Dairy commodity markets down

The following is a blog created from a regular newsletter provided by JT Macfarlane, a director of MyFarm.  JT is a dairy farm owner in his own right but he has a distinguished career as an investment banker and a particular knowledge of and interest in commodity markets.  He presented at the Grow your mind series of Seminars along with Brian Rice last year talking about how to manage with volatile commodity markets.

JT's letters can be quite technical but I trust readers will come to enjoy their publication one or two days prior to most GDT auctions.

JT Macfarlane on the right with Brian Rice of Rice Dairy during last year's Grow your mind series of seminars. 

With a long weekend in NZ and a flight (for me) to Germany in the early hours of Monday I am “publishing” early.

It has been 3 weeks since the last auction but even less since the Trump inauguration and it seems longer!

The Trump Presidency is proving challenging. Markets generally are probably proving more “tolerant” than the commentators as the new Administration goes about executing its pre-election promises with vigour. Hence equity markets have been flat to up (the Dow noticeably through 20,000 for the first time), bond markets have been trading in a narrower than expected range and commodity markets, while somewhat volatile, have traded on their own fundamentals rather than in reaction to Trump’s announcements.

Perhaps the biggest surprise (and relevant to us) has been the effort to talk down the USD. I for one, was expecting a lot of rhetoric aimed at China and even Europe and Japan on the weakness of their currencies and robust accusation of currency manipulation aimed at China…..this was the pre-election script. While there has been some of that, the US Administration has put more effort into talking the USD down and therefore doing exactly what they were criticising others for.

The result is that the USD (index below) is trading approximately 3.75% weaker today than it was on the first day of the new year despite robust economic data and company earnings out of the USA.

 The USD is trading at significantlty weaker prices which corresponds to an appreciating NZD

As a result of the USD weakness the NZD, at USD.7341, is trading over 5% stronger than it closed 2016 (USD.6941).  This rise won’t have much impact on the 2016/17 milk price but it is relevant for next season. As you can see in the chart below, the first 5 weeks of the year have seen weaker WMP prices and a stronger kiwi dollar.

Double whammy heading into the late part of the season and next year; NZD up and WMP down

While I said that commodity markets have been trading on their own fundamentals, there is a reasonable amount of noise in some specific commodity markets and Skim Milk Powder (SMP) is one of those. While SMP auction prices via GDT were robust during January, there has been a reasonable amount of noise in other markets. In the North American market, sentiment is driven partly by discussion on whether Mexico will diversify its supply sources if NAFTA is re-negotiated. Sentiment in Europe (the index chart below is from Rice Dairies) where prices were already at a discount with the “hangover” of intervention stocks have turned decidedly negative with the index trading off some 10% since the beginning of January.

SMP prices have reduced by 10% in the USA since the start of the year

The Outlook:

The first 2 auctions this year were relatively difficult to interpret and while there was realignment between physical and futures premiums, the markets were relatively robust and there were no large trends.

Over the last 3 weeks we have really set the first “trends” for 2017 emerge and most developments have been relatively negative. WMP futures have traded off across the curve (about 5-7%) with sellers across the strip meeting buyer interest at lower prices. Other products, such as SMP, have shown significant weakness in offshore markets which you would expect to  show through into GDT results. In addition, as noted above, the NZD has risen by over 5%.

The impact of this on 2016/17 is limited at this point. This is illustrated in the 2016/17 milk futures which have only sold off from $6.30/kgms into the last GDT auction to $6.20/kgms on Friday despite the above trends. The MyFarm model which was projecting $6.31 three weeks ago, is currently (on my assumptions) at $6.17/kgms.

More of the “activity” is starting to occur in the 2017/18 contract. That contract is quoted at $6.30/kgms (buyers) $6.35/kgms (sellers) and the bid offer to roll exposures from 2016/17 to 2017/18 is quoted at 13/15 cents. The absolute price for 2017/18 is still at a discount to current “spot values” but that spot value calculation (well over $7.00 a few weeks ago) is converging on the futures market.

Each 1 cent (1.4%) on the kiwi is worth 10-12 cents on the milk price and each $100 (3%) in WMP is worth 15-18 cents on the milk price.  While there are other product prices and variables, the last 3 weeks (in isolation) has seen a considerable weakening in the outlook for next season, notwithstanding the outlook for 2017/18 remains for a milk price still somewhat higher than we are currently projecting for 2016/17. 

The result this week will set early calendar year sentiment and determine buyer behaviour and so, in my view, is significantly more important than either of the first 2 auctions. My particular concern is that poor sentiment and weaker prices through the back half of this season will set prices for the NZ spring and impact significantly on 2017/18.

So I expect we will see a negative print this week. A good outcome would be 1.5% / 2% down but the risks are that we will see a larger fall. The demand across the WMP curve will be of interest but so will price cation in other key products such as SMP for the reasons discussed above.

Bottom line, it pays to be cautious in thinking about next season as margins may not be as comfortable as seemed likely 6 weeks ago.

JT Macfarlane

5 February 2017