De-intensify or sell, dairy farmers' choice
Dairy economist Peter Fraser asks - and answers - the tough questions facing dairy farmers and the dairy industry.
Around two-thirds of dairy farmers' debt is held by only a third of farmers - most with equity well under 50 per cent, and some with less than 10 per cent.
Data from the Reserve Bank shows dairy farmers are collectively borrowing about $3.5 billion a year just to stay afloat. This is "bad debt" as it is purely designed to cover on-farm losses. This works out to farmers' deficit-financing at a rate of almost $10 million a day or $300m a month - and next season is offering little in the way of respite.
How is the adjustment likely to play out on-farm?
The fundamental question is how long will banks continue to support deficit spending and at what point are on-farm balance sheets exhausted.
A third bad season combined with a realisation of a structural change in dairy prices could be extremely damaging - as farmers face the dual problem of declining land values and deficit-financing eroding whatever on-farm equity remains. For farms located in areas suitable for dairy farming they will need to de-intensify in order to restore on-farm profitability.
For farms in non-traditional areas with sticky costs there probably is no way out as the land could be worthless in terms of dairy farming. It's likely that a large number of farms won't make it - they will be sold up and recapitalised.
At a land price of $30,000 a hectare, every 10 per cent of doubtful dairy debt equates to over $130,000 a hectare of land sold - and even at $50,000 a hectare is $80,000 a hectare in total. Indeed, working on a 1.5 million hectares of dairy platform a reduction in land prices from around $50,000 to $30,000 a hectare represents a $30b value destruction/erosion of equity (which ironically is the level of increased debt since 2000).
What does this mean to the industry?
A "new normal" of a structurally lower farm gate milk price kills the notion of New Zealand having an ever increasing milk supply or that New Zealand is an abundant and low-cost producer of dairy products.
A very large part of the dairy industry is in a state of terminal confusion over the role of average costs, arguing New Zealand has the lowest average cost of production in the world, which means farmers are more efficient than those overseas, which means they are more resilient so hyper-competitive.
While somewhat true when the farm gate milk price was at $4.20 (+/- 90 cents), that simply is not true now.
Even if it was true, it is irrelevant, as commodity markets clear at the margin (and not at the average) and other countries have a lower marginal cost of production than New Zealand. The corollary is that New Zealand is not only no longer the "swing producer", but if there is an increase in demand for dairy products they will be supplied by countries with a lower marginal cost.
A comparison with the oil industry is useful. New Zealand used to be the Saudi Arabia of milk as an abundant and low-cost exporter. However, intensive and extensive dairy are the equivalent of the Canadian oil sands when the rest of the world has discovered fracking.
It is therefore unlikely New Zealand milk production will see dramatic growth and may even decline.
What does this mean to Fonterra?
It's not good news. At the very least it implies Fonterra's much touted "V3 strategy" is in tatters, because without a growing New Zealand supply the "volume" objective is eroded (and New Zealandvolume growth is critical, given Fonterra is essentially a tolling company that has neither the capital structure nor the balance sheet to pursue large volumes of milk offshore). Fonterra also doesn't have the income or balance sheet strength to really pursue a "value" strategy either (even if its farmer-shareholders could agree to that, which is doubtful), and no-one really understood what velocity meant anyway.
Fonterra has a problem that can be described as the absence of balance sheet separation, because where Fonterra's balance sheet "stops" and its suppliers' balance sheets "start" is something of a semi-permeable membrane. This is because both are linked by payout subordination to the banks. This means that the banks get first call on payout revenue. Indeed, this is the sole reasonFonterra can maintain its current credit rating (which is high) given its current gearing (which is also very high when it should be considerably lower).
The combination of a highly indebted Fonterra with a sizeable minority of highly indebted shareholders in an environment of a structurally lower farm gate milk price introduces significant fragilitiesacross the entire industry as the same dollar is essentially promised twice.
Payout subordination notwithstanding, a prudent Fonterra will need to de-lever its balance sheet and in the absence of putting out a rights issue it needs to think about retentions or asset stripping (or both).
