29 September 2011

13 minute read

Summary

International dairy commodity prices slowly ceded ground during Q3 2011. A marked deterioration in demand conditions in the US and EU and light import purchases from China and Russia proved insufficient to mop up solid supply growth, as farmers responded to what remained attractive milk prices. The closing months of 2011 are expected to see more supply looking for a home on the international market, as rising surpluses from the Northern Hemisphere collide with a strong Southern Hemisphere season. While import demand is expected to reach near-record levels for this time of year, buoyed in part by recent price falls, soaking up more supply than 12 months prior seems beyond the capacity of buyers at current prices. This is likely to bring modest downward pressure on prices in international trade through Q4.

Prices

International dairy prices slowly deflated through Q3, closing in mid-September some 5 per cent-10 per cent down on opening quarter levels in US dollar terms, depending on the commodity.

Currency factors played a minor role throughout the period, with the US dollar rising just 0.7 per cent on a broad index basis over the same period.

Milk supply growth lost steam through Q3 in the world’s largest seven export regions, and is expected to have finally fallen below 2 per cent YOY for the first time in more than a year. Adverse weather (in the US) and strong year-on-year comparables played a hand in putting the brakes on, as did the seasonal lull in the Southern Hemisphere (where returns are more attractive at present).

However, farmers also began to see margins tighten as milk prices edged back (in regions with monthly milk pricing), feed costs pushed higher (the price of September delivery corn was up 19 per cent on opening quarter levels in mid September trading) and forage became scarcer in some regions.

Unfortunately for producers, the slowdown in demand was even quicker than that in supply. In particular, battered by stagnant job markets and declining real wages, US and EU consumers tightened their purse strings further, snuffing out the nascent recovery in some product line sales evident in the first half of the year. Economic conditions held up better elsewhere, though rising retail prices presented a headwind across the board.

Import demand proved inadequate to soak up rising surpluses from the west. Q2 data now in showed yet another expansion in trade volumes, with imports up 9 per cent YOY and 26 per cent above Q2 2008 levels. But this masks a gradual fall off in buying from Russia, Algeria and China, which by June were all buying considerably less than 12 months prior. Others picked up some of the slack as prices began to fall, but with insufficient vigour to avoid prices drifting downwards as Q3 progressed.

As we enter Q4, market pricing will be heavily influenced by the size of the demand driven surpluses generated by the EU and US, the strength of the Southern Hemisphere spring peak, and buying activity from key importers, especially China and Russia. Balancing the market will likely prove challenging without further price falls.

Supply side

EU milk production increased by 1.6 per cent in the three months to July (YOY). Growth accelerated as the period progressed, reaching 2.8 per cent in July, with improving weather enabling farmers to take advantage of high milk prices. Unfortunately local demand saw no such improvement. Economic growth had slowed to just 0.2 per cent (QOQ) in Q2, with a range of data pointing to a swift deterioration since. Retail dairy prices have risen and consumer demand is distinctly weak. The world market has provided an outlet for rising EU supplies in recent months. Exports rose 3 per cent in Q2 (YOY), with vigorous growth in shipments of SMP, casein and whey more than offsetting declines in most other categories.

Milk supply growth is expected to slow in the coming months. While feed costs remain high, milk prices are starting to fall, reflecting weakening commodity markets. FrieslandCampina’s guaranteed milk price was 5 per cent below July levels in September (though still up 7 per cent YOY).

Farmers in some countries will look to rein in growth as they start to contemplate the potential for production to exceed quota levels this year.

With year-on-year comparables also particularly strong, Rabobank expects milk production growth to slow to around 1 per cent for 4Q11.

However, available supply will be boosted by the disposal of remaining intervention stocks accumulated in 2009/10, which will largely find its way into domestic feed use and exports.

The EU market is unlikely to be able to soak up what will still amount to a fairly modest increase in supply during Q4.

The economy is expected to barely expand through Q4, while consumer sentiment is weak and new jobs are still hard to come by. The costs of dairy at the retail level is also likely to remain high, with some companies still expected to push through price increases in lagged response to the rise in milk prices seen mid-year.

Rabobank thus expects to see EU companies trying to push increased surpluses onto the world market over the closing months of 2011 over this time last year.

