25 June 2011

13 minute read

Summary

International dairy commodity prices continued to trade at extremely high levels through Q2 2011.

Pricing was sustained early in the quarter by vigorous buying from China and Russia, which soaked up extremely strong supply growth in milk surplus regions.

As the quarter progressed, price support became more reliant on supply constraints as rising feed costs, dry conditions in the EU and a seasonal decline in the Southern Hemisphere kept the market tight despite reduced import growth.

Import-buying from China and Russia is likely to move closer in line with prior year levels through the second half of 2011 ― underpinning a stabilisation of import demand. With exportable supply likely to expand modestly, Rabobank anticipates some downward pressure on pricing through the back half of 2011, though pressure may be delayed until early Q4.

Prices

While the international dairy market remained broadly price supportive through Q2, the period was characterized by a shift in the relative prices of different product lines.

In particular, by mid-June WMP had fallen 13 per cent on opening quarter levels, while SMP had risen 14 per cent; much more modest movements were reported for other product lines. The realignment of relative prices was gradual during the period.

The US dollar fell 1.6 per cent on a broad index basis over the same period, providing marginal support for prices.

Figure 1: Dairy Commodity Prices fob Oceania

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

Supply growth started the second quarter with a head of steam. Milk supply grew by 4.4 per cent YOY in April in the 7 key export regions of the world on a combined basis as favorable seasonal conditions enabled farmers to respond to extremely high (and in some cases record) milk prices. Half of the increase in milk supply came from New Zealand, though all regions bar Brazil contributed meaningful growth.

Supply growth is expected to have slowed rapidly through May and into June, as high feed costs hit US farm profitability, the EU experienced dry conditions, and the Southern Hemisphere (where profitability remains higher) entered its seasonal lull.

The demand side story followed a similar pattern through Q2.

Vigorous import-buying, led by China, Russia and Brazil, proved adequate to soak up rising export supply in April, before China and Russia eased off, having accumulated comfortable inventories to see them through the balance of the quarter on reduced procurement levels. Fears of a negative market impact from the Japanese crisis receded, and the Middle East continued to buy.

Underlying global dairy consumption was almost certainly far more stable, and is likely to have expanded modestly as economic growth outweighed pressure from rising retail price inflation.

The sympathetic ebb and flow of sell and buy sides of the market were enough to keep pricing extremely firm in the global dairy complex through Q2. However, WMP prices were adversely impacted by the phenomenal spurt of growth in New Zealand supply (and to a lesser extent, Argentina and Uruguay), the direction of this milk to WMP and the eventual slowdown in Chinese buying. SMP supply was shorted by the NZ focus on WMP.

As we enter Q3, market-pricing in the dairy complex will be heavily influenced by when and how vigorously China and Russia return to the world market, and the speed at which exportable supply growth slows in key surplus regions in response to rising feed costs and increased consumption at point of origin.

Supply side

EU

EU milk production grew by an estimated 2.8 per cent in the first 4 months of 2011, as farmers responded to attractive margins brought by high milk prices, and quota expansions created room to move in some previously constrained countries. Growth was also assisted by weak year-on-year comparables.

Supply-growth momentum appeared to have stalled in May as dry conditions hit the northwest of the continent, impacting production in the most important dairying regions. Growth is reported to have slowed dramatically in at least France, Germany and the UK, with fat levels in milk also down.

Domestic market conditions improved through the early months of 2011, with Q1 GDP growth exceeding expectations and companies reporting marginally improved dairy sales. Nonetheless, milk supply growth evident until April generated ample supply to boost exports during Q1 2011. Shipments rose 19 per cent YOY in milk equivalent terms led by SMP, whey and cheese ― with much of the increase destined for Russia. Rabobank expects EU milk production growth to slow to 1 per cent in Q3.

Milk prices remain high, with FrieslandCampina’s guaranteed milk price for June stable at EUR 0.38/kg, up 11 per cent, YOY.

However, the dry Spring will limit the availability and quality of pasture and silage through Q3, and increase the dependency on purchased feed ― squeezing margins and reducing yields.

As foreshadowed, 1 June the European Commission put up just over 90,000 tonnes of SMP intervention stocks for sale to EU traders for export under the Most Deprived Persons programme. The majority of the powder is reported to have already been committed to export customers. The product is old and as such will be used mainly for animal feed or blended with fresh product, limiting its impact on market pricing.

