10 January 2011

13 minute read

Summary

Price support continued to come from strong import-buying, reflecting local supply developments as much as improvements in end consumption, which soaked up an unusually large increase in export product availability. Q1 2011 now looks set to deliver a contraction in export supply availability as hopes of a buoyant New Zealand season are dashed by signs of an early drought, more than offsetting expected strong growth from the Northern Hemisphere. With general demand conditions set to improve and import buying likely to remain extremely strong, emerging supply constraints are likely to exert significant upward pressure on international prices in Q1 2011.

US dollar prices of internationally traded dairy commodities prices drifted slightly upwards through Q4 2010, closing in mid December at 0 per cent to 7 per cent higher than opening quarter levels.

With the value of the US dollar itself largely unchanged over the same period (up just 0.1 per cent on a broad index basis) ― dairy market fundamentals appeared to have firmed somewhat during the period.

Figure 1: Dairy Commodity Prices fob Oceania

Source: Rabobank, USDA

Recent supply growth in key export regions has been in line with expectations of a strong growth spurt―with outperformance in the Northern Hemisphere offsetting weather-disrupted spring peaks in New Zealand and Australia. Total milk production in the ‘Big 6’ export regions continued to track 2.7 per cent above previous-year levels in October―with partial data suggesting further YOY growth into November.

Developments on the demand side of the market sent out mixed signals through late 2010. The global economy appeared to hit a soft patch in an already modest recovery, available data showed only slow growth in dairy sales in advanced economies while consumption in developing regions continued to expand apace.

What was clear is that import demand remained exceptionally strong, as key buyers soaked up unusually large volumes from the world market to address either increased consumption, falling local supply or a combination of both―with China and Russia continuing to lead the way.

This strong import-buying proved sufficient to soak up the wave of milk supply growth evident through late 2010, exerting modest upward pressure on prices.

Coming months are likely to bring a significant shift in market fundamentals. After almost 2 years of uninterrupted growth, exportable supply is expected to fall below previous-year levels in early 2011 as New Zealand supply contracts in the face of drought, more than offsetting strong growth in the Northern Hemisphere.

Assuming a reacceleration in the world economy, and strong ongoing purchases from the world market from China and Russia in particular, this is set to exert upward pressure on international dairy commodity prices in coming months.

Supply side

EU milk production growth gained momentum from August through to October, with high milk prices and quota expansion (in countries where still binding) providing the incentive and capacity to expand, despite rising feed costs. Milk collection rose almost 4 per cent YOY during the period, with France, Ireland and the UK leading the way.

Provisional figures suggest solid expansion continued through November at least in the UK and France, though rising feed costs and heavy snowfall will have impacted milk production and collection in some regions through December. With local dairy consumption still expanding only slowly, increased production and strong offshore demand ensured a surge in export activity through Q3 2010. Cheese and SMP shipments rose 12 per cent and 91 per cent YOY, respectively, though product shortages reduced butter exports by 15 per cent.

As 2010 draws to a close, there is a sense of optimism on farm in many key production regions. Milk prices are high, with the FrieslandCampina guaranteed milk price for December up 9 per cent YOY to EUR 35.65/100 kg. And the ongoing expansion of quotas is generating investment in some regions. Nonetheless, Rabobank expects the rate of milk supply growth to ease in early 2010, as rising feed costs start to impact.

Additional product supply is still potentially available from EU intervention stocks, with 100,000 tonnes of SMP still available in early December (after commitments to the Most Deprived Persons programme for 2011). However, the Commission is thought to prefer to retain some stocks as a buffer against future market shortages, in the absence of which any surplus product is likely to be dripped out in a slow and orderly manner so as not to disrupt prices.

Domestic demand will show modest continuing improvement in Q1 2011 in step with improving economic conditions.

With milk supply growth likely to outpace local demand growth, potential for some small intervention destocking, and strong demand from Russia and Algeria in particular, exports will likely rise above previous-year levels through Q1 2011.

US milk supply momentum remained strong through late 2010, with production up 2.8 per cent in the 3 months to October. While the herd has stabilized in recent months and sits just even with previous-year levels, improved herd composition and better feeding have driven solid yield gains. Reflecting the patchy recovery in the US economy, growth in domestic dairy consumption slowed again in Q3, with falling milk sales dampening gains from rising cheese sales volumes.

