Wednesday, 16 March 2016

The expected protracted downturn in dairy prices puts a new dimension on commodity price cycles

Historically prices have risen and fallen on a regular basis. This downtown does not appear to be part of a normal cycle. The world is awash with dairy products, subsidies to support farmers in other countries are being increased which will artificially support continuing high level production, and there are major market dynamics at play especially with worldwide increasing production, Russian markets being boycotted and shifts in Chinese demand. 

Any reasonable analysis would therefore assume no significant price rises any time soon. Given the extremely low base prices have fallen to, clearly below the cost of production, that is a real worry for all dairy farmers and particularly those that are financing significant debt.

It must also be  of major concern to banks. The determination of banks to support farmers through this crisis will be tempered by the prospect of prices remaining low into the foreseeable future. The banks will be asking themselves where the trigger point is farm by farm in terms of when they reach the limit of debt funding, which will be before the possibility of the farming business losing the ability to reduce and repay debt no matter what. If the price cycle was predictable and anticipated to be short that calculation would be much easier. In this environment assessing the point of no return is complex and fraught. 

So we can expect significant fallout  in the dairy farming sector. That, in turn, will flow through the rest of the South Island economy.  

Dairy farming  represents a significant, and until recently, growing proportion of the South Island's rural economy. We are good at producing milk at reasonable cost and we all know that there have been significant farm conversions to dairy, right across the South Island. Given that investment in this sector in the South Island is relatively recent there is a lot of bank debt associated with farm conversions and set-ups.

Smaller rural centres are already feeling the pinch. Larger centres, and indeed our South Island cities can expect to suffer negative impacts to varying degrees.  

For example, Christchurch is still dependent on what  happens in the rural sector to a significant degree. Christchurch is  buffered by the rebuild spend but we do have many businesses right across most sectors that rely on rural spend 

Regretfully  there is a flow-on effect from the downturn. An unfortunate example of this is Fonterra’s determination to extend its payment to creditors out to 90 days. That in turn puts serious cashflow constraints on suppliers who in turn will be forced to delay payments to their debtors and creditors and so it spills down through the supply chain.

Dairy farmers closing their cheque books has the same sort of impact.

This all means that  businesses need to be strategic in the context of this crisis, they need to be diligent with respect to creditor/cash flow management and they need to ensure they protect their quality business relationships.

Long term there is light at the end of the tunnel, given the increasing demand for dairy products worldwide and our ability to produce high quality products cost effectively, particularly in the added value area.

Regretfully this time around it is looking like an awfully long tunnel.

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