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DAIRY INDUSTRY:
NOTES
Tony Baldwin
www.tonybaldwin.co.nz
August 2016
2
Outline
Slides
• Payout 3 to 4
• Dairy productivity 5 to 8
• Price volatility 9 to 12
• Competitive advantage 13 to 14
• Changes in production 15 to 19
• Monopolies 19 to 22
These slides set out brief background notes relating to:
Dairy payout
3
0
100
200
300
400
500
600
700
800
900
19
50
19
52
19
54
19
56
19
58
19
60
19
62
1964
1966
19
68
19
70
19
72
19
74
19
76
19
78
19
80
19
82
19
84
19
86
19
88
19
90
19
92
19
94
19
96
19
98
20
00
2002
20
04
20
06
20
08
20
10
20
12
20
14
Cents per kg of milk solids
Average dairy company payout (inflation adjusted, June 1999 base year)
In 1999 dollars:
Average since 1950: $4.99
Average 1980-2001: $3.96
Average 2002-2015: $4.37
Average 1980-2015: $4.12
This shows the annual average payout for all dairy companies since
1950. Payout includes milk price and any dividends. Payout has been
adjusted for inflation with June 1999 as the base year.
Source: MAF and DairyNZ ($s from 2002 adjusted to June
1999 base using Reserve Bank’s CPI calculator)
Dairy payout (cont’d)
4
0
100
200
300
400
500
600
700
800
900
19
91
1
98
7
19
88
2
01
5
20
03
2
00
6
19
98
1
99
9
19
95
2
00
7
19
94
1
99
7
20
00
1
99
2
20
04
2
00
9
20
05
1
98
6
19
93
1
99
6
19
79
1
98
9
19
80
1
99
0
20
13
1
97
8
19
70
1
97
7
19
81
1
98
5
19
84
2
01
2
19
69
2
01
0
19
83
1
97
1
20
01
1
96
8
19
76
2
00
2
19
82
1
97
5
19
73
2
01
1
19
62
1
96
7
19
72
1
96
3
20
14
1
97
4
19
60
2
00
8
19
61
1
96
6
19
65
1
95
9
19
58
1
96
4
19
57
1
95
5
19
56
1
95
4
19
51
1
95
3
19
52
1
95
0
Cents per kg of milk solids
Average dairy company payout since 1950 (ranked)
(inflation adjusted, June 1999 base year)
Last year’s payout was about the 4th worst since 1950 when adjusted for inflation
Dairy productivity
• Over the last [40] years, New Zealand’s productivity performance has been relatively
dismal. We’ve plummeted from top 5 to around 30th in the international rankings and
incurred corresponding falls (followed by a sustained flattening) in our per capita
standard of living relative to other OECD countries.
• Until about 10 years ago, dairy was a stand-out in our productivity stakes, delivering
gains at a much better rate than most other sectors of the economy. Dairy kept
producing higher volumes of milk for the same or less inputs.
• This was underpinned by improvements in pasture and feed management, milking
and processing technology, and bovine genetics.
• Over the last 10 years, however, productivity in dairy has been less impressive. Milk
production has increased significantly, but much of the growth is likely to have been
negative in productivity terms with more inputs used for each unit of output.
• It is also likely to have been uneconomic with the full costs of producing an extra unit
of milk greater than the additional income it generated.
5
Dairy productivity (cont’d)
• In 2014, AUT masters student, Xiaoqi Wei, found that only 17% of dairy farms in his
sample were operating at their optimal size. Half of the farms could increase their
technical efficiency by decreasing their size.
• In another 2014 paper, Economist Peter Fraser and two colleagues suggest that much
of growth in raw milk volumes is probably not profitable. They surmise that volumes
have been increased as a result of farmers and their advisors taking an average cost
rather than marginal cost approach. Fraser concludes that less intensive production is
likely to be more profitable for farmers and better for the environment.
• Many farmers, and the environment in which they operate, would probably be better
off if milk production were reduced to more optimal levels.
• ‘Total factor productivity’ is another key performance indicator. In dairy over the last
10 years it has fallen by 7.3%.
• Growth in value-added activities has been weak, even when terms of trade and dairy
prices have been strong.
