Another testing auction (183) ...
Dairy commodity markets
The last 6 weeks has proved more challenging than expected for both dairy commodity market and market forecasters.
To recap, price action leading into Auction 181 was poor but the auction surprised with a positive (+1.3%) result against expectations of most commentators (including me) who expected a fall of 2% - 5%. Notwithstanding that positive result, price action following Auction 181 was again generally poor and prospects for Auction 182 again looked weak. My call was for a result of -3% - -5% with downside risks from SMP. As it transpired the outcome was at the more moderate end of expectations with GDT -3.2%, WMP -3.7% and SMP -3.8% (but SMP $2574/tonne against global prices of circa $400/tonne below this level).
However, post GDT 182 price action in the market has continued to be negative. As we go into Auction 183, the entire WMP curve is trading below $3000 per tonne compared with $3500/tonne - $3600/tonne at the end of December (see chart below). The chart below also shows that (auctions aside) this has been a steady move down and although we started the year with mild contango in the curve that has now disappeared, and it has essentially been a parallel move down across the curve.
In essence, the market has repriced WMP by $600/tonne across the curve.
The impact is substantial. It has reduced the Fonterra Group Milk Price (FGMP) for this season from a prospective $6.60/kgMS (at the high) to closer to $6.10/kgMS today – in line with current MKP futures pricing (justifying Fonterra’s caution with their latest update). More importantly, it has dramatically scaled back estimates for next season. A season average of $3500/tonne for WMP would have delivered a $7+/kgMS FGMP. Current pricing of $2950 suggests a 2017/18 FGMP at or just below $6.00/kgMS.
The milk futures are last at $6.06/kgMS for this season and offered at $6.00 for 2017/18. Product futures suggest a GDT outcome tomorrow night of at least -7.5% and with a weak SMP result it could record -10%!
The macro view:
It is worth putting some perspective into the move we have seen over the last 10 weeks.
Looking at the chart below (and with the health warning that it is only 3 years of data), we haven’t seen much strength in prices during Q1 and Q2 of the calendar year. The positive market moves tend to come in Q3. As noted I wouldn’t over-emphasise this seasonality but it is worth bearing in mind.
The recent weakness in commodity prices is also correlated with some re-emerging US dollar strength and so at least has been accompanied by a correction in the kiwi back to US 70.4 cents from US 73.50 just a couple of weaks ago.
Looking at commodity prices more broadly, you can see below that it has been a mixed picture YTD. Industrial and precious metals have out-performed agriculture and energy but virtually everything other than gold has shown some weakness in recent weeks as the dollar has regained its footing after Trump’s efforts to talk it down immediately after his inauguration. This USD trend has re-emerged as good US economic data has seen market expectations of another US interest rate rise in March (the FOMC has a 2 day meeting next week) rise steadily from approximately 50% just a week ago to closer to 90% today!
Just to reinforce the message – all other things being equal (a significant caveat), a stronger dollar puts pessure on USD commodity prices probably only partially offset by a resulting weaker kiwi!
The micro view:
Macro trend aside, there have been plenty of dairy market specific developments that have impacted the market.
Increased GDT volumes:
- Arguably the biggest impact has come from increased auction volumes. After a smaller increase weeks earlier, Fonterra anounced last week an additional 24,835t of milk powder would be offered over the next 12 months (15,000t of WMP and 10,000t of SMP)
- The offer volume is increased for this auction, the later March auction and both April auctions.
- The rise in offer volumes over the next 12 months represents a 3.92% increase in volumes to be offered via GDT. Volumes overall have been generally lower this season due to both supply and Fonterra’s strategy re GDT versus direct sales so this shouldn’t be over-analysed. However, at the margin it represents an increase in supply via this channel and has depressed price expectations.
- With an early Chinese New Year it is proving somewhat difficult to get a handle on Chinese demand and behaviour. Ivan Glasenberg, the South African-Australian multi billionaire CEO of Glencore insisted last week that China’s minerals, metals, energy and agriculture markets remain an “inscrutable” mystery to him. He said at a London conference “as I’ve always said, we don’t understand China, exactly what may or may not happen from one day to the next, and we all saw it in coal last year” [this from a man whose company made billions from selling coal last year and who arguably has an intelligence network in commodity markets only matched by Cargill]
China’s National People’s Conference beginning 5 March (not to be confused with the Communist Party Congress to be held in October). Observers are watching for commentary on a number of issues that may impact commodity prices including the following:
- A lowering of China growth targets (currently 6.5% - 7% but expected perhaps to be downgraded to 6.5%). This may be more subtley reflected through a lower M2 target (currently 13% but watch for a lowering to 11-12% according to ANZ) [late news: growth has been slightly downgraded to “6.5% or higher if possible” and M2 target has been set at 12%]
- Indications on pollution targets (further reductions in poor quality local coal output)
- Further targeted production cuts in inefficient local industry including coal [150 million tonnes announced] aluminium, steel and cement (at some point dairy may join this conversation)
- Measures to reduce speculation in Chinese based (Dalian) commodity futures markets (these are perceived to have heightened speculative activity in coal and iron ore and boosted prices)
- Rabobank reported China domestic milk production to be down just over 4% in 2016 and projected a 20% increase in dairy imports in 2017.
- The ongoing clampdown in grey channels (witness Bellamy’s, Blackmores - Bega, Comvita announcements) suggests there is positive potential for respected brands with licensed manufacturers.
- There was a report that many may have missed that Aldi is planning to start online sales in China this week via TMall (owned by Alibaba). It is expected that the product offering will mirror Woolworths which sells products such as “baby formula, vitamins, almonds, cereal, diet powder, UHT milk and Pawpaw ointment”.
