Mafm the case for investing in dairy (2011)

MACQUARIEAGRICULTURAL FUNDS MANAGEMENT

The case for investing in dairy

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Contents

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Executive summary 03

Demand side 05

Supply 12

Where can the world expand dairy supply? 16

Conclusion 26

Contents

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During the past three years, the grain, oilseed and meat markets have received a significant amount of attention. This can be attributed to accelerating demand from the biofuel sector and a surge in global food and feed demand from emerging economies which led to an unprecedented increase in most agricultural prices. Similar structural changes can also be seen in the global dairy markets. In rapidly developing countries, dairy products are facing unprecedented demand pressures from the emerging middle classes. Throughout the developing world the emerging middle class, higher incomes, urbanisation and access to dairy retail facilities have all had a profound impact on the world dairy markets and is likely to continue to do so for many years to come.

Oceania dairy product export prices

Source: United States Department of Agriculture (USDA), Macquarie

Global dairy markets have experienced many extremes in recent years.1 In 2007/08 dairy prices rose to record highs, along with the majority of agricultural commodities. This rise in dairy product prices was a direct result of growing global economic prosperity.2 Like in most commodity cycles, while the price boom did lead to a surge in supplies it also acted as a natural brake on demand growth.3 Thus, when the global financial crisis hit at the end of 2008 the global dairy market, like many other commodity markets, came under significant strain as supply

1. Dairy Australia2. International Dairy Federation 3. International Dairy Federation

outgrew demand and prices hit the floor. Where prices came to rest on this floor in 2009 is an important point to highlight in itself.

The new price ‘floor’ revealed in the aftermath of the global financial crisis indicated that a significant structural shift had taken place. No longer was the international dairy product price upside capped at just over $2,000/t, but this price level effectively became the new floor post-2007.

The structural changes within the global dairy markets can be attributed to several important factors, one of these being dairy demand in emerging economies. Growing levels of disposable incomes across emerging economies has led to increased demand pressures on the available global dairy supply. If more people are demanding dairy products, and are willing to pay for them, higher prices are likely to follow. Additionally, rising input costs across all major dairy production regions have also contributed to a structural shift in the global dairy markets. A combination of higher feed grain, fuel, and land prices has led to a constrained incremental demand growth across the sector. It is also important to consider that the recovery of global dairy prices by early 2010 indicated that the market had moved from oversupply to balance.4

Throughout the global economic downturn poor returns in many dairy regions contributed to a significant decline in the global dairy herd. It will take time and higher milk prices to recover production capacity lost over the duration of the financial crisis and to re-build the global dairy herd. It is anticipated that the return of dairy demand growth in 2010 will continue, and in fact there are already signs emerging of supply constraints developing in the market.

Markets such as China and South East Asia are expected to provide significant opportunities for dairy producers over the coming decades as per capita consumption of dairy products expands throughout the region. Additionally, the vast majority of countries in the world have dairy supply deficits which bode well for increasing consumption growth and dairy trade in future.

4. Australian Bureau of Agricultural and Resource Economics (ABARE)

Executive summary

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Most of the world faces a dairy supply deficit

Source: Food and Agriculture Organisation (FAO), Macquarie

Executive summary

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The global dairy markets cover an array of products including cheese, dry powdered milk, fluid milk, whey and yoghurts. This provides diversification for the market as different countries and different economic situations provide multiple layers of demand for dairy products. Our analysis of FAO data, which looked at which countries consume what dairy products, revealed that the higher a country ranks on scales of economic development, the higher both the volume and the diversification of dairy consumption. Thus, it can be inferred that with economic development comes not only more dairy consumption on a volume basis but also more consumption of higher cost, higher value-add products such as cheeses and yoghurts.

Global milk product consumption – excluding fluid milk (tonnes)

Source: USDA (2009)

Demand in developed economiesDuring the last decade dairy demand has remained relatively stable in the major developed economies. Dairy consumption trends have become entrenched with per capita usage which are already at very high levels. During the global financial crisis incremental fluid and dry milk demand growth remained on trend. However, demand for butter and cheese products fell slightly, as high unemployment rates, higher savings rates, and low consumer confidence led to a decline in higher-end food product demand.5

Total milk product demand is yet to fully recover back to the growth trend seen pre-recession.6 Once the Organisation for Economic Cooperation and Development (OECD) countries’ demand improves, a higher milk price will receive further support. Currently high demand from emerging economies, combined with OECD demand recovery will put pressure on recovering global dairy stocks.

Total EU/US/Oceania milk product demand

Source: USDA, Macquarie Research (2010)

5. Dairy Australia 6. USDA

Demand side

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The emerging economies are the key driverIn emerging markets dairy demand has grown significantly while continued high unemployment and an unsteady economic recovery in the developed world has led to flat consumption growth in traditionally strong dairy consuming regions.

Milk product consumption moves higher with GDP growth

Source: FAO, Macquarie (2007)

The strong economic performance of rapidly developing economies, such as those in South America and Asia, have provided a solid underpinning to the global dairy markets in 2010, a trend which appears to be accelerating. The key areas of dairy demand growth are centred in East Asia, South East Asia, South America and the former Soviet Union. The emerging middle classes in these countries are becoming more health conscious and with increased spending power are willing to pay more for higher-end dairy products.