• Participation in global value chains remains low, even when more prosperous firms
have been adding different elements of final goods and services in different places to
capture gains from specialisation and economies of scale. Meanwhile, Fonterra
continues to place high importance on exclusive control from cow shed to customer.
6
Dairy productivity (cont’d)
• 'Total factor productivity’ is another key performance indicator. In dairy over the last
10 years it has fallen by 7.3%.
• Growth in value-added activities has been weak, even when terms of trade and dairy
prices have been strong.
• Participation in global value chains remains low, even when more prosperous firms
have been adding different elements of final goods and services in different places to
capture gains from specialisation and economies of scale. Meanwhile, Fonterra
continues to place high importance on exclusive control from cow shed to customer.
7
Dairy productivity (cont’d)
Sources:
• http://www.treasury.govt.nz/downloads/pdfs/2025tf-2ndreport-nov10.pdf
• Xiaoqi Wei, “Efficiency measurement of New Zealand dairy farms”, AUT, 2014, pp 38 and 39
• MPI
• Fraser, Ridler, Anderson. “The intensification of the NZ Dairy Industry – Ferrari cows being run on two-
stroke fuel on a road to nowhere?, 2014 - http://www.grazingsystems.co.nz/wp-content/uploads/NZARES-
Fraser-The-intensification-of-the-NZ-Dairy-Industry-FINAL.pdf
• Rebecca Macfie, “Milk Tanks”, The Listener, April 2016 - http://www.listener.co.nz/current-
affairs/business/milk-tanks/
• DairyNZ’s ‘Economic Survey’ - http://www.dairynz.co.nz/media/4291790/dairynz-economic-survey-2014-
15.pdf. TFP measures productive value gain over and above changes in inputs like capital and labour –
MPI
• A recent OECD paper, indicated that New Zealand was in 30th place in list of OECD countries, with very
little improvement in New Zealand’s participation from 1995 to 2011 (De Backer and Yamano, 2012). See
Professor David Deakins, 15 August 2015, Blog -
http://masseyblogs.ac.nz/othersideofbusiness/2013/08/15/is-fonterra-good-for-new-zealand/
• Treasury – Holding On, Letting Go, 2014 - http://www.treasury.govt.nz/publications/briefings/holding-on-
letting-go/holg14.pdf. See also Bollard remarks to lecture in Wellington in 2015 and again in 2016
8
Price volatility
Factors that contribute to volatility in international dairy prices include:
• Overseas markets for dairy commodities are very ‘thin’. Only about [6]% of world production
is traded. So very small changes (as little as 1%) in supply and demand in the larger trading
regions can have a really big impact on prices.
• Government interventions in the dairy markets around the world tend only to increase price
variability.
• The amount of milk produced within a season can’t be readily adjusted, which means supply
volumes are somewhat slow to respond to changes in price signals.
• Weather volatility is a crucial factor that hugely influences the amount of milk produced.
• International prices are not well telegraphed. Market platforms for discovering forward prices
in dairy commodities are relatively limited.
• Volatility in our exchange rate only exacerbates volatility in the prices that New Zealand
receives for its dairy products overseas.
9
Price volatility(cont’d)
10
0
50
100
150
200
250
300
Jan 8
6
Oct 86
Jul 87
Apr
88
Jan 8
9
Oct 89
Jul 90
Apr
91
Jan 9
2
Oct 92
Jul 93
Apr
94
Jan 9
5
Oct 95
Jul 96
Apr
97
Jan 9
8
Oct 98
Jul 99
Apr
00
Jan 0
1
Oct 01
Jul 02
Apr
03
Jan 0
4
Oct 04
Jul 05
Apr
06
Jan 0
7
Oct 07
Jul 08
Apr
09
Jan 1
0
Oct 10
Jul 11
Apr
12
Jan 1
3
Oct 13
Jul 14
Apr
15
Jan 1
6
Dairy commodity price index Source: ANZ
Price volatility(cont’d)
A range of tools are used to mitigate the adverse effects of price volatility, including:
• ‘Right-sizing’ – configuring the farm (including its balance sheet) so its break even point can
cope (and flex) with peaks and troughs
• Self-insuring – building a reserve of savings to help deal with constraints in a down-turn
• ‘Pooling’ – averaging prices across all a large milk pool. (This can delay and blunt market
signals from overseas buyers to producers).