- Notwithstanding all of the above, we are seeing an improvement in both China imports and exports which is a good indicator of global and local demand. Local inflation indicators are also picking up although this is more noticeable in the PPI than in the food components of the CPI.
Dairy Australia (February Situation and Outlook) forecast an output drop of 6%-8% to below 9 billion litres for 2106/17 (last at these levels in 1995/96).
After a 30% rise in European dairy prices since June 2016, prices look to be leveling in anticipation of the April-May peak in milk supply according to MyFarm’s AgriGlobe report. There appears to be a delicate balance between higher prices, the intervention stock pile and sluggish export demand which will hopefully prevent a supply response. New rules on phoshate came into effect for Dutch farmers on 1 March and the impact will be significant.
Our US contacts continue to suggest messy markets dominated by plentiful milk supply out of the Mid West and South Central regions. Milk production increased by 2.5% in January and the USDA reported that production in 2016 was up 1.8% over 2015. Sentiment appears to be dominated by supply and while US prices are generally weak, they are also trading at a substantial discount to GDT sprices so not providing a floor to Oceania prices.
Corporate News and Activity:
Plenty of this to contemplate:
- A2 Milk bought Friesland Campina’s 8.2% stake in Synlait at $3.275. This is a smart move in my view. A2 is a respected brand but to ensure it has a seat at the table with its product provider makes a good deal of sense and addresses any perceived weakness in its supply chain.
- Less good news at Westland Milk Products. A major change in the Board and an indicated season payout of $5.30 - $5.70/kgMS suggests some unhappy suppliers and a strategy review – or a strategy execution review!
- Bellamy’s special shareholder meeting saw the resignation of the Chairman, 2 independent Directors resigned and 2 others were defeated. The company is now controlled by Jan Cameron’s representatives and 2 hedge funds. Looks messy!
- Bega and Blackmores both took smallish write-downs ($2m and $7m respectively) on their infant formual joint venture.
Murray Goulburn bad news continued with it reporting a $31.9m loss for the December half year. This involved write-offs of $41.3m but of more concern were the following:
- Net debt increased 41% in the half year to $677m (38% gearing)
- Milk supply fell 21% (3% seasonal reduction in output, 12.6% loss from suppliers switching to other companies and a further loss of 5% of their supply from industry exits)
- MG are reported to be actively considering shutting down some processing capacity (a year ago they were expanding)
- Payout guidance for the season of A$4.95/kgMS (circa NZD$5.30/kgMS)
Fonterra didn’t escape entirely with Beingmate reporting a loss of Yuan 798m (guidance was Y750-800m). Fonterra is expected to shed some more light on this result in its own update but there are some concerning (and familiar) features here:
- Group sales were reported in some media to have fallen 39% for the period (impact of grey channels?)
- Reports that black market factories were manufacturing and selling fake infant formula under the Beingmate brand.
- Current market cap of USD 1.95 blln suggests that Fonterra is sitting on a 30% loss on its initial investment. I am sure that the “strategic importance” of the investment will be emphasised but most advisors would suggest a sustained price fall of more than 25% would lead auditors to carefully consider an impairment.
- One other issue of interest to some may be the energy issues hitting Australian farmers. In short the reliance on renewables (wind) in South Australia has caused 2 significant black-outs in that state in recent weeks and the pending closure of Hazelwood coal fired power station in Victoria next month is also causing concern in this state and nationally (from a baseload power perspective). The bottom line is that some dairy farmers in Victoria are reporting power charges up 34% for off peak and 43% for peak power. Other farmers are reporting 25% increases in power costs and additional costs of $30,000 - $50,000. Those who were quick to criticise the dairy industry last year for its treatment of farmers may be slower to criticise the removal of coal fired power from the network and its impact on farming and manufacturing (or am I just more cynical in my old age?)
The RBNZ Governor, Graeme Wheeler gave a speech at a Craig’s Investment Partners investment conference last week.
Not a great deal that was new but the RBNZ did stick with their relatively dovish view of the outlook for interest rates and suggested that they would not change their prior outlook of no change in interest rates to mid 2019 based on information to hand since their February MPS.
This surprised some commentators given robust global growth numbers. However, I would suggest that now that the Federal Reserve seems to be heading down a steady tightening path, the RBNZ arguably has a favourable interst rate dynamic for the first time in many years that it will want to take advantage of. Higher US rates and a potentially stronger USD that may keep pressure on commodity prices is another reason for the RBNZ to seek a lower NZD/USD rate (or give it every opportunity to move lower) before raising interest rates [to be clear I do not expect NZ rates to be at current levels for the next 2 ½ years but I would be cautious about signalling that as well if I was the RBNZ].
- A good deal happening but we face the 3rd challenging auction in a row and the 3 auctions over March and April will look equally challenging I suspect given increased supply on GDT, European peak production and ongoing strong US supply.
- WMP prices suggest that the GDT Auction this week could be off more than 7.5% but unlike the last auction it is less likely that SMP will be supportive. A poor result there could drag the GDT result even lower to double figures! Salvation lies in interest out of Japan and China so we have to wait and see!
- Farmers will be largely unhedged for 2017/18 at this point. 2017/18 futures were trading at a substantial discount to the implied season price until recent weeks but the product futures have now rapidly caught up with the MKP futures creating a hedging dilemma for farmers.
- At this point my advice is to be disciplined around next season budgets and be thrifty with the cash surplus generated this season. The current outlook reinforces the importance of working to a $2 - $2.50 EBITDA margin of a circa $6 payout!