Competition Breaks Out! - The New Dairy Market in Transition

Steve Spencer

Director, Whitehall Associates (Management Consultants)
Ormiston, Queensland 4160

The Australian dairy industry went through a deregulation of its farmgate pricing and supply arrangements in June 2000. This process was brought about by a combination of factors, the most influential of which was the commercial pressure brought by major farmer-owned dairy product manufacturers and exporters.

These companies claimed that the regulated milk pricing placed their farmers at a disadvantage compared to their counterparts who were protected from the commercial price of milk by what was known as market milk regulation. The dairy farmers of Victoria agreed and the formal means by which dairy regulation was challenged at law - a state national competition policy review - resulted in a recommendation that the Victorian government repeal the Dairy Industry Act 1992.

During the period in which dairy regulation was under the spotlight in a number of state and federal reviews, the merits of so-called controls over the pricing and supply of milk were criticized by the rational economic fraternity for creating an artificial environment which distorted milk production and led to "undesirable economic outcomes". Such outcomes were said to result in an undue quantum of resources being attracted to the dairy industry from alternate uses of farming land, water, capital and labour.

The early effects of deregulation on the dairy industry have been well chronicled in the media which has highlighted the effects of the loss of incomes of farmers who were most significantly exposed to falls in milk prices.

This paper however outlines some of the changes that have occurred in the dairy industry value chain since the removal of regulation almost two years ago. The changes that the move towards a totally commercial milk market include:

• The effects of supply and demand on the farmgate milk market;

• The impact of change on the business of the processor/manufacturer;

• The nature of the milk producers' contract with the marketplace, and

• Transparency and ongoing development of market information.

Change in context

Change within the industry has to be taken in context. Any analysis of what has happened in the dairy industry in the two short years since deregulation has to be read against a background of ongoing change in world market dynamics and in the way that retailers and consumers influence the marketing of products at home and in offshore markets.

In specific terms, the dynamics that have affected the Australian industry whilst changes occurred in farmgate markets have included:

• Fluctuations in fortunes in world dairy markets;

• Marketplace deregulation of the pricing and wholesale distribution of packaged milk;

• The increasing use of generic brands in packaged dairy milk and a range of dairy products;

• Gradual increasing liberation and sophistication of major export markets - requiring increased product and service differentiation and specialisation, and

• Consolidation of major global dairy companies, the formation of a major single manufacturer and exporter in the NZ industry in the form of Fonterra, and that company's investment in Australian manufacturing and export marketing

Deregulation has - in my view - given the dairy industry, at a national level, greater ability to deal with these challenges. At a regional level, the impact of deregulation on farmers and processors has varied and in some areas has been extremely adverse.

Supply, demand and competition

In short, the deregulation of the dairy industry has introduced new types of competition into the industry which were previously unseen:

Much of the focus of the change in the dairy industry was placed on the formerly regulated packaged liquid milk sector - which at a national level consumes less than 20 percent of all milk produced by volume. Yet because the level of milk used in packaged milk products in certain states and regions was much higher than average the impact of this change has varied.

The Australian dairy industry now exports more than half its output in milk equivalent terms. The "world price" for dairy products that are exported is governed by several factors, including the prevailing export spot prices out of Europe and the US (determined by prices net of subsidies), the Australian dollar exchange rate, the demand for product from importing countries (which is affected by the use of tariff protection). As is the case with New Zealand (the major other "free market exporter"), the majority of those exports by volume are dairy commodities and ingredients - cheese, milk powders and butter - though there is an increasing degree of specialisation and customisation in the product range which offers some protection against spot market prices.

With the complete removal of regulated milk prices and supply management arrangements, the total returns to the industry are now more directly driven by the level of export returns available to major exporting manufacturers. In basic terms, other uses of milk in the domestic market - over time - are priced off the base level of returns set by the export market. The other direct influence of the world market on our industry is the significant volume of cheese that is imported from New Zealand, which to some extent keeps a cap on the returns that local manufacturers can extract from the domestic retail cheese market. In the past, the pooling of regulated market milk returns to farmers offered some insulation from these effects.

In the second half of 2000, while deregulation was starting to adversely effect milk prices across the liquid milk sector, export prices moved favorably for Australia, resulting in a surge in export demand and in unit selling prices. Poor seasonal conditions across the major production regions of Victoria limited available milk to meet this strong demand for milk. Within months of the change in industry arrangements, the industry faced a situation where significant shortages of milk were creating strong competition for supply between dairy manufacturers, driving up the price of milk at the farmgate and in particular in the "spot" bulk milk market for dairy components (milk protein and butterfat) between companies.