China's urban/rural dairy divide in 2008

Source: USDA Attache, Macquarie Research, (January 2011)

Demand side

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It is anticipated that demand for milk will continue to rise in line with the growing global population and the industrialisation and urbanisation process unfolding across the developing world. Across emerging markets it is evident that a young, urbanised population is altering their dietary patterns, demanding more higher-value food products and moving from lower to higher-value foods including dairy and meat products.7 In fact, data available on the divide between urban and rural per capita milk consumption in developing economies clearly illustrates that rural populations lag far behind their urban counterparts.8

Per capita milk product consumption, 2010

Source: Food and Agricultural Policy Research Institute (FAPRI), USDA, Macquarie (2010)

Health benefits of dairyDairy products are an important source of several key nutrients. Outlined below are several proven health benefits of milk consumption9:

� Essential nutrients – protein, carbohydrates, fats, vitamins (A, B12, and riboflavins), and minerals (calcium, phosophorus, magnesium, potassium and zinc)

� Blood pressure – milk products are high in potassium, magnesium and calcium; minerals which may help lower blood pressure

� Healthy bones – dairy foods are the main providers of calcium. Consumption of milk products has been shown to improve bone density and prevent osteoporosis. Studies of children have shown that those who have consumed adequate amounts of milk products

7. UN Secretariat, Macquarie Research Economics8. USDA FAS Attaché9. USDA, Dairy Australia, UK Food Standards Agency, National Dairy Council,

UN WHO, International Dairy Federation

have higher bone density levels thus lowering risk of osteoporosis later in life

� Immune protection – studies suggest milk’s whey component provides glutamine and lactoferring, which studies show may offer immune protection

� Digestion – milk’s whey protein can help provide amino acid glutamine which, when lacking, has been shown to cause upset stomachs

� Exercise recovery programs – scientists have demonstrated that dairy products such as chocolate milk are an effective exercise recovery aid due to their combination of carbohydrates and protein.

Dairy products are the richest and most effective source of calcium in the diet and cannot easily be substituted by other sources.10 According to the United Nations (UN) World Health Organisation (WHO), diets that are low in dairy products will generally not provide sufficient calcium, which is particularly vital for the proper development of young children.11 The UN considers that milk consumption is a key variable to combat malnutrition and has committed significant resources to establishing school milk programs in developing countries.12 For adults milk consumption is routinely cited as a key factor for the prevention of osteoporosis.

An increasingly urban world population boosts demand for milk products

Source: FAO Secretariat, Macquarie

10. USDA, Dairy Australia, UK Food Standards Agency, National Dairy Council, UN WHO, International Dairy Federation

11. UN WHO12. UN WHO

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The UN forecasts that the global population will reach 9.1 billion by 2050; a growth of 33 per cent from today’s population of 6.9 billion. The UN also predicts that an increasing proportion of the population will be situated in urban centres. Today the world’s population is split roughly 50/50 between urban and rural dwellers. However by 2050, the UN forecasts this split will widen to 70 per cent urban 30 per cent rural.13 As increased urbanisation and growing prosperity generates higher disposable incomes, more protein and processed foods are anticipated to be consumed. In fact, in many regions consumption of dairy products is still considered a luxury, however this is rapidly changing as milk products are becoming a dietary staple.14 Urbanisation allows for easier marketing and distribution of dairy products to consumers as people have greater access to distribution and cold storage, along with greater choice through large retailers and restaurant chains.

Comparative consumption trendsIn many developing countries per capita milk consumption remains far below North America and Europe. The graph, Comparison of per capita milk consumption across the world, highlights the growth potential inherent in the world’s dairy markets. Countries such as Brazil, India and Mexico are approximately mid-way up the demand curve but have further upside growth potential over the next decade. On the lower end of the scale countries such as China, Venezuela and South East Asia have only begun to consume increased quantities of milk which could potentially lead to large upside growth over the coming decades.

Comparison of per capita milk consumption across the world

Source: FAPRI, USDA, FAO, Macquarie

13. UN Secretariat14. KPMG

Currently, China’s per capita dairy consumption is 12.3kg/capita, 86 per cent below current United States (US) per capita consumption.15 Over the next decade China’s per capita dairy consumption is expected to rise by 160 per cent.16 South East Asian countries such as Indonesia and Vietnam have also been identified as key consumption growth regions. Currently, per capita consumption stands at 1.4kg/capita in Indonesia and 2 kg/capita in Vietnam. By 2019, per capita consumption is expected to grow by 76 per cent and 34 per cent respectively.17 According to these figures, per capita consumption across the world, and particularly in South East Asia, still has tremendous upside potential for the future.

Three stages of accelerating milk consumption growth in emerging markets

Source: USDA, Macquarie

Total milk consumption (including all products) in the three major dairy growth markets of South America, South East Asia and East Asia has been accelerating. The chart, Three stages of accelerating milk consumption growth in emerging markets, depicts three distinct growth phases. First, from 1964 to 1981, milk consumption growth was constrained by underdevelopment in these economies. Consumption growth still managed to surge 62 per cent but came from an extremely low baseline. Second, from 1982 to 1993 many of these countries saw increased rates of development with milk consumption growth at 49 per cent over the period. The third and current stage running from 1994 to present

15. FAPRI16. FAPRI17. FAPRI

Demand side

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has seen a 128 per cent surge in consumption as the industrialisation process is undertaken.18 It is difficult to gauge how long this process of strong linear year-on-year growth in demand will continue, however, judging from the comparative per capita consumption data across different countries, increasing prosperity will likely continue to act as a stimulant for increasing dairy consumption growth.

