russia and China are.  

Supply side

EU

After declining for nine months, EU milk production expanded again from May through July due to improved weather, higher milk prices and until August stable feed costs. While the local economy continues to crawl along, partial data suggests that dairy consumption at least grew, if slowly, in the key French and German markets in the first half of the year.

But export activity has been brisk. Outgoing shipments rose 13 per cent YOY in Q2, led by a surge in cheese trade. This pushed EU exports up to the highest quarterly level in 5 years. Strong export growth and some assistance from the local market proved sufficient to avoid an unusually large stock build­up through the middle of the year. PSA butter stocks reached their lowest seasonal peak in at least a decade.

Improving milk prices and expectations of strong Russian demand saw the EU Commission complete the first commercial sales of SMP intervention stocks 10 September. Around 190,000 tonnes of SMP still has to be dealt with. The closing months of 2010 are expected to see EU milk production continue to rise above previous year levels. Milk prices remain high—at EUR cents 33.75/kg, Friesland/Campina’s guaranteed milk price for September is 38 per cent above previous year level and industry sentiment is improving. However, rising feed costs are expected to limit supply upside. With profitability far from exceptional in most countries, supply growth below one per cent is likely for 2H.

Having signalled its willingness to sell, the EU Commission is expected to continue to sell down stocks through Q4, provided the market remains firm. Recent evidence suggests this will be done in an orderly manner, with limited market disruption. With local demand growth likely to remain pedestrian at best and some stock liquidation, the EU market surplus is expected to expand again in 2H.

Figure 2: Milk Production Growth in Key Export Regions 
  Last 3 months 
EU 1.6 per cent (Jul) 1.6 per cent
US 2.9 per cent (Jul) 2.2 per cent
NZ* 5 per cent for 3 months to August* 
Australia 3.2 per cent (Jul) 4.2 per cent
Argentina 11.1 per cent (Jul) 5.0 per cent
Brazil 10.2 per cent (Jul) 7.2 per cent
SUM* 3.2 per cent (Jul) 2.4 per cent


US

US milk supply continued to build through the spring peak, delivering 2.2 per cent YOY growth in the three months to July. The herd is now 7 months into an expansion phase now just 1 per cent shy of previous year levels. Yields are being pushed up by improved feeding rates and the culling of poor stock in recent years.

Growth in local dairy consumption appeared to pick up somewhat through Q2, with rising cheese sales, supported by an improving foodservice channel, more than offsetting further declines in liquid milk sales volumes.

But an even bigger contribution to the clearing of the US market came on the trade front. A combination of strong export pricing and industry funded export subsidies pushed US exports to record levels in Q2. With ongoing import replacement, net exports exceeded previous year levels by a massive 900 million litres milk equivalent in Q2.

With domestic and export sales combining to clear rising milk production, US milk prices continued to rise through August, more than offsetting rising feed costs and keeping most farmers above the break even point.

Rabobank expects US milk production to continue to rise YOY through the closing months of 2010, though somewhat below the rate evident through Q2. The current momentum of the US industry poses some risk for the international marketplace in the coming months; the potential for a slowdown in the US domestic economy and hence, one source of demand for rising local milk flows is widely recognised. Moreover, Mexico recently imposed considerable tariffs on US cheese shipments in retaliation for the US refusal to allow Mexican trucks access to the country. The industry also entered 2H with extremely high cheese stocks, though butter stocks are low.

New Zealand 

After the usual winter production lull, the 2010/11 season in New Zealand is off to a reasonably good startwith milk flows around 5 per cent ahead of last season over the first 3 months. While momentum is only just gathering pace during September particularly in the South Island where calving is later soil moisture and feed supplies are both good. Natural vulnerabilities remain the primary production risk, with recent flooding and earthquake damage likely to modestly dent early season volumes in the lower North Island and Canterbury.

As expected, export volumes through Q2 were down 9 per cent YOY, reflecting weak autumn production. July volumes were 15 per cent lower, as season­end inventories were reduced. Global product price relativities saw WMP rising 16 per cent and continuing to dominate shipments at the expense of all other products.

Forecast milk prices remain strong despite recent market volatility. Fonterra reaffirmed its opening price, and Westland lifted its forecast to NZD 6.50/kgMS to NZD 6.90/kgMS in early September.

Climate permitting, increased YOY milk production will continue to gather pace during Q4 when the seasonal flush occurs. However, fewer new dairy farms are entering production and producers are taking a considered approach to budgeted expenditure and debt reduction. Thus, milk flows are expected to show good growth of up to 5 per cent to 8 per cent over the season but not spectacular double digit increases.

Export volumes will start to reflect higher milk volumes in late Q3 but become more prominent in Q4.

Australia

While it is still early days, 2010/11 is shaping up to be the best season for the Australian dairy industry in a decade.

Buoyant export markets and the best performing domestic economy in the OECD enabled export processors to announce an opening milk price of AUD 4.75/kgMS in July—the third highest opening price ever. Despite feed wheat prices’ increasing substantially through August, the milk/feed price ratio remains attractive.

The best winter rains in years have set up pastures nicely for spring in rain fed regions, and irrigators in Northern Victoria look almost certain to receive 100 per cent of their water allocations this year. Indeed, as irony would have it, if there is a risk to the Australian season at present, it is the prospect of a slow start due to excess moisture in some regions.

Milk production rose 3.2 per cent YOY in July, with growth likely to maintain that rate through 2H.

Export recovery is inevitably lagging milk supply, with July shipments down 12 per cent in volume terms. But momentum will build late Q3/early Q4, with growth rates for exports to exceed those for milk supply by late in the year.  

