The success story of 2012 and beyond

In 2012, dairy farmers are looking ahead to a year of lower debt, higher cashflows and much stronger profit margins than ever before. Andrew Watters, a dairy farm owner and Director of farm investment company, MyFarm analyses the factors behind New Zealand’s dairy success and the challenges ahead for our biggest export industry.

In the past four years the dairy industry’s contribution to NZ’s export receipts has grown by 55% and farm profit margins have grown by 75% from an average $1650 to $2950 per hectare.

The sector’s growth may have caught some by surprise, after all it was only two and a half years ago that the Reserve Bank warned that the doubling of rural debt between 2003 and 2008 posed a serious risk to the New Zealand economy.

In reality there has been a small number of high profile receiverships but most farmers have paid down debt and the ratio of agricultural debt to agricultural export earnings has fallen by more than 20%.

The New Zealand dairy industry’s resilience to the GFC and current global recession can be traced back to three key events; the 1993 GATT Uruguay trade round, which freed up trade; the formation of Fonterra in 2001 which created a company with real supply-side power and the growth of the BRIC nations (Brazil, Russia, India and China) who collectively have added US$10 trillion of gross domestic product between 2003 and 2010.

The question is can its recent growth continue. Is it realistic to expect upwards of 40% growth in the next five years?

The answer is yes, if you base it solely on milk price trends. Developing economies are demanding more dairy, and not just because their populations are growing. In fact as countries become wealthier, consumers don’t just demand more food, they want better, higher nutrient food.

Changes in Taiwan give a glimpse of this. Between 1985 and 1990, Taiwan’s GNI per capita jumped 59.5% and during this period Taiwan’s total per capita consumption of rice and vegetables declined, but consumption of meat, milk and fruit all increased substantially.

There are biological constraints to how much dairy producing nations can increase their supply to match this demand. Fonterra estimates the most that annual global milk production can grow by is 2-3 percent per year, barely keeping up with consumption growth. On top of this there is the effect of rising bio-fuel demand, the need for agricultural feed production to support dairy and beef farms off-shore plus agricultural policy changes which could reduce subsidies and cause disruptions to supply growth.

The Reserve Bank is one of many global analysts coming to the conclusion that today’s higher milk prices are here to stay; and that underlying demand represents a “structural shift”, raising New Zealand’s terms of trade to a permanently higher level.

International consultancy, McKinsey & Company recently concluded that declines in commodity values in the latter part of the twentieth century have already been reversed in real terms and the outlook for the next 20 years is for milk prices to remain high and volatile.

Volatility is not normally a friend of growth, but the NZ dairy industry is particularly resilient to milk price fluctuations. Through our pasture-based farming systems NZ dairy farmers enjoy a milk price 3.7 times the cost of their feed costs – compared to a ratio of 1.8 times on US dairy farms. This means even very small fluctuations in milk price can switch US dairy farm profits from profit to loss.

The outlook means that more ‘dairy capable’ country will be converted. Currently a good dairy farm can generate between $4000 - $6000 per hectare earnings before interest and tax (EBIT) whereas a good sheep and beef farm’s EBIT is more likely to be $1500 - $2000 per hectare.

And from an investment perspective, dairy farms are still good buying. The global financial crises and tightening credit significantly reduced farm buying activity - with sales plummeting from more than 300 per month in 2008 to a low of 50 per month in 2010. Consequently farm values have fallen and in most provinces are still down by 15 – 20% on their peak.

Dairy farms have traditionally sold for between 3.5 and 6.5 times their annual milk income. With lower property prices and a higher milk price they have been trading towards the bottom of this range, and only recently has sales activity increased in the provinces.

Faced with this growth story, some will highlight the negative aspects of dairying, pointing to increased use of water and deterioration of water quality. Certainly there is a balance between production and the environment. But the changes that dairy brings to emerging growth areas like Southland and Canterbury are quite positive. In Canterbury for example, towns in the region are thriving, there are fewer fires, much reduced soil loss and 95% of Canterbury water from rain and snow melt still ends up in the sea. Whilst it is unlikely that the major Canterbury rivers will become polluted because of their relatively quick passage from the Southern Alps to the sea, the dairy industry does need to pay careful attention to the quality of lowland water ways and key aquifers.

The UN Food and Agriculture Organisation (FAO) notes that countries will need to ‘sustainably’ intensify land use if the world is to meet the challenge of producing what’s needed - 70% more food by 2050. The question remains as to whether we in New Zealand can engage in realistic dialogue that will facilitate intensification of land use and development of a crucial sector to the NZ economy, whilst also implementing increased environmental protections.