Indonesia’s dairy market is an example of the potential for dairy market growth in South East Asia. Between 2000 and 2010, Indonesia expanded milk production by 35 per cent, producing 1.06mt by 2010.19 However, demand growth also doubled over this period. In order to meet this demand, major dairy exporters New Zealand and Australia have had to supply much of the additional demand needs in the form of dry milk powder.20 Indonesia’s whole milk powder imports have surged 187 per cent between 2000 and 2010, while non-fat dry milk imports are up 170 per cent.21 Given this, the outlook for Gross Domestic Product (GDP) growth over the next decade coupled with constraints on expanding domestic dairy production – in line with demand growth – means Indonesia will continue to be a significant and growing net importer of milk products.

Indonesian milk consumption vs GDP growth


18. USDA19. USDA20. USDA21. USDA

Indonesia is not the only country facing growing import requirements. In 2010 Russia’s drought disaster diminished total grain production by over 35 per cent from 2009.22 This led to soaring domestic feed prices which in turn caused increasing livestock herd liquidations.23 Although China will be the largest importer of fluid and dry milk, Russia will remain the world’s largest importer of all milk products in 2010. Total demand is expected to grow by 10 per cent in 2010 from 2009. This large dependency on imported milk products will take time to reduce despite the Russian government’s current five-year plan to promote the development of the domestic livestock and poultry industries.24

Total dairy product importers (includes fluid/dry milk, cheese and butter)


China has become the world’s largest importer of fluid and dry milk products and will continue to be the dominant force in the global dairy markets. Growth in China’s milk product demand presents a significant opportunity for dairy producers. As outlined in the subsection regarding China’s dairy industry, strong import demand growth has been fuelled by consumer mistrust of domestically produced milk following the 2008 melamine-tainted milk crisis. Imports reached 335mt in 2010, tripling import levels in 2008.25 China simply cannot supply all of its milk product demand needs.

22. USDA23. USDA FAS Attaché24. USDA FAS Attaché25. USDA, Macquarie

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Despite attempts by the Chinese Government to encourage domestic dairy production, the general view is more supportive for an increasing China milk import demand program. Cash corn prices in China are now at record highs having increased 35 per cent between early 2009 and late 2010.26 A surge of feed and industrial corn demand in the absence of significant supply growth has led to internal shortages and imports of US corn for the first time in more than a decade. With flat corn yield growth and limitations on arable land expansions, it appears China will continue to struggle to produce enough feed grains domestically to support a growing dairy herd, along with other livestock and poultry supply growth. Soy meal prices have also increased nearly 10 per cent between 2009 and 2010 as feed demand requirements continue to significantly expand soybean imports.27 These feed cost pressures, along with limitations on dairy production expansion – due to disease and a lack of water resources – should prove conducive to continued milk import demand growth28.

Major dry/fluid milk importers


26. Thompson Reuters27. Thompson Reuters28. USDA

Demand side

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China’s melamine crisis offers opportunities to milk producers in exporting countriesIt has been a slow road to recovery for China’s domestic dairy production industry following the 2008 melamine-tainted milk scandal. Immediately following the crisis, demand for domestically produced milk products plummeted causing a 17 per cent reduction in the size of China’s dairy herd between 2008 and 2009. Total demand recovered quickly, however, consumption was then fuelled by dairy imports, not local production. This caused total milk product imports to surge 210 per cent between 2008 and 2010. This import surge was led by dry milk powder products due to very strong demand for infant formulas and it appears this trend will continue at least until the Chinese dairy herd size makes a full recovery.

According to the USDA, China’s dairy herd size is increasing once again as demand for domestically produced milk begins a slow turn-around. The government has adopted stringent melamine contamination prevention measures while continuing to subsidise dairy production at the farm level. The Government’s dairy plan sets a target for 48mt of milk production by 2013; nearly double current production levels. However, this target may turn out to be optimistic due to continued consumer safety concerns, extremely high feed costs, and a growing incidence of disease outbreaks such as Foot and Mouth Disease (FMD). Therefore, although China’s dairy herd is projected to have grown seven per cent between 2009 and 2010, dairy product import demand has grown at a much faster pace of 38 per cent over the same period. It may take many more years for the domestic dairy sector to make a full recovery. In the meantime it is highly likely China will remain the world’s largest market for dry milk powder exports.


Source: China Statistics Bureau


Source: USDA

According to the China Statistics Bureau, monthly dairy product output (a good proxy for demand) recovered back to pre-crisis levels by late 2010. Total output has already reached 15.6mt from January through September 2010, up nine per cent from 2009. China’s dairy consumption growth is being fuelled by higher disposable incomes, increasing health consciousness, and greater access to dairy products at the retail level. Over the past decade China’s total milk product demand has increased over 340 per cent29. However, on a per-capita basis, China’s total consumption still lags far behind that of developed economies. Even more striking is the disparity in milk consumption between China’s urban and rural populations. The graph, China’s urban / rural dairy divide in 2008 on page four, clearly shows that per capita consumption of milk in rural areas is still only a fraction of what is currently being consumed in urban areas. With China’s trend toward rapid urbanisation and an expanding middle class, the scale of milk consumption growth potential is indeed significant. This means China’s dairy market will continue to provide ample room for a solid growth in imports over the next several decades. This highlights the great opportunity which exists for the world’s major dairy exporters to continue gaining market share in China.

