Cliff Brown: Global milk price surge was a blip

The degree of angst about dairy pricing and New Zealand dollar values is unnecessary. Photo / NZ Listener

The latest leap in whole milk powder prices may be encouraging news but farmers would be wise to take a long look backwards when planning for the future.

World commodity and currency prices are so volatile that basing business decision-making assumptions on forecasts is of little more use than crystal ball gazing. A far simpler and more reliable analytical tool shows that the blip is simply that, and recent low prices are not really low at all - they are actually normal.

A burst of cautious optimism has understandably arisen from the news that Fonterra's latest whole milk powder auction prices increased by 25.8 per cent over the previous month, to an average US$2301 ($3388) per tonne. This optimism has, however, been tempered by prices still being around 39 per cent lower than this time a year ago.

Optimism has been further dampened by the NZD/USD increase since March, rising from a low of US49c to levels over US67c.

Farmers, the Reserve Bank of New Zealand and many commentators have bemoaned the dairy situation, worrying about the country's export revenues and the impact on the economy's recovery in these difficult times.

The ongoing focus on dairy farmers' fortunes is understandable, given that the dairy industry accounts for around 7.5 per cent of New Zealand's GDP and 25 per cent of our exports.

Yet the degree of angst about dairy pricing and New Zealand dollar values, and excited intake of breath over the spike, is unnecessary.

Taking a step back from recent ructions and looking at the long-term picture shows that "low" dairy pricing levels are close to trend, and should be regarded as the rule rather than the exception.

The graph, which tracks dairy prices over the past two decades, provides the true picture. As can be seen, dairy pricing has been increasingly volatile but overall demonstrates a slight upward trend.

The leap upwards during 2006 and 2007 was clearly a bubble, and the market has simply returned to "normal" levels. The latest price spike is just one move in an erratic series and prices could easily fall back again.

International dairy sales are converted to Kiwi dollars so the same cautious approach should be taken to anticipating NZD/USD trends. Although the Kiwi is sitting a little above the long-term average, it is within the normal zone.

The best approach is to take each day's rate at face value rather than trying to predict whether the rate will go up or down in the near future.

Long-term trends paint a useful picture, but volatility makes short-term predictions impossible.

When weighing up the value of casting a long look backwards, it could be argued that any number of refinements should be accounted for, such as allowing for CPI growth, accounting for wages and other input costs.

But the overall general conclusions that may be drawn are these:

International dairy prices have simply returned to "normal" after a two-year windfall bonus.

The NZD/USD is a little higher than its long-term history but not exceptionally so. It is unrealistic to be overly negative about the present state of affairs, and it does the country no favours to base business development decisions upon false impressions and short-term trends.

Some valuable lessons can be drawn from the turbulent years. Dairy and other industry leaders are more acutely aware of how managing economic risk is key to fostering business success.

Hopefully, this understanding will last beyond the next dairy price bubble.

The clearest lesson to be drawn for milk powder prices, the New Zealand dollar, or other market price variables such as interest rates is that it is prudent to figure out whether the business is sustainable at a wide range of those prices, and budget accordingly.

An export business that only makes money if the NZD/USD is below (say) US60c is not a sustainable proposition.

It is human nature to enjoy the good times, but anybody in the commodities sector should plan for the fact that what goes up sharply will most probably come down again.

Taking these basic risk management steps will help to prevent a bumpy landing when prices drop: Use financial products such as options to avoid over-committing.

Read all economic and financial forecasts with a healthy scepticism and avoid the trap of short-termism.

Budgets should be conservative, and periods where the rates or prices are advantageous should first be used to build up the company's contingency coffers rather than gear up the business and bet the farm.

In other words, look at the big picture - and enjoy the view. This is New Zealand, after all.

* Cliff Brown is client adviser for Bancorp Treasury Services.