Regulating milk prices won’t save the dairy industry

Photo: Jeff J Mitchell/ Getty Images.

Australian milk drinkers appear to be going through a bout of buyer’s remorse.

Like teenagers ignoring the advice of parents who say a new boyfriend is wrong for them, everyone who flocked to buy $2 milk over the last five years is starting to wonder why they didn’t listen.

And while it’s heartening for many to see supermarket shelves empty of higher-priced branded milks as consumers show their support for struggling Victorian dairy farmers, the question is how long will can last before everyone goes back to buying $2 milk again?

Photo: Barnaby Joyce MP/ Facebook.

It’s a bit like setting up a crowd-funding campaign for a poor bloke asking questions on Q&A. It makes people feel a little less guilty, but doesn’t address the fundamental, underlying problem.

But there’s suddenly a perception of a crisis in the dairy industry after Australia’s largest processor Murray Goulburn, which has nearly 40% of the market, and New Zealand processor Fonterra, suddenly cut farmgate prices by about 10% earlier this month.

It was disastrous news for Nationals leader and deputy PM Barnaby Joyce in the middle of an election campaign. As the pressure mounted he needed to act, announcing the government would offer $555 million in concessional loans to farmers affected by the price cuts.

Given that interest rates are already at record lows, and some dairy farmers say they’re producing at a loss, it’s hard to see how the prospect of increased debt helps, but like most commodities, dairy is cyclical, so many will bet on using the money to survive until there’s an upturn.

Joyce, a good retail politician prone to bluster with ideas of agrarian socialism, also suggested intervening to force supermarkets to raise the price of fresh milk.

“Retailers don’t want the government to jump on them, but we will if they don’t do anything,” he said.

A deputy leader of a conservative government seeking to regulate a free market? There’s never been a more exciting time to be a politician, especially when you’re the Nationals leader on a unity ticket with the Greens and independents on this issue.

But $2 milk is not the industry’s problem, any more than the temporary closure of live cattle exports to Indonesia was followed by an explosion in asylum seekers to Australia – another ridiculous thought bubble Joyce floated during a debate on agriculture this week.

When Coles started the “milk wars” on Australia Day 2011, and Woolworths quickly followed suit, the industry warned everyone the price was unsustainable, but their concerns were largely ignored and we bought $2 milk anyway.

For the first few years, Australians drank even more fresh milk, around 106 litres per person annually, but more recently, that’s begun to wane. Meanwhile, the dairy industry owes the nation’s cafes a beer. A lot of baristas are doing their bit to keep dairy margins up every time they make a flat white.

The thing about the dairy industry is that it’s a complex, export-driven and commodity-based business and fresh milk makes up just a quarter of the total market.

It’s regional too. In Queensland, nearly 100% of the milk goes into fresh milk and the farm gate price is the highest in the country. In the southern states, the focus is on export, especially to Asia.

Farmgate prices show there are regional factors coming into play. Source: Dairy Australia

The Murray Goulburn problem

The issues besetting Murray Goulburn (MGC) have more to do with specific management decisions than the broader challenges the sector face. MGC, an ASX-listed company now facing a class action over its current travails, as well as an ASIC investigation. It generates 43% of its $2.9 billion in revenue from exports with plans to shift from bulk commodities to value-added products via its Devondale brand.

It was, and still is, a good plan. Many thought the business was heading in the right direction as a brave new hybrid of co-operative with unit trust shares (with no voting rights), the money from the July IPO invested back into the business.

Macquarie Research was among those thinking the future looked bright. It’s 125-page analysis in September 2015 slapped an “outperform” on the company, whose shares had dropped 10% to $1.90, putting a $2.70 target on them.

“MGC is expected to benefit from the growing international demand for imported dairy products, and new Free Trade arrangements provide a favourable backdrop to do so, in our view,” Macquarie said.

As part of MGC’s strategy, it secured a deal to supply Coles with its private label milk, betting that as part of the trade off, it would gain additional shelf space for its more profitable products. The company spent $140 million on two new processing plants to guarantee supply on the 10-year deal, but there was no margin left for MGC on the milk and things quickly soured because consumers didn’t embrace Devondale, which Coles then sold off cheaply, and the new plants generated an oversupply in Victoria and NSW.

The other problem was the way the deal was bundled saw the cross-subsidisation margins shift from retailer to processor.

MGC hoped it could make up for the losses by selling more milk powder to China, but at that moment, that market collapsed too. A perfect storm, mostly coming from overseas, hit the business. It cost the CEO and CFO their jobs.

This can happen to businesses that take risks and step out of their comfort zones, especially when taking on a company as shrewd and, on occasion, as ruthless as Coles.

Fonterra also chased supermarket private milk deals.

Bega Cheese must be counting the blessings in disguise. After losing the Coles deal, it’s bounced back in a joint venture with Blackmores targeting infant formula to China. Bega shares have risen 10% in the year since it lost the supermarket contract.

The two major players in fresh milk in Australia are Lion Dairy & Drinks (Pura and Dairy Farmers) – yes, the people who also make Tooheys, James Boag and XXXX – and Parmalat (Pauls). Both are strong companies, along with the likes of the Norco cooperative in the northern NSW, which is part of the Coles deal with MGC.

And we know from the 2014 battle Warrnambool Cheese and Butter that many see value in the industry, with Canadian company Saputo’s $500 million takeover outbidding both Bega and MGC.

Meanwhile, in the 16 years since the Howard government deregulated the dairy industry, a number of smaller, niche players have entered the market. If you have both the desire and cash, it’s easy to pay $5-plus for 2lt of organic milk from the likes of Barambah in Queensland. The choice is out there.

