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How Will Lower Dairy Payouts Impact on Dairy Farm Values?

On 7 August 2015 Fonterra announced that the advance payout to dairy farmers for the 2015/16 season would be reduced to $3.85 per kilogramme of milk solids (kgms). That payout represents a 54.7% decrease on the record payout of $8.50 per kgms for the 2013/14 season and the lowest payout since 2002/03 of $3.63 per kgms. The final payout for the 2014/15 season is yet to be finalised but is provisionally forecast at $4.65 per kgms. This significant drop in payout from the record level of 2013/14 will reduce farm-gate income across the industry by some $2.5 billion. The payout for milk solids produced by Fonterra suppliers over the past 17 years is summarised  in the chart below.

The causes of this drop in payout level are multi-faceted arising from a wide range of factors. Collectively, however, they boil down to a dramatic change in the demand and supply characteristics of the global trade.
i.e. global supply currently  substantially exceeds global demand. Some of the main causes of that imbalance include:

•  Slow down in the rate of increase in demand for dairy products.
•  Massive Chinese stockpile of dairy commodities.
•  Russian trade embargo.
•  Increasing global dairy production in response to record returns.
•  Removal of milk production quotas in the European Union (EU).

On the demand side of the equation the growth for dairy products has slowed considerably particularly in China. Consumption is still increasing but at a slower rate than prevailed up until late 2013.

The massive Chinese stockpile is the result of the prolonged buying spree in the period leading up to 2014. That stockpile is having a major impact on global demand. Milk consumption is still growing in the Chinese economy but at a slower rate than the increase in dairy production.

The effects of that stockpile on global demand are further exacerbated by the Russian trade embargo. Russia has been the traditional market for surplus EU milk production. The trade embargo has eliminated that outlet for EU milk production. Consequently that surplus EU milk is now also competing with global dairy production for the remaining available markets.

The consistently high prices being paid for dairy products from 2007 through to 2014 stimulated a substantial increase in global dairy production particularly in the USA, Ireland, Australia  and New Zealand.  Much of that increased dairy production has arisen from substantial new investment in high input dairy farming systems. That is particularly so in Europe and the USA where there is an abundant supply of high-energy feed grain available.

The removal of EU Production quotas in March 2015 has played a major part in the increase in Irish and European production.

What is the Impact of the Global Dairy Trade Auction?

Until 2005 New Zealand dairy trade has been conducted by direct negotiation between producers and consumers. Fonterra and its predecessors had built up a strong international network of customers and agents to whom it supplied product, generally with enduring contracts that were renegotiated on a regular basis. That network served the industry exceptionally well for many years. The perceived disadvantage was that the pricing was not transparent and it was difficult to take advantage of spikes in price arising from supply shortages.

In July 2008 Fonterra joined the Global Dairy Auction (GDA) as a replacement means of sale of dairy commodities. Rather than direct negotiations with consumers of dairy products, Fonterra offered its products to the entire market in fortnightly auctions. At auction all buyers had the opportunity to bid against the market to meet their needs. The auction price each fortnight then became the direct reflection of the demand supply equilibrium at that time. Prices rose as demand increased or supply diminished and vice versa. As with all auctions the price on the day is a reflection of the balance between supply and demand on that day. Consequently fluctuations are the norm and prices seldom remain static. The movements in Global Dairy Prices are measured by the Global Dairy Trade Price Index (GDTpi). The  index  is calculated as the percentage change in prices for each specification, weighted by the quantity of each specification sold. The 16 year history of the Global Dairy Trade Index, which has been calculated since 1999, shows relative stability until 2007. Following the introduction of the auction the index has shown the characteristic fluctuating pattern expected from an open transparent auction process. That trend can be seen in the chart on the following page, which graphs the movements in the GDTpi from 1999  to 2015.

As long as the GDA is the preferred method of trading by Fonterra, significant fluctuations  in the GDTpi can be expected.

The New Zealand Farming industry has evolved over the years in an environment of relatively stable prices. Fonterra and its predecessors generally clearly communicated well in advance the payout expectations for the season based on the mix of forward contracts in place each year. The advent of the GDA has superseded that stability and the dairy farming community has had to adjust to that change in stability. The degree of fluctuation in returns has effectively increased the risk profile of dairy farming as a business. That increased risk will be reflected in the market’s perception of dairy land values.

That increased risk factor has been reflected in dairy land values over the past five years or so. The peaks in the GDTpi over  that five year period have not been reflected in the same rapid increase in land values that has been evident in the past when payouts have increased. Dairy farmers  are recognising the need to structure their debt levels to be able to cope with the fluctuations  in returns.

While the need for appropriately structured debt levels is widely accepted by dairy farmers, not all have been able to make the adjustments to their debt levels prior to the latest fall in prices. Consequently there will be some farmers whose debt levels were unsustainable while the returns were high. Some may trend to the past five years with relatively stable values. The uncertainty of the GDTpi trends is likely to constrain buyers from overbidding for land when the index improves.

On the whole the banking industry is very supportive of dairy farming and appears to be taking a very considered and constructive approach to long term debt management with their dairy farming clients. The current low interest rates are certainly helping in that respect. During previous downturns, when interest rates have been much higher, the rate at which arrears in interest payments accumulated was much greater.

There will be some dairy farms coming onto the market over the late spring and summer with buyers being scarce. Consequently sales activity will be slow with the only buyers likely to be those with either cash to invest or very high net equity buyers with the capacity to borrow and spread the risks.

There could well be some short term reduction in dairy farm values as a consequence of the weak position of the vendors on the market and the small pool of available buyers. In the longer term dairy farm values are likely to follow a similar trend to the past five years with relatively stable values.  The uncertainty of the GDTpi trends is likely to constrain buyers from overbidding for land when the index improves.

In conclusion,  some short to medium term reduction in dairy farm sales volumes and values can be expected, but is unlikely to be dramatic. Over the longer term there will be a recovery in values as returns improve.  But there is unlikely to be any significant capital growth in dairy values unless or until there is some stability in the GDTpi.