KEY POINTS:
Dairy prices have fallen more sharply than expected since peaking in November last year, and Fonterra expects them to keep dropping until at least the middle of next year.
The ANZ Commodity Price Index for dairy products rose for 15 consecutive months to peak at 291.9 in November
but has since fallen about 25 per cent. Historical trends suggest it could drop by another 25 per cent - a major blow to an industry which accounted for 27 per cent of New Zealand's exports in the year to May.
In July, Fonterra launched an internet-based sales auction called globalDairyTrade to try to keep up with volatile markets and set a global reference price for dairy products.
Last month's auction returned an 11.8 per cent drop in the average price for whole milk powder compared to the previous month.
GlobalTrade managing director Kelvin Wickham says the system made the global price more transparent and was starting to give a reference line of where the market was headed.
"It's coming under a lot of flak because people don't necessarily like the price that it's showing but that's the market, the market is falling on the back of the supply-and-demand fundamentals," Wickham said.
Dairy commodity prices have soared due to world economic growth, demand from emerging markets, reduced supply, drought in Australia and biofuel production.
Wickham said some dairy products had already dropped about 50 per cent, while cheese, butter and whole milk powder still had room to fall.
"Demand between now and Christmas is going to be very difficult and we don't expect this market to pick up until at least the second half of next year," he said.
Fonterra in September cut its forecast payout to farmers for the current season from $7 to $6.60 a kg of milksolids, compared with $7.90 and $4.46 for the previous two seasons. Fonterra distributed $9.1 billion to farmers last season.
Dairy was not a market where companies could stockpile and wait for the price to come back because of its perishable nature, the cost of funding inventories and a regular off-take by customers.
However, when prices turn companies could find themselves in or out of the money.
"It'd be unwise to go extremely long when the market's starting to pick up," he said.
Fonterra only sells a small percentage of products through the online system but can use this information to help manage its contract book.
A live demand system helps the co-operative forecast ahead 18 months, using information on supply and demand - including feedback from customers, climate, farm input costs, fuel, finance and gross domestic product in markets.
Increased global milk supply encouraged by the higher prices is colliding head on with a contraction in demand.
"No surprise then you've got a logjam in the supply chain. Inventories are starting to build and price is seen as a lever to try to get the chain moving again," Wickham said.
The contraction in demand had been more sudden than expected.
"It's been contracting across the year as you would expect in response to higher prices ... but it's really just hit the wall as consumers have suddenly run out of funds."
Consumers at the end of the chain were not buying, leading to a build up of stock. Customers in the middle of the chain were finding it difficult to finance existing inventories and buy new products.
It would take time for the commodity decline to get through to consumer prices because of current inventories and the delivery and manufacturing lead times, Wickham said.
"We believe that's one thing that needs to happen to re-invigorate demand.
"The second thing, of course, is you want the world economy to start to show a bit more signs of life."
The world economic downturn was one of the bigger unknowns.
"That will likely suppress any uptake so instead of getting some sort of V - for example, it goes down quickly and bounces up - you're more likely to have a bit of a U-shape."