Commercial stocks are low for this time of year. Domestic sales are expected to slowly expand in coming months, as employment and incomes continue to build. Despite slowing supply growth and some increase in local consumption, the EU is still expected to have a larger Q3 milk surplus than it did 12 months prior. It will be looking to place this in foreign markets through coming months, though a strong euro and weaker Russian buying will pose challenges.

US

On-farm profitability tightened again in the US in May as milk prices eased marginally and feed costs pushed up to a new record ― leaving income over feed costs at just USD 8.25/cwt. Supply growth fell to 1.5 per cent due to declining margins and cold weather through April.

Local demand conditions are improving in the form of income growth and job creation. However, significant headwinds remain, in the form of rising fuel, food and dairy prices. Against this backdrop, domestic dairy sales were up 2 per cent in Q1 on a milk equivalent basis. However, growth is lopsided, with food-service cheese the dominant growth source. Exports remained the key to sales growth for the US industry in Q1, with net trade improving 175 per cent.

April brought the first signs of the anticipated slowdown in outgoing volumes: with exports of milk powder and whey falling below prior-year levels.

Slowing supply growth, improving domestic sales and buoyant exports lay behind weaker-than-usual growth in seasonal inventories through March and April.

Rabobank expects milk supply growth to slow to 1.3 per cent, YOY, through Q3. Margins will remain skinny with some easing in feed costs likely matched by a small decline in milk price. Bank lines are also tight, equity is being rebuilt, there is declining spare capacity on farm, and the margin for cull cows over replacements looks attractive.

Consumption will continue to modestly improve as the slow growth in employment and incomes maintains marginal dominance over rising dairy prices and high fuel costs. And with some recent local supply-side disruptions to cheese manufacture, the US net exportable surplus is expected to fall through Q3, bringing a modest decline in YOY exports.

New Zealand

Farmgate milk prices reached an estimated NZD 7.50/kg MS for the 2010/11 season: the second highest price ever. Ideal climatic conditions in most dairy regions through the Southern Hemisphere autumn enabled farmers to respond to attractive margins. Milk production in the January to June period is expected to come in some 15 per cent up, YOY. Most of the additional milk flow has continued to be pushed into WMP production for China.

Buoyant markets have encouraged Fonterra to forecast a milk price of NZD 6.75/kg MS for the 2011/12 season. This will be profitable for most farmers, unless seasonal conditions turn sour, and highly profitable for those carrying little debt. Rabobank expects the 2011/12 New Zealand season to be strong. Feed availability and cow condition are good, margins attractive, and some new farm conversions will come online. However, the use of improved returns by many to retire high debt levels rather than just expand is expected to keep growth to around 4 per cent through 2 H 2011.

Moreover, it’s important to remember the NZ milk production season doesn’t really get going until September, and is highly weather-dependent. As such, the impact of the new season on Q3 pricing will be psychological rather than fundamental. New Zealand export shipments will be up on prior-year levels through Q3, but at seasonal lows, with brisk sales ensuring little uncommitted product and low inventories at present.

Australia

Despite an elevated currency, firm commodity markets have delivered southern producers in Australia their second highest farmgate price of around AUD 5.50/kg MS for 2010/11. This brought a profitable year for most, though not till late in the season. And the impact of weather disruptions meant milk production was only up 1.3 per cent in the 3 months to April YOY. Prospects for a strong start to the 2011/12 season look good. Fonterra Australia has announced an opening price of AUD 4.65/kg MS, the third highest they have ever delivered.

Soil moisture profiles in key dairy regions are good, and farmers have access to quality supply of feed grain, hay and silage, and water for irrigation farmers from the Murray Darling Basin. However, a tight pipeline of replacement heifers will likely restrict any significant herd expansions. Rabobank expects milk production to rise by around 2 per cent in 2H 2011, providing a boost to export supply.

Argentina

Milk production rose by 16 per cent in the first 4 months of 2011. Farmers enjoyed good weather. They increased feed rations to capitalise on high milk prices and discounted feed prices to the world market (arising from a 23 per cent export tax on corn). Rising supply fuelled a 42 per cent YOY jump in export volumes through Q1 and another 35 per cent increase in April. While some domestic retail price controls remain in place, there is no sign of export restrictions being reintroduced.

Given handsome margins, farmers are expected to continue to generate strong milk production growth in coming months. The main challenge for the industry will be capacity constraints: with powder plants running at close to full capacity at the current low point of the season, growth in milk supply in coming months will need to be directed to cheese.

