The NZX is launching new dairy futures and options contracts as a way to lessen the volatility in milk prices, writes Tina Morrison

In Midwest America, the Chicago Mercantile Exchange has become the hub for global wheat trading, while Malaysia's claim to fame in the commodities market is palm oil.

For New Zealand, widespread conversion to dairy farming from sheep has seen milk overtake meat and wool as the largest commodity export and set the country on the path to becoming a global hub for the dairy market.

Though New Zealand isn't the largest producer of milk in the world, our small domestic market means the country exports about 95 per cent of its production, making Fonterra Co-operative Group the world's biggest exporter of dairy products.

The country's step-up in milk production has coincided with unprecedented volatility in prices as governments rein in interventionist policies and allow dairy products to trade more freely.


Global whole milk powder commodity prices didn't change by more than 10 per cent in any month in the two decades prior to 2007. But since then, it's changed by more than 10 per cent a month on 22 occasions.

The emergence of New Zealand as a base for a physical market for dairy products, increased volatility in pricing and an uptick in global trade led by emerging market demand for protein has all helped lay the foundations for a dairy derivatives market in New Zealand.

"The dairy market globally is undergoing a transition that many other commodities including agricultural commodities have gone through, " says Kathryn Jaggard, head of derivatives at financial markets operator NZX. "Dairy is slightly late in this evolution."

Jaggard joined NZX in 2008 and has almost two decades' experience in global derivatives.

She describes "an explosion in exports and global trade where you have emerging economies who are now wealthier and they are seeking in this case reliable and quality sources of protein and food, your levels of government intervention are coming down and the management of risk is moving from the responsibility of government to markets."

Volatility and uncertainty drives demand for risk management tools which, for dairy, is spurring the development of a derivatives market offering futures and options.

NZX launched its Global Dairy Derivatives Market in October 2010, following the establishment of Fonterra's online auction platform GlobalDairyTrade in July 2008, which trades in physical dairy products.

The derivatives market started with whole milk powder futures and has since added skim milk powder, anhydrous milk fat and butter futures, and whole milk powder options.

The NZX is trading about 1000 dairy derivative contracts across its platform a day, and on track to reaching the 3000 to 5000 lots a day, which would see it hit a global liquidity benchmark.

The dairy market globally is undergoing a transition that many other commodities including agricultural commodities have gone through.


Jaggard says volume traded on the Kiwi bourse is ahead of its dairy rivals overseas and growing at a faster pace than other commodity markets for milling wheat and palm oil were at the same period of their evolution.

However, it's difficult to predict when it will reach the point of being considered the global benchmark for dairy derivatives, given the catalyst for higher volumes could be unpredictable events such as a drought or a political event.

In recent times, analysts have been caught out when the fortnightly GlobalDairyTrade (GDT) hasn't followed the futures market, although Jaggard says the gap hasn't been that large and current dairy market conditions are unusual.

"You have a futures market which is reflecting the underlying, and in the underlying right now there's not a huge consensus around where price is going," she says.

During the global financial crisis, between October 2008 and October 2009, the GDT average winning whole milk powder price was below the average US$3050 for 371 days. In comparison, in recent times, the price has been below US$3050 for about 420 days.

"No market can accurately predict exactly what's going to happen. The futures are just reflecting that the market is struggling to find consensus."

We are allowing others to skim the cream, locking our farmers into being price takers rather than price makers.


Jaggard notes that the NZX futures market is unusual globally in that there is a transparent underlying physical market every two weeks, which isn't the case for other commodity futures such as cocoa, coffee, sugar, grain or oil where the futures is the only indicator of price sentiment.

Criticism of the futures market has also come from outside financial markets, with New Zealand First leader Winston Peters likening the GDT auction system to "a glorified TAB", saying he believes New Zealand needs to establish a physical commodities exchange rather than a derivatives market.

"We are allowing others to skim the cream, locking our farmers into being price takers rather than price makers," Peters said in his usual catchy turn of phrase.

While Jaggard says she's glad that Peters is talking about risk management because it's an important topic for dairy farmers to discuss, she says we need to have "informed and sensible conversations" about tools to manage risk.

"These markets have existed for hundreds of years in other areas around the world. Without being critical, it's really an uninformed comment and you need to really have more information about how these markets grow and develop, and we need to support their development rather than making comments such as that," she says.

At the moment, what we are focused on is really building these dairy tools but absolutely there is the opportunity to expand beyond those into other commodities.


Education on risk management for dairy farmers is a hot topic for the NZX at the moment as it prepares to launch a new futures and options market for milk this month which it plans to promote at the upcoming Fieldays.

NZX sees it as offering the country's farmers a way to lessen the volatility of milk prices, putting them on a more even footing with farmers in other countries who benefit from similar schemes.

The market could also be used by milk processors to enable them to offer a fixed-price contract to farmers, or by banks to launch a swaps contract.

"High levels of volatility are unsustainable when you managing a business, whether you are a buyer or a seller, so you need some way of managing that volatility to create certainty," Jaggard says.

The push by NZX has been encouraged by the Government, which wants to see the development of new financial products as part of its reforms of financial markets.

"Price volatility in the dairy sector has obviously been a key issue for the dairy industry and the broader economy in recent times," says Commerce Minister Paul Goldsmith.

"Managing volatility assists farmers and others in the industry with their business plans. The Government welcomes NZX responding to this issue by developing the dairy futures product, and expects product innovation to continue in this sector."

This could see the development of a centre of expertise in New Zealand for a wider range of agriculture commodities that the country is dominant in, such as forestry, meat or wool.

"The ambition is to meet the demand where it sits," Jaggard says.

"At the moment, what we are focused on is really building these dairy tools but absolutely there is the opportunity to expand beyond those into other commodities."