April 15, 2015

Prem Maan Managing Director & Chief Executive Officer Southern Pastures

Global dairy consumption is growing at greater than 2% per annum and is expected to double by 2050. This demand growth is driven primarily by an increasing demand for animal protein in the emerging world’s middle classes. The long-term milk production forecasts show a 1.8% p.a. growth rate, which implies an ever-increasing shortfall as production growth is naturally constrained by land, water, feed, and livestock availability.

The milk deficit is highest amongst milk importing countries that have little choice but to turn to the international cross border trade to satisfy their needs. Only around 8% of the world’s milk is traded across borders (excluding intra European trade). This means that the 0.20% p.a. shortfall in global supply amplifies to an increased demand on the cross border trade of 2.5% p.a.

Therefore the medium and long-term prospects for the global dairy trade are indisputably positive and the basic economics of increasing demand over supply supports long-term price growth.

In the short-term milk prices are volatile. The key reason for the volatility is that small movements in global supply or demand have a large impact on the global trade dynamics. A 1% increase or decrease in global supply or demand impacts on the global dairy trade by 12.5%. A secondary reason for the volatility is the advent of the semi-monthly GlobalDairyTrade™ (GDT) auctions that makes short-term fluctuations transparent.

The chart below shows the milk prices received by New Zealand farmers and the GDT Price Index.

The chart demonstrates both the volatility and the long-term price trends. It is worth noting that even at mean minus three standard deviations, the pricing trend is favourably positive, as should be expected given the global supply demand imbalance. Despite recent short-term volatility, long-term investors can focus on mean reversion.

The current downturn in milk prices is due to an unprecedented perfect storm of good weather on the supply side and two specific disruptions on the demand side. Favourable weather conditions and feed prices allowed for an increase in global milk supply. On the demand side, China reduced its buying due to a need to utilise existing inventory and Russia effectively withdrew from the market as a result of the sanctions that it imposed on various milk exporting countries. China and Russia had previously been the largest two dairy importers. China is expected to deplete its inventories and resume its traditional buying patterns over the year whereas Russia is expected to stay on the sidelines.

Investing in dairy farmland substantially reduces this volatility as the price of land “sees through” the short-term volatility in the dairy price. In this context we believe investors should be investing in low-cost dairy farming, which remains competitive through the cycle. New Zealand is the low-cost producer essentially due to plentiful grass and water that provide low-cost feed. This combined with a highly developed industry with a deep pool of skilled farmers married to the scale of Fonterra equals a long-term sustainable advantage.

Within New Zealand there are opportunities to take under-performing farms up to best-in-class production within the low cost pasture-based free-range extensive farming systems in which Southern Pastures specialises. Within a global context Southern Pastures’ farms are well placed to withstand milk price volatility without culling cows due to the low cost of production and scale efficiencies. By contrast, high cost purchased feed based intensive farming systems have to cull cows to survive. As most of the milk in the world is produced using such intensive systems, culling ensures that milk production falls which in turn creates a self-correcting mechanism for global dairy trade prices.

As milk prices recover, the pasture-based farming systems are able to immediately capitalise on this by ramping up production. For intensive farming systems there can be up to two years delay in reverting to previous production levels as new livestock have to be bred to replenish herds.

For long-term investors who do not have debt servicing issues, milk price volatility represents an opportunity. Each substantial downturn forces farm owners who are not well capitalised to consider exiting and this creates buying opportunities with the comfort of knowing that the long-term trend remains positive. For extensive pasture-based farming systems, such downturns create the opportunity to bounce back stronger and build market share whilst intensive systems competitors focus on rebuilding.

Dairy farmland investment in extensive pasture-based free-range farming systems continues to offer a compelling proposition for investors seeking exposure to long-term growth and especially to the emerging middle-income populations.

Prem Maan is a member of the speaking faculty for Global AgInvesting 2015 at the Waldorf Astoria New York City, April 27-30.

The opinions expressed in this editorial are the author's own and do not reflect the views of GAI News.