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There's still more milk than market

Alan Levitt and Marc Beck

The Northern Hemisphere spring flush is approaching its peak with all the fanfare of a guest who's overstayed his welcome. The markets remain characterized by oversupply, low prices and a buying community that does not have pressure to accelerate buying. Commodity prices are hovering about where they were last August. Moreover, absent a substantial negative weather event, there's little to suggest a legitimate and sustainable recovery any time before 2017. 

There's still more milk than market - and virtually all the growth has come from the EU. In the first quarter, EU-28 milk production was up about 5.9 percent year-over-year (adjusting for leap day). The comparisons are a little skewed because EU farmers pulled back in Q1-2015 at the end of the quota year, but this year's output is still up 4.6 percent compared with two years ago.

Within the EU, the growth engines remain Ireland (+31 percent in Q1, year-over-year, adjusted for leap day); the Netherlands (+17 percent); and Germany (est. +5 percent).

The United States also has contributed a bit to the glut: output was up 1.0 percent in the first quarter. However, it's a different story in Oceania, where production in New Zealand and Australia was down 0.4 percent and 4.4 percent, respectively. Weather in New Zealand has been pretty good, boosting end-of-season production. Kiwi production is in line to finish the season down about 2 percent, a far cry from local forecasts of a 6-10 percent decline voiced in late 2015.

China's appetite looked promising in early 2016, with total dairy imports up 32 percent on a milk-equivalent basis in the first quarter. However, New Zealand's WMP exports to China were down significantly in March, suggesting China's April import numbers will show a reversal. The volume China bought on the latest Global Dairy Trade auction also was near the lowest ever. China milk production remains stable and is filling domestic needs, despite the higher cost of locally produced milk, augmented by imports. New government regulations attempting to limit use of powder in reconstituted milk could potentially become be an additional drag. Chinese consumer dairy demand is said to be lackluster.
Rumors of a possible détente between the EU and Russia that would remove sanctions in August seem premature. We don't expect the ban on dairy trade will be lifted in 2016.

Other key importers are pulling back as well. Venezuela, historically the world's third-largest WMP importer (average imports of 150,000 tons/year 2009-2014), bought virtually nothing in the second half of 2015. The country is crippled by economic and political crises, in large part due to the crash in oil revenues, and can't afford to pay for imported powder. However trade rumors suggest Argentina will provide product for Venezuela against oil and government guarantees.

The jury is still out on how the oil-based economies of the Middle East/North Africa (MENA) region are faring, but early 2016 trade data suggests imports are slowing. In the first quarter, New Zealand's WMP exports to the MENA region were down 31 percent, led by a 57-percent drop in sales to Algeria. Shipments to sub-Saharan Africa were off 39 percent. In the first two months of the year, EU exports of SMP to the MENA region were down 6 percent, including a 12-percent drop in sales to Algeria.

Further: in the first quarter, Japan imports of milk powder, cheese, butterfat and whey were down 3 percent year-over-year, while South Korea imports were down 8 percent. We estimate Southeast Asia's imports were down about 4 percent in the first quarter, with big drops in Malaysia and Singapore, after the region posted a 5-percent gain in 2015. And Mexico's imports were outstanding in January-February (+19 percent), but a slowdown in U.S. NDM/SMP exports in March suggests Mexico's powder imports have decelerated as well.

On balance, import demand is good in some places, with some stress signals in others, and weakness in a number of important markets. Thus, less milk is needed around the globe to "recalibrate" the market.

Which brings us back to the European Union. The EU surplus has meant two things: European exporters are offering very aggressively, putting downward pressure on world prices; and excesses are being turned into powder that's piling up in intervention and public warehouses.

In the first four months of the year, more than one third of EU SMP production went into either intervention or Private Storage Aid (PSA). Or, split another way, more than half of the incremental milk production growth in Europe this year has gone into powder for storage. At the end of April, the EU had about 206,000 tons of SMP in intervention and approximately 33,000 tons in PSA warehouses. The intervention limit, just 58,000 tons away as of May 8, is likely to be reached in the first half of June. We expect the Commission will continue to take product via tender, which will only prolong the inventory overhang.

At some point, intervention stocks have to come back on the market, though the Commission is not likely to release them until prices move much higher. But they'll have at least 280,000 tons of powder to dispose of - equivalent to about five months of EU export volume.

Likewise, suppliers are clearing butterfat into the PSA scheme, and this is helping support the market. Over the last month, 5,200 tons of per week of butter has moved into PSA, bringing the 2016 total to 74,457 tons. At the end of March (the latest figures available) holdings were 63,650 tons, though they're likely higher now.

That said, production growth in Europe is indeed starting to slow as lower milk prices squeeze margins. Payouts are falling more quickly now - 23 euros/100 kg (equivalent to about $12.00/cwt.) in some areas. EU-wide output in April is estimated to have been up "only" 2.0 to 2.5 percent year-over-year. Sources say Ireland production growth has slowed to single digits, Germany was up 2-3 percent and France has gone into negative territory. By third quarter, overall EU production should be flat, and by fourth quarter it should slip below year-ago levels.

The EU Commission authorized individual co-ops and producer organizations to implement supply management programs if they choose (Reg. 222). However, it's unlikely any will do so.

Farmers in Oceania also are feeling the hurt. Fonterra's current 2015/16 payout forecast is NZ$3.90/kgMS (equivalent to about $10.40/cwt.). And Murray Goulburn's dramatic payout reduction and subsequent leadership shakeout has left Australian farmers in dire straits. Projections for 2016/17 payouts don't look great either. The banks Down Under seem committed to helping farmers ride out another year of negative margins, but the financial stress is taking its toll.

And in the United States, the benchmark all-milk price looks like it'll fall below $14.00/cwt. in upcoming months. Further erosion in cheese or butter prices will take farmgate prices down even lower. Farmers will be under margin pressure this summer - at levels similar to what they experienced in 2012 - which could accelerate herd contraction. In addition, there is early talk of a La Niña-driven hot, dry summer in the Northern Hemisphere, which could drive feed prices higher, as well as reducing cow comfort.

Our outlook hasn't changed materially from previous reports. Modest improvement and a bounce in prices within current price ranges is possible as we move into the second half of the year, which likely will mean U.S. cheese prices adjusting downward in the near term. Powder prices are tethered to the EU intervention price for now.

We're coming up on the trough in the global milk production cycle. Among the top five suppliers (EU, U.S., New Zealand, Australia and Argentina), milk production in June-August is typically about 6 percent lower than it is in the other nine months of the year; that will ease some of the ongoing surplus.

However, a true recovery just isn't in sight. We define "recovery" as sustainable world WMP prices of at least $3000/ton, and we're still a long way from that benchmark. As an indicator of the market's sentiment, NZX WMP futures for December 2016 are $2450/ton, while SMP futures are $2085.

Buyers have good coverage, and in the face of heavy supplies have no reason to overbid. In addition, weakness in the overall commodity complex (grains, oil) keeps a lid on dairy prices. Global supply still needs to rebalance with global demand. The long process has been underway for a while now, and we're probably closer to the end of this down cycle than the beginning but with some stress in the months ahead. However, we think markets may not start to feel in balance again with an ensuing firmer price environment until at least second quarter 2017.