Futures markets could provide a way for the Australian dairy industry to mitigate the price volatility that severely impacts on farmers, according to KPMG chief economist Brendan Rynne.
Mr Rynne was prompted to prepare a research paper looking at the options for the dairy industry after hearing about the challenges facing dairyfarmers while listening to the radio one morning on his way to work.
“I was thinking this sounds too regular and I wonder if there is a ‘hog cycle’,” he said.
KPMG’s research paper, Trading places…The role for derivatives in the Australian dairy industry, reveals the Australian milk cycle is a near perfect ‘hog cycle’, a phenomenon first recognised in the 1920s.
Mr Rynne said the problem for Australia was that it was a relatively small player in the global market.
“And that really led me to thinking there’s got to be a better way to manage this price risk through the use of derivatives, like futures,” he said.
“The fact there are ready existing futures markets for dairy products elsewhere around the world and there exists hedging contracts for foreign exchange means there is the opportunity to try to minimise the price volatility.”
He proposes milk pools that would allow farmers to fix the price for part of their production as the best way for the Australian industry to take advantage of futures.
This would be similar to a system used by the Australian sugar industry, which offers growers the opportunity to lock in prices for part of their harvest up to two years in advance.
Mr Rynne this system would mean less price volatility and potentially less debt in the industry.
Prices for dairyfarmers had been extremely volatile since 1998.
But a pools system would not necessarily mean higher prices every year for farmers - it would take out the extremes.
“So if they do this, they aren’t going to be able to necessarily capture all the super-normal profits that might occur in a particular season, but they are also not going to capture the super-normal losses that are going to come on the downside swing,” he said.
“So that’s the trade-off.”
Mr Rynne said this would give farmers increased certainty to allow them to make better decisions about investment in their business.
It would also help stop the slow creep of increased debt in the industry.
Mr Rynne’s research revealed farm debt as a percentage of milk receipts had followed the price cycle but had been increasing, particularly in the past decade.
“So while dairyfarmers are repaying debt that they might be accumulating in off seasons, in aggregate it’s steadily creeping up,” he said.
“So what that means is the interest payments that dairyfarmers are having on a year-on-year basis are taking more of their pre-tax income than has otherwise been the case.
“So there’s actually even less funds to grow and invest in their business.”
Mr Rynne said pools would need to operate at a high enough level - probably best at a processor level - to be able to effectively use the overseas futures markets.
“It makes sense to me that it is probably at the processor level for a variety of reasons,” he said.
“They are large enough to aggregate the product, they are large enough to manage the financial risk associated with getting into the derivative markets, they are large enough to deal with the foreign exchange hedges and ultimately they are the ones that are probably going to be able to process the product into its different forms to be able to access those derivative markets.”
But Mr Rynne said he had encountered some reluctance to look at the concept in his initial discussions with Australian dairy industry representatives, who were concerned about having to hedge dairy product in a foreign currency.
He said his research paper was designed to prompt discussion within the industry.
“They (the industry) need to do proper investigation to how they could make this work: what would be the mechanisms, what would be the product mix, what would be the scale that you would need to make it work; the interplay between foreign exchange contracts and dairy contracts are the things that need to be investigated and are reasonably complex,” he said.
“The challenge from the industry perspective is if you are in the same situation in two years, which is not unlikely when you see the cycles that we go through, there has to come a point where you say as industry you’ve got to stand up to try to solve it yourself.”
What is the milk hog cycle
In the milk ‘hog cycle’, profitable milk production prompts producers as a group to expand to take advantage of the expected opportunity.
Expansion continues until the larger supply cause prices to drop to unprofitable levels for most producers.
Producers respond by either cutting back on their production (through slaughtering stock) or by leaving the dairy business.
The subsequent smaller supplies of milk prompt an increase in prices and profits, and the cycle starts again.