Demand not always a harbinger

By Aaron Drew

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Commodity price hikes don't always correlate with demand says Aaron Drew.
Commodity price hikes don't always correlate with demand says Aaron Drew.

Hawke's Bay Today's newest columnist is New Zealand Institute of Economic Research economist Aaron Drew, who has moved to Hawke's Bay to also be chief investment officer with Hastings-based wealth manager Stewart Financial Group.
Mr Drew has previously managed modelling and research teams with the Reserve Bank of New Zealand and was a consultant to the IMF and spent four years in France as an OECD economist. He spent seven years with the New Zealand Superannuation Fund, where he developed asset and investment strategies and was a member of its investment committee.


Fonterra expects to pay out $3.90 per kg/MS for the upcoming season. At these levels the majority of dairy farms in New Zealand will struggle to cover their operating costs, which DairyNZ estimates is around $5.25 for the average farm, let alone the cost of debt servicing.

The hope is that prices will recover to limit distress in the sector, and spill-over risks to the rest of the economy. The interest rate cut last week by the RBNZ to record lows illustrates they are concerned, and history also does not provide much comfort.

From a statistical perspective commodity prices are what economists call a "near random walk". The fundamental drivers of demand and supply conditions only weakly exert their impact on prices over a long-term horizon. Over shorter timeframes, which may run into several years, the best guess of tomorrow's price is the price observed today.

Present dairy price levels are unsustainable, and any meaningful cut back from our shores should raise world prices. Should is the operative word. Oil drilling activity on North American shale grounds has declined a massive 40 per cent since the peak in 2014, but despite these resources being the world's key marginal supply source oil prices remain below their break-even costs. Many other hard commodity prices remain in the doldrums.

From an investment perspective there are several lessons that can be drawn from this experience.

The first is to avoid the trap of assuming favourable long-term demand trends translate to ever-increasing prices. Time and time again history suggests that high profitability levels for commodity producers do not last forever - supply eventually catches up. This seems obvious, but the lesson appeared to have been forgotten in the euphoria of the Chinese demand story. Dairy farm prices rose steadily with pay-out levels. NZIER modelling of dairy farms suggests dairy land prices still embed a strong recovery of payout levels over the medium term.

The second lesson is to take "expert" forecasts with a grain of salt and ensure that an investment proposition remains viable under a range of downside risks. Would dairy farmers have taken on as much debt, or banks have been as prepared to lend, if they had of put more stock in sustained low pay-out risk scenarios?

Finally, sometimes the best thing to do is sit on the sidelines. It is notable that the New Zealand Superannuation Fund made most of its dairy farming investments over 2010 to 2012 when dairy farm prices were considerably lower. We should feel for the younger dairy farmer who felt compelled to jump into the first farm on the fear of forever missing out.

We should hope that the prospective first-time property buyer in Auckland is paying attention.

- Hawkes Bay Today

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