Federated Farmers: Cautious optimism as dairy prices recover

Dairy prices have had their ups and downs of late.

The fortunes of New Zealand's dairy farmers have taken another dramatic shift.

The steep fall in world dairy prices through to early August has been followed by an equally rapid rebound in recent weeks.

While prices are still at the low end of their historic ranges, a farmgate milk price with a five in front of it now looks plausible for this season, though far from certain.

While the bounce has come as a welcome relief, we're taking a cautious view of where dairy prices head from here. The fall in prices was widely recognised as a product of slowing demand along with a global supply glut, and it's not obvious that much has fundamentally changed with this story.

The rebound in prices appears to have been sparked by Fonterra's announcement that it expects its milk collection to be down for this season -- initially a 2 per cent shortfall, now estimated to be 5 per cent or more. As we've noted in the past, world prices are very sensitive even to small unanticipated changes in supply. Often, buyers of dairy ingredients don't have a lot of flexibility in their requirements over the short term, and are willing to bid up in order to guarantee supply.

But even if Fonterra's forecast proves to be accurate, does a 5 per cent shortfall in New Zealand's milk production justify a nearly 50 per cent rise in world prices? Probably not. Which suggests that one of the last two legs in dairy prices -- the plunge in March-July, or the rebound since then -- was overcooked. We just can't be sure which one.

We should bear in mind that New Zealand's position as the 'swing factor' in the international dairy market is not a strong as it once was. Milk production in the Northern Hemisphere has grown substantially in recent years, in part incentivised by years of higher prices. And with domestic consumption of dairy products more or less flat in the Western world, all of this growth has been destined for the export market.

In addition, the removal of the EU's production quota system has provided a fresh disruption. Milk production in some regions such as Ireland, the UK and the Netherlands is now growing at double-digit rates: as the relatively lower-cost producers within Europe, they are looking to claim the greater market share that the quota system prevented them from doing until now. The flipside of this is that the higher-cost producers within Europe will eventually be forced to scale back, but that hasn't happened yet. The net effect has been a renewed surge in European milk production in since April.

Meanwhile, global demand for dairy products has shown no meaningful signs of improvement. China's economy remains opaque in many respects, but there are strong indications that the pace of growth is slowing sharply (although consumers seem to be in relatively good form). And Russia's ban on food imports from many Western nations has been officially extended until August 2016 (and in some cases, such as beef, has effectively been declared permanent).

So we see the outlook for milk prices as finely balanced between two plausible scenarios.

In one scenario, buyers could scramble to secure supply as they have done in the past, pushing prices even higher in short order.

But in another scenario, Fonterra's forecast of a production slowdown may not pan out, low feed costs continue to encourage US milk production, and European countries continue to produce at a loss in order to gain market share. In this case, world dairy prices could capitulate again.

Finally, there's the growing prospect of El Nino. We're not weather forecasters, and even the professionals are uncertain as to how significant the impact will be for New Zealand this summer.

But another drought here could push world dairy prices sharply higher, though to the detriment of those regions that miss out on rainfall or don't have access to irrigation.