Co-operative faces milk powder dilemma but chief executive confident dairying in good stead for 5-10 years.
Fonterra's top executives will have plenty to think about early next year when they devise the co-operative's next three-year business plan.
Uppermost in their minds will be the rampant demand for milk powder, particularly from Fonterra's biggest customer, China.
They will also need to take a long, hard look at the widening price gap between milk powder and the more value-added products and consider whether it is a passing phase or something a little more permanent.
Fonterra is treating it as an aberration, but if powder continues to command a big premium over the more elaborately transformed products of cheese and casein, things could change.
Fonterra has already invested heavily in milk powder production. In Canterbury, it has installed the Godzilla of all driers - capable of cranking out 30 tonnes of milk powder an hour. At Pahiatua, in the northern Wairarapa, it plans to install another Darfield-sized drier at a cost of $235 million.
In a season update last week, Fonterra said the divergence in the price of milk powder relative to other dairy products had forced it to cut its dividend and earnings forecasts for the 2013/14 year.
Fonterra also said its earnings before interest and tax would fall to about $500 million to $600 million in the July 31, 2014 year, down from $1 billion a year earlier, mostly because of higher costs to the co-operative imposed by strong dairy prices. The dividend cut came at a time when everything looked to be rosy for Fonterra, but the co-operative is a complex beast, even at the best of times.
High milk powder prices generally translate into higher farmgate milk prices, but high farmgate milk prices put downward pressure on Fonterra's dividend because they represent an added input cost in the making of products like cheese and casein.
The simple disparity between the two main product streams has blown a gaping $800 million hole in Fon-terra's profit and loss account.
As it stands, about 70 per cent of Fonterra's production is powder and 30 per cent is the value-added products like cheese and casein.
"If this is the new reality, should this be 70/30, or should it be 95/5," chief executive Theo Spierings said in an interview.
Despite last week's setback for the dividend, farmers will still be looking at a record year for the total payout and production, if conditions persist.
But strong dairy prices have not gone unnoticed in other markets, so economists expect major northern hemisphere players to ramp up production next year, which could bring pressure to bear through increased supply.
Spierings said the northern hemisphere markets were more inward looking, and geared for domestic production. In the United States and Europe, the ratio of powder manufacture to cheese and butter was the reverse what it is in New Zealand.
"Yes, there will be more milk, but the question is: Who has the assets to cope with the extra demand for milk powder.
"It's mainly us, and possibly Australia, so I would expect milk prices to be strong for a longer period of time," Spierings said.
While last week's announcement came as a shock to many, BNZ economist Doug Steel said the fact that Fonterra was struggling to keep up with demand for its powder is "kind of a good problem to have".
Steel said Fonterra would need to make a call on whether the market dynamic was going to be a permanent fixture or a passing fad.
Economists said the price gap reflected a developing markets story that was starting to show up in other commodities, where the product in its more basic form was attracting higher prices than elaborately transformed goods. Steel said a case in point was meat, where a full carcass can attract more value than specialised cuts.
"You can in some ways liken it, in the bigger picture, to New World versus the Old World, or East versus West," Steel said.
He said the strong growth in developing markets for powder for use in infant formula was in stark contrast to slower growing, mature markets and inwardly focused, northern hemisphere markets for cheese and butter.
ASB Bank chief economist Nick Tuffley said the market was giving Fonterra a strong price signal to invest in more milk powder producing facilities but that projects like Darfield and Pahiatua are capital intensive and have long lead times.
Spierings said that while the issue of product mix would be a big question for the co-operative to face, the outlook for the New Zealand dairy industry remained positive. "Dairy is going to be strong for the next five to 10 years," he said. "Easily."