In contrast, strong offshore demand and CWT subsidies saw Q3 net exports up almost 200 per cent (670 million litres) YOY―with further gains registered in October. But even an export surge proved insufficient to soak up local milk production. Seasonal reductions in cheese stocks through autumn were less sharp than usual, with all stocks except butter well up YOY.

The rising local surplus pushed milk prices down in December, and with feed costs rising at the same time, margins had already been snuffed out as the year drew to a close. Q1 2011 is shaping up to be a challenging period for the US. Milk production is already running ahead of domestic market needs, and stocks are heavy. The domestic market will likely improve in line with the economy, but slowly.

The export market will likely take more product from the US in Q1 2011, mitigating downward price pressure, with the potential for a global market shortfall in early 2011 offering some prospect for an export-led stabilization of local prices. But with the imperfect linkages between US and world markets, a rising local surplus and further increases in feed costs, Q1 2011 producer margins will likely deteriorate.

This should slow milk production growth considerably, though the potential for a slow response to a loss-making environment poses a risk to local and global markets alike.

Nature was always the risk to the buoyant expectations for New Zealand’s production season and Q4 2010 saw a range of elements thrown at dairy producers. September was impacted by the Canterbury earthquake, flooding in the lower North Island and severe snow storms in Southland. While most companies still noted record-high spring flush processing volumes and production had recovered to be tracking ahead of last season by the end of November, dry summer conditions arrived early―and swiftly―later in the month. At the end of Q4 2010, milk flows are likely to have started to trail below last season in most regions, with the large production regions of Waikato and Taranaki more severely impacted.

With around 60 per cent of seasonal production complete by the end of Q4 2010, there are at least 2 main scenarios for Q1 2011. The first: summer remains dry (or rains arrive after mid-January), lactation is shortened and a scenario similar to 2008 unfolds but impacting a wider production region and occurring much earlier. The second: the prevailing La Niña weather pattern brings summer rain to the northern parts of the North Island and provides a reasonable finish to the season for those with sufficient supplementary feed to keep cows lactating in the interim.

Either way, a large chunk of production will have been compromised and could result in milk production down 5 per cent to 15 per cent in the second half of the season. At least producers are able to secure additional feed, having some comfort that milk price forecasts are holding for the season. Most companies have increased advance payment rates during Q4 2010, and Fonterra lifted the milk price by NZD 0.30 /kgMS.

Export volumes during Q1 2011 are likely to reflect the lower milk production levels and see a steeper seasonal decline than usual from the Q4 2010 peak.

Despite the buoyant Australian dollar, solid commodity prices allowed export processors to step up milk prices above already high opening prices through November, helping buttress farmgate margins against rising feed costs. But hopes for a bumper 2010/11 season have hit an almost forgotten hurdle in Australia. La Niña-related rainfall has caused excessive moisture on farm and flooding in many areas in September and again in early December―lowering feed quality by delaying fodder harvests and disrupting grazing. The extended wet period has impeded milk production, with supply down -0.5 per cent YOY in the 3 months to October. But every cloud has a silver lining, and the wet first half to the Australian season should create a favourable environment for many farmers in early 2011. Heavy rains will ensure an extended growing season for pasture, the best irrigation water availability in a decade and improved supply of feed grain via the rain-driven downgrade of much of the local grain crop.

Rabobank thus expects milk production to rise significantly above previous-year levels through early 2011. Unfortunately, this strong shoulder season is likely to come too late to buttress export supply, with the poor spring peak likely to snuff out the nascent export recovery evident in October. Outgoing shipments are expected to remain weak through early 2011.

Milk production continued to grow vigorously though late 2010, with growth anticipated through to year end. While farm-gate prices have fallen slightly from their mid-year peak and corn costs have increased substantially, the milk/corn ratio remains above the long-term average. Export volumes began to climb above previous-year levels in August and were up 10 per cent in 3 months to October YOY. They are expected to have remained high for the rest of the year. Assuming a normal summer and stable or modestly rising feed costs, improved sentiment and recent investments will drive strong growth in Argentina’s milk production through Q1 2011, feeding through to double-digit growth in export volumes. However, the prevailing La Niña weather pattern and early signs of a dry summer pose a significant downside risk.