29. FAO, National Bureau of Statistics China

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Global dairy production has remained on an upward trend over recent decades and more specifically over the last ten years to 2008; global milk production has increased on average by two per cent per annum.30 In contrast, for decades dairy herds globally have been in structural decline shrinking 28 per cent between 1984 and 2009. In fact, the global dairy herd declined to 124.7m head by 2009 after a short-term peak in cattle numbers in 2008 at 126.5m head. In 2010 the dairy cattle supply stabilised at 125.5m head, up 0.63 per cent from 2009 following a recovery in international dairy prices and improving import demand.

Global milk production

Source: Macquarie Research (November 2010)

Productivity per animal has improved markedly over the past few decades due to improvements in dairy farming practices including more scientific feed rations, industry consolidation (economies of scale) and improvements in dairy health. In 1965 the world average milk produced per cow in one year stood at 2.1 tonnes per year improving 13.4 per cent to 2.48 tonnes by 1985. By 2010 the average was 3.5 tonnes, a total increase of 60 per cent from the 1965 level.31 The boost in efficiency and productivity has contributed, in part, to the decline in the total world herd size while keeping total milk production on a steady uptrend.

30. USDA, FAO31. USDA

Global dairy herd vs productivity

Source: USDA

It is also important to look at the dispersion of dairy cattle herds globally. From the late 1990s to 2010, the world’s major traditional dairy exporters saw a 10 per cent decline in overall herd numbers. Between 2009 and 2010, the economic slowdown accelerated this trend with dairy cattle numbers falling 1.6 per cent. In 2009 and early 2010 slow demand growth in developed countries, combined with weak export markets, contributed to weak dairy producer margins in Europe and the US, which in turn led to herd reductions. Of this group, only New Zealand realised herd growth over the 2008 to 2010 period with four per cent growth registered between 2008 and 2009 and another 2.4 per cent growth between 2009 and 2010.32

32. USDA

Supply

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Major milk exporters’ dairy herds shrinking

Source: USDA

Beyond the traditional dairy exporters, dairy herds have also been increasing in South America, and more specifically Brazil. Although dairy exports have been increasing from South America, strong rates on internal milk consumption have prevented South America from becoming a major player in the world milk trade.33 Although there will be many constraints on dairy herd expansion moving forward, global dairy herd numbers are predicted to begin stabilising into 2011 and may even gradually increase.

Global dairy herd

Million head 2005 2006 2007 2008 2009 2010India 38.00 38.00 38.00 38.50 38.00 38.50

EU 25.36 24.94 24.18 24.18 24.19 23.66

Brazil 15.10 15.29 15.93 16.70 17.20 17.60

FSU12 14.53 13.74 13.13 12.90 12.39 12.17

United States 9.05 9.14 9.19 9.32 9.20 9.12China 6.80 7.90 8.76 8.58 7.12 7.63

New Zealand 3.97 4.10 4.16 4.20 4.37 4.47Argentina 2.10 2.15 2.15 2.15 2.10 2.10

Australia 2.04 1.87 1.80 1.64 1.68 1.60

Canada 1.07 1.02 1.00 0.99 0.98 0.98

Source: USDA

33. Dairy Australia

In terms of overall dairy production, Europe and North America are the largest dairy producing regions, making up over 50 per cent of the total world production.34 Due to the high population base in the US and European Union (EU), these dairy markets are focused mainly on internal market dynamics. Dairy is a thinly traded agricultural commodity as many countries are focused on maintaining internal balance with only a few major players involved in export markets. Only between seven and eight per cent of total global milk production is traded internationally.35

World milk production by region in 2010

Source: USDA (2010)

Fresh milk is a highly perishable good which means most countries with high levels of dairy consumption also have high levels of dairy production. Thus, international dairy trade is dominated by products with a longer shelf-life such as powdered milk products, primarily skim-milk powder (SMP) or whole milk powder (WMP). Combined, these products make up the bulk of international dairy trade at 21 per cent and 26 per cent respectively. Cheese and butter products comprise the balance at 25 per cent and 21 per cent respectively. Fluid milk exports, however, only account for seven per cent of global dairy product trade.

34. USDA35. Fonterra

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World dairy product exports by type in 2010

Source: USDA (2010)

Australia and New Zealand (Oceania) only account for six per cent of total world milk production however, these two countries provide over half of global dairy trade.36 Efficient, export-oriented production models, coupled with low domestic populations and proximity to key markets in Asia means this region has become the pivotal dairy supplier to world markets. The EU is the second largest dairy exporting region, accounting for 31 per cent of global dairy trade in 2010.