Brazil

Brazilian milk supply continued decreasing in 2Q11 driven by the reduction in forage production - due to the colder and dry weather - coupled with high grain costs, which has not been offset by the increase in farm gate prices. Reduced availability of milk and buoyant consumption have paved the way for higher dairy prices in the local market. Boosted by the high local prices and the strong Brazilian real, imports have increased significantly, with milk powder purchases in May rising 86 per cent, YOY. Entering the seasonal supply trough, Q3 milk production will remain constrained by high feed costs. And with local demand expected to continue to expand, though tempered by a surge in retail price inflation, Brazilian imports will remain strong over the next quarter.

Demand side

Recent months have brought a lull in dairy purchasing. The global economy hit a softer patch. Q1 GDP figures were weaker than expected in the US and Japan, with growth decelerating as anticipated in parts of South East Asia and Brazil.

Demand for dairy is also being tempered by rising prices at retail and wholesale levels in many regions, particularly where it adds to pressure applied by rising fuel prices and food price inflation.

Actual sales of dairy products have improved in the west. In the US, the recovery of takeout expenditure appears to be underpinning improved cheese sales, more than offsetting ongoing declines in the liquid milk category. EU companies are reporting marginally improved sales in a range of markets.

In developing regions, companies have reported more mixed performances. Sales growth has been strong in Brazil and China, but consumption in parts of South East Asia was impacted by rising prices and general inflation.

Import-buying held up extremely well through Q1. Driven mainly by a 45 per cent increase in Chinese milk powder purchases and a 21 per cent rise in Russian import volumes, total MEQ dairy trade volumes rose 19 per cent in the opening three months of the year. Even Japan held up reasonably well, with a weak March more than offset in April.

Figure 3: Change in Export Volumes for ‘Big 7’ Exporters

Note: Includes NZ, EU, US, Australia, Argentina, Uruguay and Brazil
Source: Rabobank, national statistical agencies

Partial data and anecdotal evidence suggest that import-buying from China and Russia has dropped off substantially since the opening 3 to 4 months of the year. Q1 buying almost certainly reflected heavy stock building as buyers rushed to avoid being caught short at a time when the New Zealand season looked less promising than it turned out to be.

Q3 should bring a more stable buying situation than evident through 1H 2011. Underlying global demand for dairy will improve. The economic environment will strengthen further in the west and Russian economic activity is also building. Chinese growth will slow in response to tightening monetary policy, but not alarmingly so.

Rising dairy prices will bring stiffening headwinds to some regions. Companies are expected to push through price increases on most products in regions where it is allowed in Q3. But the impact of rising prices on demand may be less evident than in 2007/08. This time the percentage increases at retail level are likely to be less shocking, while many of the easiest options for substitution in ingredient use were taken in the last price boom.

Purchasing activity from the world’s milk-deficit regions will remain central to the market through the second half of 2011. Russian milk production has improved, but not enough to wipe out its recent increased need for import supply, while Chinese milk production growth is still struggling to keep up with rising demand. Stocks accumulated in 1H will enable lighter imports from these two giants through Q3, before they return to the market in Q4 for similar volumes to the prior year. Import buying from North Africa and Brazil is expected to remain strong.

Outlook

Rabobank expectations

After a frenetic stock build through the opening 3 months of the year, and reduced purchasing through Q2, import-buying from China and Russia is likely to move closer in line with prior- year levels through 2H 2011 ― underpinning a stabilisation of import demand.

While exportable supply growth is expected to slow in coming months in response to rising feed costs, dry conditions in the EU and improving consumption at point of origin, a modest increase in exportable supply is likely for H2.

This brings the distinct possibility of some further softening of prices in international trade through the back half of the year: though this may be delayed until Q4 when the Southern Hemisphere milk production season gathers momentum.

However, the extent of any downward price movement is likely to be limited: as many buyers that have been squeezed out of the market by high pricing through recent months are likely to re-enter the market should product become even modestly more affordable.

The unusually large premium in place for SMP/butter production over WMP production as at mid-June is expected to close over coming months as milk is redirected to its higher value use.

Downside influences

The downside risk for prices would increase if weak buying from China and Russia continues through Q3, rather than recovering to around prior-year levels as anticipated.

Ongoing growth in EU and US milk supply of above 2 per cent through coming months would also likely further suppress prices.

Upside influences

On the buy side, any increase in Indian purchases from the world market in coming months beyond that already scheduled would create upside price potential.

On the supply side, a further spike in grain costs would lead to a faster-than-anticipated slowdown in supply growth (especially in the US).

More technically, a further decline in the value of the US dollar (a distinct possibility) would exert upward pressure on the prices of dairy commodities in US dollar terms.