Thursday, 17 February 2011 10:21

Dairy market will remain volatile but Australians better placed

Written by 
Micheal Harvey Micheal Harvey

IT IS common knowledge that all dairy farmers are exposed to a range of risks.

Market price risk has become increasingly more volatile than in the past due to a changing landscape of operating conditions in the Australian and international markets.

The chart highlights recent volatility of commodity price trends using of whole milk powder as an example.

Some encouragement can be drawn from 2010 when the market began to settle after three extreme years. However, volatility will remain a key feature of the dairy market.

It is because of this market volatility that in the dairy world there is plenty happening in the way of the introduction of new risk management tools.

Last year saw the launch of two separate dairy futures markets in Europe and New Zealand.

Interestingly, price risk management tools have a long history in the US dairy industry, and can be dated back to as early as 1898 when trading on the Chicago Butter and Egg Board commenced.

Both of the new futures markets in New Zealand and Europe have had slow starts, although the New Zealand counterpart appears more successful at

the moment.

As they attempt to gain traction, it’s worthwhile reflecting on why dairy futures have been so successful in the US.

This success lies in part in the very complex and heavily regulated milk pricing system at play.

The pricing of milk in the US involves a variety of pricing regulations, with most states covered by the federal milk marketing order system.

California operates a state level marketing order.

Federal milk marketing orders are concerned primarily with the regulated marketing of raw milk from the producer to the processor; with legal and technical language making them complex.

Underlying the entire pricing system is the situation whereby the milk used in various products sells for different prices.

This creates a very complex and volatile milk pricing system. The milk price paid to a farmer changes significantly from month to month and the variation is not generally known prior to receiving the milk cheque.

Trends can be monitored based of swings in commodity prices on the local market, but ultimately it is difficult to know exactly what the price will be.

Compare this to farmgate milk pricing in Australia and New Zealand where most processors offer an opening price which is a floor price; albeit with some risk.

The farmer then has some knowledge of future monthly farmgate prices based on the pricing schedule which incorporates seasonal, loyalty and quality incentives.

There is significant unknown price variation from season to season, but the intra-season variation is reasonably predictable because of the opening ‘base’ price.

Like Australia, New Zealand has a pricing system centred on a base price (forecast payout) which is adjusted depending on market conditions throughout the season.

In Europe, farmgate pricing is the most stable of all the major dairy exporters. This is because they operate a protected industry and offer market support (through subsidies and floor pricing) which ultimately provides security for the farmer.

As reform continues in Europe a less regulated market will likely lead to more volatility for their farmers.

Some participants in the Australian dairy industry are likely to explore the possibilities of using dairy futures as a means to manage price risk.

As my colleague suggested in an article last year (October 2010), farmers can benefit from futures, even if they don’t participate, by using the price information published on the futures exchange.

Nevertheless, the local milk pricing system does provide some level of income risk management to dairy farmers, as the opening price has traditionally been a pretty good indicator of the full year price for dairy farmers – typically averaging 80-90% of the final season payment.

Michael Harvey is international industry analyst with Dairy Australia.

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