World dairy exports by region as proportion of total world dairy trade

Source: USDA

36. USDA

Total dairy exports and production have been steadily increasing as regions which lack dairy production capacity have seen the strongest demand growth. Long-term trends in dairy exports from the three major exporting regions of the US, EU, and Oceania suggest that a solid upward trend remains intact. Total net exports from these three major exporting regions have increased on an average of one per cent per year over the past decade leading into 2010. Looking ahead, FAPRI estimates that net-export growth from the top three exporting regions will accelerate with average yearly increases of two per cent per annum over the next decade.37

Total net milk product exports

Source: FAPRI, USDA (201)

FAPRI’s data highlights another important trend in regards to export market share. Due to the competitive dairy production models in Australia and New Zealand, and proximity to key import markets in Asia, the share of Oceania milk product exports as a proportion of total net trade among the major exporting regions is expected to increase over the next ten years.

37. FAPRI

Supply

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Per cent share of export market

Source: Macquarie Research, January 2011

This will likely come at the expense of the higher-cost producers in Europe and the US. Australia is expected to experience the greatest increase in the share of total net trade, climbing 15 per cent by 2019 compared to an 11 per cent share in 2010. New Zealand’s share of dairy export trade is also expected to increase to 48 per cent from a current 46 per cent. In contrast, it is anticipated that EU market share will decrease to 21 per cent by 2019 compared to nearly 30 per cent in 2010. US market share is expected to remain relatively steady near eight per cent, increasing only slightly from a current share of approximately 7.5 per cent.

These projections suggest that the countries which already have established export-oriented, deregulated dairy industries will be able to benefit most from emerging market demand. Australia, with a recently deregulated market, is expected to receive a much greater share of the new import demand emerging from Asia.

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Regional supply focus Growth in global milk supply can come about in two ways – either by increasing the global dairy herd and/or increasing productivity per cow. Increasing herd sizes requires significant investments at the farm level while increasing productivity per cow generally involves higher feed and management costs. Thus, there is usually a time lag between when additional supply is needed by the market and when producers will be able to increase production.

EuropeThe European dairy production model can be described as highly policy-oriented. Since World War II most major dairy producing countries in Europe and now the EU forged a dairy industry reliant on a complex government support program utilising subsidies, quotas, intervention purchasing, and high tariffs.38 This has meant that internal EU milk prices have generally trended higher than international equivalent prices over much of this post-war period.39

These measures were implemented at various times in order to preserve internal market balance. The EU’s milk quota system was introduced in 1984 to restrict milk production and control surpluses.40 However, the policy is expected to expire in 2015 which means the EU dairy industry faces considerable liberalisation over the next decade. The likely restructuring of the EU dairy sector is anticipated to align EU milk prices closer to international prices over time (which could translate to lower prices in the EU). While the number of dairy farms will likely decrease, farm sizes will increase to take advantage of economies of scale.41 However, because of the high-cost model of dairy production in the EU, it is far from certain whether this liberalisation will provide a situation which will lead to a significant increase in total EU milk production.

38. Dairy Australia39. DIN Consultancy40. EAAE Seminar paper: Agri-Food and Biosciences Institute Northern Ireland,

FAPRI, Queen’s University Belfast41. EAAE Seminar paper: Agricultural Economics and Rural Policy Group,

Wageningen University

Average producer milk prices 2009 ($US/cwt)

Source: International Dairy Federation (2009)

The EU also makes use of intervention purchasing programs to ease market surpluses. The common reference to “lakes of milk” and “mountains of butter” in discussions over the EU’s Common Agricultural Policy (CAP) describes the EU historical policy of storing large amounts of these products as a price support mechanism. This policy still exists but has evolved into more of a safety-net than a price support program with predetermined limits set on prices and quantities offered into the intervention program.42

In recent times the EU has again used the intervention program to ease excess milk supplies which temporarily developed during the global financial crisis. Although EU intervention dairy stocks reached the highest level since 2003 by the early months of 2010, stocks have decreased significantly as supplies are absorbed by the export and domestic markets. The EU Government’s dairy stocks continue to have an impact on wholesale milk prices in the EU. With low butter stocks, wholesale butter prices have rebounded much stronger than SMP prices. The gap between these two prices has in fact widened showing that the EU’s support programs continue to have a direct impact on prices. Dutch butter prices have rebounded 83 per cent from the lows seen in 2009 to the highs in 2010 while SMP prices have only increased 40 per cent over the same period.43

42. Joint AES and SFER Conference ‘The Common Agricultural Policy Post 2013’ Paper presented by Alan Matthews, Trinity College Dublin

43. DIN Consultancy

Where can the world expand dairy supply?

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EU dairy wholesale prices

Source: DIN Consultancy

As highlighted in the table, Global dairy herd, the EU’s dairy herd has shrunk significantly over the past five years; declining 6.7 per cent or 1.7m head between 2005 and 2010. Poor returns due to weak demand growth domestically and high feed prices has contributed to the decline over the past five years. However, like most other major dairy producing regions, the EU is experiencing consolidation in the industry as the number of farms shrinks while at the same time the sector is experiencing an expansion in farm sizes. Efficiency gains are driving this process of consolidation. In the EU 4,723kg of milk were produced per cow in 1999 but this has increased 1,000kg/cow or nearly 20 per cent by 2010.44

EU herd decreasing along with productivity gains

Source: FAPRI

44. FAPRI

Thus, even though the EU’s dairy herd is expected to continue declining over the next decade, increasing productivity will support slow incremental supply growth. FAPRI data suggests EU milk production should continue its slow incremental growth of 0.30 percent over the next decade, roughly in line with incremental demand growth.45

EU dairy balance

Source: USDA, FAPRI

The EU dairy market could remain relatively static, as a result of incremental supply growth, over the medium term due to existing entry barriers (quotas), the distortionary impact of various price intervention measures, and the high costs associated with production. In the medium-term, increasing market liberalisation in the EU will provide efficient producers with an opportunity to expand production. However, there could be an extended period of adjustment to this liberalisation and to the higher feed grain price plateau which could result in temporary contraction and consolidation before the industry would be in a position to expand once again. However, at this point, the length and severity of the adjustment process is highly uncertain.

