Dairy derivatives: a sweet solution for milk producers

Brendan Rynne, Partner, Chief Economist
Brendan Rynne, Partner, Chief Economist

There is an existential threat to the 1.7 million dairy cows currently spending their days on Australian dairy pastures, and the farmers who literally milk their livelihood from these herds. But the answer could be sweeter than you think.

Let’s start with the problem.

The Australian dairy industry is currently experiencing significant turmoil. Nobody who saw the news of 16 year old Chloe Scott and her Victorian family on the brink of collapse could fail to be moved by the plight. And there are far too many more stories like this.

The lineage of the Australian dairy industry can be traced back to 1788, where seven cows and two bulls made the journey with the First Fleet to become the embryo of the modern industry. From these modest beginnings – which, consistent with the theme of the First Fleet, included a 7-year period on-the-run when the cattle escaped their ‘captivity’ from a farm at Parramatta – the national dairy herd today generates nearly AU$5 billion in farmgate revenues. This is transformed into about AU$13 billion of dairy products for consumption.

However, the industry is at the mercy of global markets, and has been shaken up considerably over the past two decades. As a result the price dairy farmers can charge for their product is extremely volatile, with fluctuations, since 1998, from the average nominal price over time of up to 25 percent. The average gross revenue from milk production per dairy business is also extremely volatile, with year-on-year revenue swings ranging between +51 percent and -33 percent between 1998 and 2015.

The costs to farmers is visible on many levels. Alarmingly, they are consistently carrying higher debt levels than ever before. Since 2009 average debt per dairy farm has ranged between 125 percent and 150 percent of their annual revenue from milk production. Dairy farmers face uncertain returns and at the same time are under pressure to modernise and plan for the future. The situation is stark.

One potential solution to their plight can be found in another agricultural sector: sugar. While at first glance it may seem strange, there are a number of similarities between the two sectors. Sugar cane and fresh milk both require ‘processing’ in order for the product to be stored for longer periods. Also, the domestic market only consumes about 21.5 percent of local production, with the remainder exported. In fact, the Australian sugar industry produces about 2.5 percent of overall world sugar production.

Unlike the dairy industry, domestic sugar growers have a distinct advantage. Through the use of a derivatives model, they have the ability to lock in a guaranteed price at the beginning of the season for up to 65 percent of their production. Or, they choose to take on the price risk through selling their product on the spot market at the time of harvest. This allows sugar growers to more effectively manage their risk in an agricultural market subject to significant price volatility.

The KPMG Economics paper, Trading places…The role for derivatives in the Australian dairy industry argues that a combination of spot, futures and options contracts might allow Australian dairy producers, processors and industrial consumers to more effectively manage price shocks that impact the industry regularly.

Far beyond a case of “the grass is always greener on the other side”, achieving this would transform the Australian dairy industry, enabling it to have a ‘premium’ discussion between the supply chain participants, rather than a ‘price’ discussion.

While the derivative products necessary to achieve this feat are not yet readily available in the Australian financial market, they are available in overseas markets, and with the use of foreign exchange hedges, AUD price certainty could be achieved for Australian dairy suppliers. It will require a leap of faith from an industry that is already on tenterhooks, but taking this leap would be good news for the 1.7 million Australia dairy cows and the people who manage them.

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