Federated Farmers: Dairy industry faces new global reality

Milk production in the United States and Europe had accelerated in the past 10 years but with the drop in dairy prices it is starting to tail off.

The current weakness in dairy prices is leading to some soul-searching about the longer-term prospects of New Zealand's largest export industry.

Our view is that a perfect storm of negative forces came together this season.

Stronger global production: In a sense, the dairy price boom in 2013 sowed the seeds of its own demise.

The near-record prices on offer provided the incentive for a strong lift in milk production the following season, particularly in the US and Europe.

That dynamic has since reversed: with prices now at very low levels, milk production in those two regions has started to fall again in recent months.

China's slowdown: The pace of GDP growth in China slowed further to 7 per cent last year, a pace that we expect to be maintained over the next two years. But on a positive note, recent policy measures to stimulate the economy have been directed more towards the household sector, which is of most relevance to New Zealand's major exports to China.

Overstocking: Chinese demand for milk powder went ballistic in late 2013, first in response to drought in New Zealand, then on fears that an outbreak of foot-and-mouth disease would decimate China's own dairy herd. In hindsight, the fears of a disruption to the supply of milk were overstated; Chinese buyers found themselves holding greater stocks of milk powder than needed, and consequently have been less of a presence in the market in the past year. These buyers will eventually return as their excess stocks are run down.

Russia's trade ban: In the midst of the Ukraine conflict, Russia placed a ban on food imports from many Western nations last August. While New Zealand itself wasn't subject to the ban, it meant that dairy products from competing exporters such as Europe and the US had to find a home elsewhere. Russia is -- or was -- the world's second-largest importer of dairy products, so its absence from the market will have been a significant drag on prices. The trade ban is due to expire this August, although the risk is that it is extended.

We wouldn't expect all of these forces to be repeated next season, or at least not to the same degree. Nevertheless, there are signs that the global dairy industry has evolved since the 2008-2013, period when New Zealand was uniquely well positioned to service the growth of the Chinese market. Several years of higher dairy prices (on average) have incentivised other countries -- including China itself -- to expand capacity in their own dairying sectors, leaving them better positioned to respond to changes in demand.

The end of the European Union's milk production quota system is one facet of the global industry's greater responsiveness.

The term 'quota' is somewhat misleading: in practice it worked as a levy on excess production, equating to around US$250 per tonne of milksolids, which was easily affordable and did little to discourage expansion when world dairy prices were high. That's why, despite predictions of an explosion in milk production after the removal of the quotas, we think that production in Europe will actually be restrained over the next year by low prices. But over the longer term, the removal of the quota system should lead to greater flexibility in the global milk supply.

At the least, this suggests that the days of farmgate milk prices in New Zealand shooting up towards $8/kg in any given season could be a thing of the past.

With the upward march in milk prices checked by global forces, and biological constraints to the rate of growth in milk volumes produced within New Zealand, it will be difficult for dairying to increase its contribution to GDP in the same way it has done in previous years.

Michael Gordon is a senior economist at Westpac.