45. FAPRI

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The United StatesThe US dairy production system is highly intensive and heavily exposed to increasing feed costs. Milk is predominantly produced in consolidated feedlot operations which utilise large amounts of feed grains and protein meals. This milk production system can take advantage of economies of scale while the high-intensity feeding rations mean productivity per cow is much higher than the world average. In 2010 the average milk produced per cow in the US stood at 9.5t/year, this compares to 5.75t/year in Australia; 5.6t/year in the EU; and only 3.7t/year in New Zealand.46

US dairy farm concentration

Source: USDA

However, the major inhibitor to US dairy production growth going forward is cost. Whereas Australia and New Zealand can take advantage of a relatively warm climate and pasture-feeding year-round, much of US dairy production occurs in states such as Wisconsin which experience cold winters. Thus, the average US dairy operation is much more input-intensive, requiring more buildings, equipment, and feed as well as labour.47

46. USDA47. University of Wisconsin-Madison


19

Productivity per cow

Source: USDA

Feed costs alone account for approximately 70 per cent of total dairy operating costs in Wisconsin.48 According to USDA data dairy feed prices have increased 69 per cent between 2003 and 2010. The drought in Russia during the summer of 2010 combined with disappointing US corn yields are a reminder that significant grain price volatility may persist in the future. Accelerating feed grain and protein demand from Asia and biofuel use worldwide, has proved difficult for livestock producers in the US to keep up with, due to heightened competition for available supplies. This has pushed grain prices well above historical averages.

Feed prices increasing in the US

Source: Thompson Reuters

48. USDA

US dairy production margins

Source: USDA

A key determinant of dairy producer profitability in the US is the milk to feed price ratio. The milk to feed price ratio trend has grown increasingly negative for US dairy farmers over the past decade. The following graph depicts the milk to feed price ratio since 1985 as well as an indicative range between which US dairy farmers typically begin to expand production. It suggests that since late 2007 there has been little incentive to expand dairy herds significantly. It also illustrates that the current recovery in milk prices relative to feed prices still does not indicate a solid milk supply expansion is imminent.49 The unfavourable milk to feed ratio will likely mean that the US dairy herd will struggle to grow over the medium-term. To turn this situation around the US dairy market would need to see either a structural shift higher in milk prices internationally or a structural shift lower in feed prices.

49. USDA

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US milk:feed price ratio

Source: USDA

US dairy herd size falling; productivity growing

Source: USDA

These economic dynamics have had clear implications for the size of the US dairy herd. US dairy herd had previously posted consistent growth rates, increasing by four per cent or 351,000 head between January 2004 and December 2008. By December 2009 the US dairy herd had peaked at 9.33m head. The herd decline has bottomed out near 9.1m head by late 2009 due to the poor margins outlined above. High dairy slaughter rates through 2009 and 2010 have reduced the dairy herd by 2.3 per cent between 2008 and the end of 2010. Improving margins into 2010 has led to a stabilisation of the dairy herd at 9.18m head. However, with the unfavourable milk to feed ratios it is unlikely that the herd size will increase significantly over the medium or even longer term.

US monthly dairy cow slaughter rates

Source: USDA

Similar to the trend in all major dairy producing regions, the US dairy herd has decreased over the past few years while productivity has increased. US dairy cow productivity is highly seasonal with peaks in the spring and troughs into the autumn. Average production per cow per month in the US has increased eight per cent between 2005 and 2010. Thus, despite the record monthly dairy cow slaughter rates brought about by the herd liquidations in 2009 and the early months of 2010 (shown above), total milk production did not fall significantly owing to these productivity gains.50

It is also important to remember that the US dairy industry operates alongside various government intervention programs including direct subsidies and intervention stock purchasing programs. The 2008 Farm Bill included even greater potential support than previously existed for dairy farmers by providing greater protection against decreases in milk prices or feed cost increases.51 The dairy intervention stock program has receded somewhat in importance if looked at from the basis of stocks (government and private combined) as a proportion of total domestic consumption. Compared to the heavy stock-build seen in the early 2000s, the increase in dairy product stocks through 2008 and 2009 never surpassed 15 per cent proportion per total domestic demand, compared to 20-25 per cent in the early 2000s.

50. USDA51. ABARE


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US dairy product stocks

Source: USDA

Although the US dairy industry retains expansion capacity through herd or productivity growth, higher costs of production and relatively high internal dairy stocks will continue to constrain expansion over the medium term. This will be an important factor that may provide other dairy producing regions, which are not as heavily exposed to grain prices, a key advantage to attain a greater share of demand growth in emerging markets.

