Australia and NZ are perfectly positioned to capitalise on growing global demand for dairy… so long as they can overcome some very real challenges.
Global demand for dairy products is on the rise and the Australian and New Zealand dairy industries are perhaps better placed than any to exploit it. That is, so long as they can overcome some very real challenges.
We explore the opportunities and look at the role private debt could play in helping overcome some of the obstacles standing in the way.
The world’s growing demand for dairy
As the world gets richer and its middle class grows, dairy is increasingly in demand. The OECD forecasts that global demand for fresh and processed dairy products will grow by 2.1% and 1.7% respectively over the decade between 2017 and 2027.
Importantly, almost all of this growth will come from the developing world. Outside of India and Pakistan, domestic producers in these countries do not have the capacity to keep up with growing demand. That means, established dairy exporters will need to fill the growing discrepancy in markets in Africa, the Middle East and, most importantly, East Asia.
A reputation for quality
In fact, exports from the largest six dairy exporters (New Zealand, the EU, the United States, Australia, Argentina and Uruguay) already rose by almost four per cent in the 12 months to October 2018. But if all goes according to plan, Australia and New Zealand look well poised to take up an even bigger share of the growing global market.
Both countries boast efficient, export-driven dairy sectors. Dairy products are New Zealand’s largest export, accounting for NZ$13.96b (US$8.93b) in 2017. Australia, despite its substantially larger domestic consumer market and smaller dairy industry, still exported roughly 36 per cent of all dairy products in 2017/2018, making it a $A3.4 billion ($2.34b) export industry. It is also the country’s third largest agricultural export behind only beef and wheat and above wool.
One reason AUNZ producers find themselves in such is demand is that both countries enjoy a reputation for superior quality and food safety in markets where that matters a lot. For instance, the 2008 melamine scandal remains front of mind in China’s consumer market. Studies show most Chinese still trust foreign dairy brands more than local ones, particularly when it comes to feeding their infants.
Similarly, a test on East African milk revealed six per cent of all samples tested contained melamine concentrations of up to 5.5mg per kilogram of milk powder. Meanwhile, a Brazilian study of 100 samples of locally processed UHT milk found 55 per cent were adulterated with urine and 44 per cent with formaldehyde. Another 30 per cent were adulterated with hydrogen peroxide, while traces of chlorine were found 12%.
In part, it is this kind of unreliability that has helped spawn the spectacular success of Australian and New Zealand dairy companies such as The a2 Milk Company (ASX: A2M) and Bellamy’s Australia (ASX:BAL). Both companies have managed to trade off the Antipodean reputation for quality produce and food safety, illustrating the real potential of the two countries’ dairy sectors in the developing world.
Not all plain sailing
But for all the good news in the AUNZ dairy sector, there are still many serious obstacles to be overcome if this success is to be emulated across the board. For starters, higher milk yields may act to drive down the price of dairy products around the world.
Perhaps more pressing – at least in Australia – is coming to terms with the effects of a prolonged and sustained drought. Australia’s weather cycles are unlike those in other major dairy producing countries, with more variable seasonal and annual rainfall patterns. Nowhere is this being felt more than in the country’s largest river system, the Murray-Darling Basin, which supplies water to two-thirds of Australia’s irrigated farmland, including the dairy-rich country of Northern Victoria and Southern NSW.
Already facing substantially less run off than usual, the Murray-Darling is also suffering the effects of an increased number of permanent plantings, including water-hungry nut farms. This is driving up water demand and in turn forcing up the price of both water and feed for downstream dairy farmers. For many dairy farmers, this means that increasingly it is no longer viable to continue production at all.
This, in turn, is forcing the loss of productive dairy capacity in northern Victoria that will in all likelihood not return.
The ongoing urban sprawl and generational succession challenges are further fueling an emerging systemic undersupply.
A long-term upside?
All this means that, despite growing domestic and international demand the size of Australia’s dairy production has actually decreased by 2.25 billion litres between 2002 and 2016. The number of Australian dairy farms has also more than halved over the twenty-first century from 12,896 in 1999/2000 to 5,699 in 2017/2018.
The adversity being experienced is driving a rationalisation of Australia’s dairy industry – delivering an economy of scale and efficiency that has been absent to date.
Importantly, lower relative currency prices and the potential for an ongoing China/US trade war mean that there is real potential for AUNZ dairy industries to continue taking market share, especially once the drought lifts.
A capital problem
But to take advantage of growing global demand, the dairy sector requires finance, especially in the short-term. At the farm level, short-term money is needed to compensate for lumpy cashflow and increased volatility, especially when it comes to riding out the drought. The larger farms that will increasingly become the model for dairy farming in the future will also need finance to buy cows, plant and equipment and aggregate neighbouring properties to reach the scale at which they become viable.
Money is also needed to fund farm succession plans. Those children of dairy farmers who do want to continue working the land find that they need to borrow capital to buy the farm from their parents and allow them to retire. As it is no longer viable to base a dairy farm on milking just 200-300 cows, they also need capital to invest in increasing the herd size.
Little of this finance is likely to come from the banks who are increasingly finding it difficult to reconcile the natural financial patterns of dairy farming with their own asset and income-based lending criteria.
In fact, if anything, the distance between farmers and banks is likely to become more pronounced. In Australia that’s due in part to a more conservative post-Royal Commission lending environment. In New Zealand, it is down to the Reserve Bank of New Zealand’s recommendation for a 40% lift in the capital backing the New Zealand banking system.
Funding the future of dairy farming
The reality is that to truly take advantage of growing global demand for dairy, both Australia and New Zealand’s sectors will require alternative funding models and financiers with the capacity for flexible structures – the kind that only private debt can bring.
Merricks Capital is committed to providing short-term financing solutions that take into account both the reality of dairy farming and its business model.
We have several existing investments and strategic relationships in the sector including dairy production, farm management and structured offtake arrangements. In addition, and as part of its lending activities to the wider agricultural sector, Merricks is currently looking at a number of dairy based opportunities in the Australian and New Zealand markets.
Read more about our investments and expertise.