Lessons for farmers from dairy slump

Nathan Penny, ASB rural economist. Photo / Supplied

As the milk price moves well above break-even, the story has been been very much one of delayed reactions

Up until August, dairy farmers were thinking the unthinkable - another year of milking cows at a loss.

Whole milk powder - the key product for New Zealand producers - had been trading at under US$3000 a tonne for more than 20 months.

A brief rebound in February 2015 to US$3072/tonne was followed by a brutal decline to just US$1590/tonne in August that year.

Signs of life returned midway through this year, but it was not until August that whole milk powder prices started to rally convincingly.

At the last auction for 2016, whole milk powder traded at US$3586/tonne - inside the comfort zone for most farmers - and almost double the price reached early in the year.

Last month, gains in the GlobalDairyTrade convinced Fonterra to raise its farmgate milk price by 75c to $6.00 a kg - about $1/kg above the average break-even point and well ahead of the $4.40/kg milk price for 2014/15 and $3.90/kg for 2015/16.

All going well, the milk price could be revised up to $6.50/kg next year, economists say.

While it remains a difficult call to make - out of all the world's traded commodities dairy has proven to be one of the most volatile - economists and industry insiders say the current rally has legs, based purely on reducing supply and increasing demand.

When the trend started to look more entrenched, the sense of relief among farmers was almost palpable.

Even so, farmers remain cautious and for many it will take years to recover from the last two.

The Reserve Bank, in its last few financial stability reports, has raised the issue of dairy farm debt - which accounts for 10 per cent of all debt in the New Zealand financial system - as a concern.

"Even with the improvement in dairy payouts, some farms may struggle to achieve profitability - especially given that 20 per cent of farms account for around 50 per cent of overall dairy debt," it said.

Old hands in the sector have come to accept the slings and arrows of market cycles.

The trouble this time around was simply the duration of the downturn - two seasons of cripplingly low prices, and heading towards a third.

Farmers simply did not expect the slump to last long as it did.

Sense of relief"There is cautious relief in the sense that the pressure has come off them mentally, and that's a great thing," Tim Mackle, chief executive of the farmer funded DairyNZ says.

"At the same time, they are not running out there thinking that they are out of the woods," he says.

"Many realise that they have got some ground to make up in terms of the debt that they have accumulated.

"It's been a tough period. No farmers around the world have felt this more keenly than our farmers," he says.

New Zealand is the world's biggest dairy exporter - sending about 95 per cent of its production offshore.

Unlike its competitors, it does not have a big home market to fall back on when world markets go bad, and there are no government handouts.

"They are the most exposed in terms of exports and they are unsubsidised," Mackle says.

Mackle and others in the industry said few anticipated that the slump would last as it long as it did.

But it helped to drive home the theme that has been the secret behind its success - New Zealand's ability to grow grass.

Long slump"I don't think that the penny dropped - that the downturn could could go on longer and that change needed to happen in some farm systems - until January this year," Mackle said.

"I think that we all thought that the normal three or four year cycle would at some stage kick in," he says.

"Then of course we got to last Christmas and commentators were saying that this could last for the whole year.

It was around that point that DairyNZ suddenly experienced a lot more interest from farmers seeking budget advice, and turning up to its "pasture first" workshops.

"The lessons learned from that is that we have to respond a lot earlier. But it goes beyond that. How do we set up our businesses to be resilient so that you don't have to make a lot of significant adjustments," Mackle says.

The key message from DairyNZ has been getting farmers to return to a pasture first model - focusing more and grass and less on more complex - and expensive - farming systems. He said the challenge for farmers would be to run leaner systems in good times and in bad.

"Globally we have seen much stronger customer interest in food produced from pasture. That's an exciting thing for New Zealand because we know we are good at it and that there is consumer demand for it," he says.

Bank foreclosuresSurprisingly, land prices have held up quite well, despite the slump.

"As well as that, the banks have generally had a bit of skin in the game too. It has been in their interests to help farmers get through as well," Mackle says.

Despite the financial stress, reports of mortgagee sales have been rare.

For the most part, farmers have managed to stay confident and land prices have generally held well.

Nevertheless, Federated Farmers Waikato provincial president Chris Lewis says the personal cost to farmers has been "serious".

"It's been very tough out there, but it's been very well hidden," he says.

"People are not going to put their personal problems out there in front of the media, are they? There have been a few sales that have been 'encouraged' but really no mortgagee sales or receiverships," he said.

Lewis says the "pasture first" message expounded by DairyNZ has been taken on board, but that feed supplements still had their place as a "top up" when the weather turns bad.

Milking at a lossASB rural economist Nathan Penny was convinced at the start of the year that the tried and true principles of supply and demand would kick in sooner rather than later.

In other words, farmers here and around the world soon desist from churning out product at a loss.

Back in February, Penny predicted a $6.00 per kg of milk solids milk price when others were forecasting just $4.00/kg.

The forecast reflected the fact that farmers in New Zealand, Europe and Australia - key exporting countries - were suffering from a lack of profitability and that there needed to be a swift cut back in production.

Mark Heer, ASB Bank's general manager for rural banking, said the growth in supply simply could not continue.

"It had to correct and when it would correct, it would have to correct quite quickly," Heer said.

"Nine months ago, people were doubting that economic principle but today, when you look back, you can see that it has played out," he says.

At the same time the European Commission was rolling out support packages for EU farmers in crisis.

"We think that the supply response that we have seen has lined up with the fact that there was a crisis in profitability," he said.

At the bottom of the cycle, Heer said many farmers would have felt that they had lost control of their business.

"The question that I am posing to customers at the moment is: the next time we have a $4.00/kg payout, what do you want your balance sheet to look like?

"When your profit is negative and your cashflow is negative, it's your balance sheet that gives you control," he says.

"In times of difficulty, it always comes back to our competitive advantage - and that's the grass-based model."

"At the top of the cycle, the tendency has been to move away from it."

Like DairyNZ's message, "pasture first" has been a key theme of Heer's meetings with farmer groups up and down the country over the past couple of months.

A look in the mirrorAs the world's biggest dairy exporter, what happens with New Zealand production has a large bearing on the world market. Heer said local supply was skewed by the fact Fonterra's record high milk price of $8.40 in 2013/4 meant the deferred payment of $2.00/kg carried over into 2014/15, when the milk price was just $4.40.

It meant that farmers did not really feel the full brunt of the downturn until the second year of the slump, when the milk price dropped to $3.90.

In other words, the appropriate supply response did not happen as quickly as it should have.

"We need to be careful that we don't get caught in that again," Heer said. "We don't know if there was enough conversation around it.

"We think that if farmers had not received that big deferred payment in the first year, then that would have shown up in their bank account and the production response would have been quicker," he said.

Personal costHeer said there had been an "elevated level of conversation" between the farmers and their banks during the downturn.

"If you were a new contract milker or sharemilker, or it was your first year on the farm, then the last two years would have been devastating," Heer said. "But I feel that dairy farmers have coped with the last two year really well - they have maintained their confidence."

Heer estimates that farmers have taken about $1.00 to $1.20 per kg out of their costs - and about half that has been in the form of deferred maintenance.

He urged farmers to keep hold of as much of their cost savings as possible.

In the big picture, the trend in dairy has been been very much one of delayed reactions. When prices go up, farmers here and around the world have tended to ramp up production to cash in.

But it takes time to ramp up production and there is no "tap" to turn it off immediately when prices fall. Then supply starts to outstrip demand, creating a price slump. Given the experience of the last two years, Federated Farmers' Lewis hopes that the pattern has changed.

"I would like to think that it has," he says. "But with human nature, who knows?"