Milk production growth has slowed in recent months, and was up just 0.7 per cent in July YOY. The deceleration was mainly accounted for by extreme heat in the Midwest, while non-weather impacted regions were well up. With a local cheese price rally driving up milk prices, income over feed costs actually remained attractive through August, and herds are still well above prior year levels. Even weather-impacted regions are reported to have recovered strongly in August. Meanwhile, US demand growth has stalled. A depressing combination of lacklustre economic growth, zero net job creation, falling real wages and rising dairy prices has taken its toll. Liquid milk sales have continued to decline, retail cheese demand remains poor and the food service engine has stalled.

The stalling of the domestic market has coincided with a plateau in exports, which were down marginally YOY in the three months to July (cheese being the only exception). Inventories rose, with July bringing the largest monthly increase in US cheese stocks for that period in nine years. After what was expected to have been a recovery in growth through August, the rate of expansion in US milk production is likely to decline through the closing months of 2011, though at a slower pace than the market might warrant.

While commodity market prices shifted down in August, and feed costs remain brutally high, the impacts of this have yet to show up in milk checks. Even when margins do disappear, the lag in US supply response tends to be considerable, with YOY growth likely to track close to 1 per cent deep into Q4. This may yet prove too fast for domestic requirements. The local economy looks set to post marginal growth at best through Q4, bringing little hope of meaningful job creation. With lagged price adjustments more likely to see retail product prices push up than down in coming months, demand growth risks becoming a rounding error.

With weak supply growth to exceed even weaker local requirements, Rabobank expects the US to face a rising surplus of dairy product through Q4 available for export or stock accumulation. Given expectations of a well-supplied world market, this is likely to prove a problem for the US industry.

Q2 11 milk flows were remarkably strong, with the tail of the season pushed one third higher than last year due to near perfect climatic conditions. The season finished more than 5 per cent ahead, which enabled greater export volumes to be shipped through the traditional seasonal trough.

Supply growth pushed exports 4 per cent higher over the three months to July. While WMP exports were up 1 per cent YOY, increased volumes went towards SMP (+20 per cent), butter (+2 per cent) and casein (+5 per cent) due to higher returns and weaker Chinese demand. Producers have generally started the new season well, with good feed availability and cow condition and a robust Fonterra opening forecast of NZD 6.75/kgMS, all contributing to a lift in early season milk flows.

Milk flows will reach their seasonal peak through Q4 2011. Barring major climatic disruption through spring, Rabobank expects milk flow to be up around 5 per cent YOY given the weak comparable Q4 10 and the addition of new farms coming into production this season. Export volumes will reflect this lift, with WMP continuing to dominate the product mix.

Following a good close to the 2010/11 season, Australian milk production finished 0.9 per cent higher on the previous year.

Over winter, most dairy regions enjoyed average rainfall ensuring good soil moisture leading into spring. Water storage levels are close to full, ensuring good irrigation water availability for the 2011/12 season. Farmers are conscious of rising input costs, falling commodity prices, the strong local dollar and economic uncertainty. Nevertheless, optimism remains high given solid opening farmgate prices and good seasonal conditions.

The Australian dollar remains highly volatile, ensuring that hedging strategies will play a role in determining the ability of processors to offer competitive milk prices this season. Weather permitting, Rabobank expects national milk production to gain momentum in the coming quarter as the flush approaches and subsequently bolsters export supply.

Milk production rose by 11 per cent in the 3 months to July (YOY), as farmers enjoyed good weather, high milk prices and feed costs kept below world levels by an export tax on corn. Rising supply fuelled a doubling of export volumes in Q2, much of it headed for Brazil.

Rabobank expects Argentine milk production to continue to rise above prior year levels through Q4. Margins remain attractive, weather is good and soil moisture is at optimal levels.

However YOY growth will slow given stronger comparables, while a La Niña cycle will bring the risk of a dry summer. In any event, processors will be juggling capacity constraints as milk supply approaches its seasonal peak in spring. Powder plants have been running at full capacity throughout the low season and more milk will have to be directed to cheese in Q4.

In stark contrast to its Southern neighbours, Brazilian milk supply continued to fall below prior year levels through at least early Q3. The weather has been worse, and while milk prices are higher than in Argentina, feed prices are far higher and farmers use more of it.

Reduced milk availability and solid demand have driven up wholesale and retail prices. Together with a strong local currency, this has attracted a wave of imports, with imported milk powder purchases rising 40 per cent in the three months to July. While milk supply will rise seasonally in Q4, Rabobank expects production to continue to fall short of year ago levels, given a breakeven scenario for producers and forecasts of a late arrival of rains in key regions.

This will see Brazil continue to soak up large import volumes through the peak production period, with exports largely on hold for another year.