Fonterra is already starting down the asset-stripping track - recently selling its share of Dairy Concepts (which, until quite recently, was trumpeted as a great example of Fonterra moving into higher value products). Outside of shuffling activities, such as selling off and leasing back its tanker fleet (which must be worth around $250m), the only bits that are easy to separate are the value-added businesses such as Tip Top (reputedly worth upwards of $600m). However, the net result of asset-stripping will be to limit Fonterra to being a FedEx for milk powder.
If retentions are the funding source then it means shaving either the farm gate milk price or the dividend stream (or both) - and neither is attractive.
In the world of a static New Zealand milk supply Fonterra still has a capital structure problem in that it has merely swapped a redemption problem with a stranded asset problem - and given the recent investment in wholemilk powder processing a falling New Zealand milk supply is likely to make Fonterra even more unbalanced with a yet greater reliance on one product (WMP) and one market (China) as it is forced to write down the processing assets of lower-value product lines.
Fonterra's supply base is also reputedly non-normally distributed - as about 30 per cent of shareholders (by number) produce about 70 per cent of Fonterra's milk (by volume). If this asymmetry matches the debt asymmetry then that is cause for serious concern for Fonterra, because prospective farm purchasers may by-pass Fonterra and simply build their own processing plants (and vertically integrate along the entire value chain).
What does this mean to the Government?
First and foremost the Government has a competition policy problem in that Fonterra is hamstrung by a milk-pricing manual of its own design that prices milk based on "an imaginary friend" rather than Fonterra's actual performance - and this imaginary friend is likely to cause more damage to Fonterra than to its competitors. It also reduces the level of contestability in relevant markets, and by favouring static productive efficiency over dynamic efficiency arguably stifles the sector of innovation by reducing firm-level profitability.
Secondly, the Government has an industrial policy problem in that the creation of Fonterra means there is an absence of alternative business strategies, which magnifies any failures or stumbles that befalls Fonterra. In short, the industry has all its eggs in a single basket.
Thirdly, the Government has an economic development problem as the BGA export growth figures are now highly doubtful if there is little or no growth in dairy volumes (and a Fonterra unable/unwilling to value-add or upgrade).
Fourthly, the Government has a programme-policy problem in that schemes such as the Irrigation Acceleration Fund are now superfluous because projects like the Ruataniwha are neither commercially nor economically feasible as they were premised on a $6.50 farm gate milk price with irrigated dairy being the cornerstone user.
Finally, it has a policy credibility and inconsistency problem regarding the exclusion of agriculture from the Emissions Trading Scheme and the cost of agriculture's emissions being socialised to taxpayers. This is nothing more than a direct government production-based subsidy. Given a cow produces at least three tonnes of emissions a year and New Zealand has 6.5 millon dairy cows then that implies a subsidy of $97.5m a year at $5 a tonne of carbon if all dairy emissions are included. At 1.8 billion kgMS total production, that's a subsidy of more than 5 cents kgMS for each $5 of carbon costs.
What about the extra billion kgMS?
Fonterra has talked about the New Zealand milk supply growing at a 3.5 per cent CAGR, which leads to an additional 1 billion kgMS by 2025 - indeed, the Government's BGA export target of doubling the value of exports as a percentage of GDP assumes a significant volume increase from dairy. This is a big deal, as it took New Zealand 100 years to get to 1 billion and a further 15 to 1.8 billion - so an extra billion within a decade is enormous.
Let's assume productivity gains of a little over 10 per cent with the existing herd which is about 200 million kgMS. This leaves 800 million kgMS to be produced by "new" cows.
Let's also assume each cow can do 400kgMS a year - so to get 800 million kgMS we need an extra 2 million cows.
Now, let's say that each cow lasts for five lactations - so that's a 20 per cent turnover rate of cull cows a year. This means you need 2.4 million cows to maintain a 2 million milking herd.
Cows have a water footprint equivalent to between 14 and 21 people - so using 15 as the multiplier an extra 2.4 million cows is like increasing New Zealand's population by 36 million people, though without a sewage system (though some streams will be fenced [and some not] and there will be some riparian strips).
Assuming a carbon price of $10 per tonne in 2025 and agriculture still being outside of the ETS the subsidy from taxpayers to farmers will be:
$195m a year for the 6.5 million cows and $72m for the extra 2.4 million cows.
This is a grand total of $267m a year.
Wellington-based economist Peter Fraser heads Ropere Consulting.