In rural and mainstream news services there is a regular stream of stories recounting the disastrous situation dairy farmers find themselves in as a result of the “claw-backs” advised by the milk processors last month.
Unfortunate as it is, these claw-backs are part and parcel of the milk supply agreements most of the dairy farmers in Australia commit to. In this article we aim to give an insight into dairy contracts for those outwith the dairy industry, and why most of the risk is held by the farmer.
Usually, milk processors at the beginning of the season announce an “opening price”. Traditionally the opening price is the “best guess” the milk factories have as to what they expect to be able to return to the grower in the milk cheque over the coming twelve months.
This equation includes the expected sale price of the various milk products produced, less the operating cost of the business.
On most occasions, this opening price is below the eventual price the dairy farmer finally receives – there is what is called a “top up” price added. The dairy farmer receives additional cents per kilogram “end of season bonus” over the total amount of the produce delivered for the season.
In most of the recent seasons, this worked fine. The “opening” milk price was at a level the dairy farmer could operate on, and at the end of the season a supplementary payment was received.
Many other farmers would look at this model with envy; regular cash flow to meet the bills, with an end of season bonus.
Dairy farming however is not without its challenges, mostly relating to the drier seasons experienced in recent times. That said, with a growing Asian middle class demanding more protein as recently as 2015 the prediction was for strong demand to continue.
It is also accepted that Australian dairy farmers along with their Kiwi mates are the most efficient producers in the world. The dairy industry is recognised as a leader in productivity with a range of initiatives implemented over recent years to improve the bottom line.
Why have milk contracts?
The nature of milk production and the inherent fresh requirement of milk requires a delivery and production system that is of the highest level and can meet the requirements of a modern food supply system. Contrast this with the grain industry; a grain grower could harvest his grain, store it on farm and then sometime over the coming months load it onto his truck and deliver it to a customer. Clearly this type of system is impossible with milk.
Milk also requires sophisticated processing to ensure that the highest standards are maintained to produce a safe product. So the existing process of state-of-the-art milk factories located in the dairy districts makes sense; it also creates a reliable collection system operating 365 days a year.
So what went wrong?
Well, the economic fundamentals of supply and demand are powerful influences. There is a saying that “high prices fix high prices”. Fig 1. Shows the roller coaster ride the milk price has had, especially since 2007-08. The roller coaster however has been at good levels in recent seasons, and on some of the years (2013-14) extraordinary levels. This resulted in unprecedented
investment in dairy farm production and is the cause of the current price collapse worldwide.
The New Zealand Friesian herd is at a record 4.8 million (there are only 4.2 million New Zealanders!) The US has been steadily increasing cow numbers, while the world’s largest producer (the EU) has increased by more than 5% year-over-year since the elimination of milk quotas the end of March last year.
The increase is significant as Europe’s dairy production is already one-and-a-half times larger than the U.S. and seven-and-a-half times larger than New Zealand and comes at a time when Russia is banning imports.
The story is somewhat complex though, while Australia doesn’t even make it into the Top 10 Milk producing countries (Table 1), it is a big player in the export market (Table 2.)
The Australian dairy producer relies on the international market, like a lot of our commodities we produce far more than we consume so we are an exporter of milk products.
So when we see an increase in production worldwide it is only a matter of time before it impacts on local milk demand and prices.
Is there a systemic problem?
It’s not usually productive to apportion blame when these type of calamities occur; however, it should be noted that the Australian Dairy Industry operates via “supply agreements”.
As outlined previously, there are good reasons for this system.
A consequence of this arrangement is that the milk factory has “captured” supply; it has effectively removed a significant risk for a manufacturing business. Under these agreements the dairy farmer is obligated to supply to the nominated factory, sometimes under long term agreements.
The interesting factor is that the farmer has no contract price; as seen this year the opening price can melt away if the factory sales do not meet expectation or if prices fall.
Not only has the milk factory covered its supply risk, it has also left all price risk with the dairy farmer. It’s almost the perfect model for manufacturing!
To be fair, in most of the recent past this model has worked fine. For many years the system was reasonably reliable with the “opening price” payments covering farmer’s regular expenses and often the end of year top up payments were the added “cream” to the farmer’s bottom line. Many dairy farmers built their business model on the opening price plus end of year top up. They were able to expand and increase production on the back of what were considered assured incomes. Banks also enjoyed this model of regular cash flow making it easier to budget plus an end of year bonus. The infrequent/non-existent use of claw back option meant that farmer’s paid minimal attention to this part of the sales agreement with the manufacturer until this season, when it hit hard.
Demand for Dairy products will continue its upward trend; the world population able to access milk products will continue to grow. It should however be noted that a trend can have retracements as is currently in play.
The future will see dairy farmers far more suspicious of the future, hence their investment decisions will be more cautious.
This will have spin off ramifications for many; land prices, grain and other feed inputs, even the local communities will be effected.
The challenge for many will be to first get through this shock; but importantly re-position for the future with a more cynical viewpoint in an industry that can provide great rewards.