South AmericaOne possible region which can sustain long-term dairy production growth is South America. South America is endowed with generally ample feed grain and oilseed supplies, low labour costs, and vast grasslands which can support larger and more productive dairy herds. In fact South American countries, like Brazil, are increasing per capita dairy consumption at a rapid pace.

The South American dairy markets are largely balanced with production increasing to supply the fast growth pace of domestic milk demand.52 This leaves little room for exports.53 Total dairy product exports from South America reached 296,000 tonnes in 2009; only a fraction of the 2.6mt of combined New Zealand and Australia dairy exports54.

52. Dairy Australia53. Dairy Australia54. USDA

This matching of production growth (roughly four per cent over the past five years) and consumption growth (also at four per cent) will very likely limit South American milk product export growth until the region’s per capita consumption rates begin to level off.55 This may take many years due to the high population in Brazil and other South American countries coupled with per capita consumption rates only half that of countries such as Australia and Canada.

Balanced dairy market in South America provides little room for exports

Source: USDA

New ZealandAlong with Australia, New Zealand dairy production can be characterised as a deregulated, export-oriented, grass-fed production system. In fact, New Zealand is the dominant milk exporter in the world market accounting for 34 per cent of world dairy trade in 2010.56 New Zealand has been one of the only countries in the world to expand milk production throughout the global financial crisis of 2008-2009 thereby continuing to entrench its dominant position in global dairy trade.

55. USDA56. USDA

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Concentration of New Zealand dairy production

Source: Dairy New Zealand (2009)

New Zealand dairy herd growth has remained on a steady uptrend for many years. Between 2000 and 2010 New Zealand expanded its dairy cattle herd by 28 per cent to a record high 4.5m head.57 Milk production has also remained on a steady uptrend increasing 36 per cent over the same period. Although New Zealand’s annual milk production per cow remains low compared to other major dairy production regions at only 3.7t/head compared to the world average at 3.5t/head and the US at 9.5t/head, New Zealand’s dairy sector is still highly competitive. Its low-cost grass feeding production system has effectively insulated the industry to a large degree from swings in global grain prices over history.

57. USDA

Herd size and overall production moving higher

Source: Dairy New Zealand, USDA

The structure of the New Zealand dairy industry has evolved quickly into a highly consolidated system. Average herd size per farm has increased from only 154 head in 1988 to 366 head by 2008, an increase of 137 per cent. The number of herds in production in New Zealand has meanwhile remained on a steady downtrend, declining 21 per cent between 1988 and 2008.58

Increasing consolidation and efficiency gains in New Zealand

Source: Dairy New Zealand

These industry dynamics, within the context of a deregulated, export-led dairy market have produced efficient economies of scale and allowed New Zealand dairy farmers to secure a place among the world’s largest milk exporters.

58. Dairy New Zealand


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New Zealand’s total dairy product exports slumped in 2008 and 2009 from the all-time record highs established in 2007. Export volumes declined 11 per cent between 2007 and 2008 but quickly stabilised into 2009 with a growth rate of eight per cent year-on-year. For the 2010 season, New Zealand dairy exports rose to 2.1mt, up 21 per cent over 2009. The trajectory of consolidation and improving productivity per cow will mean New Zealand will likely maintain solid production and export growth over the foreseeable future.

New Zealand dairy product exports

Source: USDA

Australia Despite producing a small proportion of the world’s total milk supply, Australia is among the world’s major players in global dairy trade. This role as major dairy supplier to the world is expected to increase over the coming decades. Dairy farmers in export-oriented regions have generally fared better during world economic slowdown compared to regions focused on maintaining an internal dairy supply and demand balance. The deregulated dairy industry in Australia has enabled greater flexibility to adapt to changing global market dynamics and capitalise on growing import demand from Asia. Certainly the geographical proximity to these major import markets is a key reason for this competitiveness. Australia is also less exposed to high international grain prices due to a low-cost production model based on a high proportion of grass-feeding operations.

In Australia the dairy industry comprises a large proportion of the rural economy. Measured in value of production, dairy comprises roughly 10 per cent of the agricultural sector in Australia, or $A3.8 billion in 2009.59 Dairy production is centred in the southeast corner of Australia, in the states of Victoria, Tasmania, and South Australia. These areas combined comprise 80 per cent of national dairy output.60 Dairy production is concentrated in these coastal regions as these areas generally received higher amounts of natural rainfall.

Dairy producing regions of Australia

Source: ABARE (2010)

Due to the warm climate and abundance of pasture lands, Australia is well suited for dairy farming. This favourable combination of natural resources means that the Australian dairy industry is predominantly pasture-based which results in an efficient, low-cost milk production model when compared to many other major dairy producing countries (EU and US).61 Only two per cent of the Australian dairy sector operates as complete feedlots while over 75 per cent utilise some proportion of both pasture and supplementary feeding.62

59. ABARE60. Dairy Australia61. Diary Australia62. Dairy Australia

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The dairy industry is a significant contributor to overall Australian agricultural earnings

Source: Australian Bureau of Statistics

The Australian dairy market has been gradually deregulated since July 2000 leading to a rationalisation and consolidation of the sector over the past decade.63 This has aligned international dairy prices with those received by the Australian farmers and has resulted in a highly cost-efficient production system geared toward the export markets. This has decreased the number of farms but increased farm size and efficiency.64 Indeed, the structure of the Australian dairy industry is changing rapidly. The number of dairy farms operated by a single person only or with a partner (typical family farm) has fallen rapidly from 43 per cent in 2007 to 28 per cent by 2009.65 Between 1991 and 2007 the number of dairy farms in Australia declined by approximately one third.66 Over the same period, the number of cows per farm also increased significantly.