But there’s no doubt supermarket private label milks have had an impact.

Total supermarket milk sales have remained relatively steady since 2010 at around 53-54% – the retail value is $2 billion – of the total milk market in Australia. But house-brand sales as a share of supermarket sales have moved from 25% in 2000, to 64% of fresh full cream milk and 51% of modified (ie. skim, light etc) sales. That is a big shift.

A snapshot

Dairy is Australia’s third largest agriculture sector, after beef and wheat, generating around $13.5 billion with 6100 farms, around 120 factories and 39,000 people employed.

In 2014/15 the farmgate value was $4.7 billion – the industry does well out of value-adding.

Farmgate value V export sales for various agriculture industries. Source: Dairy Australia

The industry saw massive change when it was deregulated in 2000. It was a case of get bigger or get out, and that’s what happened.

Many farmers left the industry, and herd sizes trebled for those who remained. It’s also worth noting that since 1980, milk production from a single cow has doubled to 5,731 litres annually. At the same time, the number of farms has gone in the opposite direction, down nearly 70% from nearly 22,000 in 1980 to just over 6000 today. The clear long-term trend is an industry shrinking while productivity gains make up for the losses.

Here’s Dairy Australia’s observation on where things are heading:

The long-term downward trend in inflation-adjusted farmgate milk prices … until early last decade is in line with returns from most other agricultural commodities.

Despite the occasional peaks — in 1992/93, 2001/02, 2007/08 and 2013/14 — the line has traditionally returned to trend and clearly illustrates the imperative to continually improve productivity throughout the industry.

While it does appear that the international dairy market might be undergoing a structural realignment in recent years to support stronger farmgate milk prices, the level of volatility has also increased significantly over this time.

It all sounds a bit like the local car industry, except dairy is coming off the back of two years of something akin to a mining boom.

As mentioned earlier, dairy is a commodity, but unlike an iron ore mine, you can’t mothball a cow when prices fall below production costs, and waiting it out to restart supply when the numbers stack up again. But that makes Australian dairy farmers a price taker in a global market and the value of the dollar is critical.

The global trends in farmgate milk prices. Source: Dairy Australia

Here’s what Dairy Australia says about the farm gate price (emphasis added):

Australian prices are driven by world dairy commodity prices which determine local export returns.

Therefore, world dairy prices directly impact on the company returns for the 35-40% of local milk production that finds its way into export products such as butter, cheese and milk powders; as well as the additional 30-35% of production that goes into locally consumed butter, cheese and milk powders.

This means that up to 75% of milk production is exposed to world prices for butter, cheese and milk powders; while the remaining 25% is consumed within Australia as liquid drinking milk.

Hence average Australian farmgate milk prices are strongly correlated with export returns, and over the last three decades more than 90% of the annual variation in farmgate milk prices is explained by movements in average export returns.

Apart from Australia’s actual export product mix and prevailing world dairy commodity prices, another layer of complexity is the value of the Australian dollar against the US dollar in foreign exchange markets, as it is critical in determining company returns.

Australian dairy industry returns benefit from a ‘lower’ Australian dollar (compared to the US dollar) as was the case early last decade when it was as low as USD$0.52 to $0.55. However, the local currency has been much ‘stronger’ in recent years (around and even above parity with the US dollar) and this significantly lowered the Australian dollar returns despite relatively strong export markets over much of this period.

As commodity prices have come off their peaks since early-2014, so the Australian dollar has also fallen significantly since early-2015, and helped to maintain local milk prices paid to farmers.

Consequently, the exchange rate can significantly affect what the dairy companies can pay for milk.

There are other external factors too, such as climate change and drought for an industry that relies heavily on natural, rain-fed pastures. Australian producers are efficient and globally competitive, but costs are escalating, especially as supplementary feed needs to be brought in. Climate is eroding the competitive advantage that made Australia the world’s fourth largest dairy exporter, with 6% of the global market, behind New Zealand (38%), the EU (32%) and USA (14%).

New Zealand, right now, is another story for another time.

Here’s what Dairy Australia says:

Australian farms consistently had costs of production in the lower cost category of all farms in such surveys. The fact that around half of Australia’s milk production was exported until recent years reflects this high level of competitiveness.

However, this has become increasingly difficult in recent years. Farm cost structures have increased in response to the need to adapt to drier conditions where rain-fed pastures were regularly contributing a lower proportion of the total feed available to the national herd. Despite the increased rainfall in recent seasons, farm cost structures have not returned to those of a decade ago for many reasons.

As a result, Australia’s share of international trade has trended lower as local milk production has contracted over the past decade.

Yes, supermarkets should be criticised for the milk wars, especially Coles, which has been caught out previously for misleading consumers about milk prices and what they pay.

And we know the supermarket giant has a slick PR campaign behind its marketing strategy to “neutralise the noise”.

That was especially evident last week in its offer to create a more expensive milk brand and donate the proceeds to farmers. Many saw it as a cynical attempt to pre-empt attention focussing on the supermarkets in the wake of Murray Goulburn’s problems, because what Coles failed to reveal in its gesture was that the company was paying 19% less for its $2 milk than it was two years ago.

Now both Coles and Woolies are facing the wrath of consumers wanting to buy branded milks and those empty shelves are no longer being seen as a sign of public support, but rather manipulation by the supermarkets to thwart the will of the people and failing to restock the shelves.

Barnaby Joyce doesn’t need to regulate supermarkets. If consumers really want to back the dairy industry and its long term sustainability, they’ll do it for him. But they need to realise they’re just one quarter of a global force, two litres at a time.