Demand side

Recent months have brought about deterioration in demand conditions for dairy.

Instead of strengthening as anticipated, the economies of the EU and US weakened further. Escalating sovereign debt problems in both regions triggered a crash in financial markets, just as a wave of data releases showed underlying economic activity to be losing any semblance of momentum on both sides of the Atlantic, sapping consumer and investor confidence.

Dairy retail prices continued to rise in most jurisdictions, putting further pressure on consumers.

Lack of employment growth, falling real incomes and rising prices clearly started to bite in Q3 in the West. In the US, the recent growth engine provided by rising food service sales appeared to stall, while retail sales of cheese and liquid milk continued to slide.

The picture in developing markets was more mixed. Underpinned by far more buoyant economies, companies in China and Vietnam continued to report double digit dairy sales growth, while demand from the Middle East remained strong despite ongoing political unrest. In contrast, the Philippines market appears to have stagnated as consumers wilt under rising food and fuel prices.

Data now available shows that import demand actually held up extremely well through Q2. Trade data from the world’s seven key exporters suggests a 9 per cent YOY expansion in trade during the period. However, this masks a gradual fall off in buying from Russia, China and Algeria, who by June were buying considerably less than 12 months prior as they continued to work their way through inventory accumulated in an early-year buying spree. Anecdotal evidence and partial data point to subdued trade through Q3.

Q4 is likely to bring little improvement in dairy consumption in key western regions. Economic performance in the US and EU will remain lacklustre, with uncertainty undermining hopes for significant job creation. Lagged pricing will ensure that consumers see what may be the last wave of price increases in this cycle through Q4, despite weakening market conditions.

Stagnancy in the West increases the sector’s reliance on importers to drive demand growth through the closing months of the year.

Chinese buyers are expected to return to the market with vigour in the coming months. Local sales momentum remains strong, even if less strong than in H1, while we believe that stocks accumulated earlier in the year have been whittled down. Together with high local milk prices, a rising currency, lower international commodity prices and the forthcoming window for reduced duty shipments from NZ, import purchasing in Q4 will likely be both necessary and attractive.

Russia is still facing milk supply shortages and high prices, as milk production has not yet succeeded in gaining sufficient momentum following the 2010 drought. However, purchases are expected to fall short of prior year levels through Q4, with demand less buoyant than in China and the supply gap still somewhat reduced.

Elsewhere, import demand is expected to be brisk. Recent price falls should bring back buyers who had been squeezed out by higher price tags, with solid buying expected from the Middle East, North Africa, South East Asia and Brazil. India has announced it needs to top up its local supply again, to the tune of 20kt of SMP, while Korean purchases will exceed pre-FMD levels.

In sum, Rabobank expects key importers to soak up almost record volumes of product in Q4 for this time of year. But pushing above the levels set 12 months prior appears to be beyond their capacity. And that, for sellers, is likely to be a problem.

Outlook

Q4 was always going to see the global dairy market loosen somewhat; developments in recent months will likely magnify that shift.

Beset by economic headwinds, demand in the key US and EU markets will slow to a crawl. The expansion of local supply in these regions will also slow, but given lagged price signals and low price elasticity, milk production growth will probably further overshoot domestic market requirements.

This will see the Northern Hemisphere looking to push more production to the international market than 12 months prior, just as the Southern Hemisphere launches into what is expected to be a solid supply growth year. While exportable supply will rise YOY in Q4, at current prices import demand is likely to hold level. China will return to the market, but Russian buying will fall short of year ago levels, more or less offsetting increased purchases from other buyers, whose appetites have been whet by recent price falls.

This is likely to bring further downward pressure on international market pricing through Q4. 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 in 2011 to date are likely to re-enter the market as product becomes more affordable.

An ongoing deterioration of the sovereign debt crisis in the EU, and spill-over to financial institution risk, would further undermine consumption and prices.

Our outlook still hinges on strong Chinese buying in Q4: if this doesn’t materialise, the downside looks greater. It has been a long time since New Zealand hit a perfect production season: other sellers will be hoping this is not the year it comes about.

Climatic conditions always play a strong hand in determining milk supply strength in the Southern Hemisphere in Q4, with any adverse weather, particularly in New Zealand, likely to reduce forecast surpluses.

With global grain stocks alarmingly low, and forage short in key parts of the US, farmers in more feed intensive regions remain exposed to potential feed market shocks that could further reduce supply. Brazil’s supply shortage could prove greater than anticipated.