63. Dairy Australia64. ABARE65. Dairy Australia66. ABARE

Total Australia milk production

Source: ABARE

Australian milk production peaked in 2001 at 11.3 billion litres shortly after the market deregulation program was initiated. Drought and market consolidation since then have led to a decline in milk production into 2009. Australia’s dairy herd fell by 26 per cent between 2001 and 2009 with total milk production declining 20.5 per cent over this period. Poor pasture conditions and high feed costs contributed to this herd liquidation however, improving productivity also played a role. Through consolidation and efficiency gains, Australian producers have been able to steadily push up milk yields per cow. In 2000, the average milk yield per cow stood at only 4,800 litres/cow, but has since increased 15 per cent to just under 5,700 litres/cow by 2010.67 This means that through flexibility in supplementary feeding rations producers have been able to increase milk production in 2010 despite no significant increase in dairy herd numbers.

Providing there is a return of ample rainfall across eastern Australia in the 2010 season the dairy herd size should begin to stabilise and slowly increase in 2011. Additionally, ample feed supplies should also allow milk output to make steady gains. Over the longer term, Australian dairy producers still have room to increase productivity per cow. Average annual milk produced per cow in Australia by 2009 had reached 5.8t/head compared to 3.8t/head in 1990.68 This suggests that Australian producers have managed to increase productivity rates at one

67. ABARE. USDA68. USDA


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of the fastest rates of any major dairy producing region. Thus, even though Australia maintains a grass-based production system, productivity is increasing very quickly through improvements in herd management and strategic use of feed supplements. Clearly, if the economics work for feeding more high protein feeds as supplement to pastures, the Australian dairy sector can continue to boost productivity levels going forward.

Australia dairy herd declining into 2009, but productivity continues higher

Source: ABARE

Australia also has the advantage of well developed export markets throughout Asia. Japan remains the largest buyer of Australian dairy products accounting for 51 per cent of Australia’s cheese exports and four per cent of SMP exports in the 2008/09 season.69 Other major buyers of Australian dairy products (SMP, WMP, cheese and butter) include China, Malaysia, Philippines, Singapore, Thailand and Saudi Arabia.

Australia’s milk product exports have declined over the last decade along with the drought-induced dairy herd reduction. Total net-trade of dairy products in Australia declined 40 per cent between 1999 and 2008.70 However, there are signs that this trend is beginning to turn around. According to FAPRI’s latest figures net dairy trade increased 5.8 per cent into 2009 and another seven per cent in 2010. Projected net exports

69. ABARE70. FAPRI

are expected to increase another 3.6 per cent in 2011, and thereafter maintain a solid uptrend into the end of the decade.71 Indeed, Australia is expected to be one of the principal beneficiaries of growing milk product demand throughout Asia.

Total value of Australian milk exports

Source: ABARE

Judging from the demand analysis provided in this report incremental supply growth from Australia will be required longer term. With the slowdown in milk production throughout most major producing countries into 2010, higher feed prices and potential for market liberalisation, it is important for Australia to provide efficient supply growth. As milk demand continues to recover in the developed economies and accelerates in developing countries, Australian dairy producers are well placed to seize the opportunities that will arise.

Australia dairy product net trade

Source: USDA, FAPRI forecasts

71. FAPRI

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Demand for dairy is expected to grow due to increasing population, rising gross domestic product (GDP), income growth and increased urbanisation. These factors are leading to changes in diets and increased consumption of dairy products. In addition, the nutritional benefits of dairy are also driving demand as consumers and governments in developing countries are becoming increasingly aware of these benefits and are starting to promote the consumption of these products. Export focussed countries, such as Australia, are well placed to benefit from this increased demand, in particular the growing demand from South East Asia.

While there are a range of factors driving demand for dairy products, supply must increase to meet this demand. Supply challenges include the increased cost of production, quality of products, few surplus producing countries surplus producers and reduction of herd sizes.

The majority of countries have dairy supply deficits with only a handful of countries being surplus producers including Australia and New Zealand. Australia has the benefit of a mature, well established dairy industry, trade relationships with key growing markets and is also recognised as a reliable source of quality products.

The structural changes occurring in global dairy markets have seen international dairy product prices break through $2,000/t, with this price level effectively becoming the new floor post-2007. It is anticipated that the return of dairy demand growth will continue, in turn leading to growth in supply constraints to the global market and enabling surplus producers to take advantage of these conditions.

Global dairy production cost comparison

Conclusion

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ContentsFor more information about Macquarie Agricultural Funds Management, please contact: Tim Hornibrook,Co-Head, Macquarie Agricultural Funds Management

P: +61 2 82320579 F: +61 2 82329999 E: [email protected]

Macquarie Agricultural Funds ManagementMacquarie Group Limited 1 Shelley Street, Sydney NSW 2000 Australia

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Contents

Business

Mafm the case for investing in dairy (2011)