Argentina 

Argentine milk prices were 62 per cent above previous year levels in July, reflecting continuing market tightness following a poor 2009/10 production season, strong export prices and the absence of government export restrictions. With a favourable milk/corn price ratio, milder temperatures and good rainfall, milk production rose 11 per cent YOY in July. Export volumes were around half previous­year levels through the middle of 2010, reflectin until recently falling milk supply. While conditions vary from region to region, Rabobank expects milk production to continue to show strong growth on previous year levels as the season peaks through the closing months of the year, supported by solid margins for farmers. Increased production will lower domestic wholesale prices, directing more milk to powder for export through Q4.

Brazil 

Brazilian milk production rose 10 per cent in July YOY as the benefits of a favourable milk/feed price ratio and good winter pasture growth in the South offset dry conditions elsewhere. Despite a slowdown in economic growth and high retail prices, local consumption continued to grow. This more than soaked up recent supply growth and drew in more imports, which easily exceeded the trickle of exports registered through Q2. But strong milk production growth and rising imports have relieved some of the recent market tightness in Brazil, pushing milk prices 10 per cent below previous­year levels in August. Despite the recent drop in milk prices and increase in feed costs, dairy margins remain above average levels and are expected to underpin ongoing milk supply growth through Q4. A La Nina weather pattern is likely to bring dry conditions through the closing months of the year, though its impacts will be limited by good availability of supplementary feed. With supply growth set to exceed local consumptiongrowth through Q4, Rabobank expects to see a reduction in Brazil’s net import position through the periodwith a return to a marginal surplus not out of the question.

Demand side 

Recent months appear to have seen global dairy demand continue to expand, though predominantly driven by developing regions and quite likely at a slowing rate compared to early in the year.

Among key advanced economies, the US, the EU and Japan continue to tread an unexciting and below trend recovery, with painfully slow progress at best in generating jobs—US employment actually declined in May through August. Nonetheless, dairy sales do appear to have been rising YOY. Recent data showed a foodservice led pick­up in US cheese consumption offsetting declining liquid milk sales. The data also showed slow but welcome growth in the French and German dairy markets and even signs of some stabilisation in Japanese drinking milk sales.

The economic environment is far more supportive in developing regions. China’s growth looks increasingly robust and is pulling along much of developing Asia with it. Good growth is also being registered in regions like Latin America. However, almost across the board, growth through the middle of the year will fall short of Q1 as global trade slows and/or policies are tweaked to rein in unsustainable growth.

Positive economic conditions continued to support good dairy sales growth in these regions through the middle of the year. Q2 results for South East Asian processors continued to show robust sales growth, with anecdotal reports suggesting solid market expansion in Latin America and China.

A combination of strong demand in import regions and surplus product availability in the Northern Hemisphere saw dairy trade volumes continue to expand through Q2. Exports from key regions rose 7 per cent YOY, representing the 5th consecutive quarter of trade growth. Much of the pull to expanded trade continued to come from China, where milk powder imports rose 70 per cent in the 3 months to July.

Figure 3: Change in Export Volumes for ‘Big 6’ Exporters 

Note: Includes NZ, the EU, the US, Australia, Argentina and Brazil.    
Source: Rabobank, National statistical agencies. 

The closing months of 2010 will be a testing time for global dairy demand. On the economic front, the impact of monetary and fiscal stimulus is fading fast in advanced economies, with the private sector still on shaky legs. A double dip US recession still appears unlikely but presents a disconcerting downside risk.

While economic prospects appear far more robust in developing countries, consumers in many of them are seeing retail dairy prices on the rise again, which will test local appetites to increase consumption. And while butterfat prices have appeared immune to the massive premium demanded over competing vegetable oils for much of 2010, it is unlikely that ingredient users are quite so indifferent.

Rabobank expects sluggish growth and weak labour markets in the west and price pressure in faster growing economies to see global dairy consumption tracking below trend through the closing months of 2010. However, import demand is likely to again outperform, given strong economic growth in key milk deficit regions, supply disruptions in Russia (and Pakistan), and slow progress rebuilding the milk supply base in China.  

Outlook

Rabobank expectations

Q4 is likely to see an unusually large exportable milk surplus develop in key production regions. A promising Southern Hemisphere production season is set to overlap with strong supply growth momentum in the EU and US, and good inventories in select markets (butter stocks representing a clear exception).

Pricing through the period will depend much on the economies of the US and the EU where local consumption growth will be important in preventing an even larger exportable surplus from developing and the ability of dairy importers to soak up increased product on world markets. Assuming western

economies continue to expand, Rabobank expects that import demand will likely prove sufficient to soak up these surpluses through Q4, led by vigorous buying from China and Russia. This should keep the market tight through Q4, supporting prices close to the high levels achieved in early September. Risks that would trigger an alternative scenario for dairy commodity pricing appear evenly weighted on the upside and downside.

Upside influences

Any adverse weather event in New Zealand through Q4 would significantly alter market sentiment, given its central role in determining Southern Hemisphere surpluses this season. While we expect Russia to increase its purchases from the international market through Q4 in the wake ofthe recent drought, a particularly strong buying spree would significantly tighten trade supplies. While the recent grain price rally will have a limited near term impact on supply, a further material shift upwards would dampen milk production volumes in grain fed regions through Q4.

Downside influences 

Suppliers are heavily reliant on strong Chinese and Russian import buying to balance the market through Q4. If this does not eventuate, the chance that prices will fall increases considerably. A double dip recession in the US would choke off domestic demand growth at a time when local supply momentum is strong and cheese inventories are heavy. This would bring unusually large US exports through Q4. An aggressive liquidation of EU intervention stocks through Q4 would be price depressive.      

September 2010

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