• Forward contracts – agreeing to sell a physical volume in the future at an agreed price. (It is
not clear whether processors will keep offering these contracts).
• Futures contracts – derivative contracts, which NZX is now promoting. (These are used in
some larger overseas dairy markets, but uptake is relatively low. According to various
sources, despite the availability of futures markets in the US for around 20 years, less than
5% of dairy farmers use them directly, and less than 10 percent of total U.S. milk production
is hedged).
Note – ‘Single seller’ – for many years, New Zealand dairy has assumed that selling through a
‘single seller’ could influence prices and therefore mitigate volatility. Except in rare
circumstances, it does not work.
11
Price volatility(cont’d)
Sources:
• http://www.agmrc.org/media/cms/FutDairyUS_7ACAB66094C9A.pdf;
• http://future.aae.wisc.edu/publications/err28.pdf ;
• https://core.ac.uk/download/files/153/7035446.pdf;
• http://www.teagasc.ie/publications/2012/1607/National_Dairy_Conference_2012.pdf#page=91;
http://fieldnotes.co.nz/dairy/milk-price-hedge-passes-final-hurdles/; and
• http://ageconsearch.umn.edu/bitstream/211369/2/Bozic-
Price%20Discovery%2c%20Volatility%20Spillovers%20and%20Adequacy-1203.pdf
12
13
Competitive advantage
• NZ dairy’s main competitive advantage is low cost feed (grass) year round.
• Only about 10% of dairy cows in the world have pasture grazing as the major
component of their total food intake
• Hay, silage and grains are typically a lot more expensive than grass but are also more
energy-rich producing more milk solids per cow.
• Grass is lower energy [10-12] mega joules of metabolisable energy per kg of DM
(depending on season and pasture condition). Therefore milk production per cow is
relatively low in NZ – on average about 4,200 litres per year (at 2014/15).
• By contrast, in the northern-hemisphere it is about 10,000 litres per cow per year, using
higher energy feeds (with high Govt supports) (as at 2004 – updated figures pending)
14
Competitive advantage (cont’d)
• Low cost water and electricity has been key to NZ production growth over last 40
years
• Unlike, many competitors, no need for seasonal housing – cows kept outside year
round
• Avoid extra labour for feeding and mucking out faced by many competitors
• However, key cost drivers of dairy farm profitability are milksolids produced per
hectare, and cost of capital
• Much of the growth in production over recent years relied on higher cost feed and
more expensive irrigation, rather than low cost grass feed.
Changes in production
• Since Fonterra was formed in 2001, raw milk production in New Zealand has increased by
about 58% (up until mid 2015):
– More cows (up 33%)
– More milk per cow (up 21% on average)
– More land used for dairying (up 22%)
– More investment in milk processing plant
– More on-farm plant and equipment
– More water for irrigation
– More borrowings. (Dairy debt almost trebled over the past decade to reach $32 billion in
2015)
– More cow genetics, more pasture management and, of course, more waste
15
Changes in production (cont’d)
16
1,050,000
1,150,000
1,250,000
1,350,000
1,450,000
1,550,000
1,650,000
1,750,000
92/9
3
93/9
4
94/9
5
95/9
6
96/9
7
97/9
8
98/9
9
99/0
0
00/0
1
01/0
2
02/0
3
03/0
4
04/0
5
05/0
6
06/0
7
07/0
8
08/0
9
09/1
0
10/1
1
11/1
2
12/1
3
13/1
4
14/1
5
Hectares Total effective hectares of land used in dairying
Fonterra formed
Changes in production (cont’d)
17
450
650
850
1050
1250
1450
1650
1850
2050
76/7
7
77/7
8
78/7
9
79/8
0
80/8
1
81/8
2
82/8
3
83/8
4
84/8
5
85/8
6
86/8
7
87/8
8
88/8
9
89/9
0
90/9
1
91/9
2
92/9
3
93/9
4
94/9
5
95/9
6
96/9
7
97/9
8
98/9
9
99/0
0
00/0
1
01/0
2
02/0
3
03/0
4
04/0
5
05/0
6
06/0
7
07/0
8
08/0
9
09/1
0
10/1
1
11/1
2
12/1
3
13/1
4
14/1
5
Millions of kgs millk solids
Total NZ milk production
Fonterra formed
Changes in production (cont’d)
18
1,050,000
1,150,000
1,250,000
1,350,000
1,450,000
1,550,000
1,650,000
1,750,000
92/9
3
93/9
4
94/9
5
95/9
6
96/9
7
97/9
8
98/9
9
99/0
0
00/0
1
01/0
2
02/0
3
03/0
4
04/0
5
05/0
6
06/0
7
07/0
8
08/0
9
09/1
0
10/1
1
11/1
2
12/1
3
13/1
4
14/1
5
Hectares Total effective hectares of land used in dairying
Fonterra formed
Monopolies
By way of background, it’s helpful to understand the role and effects of monopolies in
economic terms. The following explanation has been kindly provided by David Pickens, a
regulatory economist:
• Monopolies are entities that provide goods or services to consumers who will have little
choice but to buy those goods and services from that provider. Typically, it is difficult for
consumers to go without that good or service, there are few reasonable substitutes and
it is difficult for other providers to set up in competition with the incumbent (the
monopolist).