Supply competition has taken two forms:

• The scurry for sufficient milk to fill (mostly export) market orders. This occurred across south-east Australia driving up milk prices in the second half of the 2000-1 season.

• The use of milk price to capture milk supply to damage competitors by limiting throughput, weakening factory profits and the ability to respond to market competition. This form occurred as Murray Goulburn and Nestle took supply from Bonlac in 1998-2001. It is still occurring in South East Queensland in 2001-2 between Pauls and Dairy Farmers.

Neither form is specifically new since July 2000, but the emergence of the latter has come about due to the weakening of companies who were and are exposed to milk supply that depended upon regulated incomes.

Change to the business of the processor

The lead up to farmgate deregulation saw the introduction of new demands on the business of certain processors. New milk purchase contracts were released by companies that were previously able to rely on regulated supply management arrangements to deliver milk to their factory door. The prices offered at the time in such contracts had not fully anticipated the sudden swing in world market fortunes.

With the onset of commercial farmgate prices (and given the transparency of those prices), major retail chains stepped up to the plate and called for fresh rounds of tenders, forcing strong price competition between processors for the share of the supermarket segment of the packaged milk market (which is approximately 50 percent of all packaged milk sales).

As a result of the fall in packaged milk margins as new lower prices swept the supermarket shelves, the sharp fall in milk prices was passed onto farmers with the most severe effects being felt in NSW and Queensland regions.

Average milk prices at farmgate quickly fell by as much as 8 cents a litre (depending on the dairy company supplied and the farmer's former access to market milk returns). Over time, the effects of the supply response to falls in returns took their toll on milk production volumes in these regions through the exit of hundreds of producers.

In this respect, the effects of reduced supply has put significant pressure on the profitability of commodity product manufacturing operations in areas north of the Murray River, ironically at a time when export product prices were at their highest for many years.

The total lower supply has not enabled recovery of fixed production overheads - forcing consolidation and closure of many small regional operations.

The nature of the milk supply contract

In the absence of certain regulatory controls on the supply and pricing of milk, the milk supply agreement is the major form of commercial regulation of milk supply that operates in the industry today.

The major form of contract used in the industry prior to deregulation has been in the form of a co-operative milk supply policy, where each of the farmer-owned businesses sought to operate with a generic milk purchasing policy common to all member-suppliers. The use of these pricing policies is today largely unchanged.

The advent of a range of sophisticated milk supply contracts, mostly by liquid milk processors, has accompanied the deregulated farmgate market.

Certain co-operatives have been forced to adopt more differentiation in their pricing in order to produce a milk supply curve more suited to their business needs, and/or to lay-off some pricing risk to the producer.

The greater role for "the contract" as a tool provides the following contrast between the past and future:

Conveying signals in milk pricing

As identified above, in the past two years, there has been some advancement in the sophistication of the price signals conveyed by processors and manufacturers to their suppliers. Chiefly, signals are used to:

• Enhance the overall quality of milk;

• Promote expansion of individual farm business enterprises;

• Match milk flows to the market demand according to each company's market/product mix, and

• Share the cost of unplanned milk production.

The great majority of milk purchased at farmgate in the industry is priced according to standard terms and conditions that are offered by co-operatives and other major exporting manufacturers. The will to vary these policies is not strong; the major co-operatives still treat as sacrosanct the obligation to take all the milk produced by their suppliers at the times when it is cheapest to make milk, without discriminating between suppliers on the basis of size and location. Co-operatives lead in the structure of those policies; their competitor exporters and milk buyers mimic those buying policies.

Despite the broad trends towards the market for Australian dairy product requiring more year-round product supply, the structure of these policies has not changed significantly in the past few years. Farmer-owned manufacturers remain committed to supporting seasonal milk production as a low-cost strategy to their suppliers, whilst maintaining investments in facilities sufficient to cope with the mounting peak supply volume on the highest milk production day of the year. Only timid use of pricing signals to encourage a flattening of the production pattern, which would provide more efficient utilisation of factory capacity, has been advocated. However, the desire of company managers to achieve that outcome is strong.

In this time however, some greater use has been made of:

• Seasonal production incentives, which promote movement of production towards the times of the year when milk is more difficult to produce;

• Bonuses and penalties for quality parameters;

• Differential payments rewarding larger producers, both through fixed cartage charges and production volume incentives, and

• Growth incentives - rewarding increases in production over the prior season.

