What have Russia and El Niño got in common?

Dairy farmers let out a collective sigh of relief last week as dairy prices rose sharply at the GlobalDairyTrade (GDT) auction for the third consecutive time.  Prices at last week’s auction were up an average of 16%, with the all-important price of whole milk powder climbing an even more rapid 21%.  Dairy prices are now up an average of 48% from their early-August trough, with whole milk powder prices pushing up 61%.  Whole milk powder prices are now within 5.2% of their level a year ago.

The rapid turnaround in dairy prices begs the questions: what happened and are we out of the woods yet?

Many analysts, including the Reserve Bank, have been quick to point to lower volumes of dairy products being offered for sale by Fonterra on the GDT auction platform as being the key price stimulant.  At the past three auctions, there was an average of 36,810 metric tonnes (MT) of dairy products offered, compared to an average of 52,740 MT at the same three auctions last year.

But although lower volumes at GDT auctions could affect pricing at the margins, we are sceptical that they could have caused so much movement in prices.  Total annual trade on the GDT platform across all suppliers is only equivalent to around a quarter of Fonterra’s total sales volumes.  The GDT auction platform is merely one method of price discovery, and represents demand and supply based on broader fundamentals and market expectations.

To us, the more compelling reasons for the sudden lift in dairy prices relate to overseas demand and supply, as well as growing concern regarding milk production levels in New Zealand for the current dairy season.  Dairy prices at GDT auctions first rose sharply in mid-August, immediately following the news that Russian authorities were lifting a ban on New Zealand dairy imports.  This may seem minor given Russia buys less than 1% of New Zealand’s total dairy exports.  But growth potential into Russia is huge at present, as Russia is the second-biggest importer of dairy products globally and is continuing to ban imports from Europe, which was formerly a key supplier.  This decision has effectively given New Zealand a preferential position into a large market and will have given New Zealand dairy prices some support from their low base.

International dairy markets are also beginning to price in downside risks to New Zealand’s milk supply over the coming season.  The prolonged period of low farmgate milk prices has encouraged many farmers to cull low-performing stock and reduce supplementary feed use.  As a result, Fonterra has forecast that milk production this season will be 2-3% below its 2014/15 season level.  Furthermore, there is also a growing risk that a strong El Niño weather system will cause dry conditions and hamper production later in the summer, with Niwa putting the risk of such an event at 90%.  If this situation does eventuate, then we see a scenario where New Zealand’s milk production this season could plunge by 5% or more.

Taking these factors together, it is no surprise that dairy prices have risen sharply from their historically low levels of July and early August.   Some further stabilisation is not out of the question, but we would caution getting too excited just yet as strong growth in global dairy supplies remains a limiting factor on how far prices will rise.  Milk production in the US continues to grow at a rate of 1-2%pa, while European data shows that milk production in May and June was up 3.0% from a year earlier.

At this stage, our June forecast for the 2015/16 farmgate milk price of $4.80/kgms appears to be well supported, compared to Fonterra’s current forecast of $3.85/kgms.  We will revisit this view again in our October forecasts.  It’s fair to say that although many farmers will still be making a loss at these levels, there will be some who manage to etch out a meagre profit.  Against this backdrop, the odds of the Reserve Bank keeping the official cash rate on hold at its October review have risen, as the Bank appears yet to be taking the risk of El Niño seriously.

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