A 13-month long expansion in Brazilian milk supply came to an end in October as rising feed costs and scarce rainfall bit. With a vibrant local economy underpinning strong local sales growth, buyers were forced to look outside Brazil for coverage, driving a significant jump in import volumes in November. In response to tight local market conditions, milk prices rose unseasonably in November over the previous month. Rainfall has recently returned to near normal levels in most regions, which should support increased forage production. Rabobank expects positive margins and better conditions to see milk production return to YOY growth in early 2011, though solid market demand will keep Brazil largely out of export markets.

The global dairy market has in recent months been characterised by an inconsistent and two-speed recovery in end use, overlaid by a surge in demand for imported product.

The global economy hit a soft patch in an already weak recovery. In the OECD, growth slowed as government stimulus programmes ran down, and private sector momentum failed to materialise in the face of weak employment growth and the need to deleverage. Growth also lost some speed in countries like China and Brazil, due to tightening monetary policy and the end of restocking.

Trends in end use of dairy continued to reflect economic conditions and longer-term structural trends in diets and demographics. The US experienced only fractional market growth, with declining milk sales partly offsetting decent cheese sales growth (supported by an improving foodservice channel). EU consumption continues to expand albeit slowly. Developing markets continue to outperform, with high single-digit sales volume growth reported in South East Asian markets in particular.

While dairy consumption continues to grow at global level, most demand-side support for recent price momentum appears to have been generated by the expansion of import-buying, driven as much by local supply events in importing countries as demand improvement. Import-buying (as reported by ‘big 6’ exporters) rose more than 10 per cent above previous-year levels in Q3 2010. China and Russia continued to call heavily on the world market into October, with strong buying also reported from parts of South East Asia and North Africa.

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

Source: Rabobank, national statistical agencies

Q1 2011 is likely to see an improving environment for global dairy demand.

At the economic level, the loss of global growth momentum in late 2010 is likely to prove temporary. In the OECD, rising consumer confidence and a slow pick-up in employment growth should underpin a strengthening of consumer spending―though growth will remain muted. The developing world will see growth reaccelerate, driven by robust internal demand.

Retail prices in dairy, relatively stable through late 2010, may rise in early 2011, in line with commodity price expectations, but are expected to exert only moderate influence on consumption. Modest improvements on the economic front, despite retail-price inflation, should support ongoing improvements in dairy consumption, though growth in the OECD will remain pedestrian.

Import-buying may well stabilise in early 2011, though at extremely high levels. Russia will likely continue to seek product to supplement drought-depleted local supplies, while Chinese purchasing will be buttressed by market growth, milk supply shortfalls and the high cost of sourcing product locally.

Further gradual improvements in end-use consumption of dairy, together with vigorous import demand, will create a strong demand-side environment for internationally traded product―though reliance on China and Russia remains heavy.

Outlook

Pricing in Q1 2011 will depend much on the net impacts of what appear to be diverging trends in supply availability in the Northern and Southern Hemispheres.

Rabobank’s current expectation is that a drought-driven contraction in New Zealand supply through early 2011 will more than offset expected strong growth in the Northern Hemisphere. As a result, after almost 2 years of uninterrupted growth, exportable supply is expected to fall marginally below previous-year levels in early 2011.

Assuming a reacceleration in the world economy, and strong ongoing purchases from the world market from China and Russia in particular, this will exert upward pressure on international dairy commodity prices in coming months, with considerable upside potential. Risks that would trigger an alternative scenario for dairy commodity pricing appear evenly weighted on the upside and downside (see below).

Bullish fundamentals in the grains complex are already expected to bring a further rise in the price of grain-based feed through Q1 2011, though any further market shocks would place additional pressure on margins — and production appetite — for users of grain-based feeds.

Any evidence of tightening fundamentals in dairy may drive a rush from buyers to cover short-term needs, bringing potential for a short-term market squeeze.

With the Southern Hemisphere season already gripped by adverse weather, the market will show heightened sensitivity to seasonal conditions in the US and the EU as the season starts to build in early 2011―with any hiccups providing further price upside.

Decent rains in New Zealand prior to Christmas may yet limit the significant downside potential for local supply in early 2011. US supply growth may fail to slow in Q1 2011 despite tightening margins, which would generate considerable additional exportable supply from the region.

Strong buying from Russia and China in early 2011 remains central to our expectations for price upside in Q1 2011: expectations would be substantially downgraded should this fail to materialise.