Milk prices on the up – supply and demand

With the start of the academic year in New Zealand the first week of teaching usually looks at the price mechanism and scarcity. A good example in the NZ economy is the reasoning behind the payout that Fonterra pays its farmers that supply them with milk. Fonterra is a monopsony (they have approximately 81% share of the NZ dairy market) in that it is one buyer and many sellers (the farmers) – the farmers look to Fonterra to get them the best price in the Global Dairy market. Fonterra has indicated that the price for the current 2021/2022 season is going to be between $8.90 to $9.50/kgMS.

The mid-point is $9.20/kg and at that level it will be paying out New Zealand suppliers $13.8 bln – see graph below. Ultimately the price of the Fonterra payout is determined by supply and demand on the Global Dairy Trade auction – see below.

Why have prices increased?

Supply – there has been weak production in New Zealand and overseas with poor weather with challenging growing conditions and higher feed costs. Fonterra lowered its forecast on the amount of milk collected by 1.6% – 1,525 million kgMS in 2020/21 to 1,500 million kgMS in 2021/22. A lower production outlook for Europe and North America has increased the forecast milk price.

Demand – demand globally remains strong with North Asian buyers securing over 50% of the total volume sold in the recent Global Dairy Auction. According to the OECD the world per capita consumption of fresh dairy products is projected to increase by 1.0% p.a. over the coming decade, slightly faster than over the past ten years, driven by higher per-capita income growth. Today total dairy consumption in Africa, South East Asian countries, and the Middle East and North Africa is expected to grow faster than production, leading to an increase in dairy imports. As liquid milk is more expensive to trade, this additional demand growth is expected to be met with milk powders, where water is added for final consumption or further processing.

How does the GDT work?

GlobalDairyTrade trading events are conducted as ascending-price clock auctions run over several bidding rounds.  In each auction a specified maximum quantity of each product is offered for sale at a pre-announced starting price. Bidders bid the quantity of each product that they wish to purchase at the announced price. If the price of a product increases between rounds, to ensure their desired quantity a bidder must bid their desired quantity at the new, higher price. Generally, as the price of a product increases, the quantity of bids received for that product decreases. The trading event runs over several rounds with the prices increasing round to round until the quantity of bids received for each product on offer matches the quantity on offer for the product (as shown in the diagram below). Each trading event typically lasts approximately 2 hours.

Fall in Global Dairy Prices and Multiplier Effect.

Recently prices on Fonterra’s global dairy auction fell but analysts feel that this is not going to be long-term. The fall has been mainly caused by:

Supply increasing significantly relative to the demand – March, April and May tend to be very productive for northern hemisphere farmers as that is when they have peak supply figures. Furthermore over the summer in New Zealand we have had excellent growing conditions with soil moisture levels being very high for the time of year. This transfers into an increase in available feed for dairy units and increased milk output.

The graph below shows the Global Dairy Trade Weighted Average Prices and it is believed that this drop in prices is not a re-run of the global financial crisis when prices dropped to below US$2,000 a tonne. This was due to stagnant demand which does not seem prevalent today.

It is estimated that a US$1 difference in the milk price between seasons represents about $1 billion
in cash flow for Fonterra’s 10,000 supply farms. When you consider the multiplier effect this can translate to 4 times that for the rural sector as a whole.

The Multiplier

An initial change in aggregate expenditure can have a greater final impact on equilibrium national income. This is known as the multiplier effect and it comes about because injections of demand into the circular flow of income stimulate further rounds of spending.

Multiplier Process
Consider a $300 million increase in business capital investment. This will set off a chain reaction of increases in expenditures. Firms who produce the capital goods that are ultimately purchased will experience an increase in their incomes. If they in turn, collectively spend about 3/5 of that additional income, then $180m will be added to the incomes of others. At this point, total income has grown by ($300m + (0.6 x $300m). The sum will continue to increase as the producers of the additional goods and services realize an increase in their incomes, of which they in turn spend 60% on even more goods and services. The increase in total income will then be ($300m + (0.6 x $300m) + (0.6 x $180m). The process can continue indefinitely. But each time, the additional rise in spending and income is a fraction of the previous addition to the circular flow.

The value of the multiplier can be found by the equation 1 ÷ (1-MPC)

You can also use the following formula which represents a four sector economy

MPS = Marginal propensity to save
MRT = Marginal rate of tax
MPM = Marginal propensity to import

Commodity boom – why we should be vigilant

With all the hype about the increasing price of commodities and our reliance on this sector to boost the NZ economy, we shouldn’t get too carried away. Fonterra Cooperative Group lifted its forecast 2011 pay-out to farmers to a range of $8 to $8.10 per kilogram of milksolids. Historically the NZ economy has relied on commodities such as wool, timber and more recently meat and dairy. However, the May “National Farming Review” publication came up with four areas of concern:

1. Commodities are volatile:
Prices are at the mercy of supply and demand and events like the global financial crisis can have a significant impacts on demand and ultimately price. Furthermore, the weather can cause supply shocks and volatility – see previous post Demand↑ and Supply↓ = Food Prices↑. As noted by the Reserve Bank – “it is fiendishly difficult to predict the future path of commodity prices”.

2. Exchange rate impact: The NZ$ is driven largely by the value of commodities so the recent rise in commodity prices had the effect increasing the value of the NZ$. This smooths the volatility of commodity prices, but can cause problems at the farm-gate. In 2007/08 when dairy prices were high and the NZ$ was also strong, world meat prices were rock-bottom. With the low prices and the high exchange rate meat famers had a bad year whilst their dairy farming counterparts were buying new tractors.

3. Induced supply: When you have high prices for commodities it starts to induce new supply from other countries in that they are trying to take some of the ‘pie’- but ultimately this reduces the price as markets become flooded with excess stock. The US has seen a big increase in dairy exports. It is predicted that increased food production will come from low cost food producers in the developing world who will become serious competition to the NZ farming industry.

4. Deleveraging: there is a widesptread belief that when there is a big payout to dairy farmers people are of the understanding that they are quite well off. However, what they fail to comprehend is that there have been many years of hardship and significant debt – NZ$48bn has beeen accumulated in the 2000’s. Ultimately they have to payoff this debt and only a small part of this income will find its way into the general economy, although services and products associated with primary sector will benefit from a cash injection.

The commodity boom is good for NZ farmers and the economy but there is no room for complacency or becoming a high cost producer.