• There are two types of monopolies to think about – natural monopolies and government
created monopolies. Natural monopolies exist because the goods or services they
provide are most cheaply provided by one provider. A good example is the national grid
for electricity (Transpower). While it is feasible to provide another network to operate in
parallel to Transpower, carrying electricity from generators (electricity producers) to
lines companies (consumers), it is not sensible. It is too costly.
• Monopolies are both good and bad. A useful way to think about the good and bad that
might come from a monopoly is economic efficiency.
19
Monopolies (cont’d)
• Economic efficiency is broken into:
Productive efficiency: This refers to the amount of resource needed to produce a
good or service. If less resource is needed to produce a given level of good or
service, then inputs are freed up to produce value for the community elsewhere.
Where this happens there is an improvement in productive efficiency.
Allocative efficiency: This is about making sure those things most valued by the
community are supplied, and supplied in the correct amounts (formally, where the
marginal cost of producing the good or service equals the marginal benefit to
consumers of consuming it) to best promote public welfare.
Dynamic efficiency: This is the change in allocative and productive efficiency that
occurs over time. It is commonly described as innovation.
• Pulling the three types of efficiency together, economic efficiency can be described as
“providing valued goods and services in the quantities most valued by the community,
at least cost, over time.”
20
Monopolies (cont’d)
• In economic efficiency terms, monopolies are both good and bad. A natural monopoly
can produce goods and services much cheaper by itself than could two or more
providers operating in the same market. In these circumstances a monopoly is likely to
be the most productively efficient way to produce the good or service. However, this
comes at some cost elsewhere.
• First, it is easy for a monopoly to reduce supply (formally, to a point where the marginal
cost to the monopoly is less than marginal benefit to the consumer) and force up prices.
The reasons a monopoly will do this is to increase the money it gets from consumers,
money that will either go to owners in the form of high profits, and or to the inputs used
to provide the good of service, for example, higher wages, more expensive supplier
inputs or just waste (this is known as gold plating). Natural monopolies tend, therefore,
to be allocatively inefficient.
21
Monopolies (cont’d)
• Next, without another provider working to better provide what customers want, and in
this way take market share and profits from the monopoly provider, there is little reason
for a monopoly to try and produce goods and services more cheaply or that better meet
what customers want, or even search out new markets, including value add processing.
• Also, entities (if they are any good) will have a distinct culture and a consistent
operating strategy.. No two entities will be the same in this respect. This means in a
monopolistic market, by definition, there is less strategic and cultural variety and
therefore greater risk of a mismatch with what a range of consumers and potential
consumers might want - a bit like having all your eggs in one basket. In short,
monopolies will tend to score poorly against dynamic efficiency.
• In summary, economists would tend to expect monopolies to be good for productive
efficiency, but bad for allocative and dynamic efficiency. To encourage the good
aspects (productive efficiency) and discourage the bad aspects (allocative and dynamic
Inefficiency), governments will often allow natural monopolies, but regulate their prices,
profits and the quality of their goods and services. Over time, governments try to make
monopolies innovate – through applying higher standards and/or by allowing them to
make more money.
• Further discussion is required in relation to government-created monopolies.
22
