The long-term outlook for the dairy sector is strong, but the immediate future is highly concerning. Global prices are down 12 per cent this year and about a third lower than a year ago. Against that backdrop, it was unsurprising to see Fonterra reduce its milk payout forecast to $3.90 per kg of milksolids this week. Adding in the dividend from Fonterra, the total payout will be about $4.25. This is the lowest payout since 2006/07, and with a break-even price of about $5.30, the majority of farmers will suffer a second year of operating losses. READ MORE: • Fran O'Sullivan: Questions get even harder for milk giant • Fonterra remains sound, says CFO Unless a significant rebound is forthcoming over the next month or two, the 2016/17 payout is very likely to be below $5 for the third year in a row. Highly indebted farmers will suffer, farm prices will fall and non-performing loans for those who've lent to the sector will increase. The banking sector has the capacity to weather the storm, but there will undoubtedly be flow-on effects in communities where dairy is a dominant part of the economy. This will dent economic growth, and should put some downward pressure on the New Zealand dollar. The effect of the latter could offset some of the decline in global prices, softening the blow to some degree. The blame game seems to be in full swing now, and Fonterra is firmly in the gun for a lot of the finger pointing. I'm not sure that's fair. This is a commodity after all, just like oil, iron ore or coal. Draw a chart of oil prices and dairy prices, and you'll see two lines that follow each other pretty closely.
Now I'm no dairy expert, but it looks to me like a lot of people ignored history and took on far too much risk during those strong years.Commodity prices are cyclical by nature, and they're influenced by a whole range of factors that can't be controlled or predicted accurately, such as the weather, the currency and global demand. Fonterra is far from perfect, but you can't blame it for slowing economic growth in emerging markets, changes to the European quota system or better production from other countries on the back of decent weather. Dairy farmers had a great run for six or seven years, which culminated in the record payout of $8.50 in the 2014 season. The average payout during that period was about $6.85, and even those with high debt levels were making good money at those prices. But take a look at the period just before that. In the five years leading up to 2007, the average total payout was about $4.20, very close to where it is today.
Rather than blaming Fonterra, the banks or the currency, a few of our over-leveraged dairy farmers on over-priced farms have simply over-stretched themselves.Now I'm no dairy expert, but it looks to me like a lot of people ignored history and took on far too much risk during those strong years. When the going was good, some blindly assumed prices would continue to go one way. They borrowed too much, and paid very high prices for farms, which didn't reflect the cyclical nature of the industry. We don't need to look too far back to find another period like the one we're in now, but that was conveniently forgotten during the boom years. Rather than blaming Fonterra, the banks or the currency, a few of our over-leveraged dairy farmers on over-priced farms have simply over-stretched themselves. Mark Lister is head of private wealth research at Craigs Investment Partners. His disclosure statement is available free of charge under his profile on www.craigsip.com. This column is general in nature and should not be regarded as specific investment advice.