The greatest use of signals in pricing has come from companies who have the greatest at stake in ensuring their milk supply flows match their market requirement (liquid milk leaders National Foods, Parmalat and Dairy Farmers) across a range of dairy products. The companies have adopted different strategies to deal with the trade-off to their own respective businesses between security of milk supplies at controlled prices versus investment in milk balancing and storage facilities.

Accordingly, the industry has seen the use of the concept of the production plans or supply allocation by these groups in their contracts, coupled with the use of penalty prices to combat unplanned volumes. The use of these varies according to the overall supply and demand situation. When an over-supply of milk was feared upon deregulation, the used of tiered prices by several companies discouraged excess milk to plan. This quickly swung when milk shortages were apparent such that production over plan was actually rewarded in most cases.

Collective bargaining

Since the advent of a commercial marketplace, the peak industry body for dairy farmers has sought to remedy the position of the individual dairy farmer through authorized collective bargaining under Trade Practice law. Dairy companies have shown mixed interest in this concept. One company has embodied the principles into its dealings. Co-operatives largely feel this is redundant as collective bargaining is their main role. Other companies have rejected collective negotiation. The impact of the facility on the structure and dynamics of the farmgate market is uncertain but likely to be limited.

In my view, the greatest tools that producers have in ensuring that bargaining is broadly fair are:

• The existence of strong, viable integrated dairy co-operatives, and

• Knowledge of options they have for their milk and/or their enterprise.

With few to endorse intervention between farmer and processor the market will govern all other outcomes.

Transparency and information

The transparency of farmgate milk prices has always been relatively high in the dairy industry, although comparisons between company price offerings have been made increasingly complicated in recent years as supply competition between processors has intensified.

Transparency of pricing information in the hands of the wholesale and retail sector today affects the dairy industry in two major ways:

• It allows the buyers to understand milk pricing and margin structures of processors when calling for bids on milk supply tenders, and

• The landed world price for cheese effectively becomes the benchmark buying price for cheese into this domestic market, more so now that the NZ dairy industry has a major direct stake in the Australian industry at manufacturer level.

These changes give industry participants at farm and factory level less control over price setting for their businesses. While the absolute level of prices has become more transparent, the complexity of different pricing structures has made the comparison between company offerings much more complex.

In the background, one of the greatest challenges faced by the total industry is to communicate (in language that can lead to decision-making) the big picture and the market dynamics that surround the industry in the context of the world market. The future growth of the industry compels a clear view of the demands and expectations of the available markets.

Conclusion

Deregulation in 2000 has created a new Australian dairy market to which the industry is still adjusting. The UK dairy industry deregulated in 1994 and is still enduring the pain of transition through ongoing changes that are driven by the industry's inability to match supply with demand. Our strength in this regard is far greater as a total industry, but we are still very early into change for many participants.

Over time, we can expect to see more diversity in the devices that are used to manage the milk volumes and its cost, despite increasing pressure to consolidate our food sector for more effective global positioning. The pressures brought on by new forms of competition will be some of the drivers for ongoing change at corporate level.

The major impact of change in farm incomes in high-cost milk production areas will take several years to have its full and lasting effect on the industry. Future changes are not solely governed by the supply response of farmers to changes in market access, but also (and largely) by the ability of people to realise their available options, and to make and act on life choices. The culture in these affected regions has been shaped by a dependence on farming sustained by certainty of prices at regulated levels.

In the dairy industry, that will see greater use of signals in the pricing of milk to suit the business outcomes of processors, but also see the advent of risk management tools to enable prices and input costs to be managed by professional farmers and major processors.

The future will also see the need for greater responsibility to be taken by dairy farmers for the ethical standards of the product they supply in terms of animal welfare, food safety, environmental impact and service reliability. Today these elements are market differentiators. In future they will be basic business requirements and their commercial enforcement through business contracts is inevitable.

References

ABARE 2001, The Australian Dairy Industry: Impact of an Open Market in Fluid Milk Supply , ABARE Report to the Federal Minister for Agriculture, Fisheries and Forestry, Canberra, January.

Senate Rural and Regional affairs and Transport References Committee 1999, Deregulation of the Australian Dairy Industry . The Parliament of the Commonwealth of Australia.

Milk Development Council [1] (United Kingdom) www.mdcdatum.org.uk

[1] The MDC is an industry services agency that provides a contract reporting service to the UK industry. The agency offers a price transparency service to producers which illustrates milk prices accessible by producers, and provides a graphic illustration of a commercial farmgate market featuring both co-operatives and private companies. Many variations of contract structure are identifiable in the UK industry and the lead taken in the development of Australian models has borrowed heavily from the UK.