Fonterra’s advance price is the crucial number

Fonterra’s advance price is the crucial number

This week is important for all New Zealand dairy farmers. The key announcement will be Fonterra’s decision as to the advance price for milksolids, which will be paid to farmers during the first half of the forthcoming 2015/16 season.

In contrast, most media discussion as to milk prices for the forthcoming 2015/16 year has been and will be about what Fonterra will estimate this week as the expected overall price per kg milksolids for the coming year, which runs from 1 June 2015 through to 31 May 2016.

Most pundits are suggesting an overall expected price for 2015/16 of between $5 and $6 per kg milksolids. But right now that estimate, which is little more than a guess, is largely irrelevant. It is the advance price that counts down on the farm, but which the media largely ignores.

The Fonterra advance payments are also important for Synlait and Open Country suppliers. These investor-oriented companies pay whatever they need to stay competitive with Fonterra.

Fonterra pays what are called ‘advance’ payments on the 20th of the month following when the milk is received. The rest of it dribbles in through to October of the following year.

In a normal year, Fonterra pays these so-called advances at about 65% of the expected final payout. But this year could be different. That is because Fonterra’s own cash inflows during the first half of the year will be modest.

Fonterra is already selling early season milk on the GDT auction platform, despite the milk not having been produced yet. There is nothing wrong with that; in fact it makes lots of sense if trading is to be at least somewhat orderly. However, the prices at which this milk is currently being sold will only support a final payout of about $4.50 at best.

So how should Fonterra price the advance payouts? Should they be priced as a percentage of the early season prices, or should they be based on best estimates of the final price?
If Fonterra bases its advance payments on the current prices, then some farmers are in for a shock. The advances could be well under $4, with a likely figure being in the ‘low threes’.
If Fonterra bases the advance on overall expected prices, then the advance could be closer to $4.
The problem with the second scenario is that the overall price for the coming 2015/16 season is still such a guess. Despite the pundits predicting prices between $5 and $6, the reality is that it could be anywhere between about $4 and $7, or even outside that range.

Last year at this same time, Fonterra was predicting $7 per kg milksolids for the 2014/15 year. Yet the latest estimate for the 2014/15 season, which is now about to end, is $4.50. Surely that should convince everyone that estimating milk prices this far out is almost total guesswork. Quite simply, no-one knows.

Everyone knows that international dairy prices are currently very low, but less well understood is the lags inherent in the system. Given those lags, most farmers will have received milk cheques during the current 2014/15 year in excess of $6 per kg of milksolids actually supplied. This is despite the estimate for the year about to end as being $4.50. It is only now that the cash crunch is beginning to bite.

Most farmers will receive some very modest payments in June for their May production, nothing in July, and then some tiny retro payments in August, September and October.
The new season’s payments will include the advance payment on 20th September for August production, with increasing payments in the following months as spring production cranks up. But if advance payments are only in the ‘low threes’, then for many farmers the overdrafts will continue to rise.

Down on the farms, there is a lot of frustration at Fonterra’s failure to accurately predict prices. But that is not Fonterra’s fault; it is the simple reality of global commodity markets.

Ironically, part of the volatility that we now see in international markets is a function of the open- market free-trade policies that we in New Zealand have advocated for so strongly. Whereas in the past, both Europe and the USA would beat to their own drums in terms of production and pricing signals, everyone is now responding to the same international free-market signals.

Commodity markets can be very profitable. Australia’s wealth is built on mineral commodities, Saudi Arabia and Norway have built their economies on oil as a commodity, and New Zealand has itself done rather well from our agricultural commodities. But the nature of commodities is that they are very volatile.

For the last 15 years, I have been telling Lincoln University students that I can guarantee that at some stage of their professional careers they will face a major downturn, but that neither I nor anyone else can tell them when that will happen. The trick is to have thought out in advance how to deal with that downturn, and not to make silly decisions in a panic.

Currently, I am seeing some indications that not all of the advice that farmers are receiving is sound. There are many costs that can be forestalled, but there is no point in saving costs unless those savings exceed the consequent loss of income in the same season. The key issue is that hungry cows punish their owners. I will have more to say on that at another time.

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