Farm Credit East is a major source of financing and support services to the agricultural community in the northeast. Many in the dairy industry rely on its services as a source of both long and short term financing to insure that their operations are as financially efficient as market conditions allow. It will come as no surprise to anyone that dairy farming has ridden the waves of market turmoil for many years. Those who have ridden this roller coaster have been buffeted by economic uncertainty with little ability to control or modify the trends of the market. With this in mind a group of concerned staff and advisors at Farm Credit East took at look at both the historical, current and future of dairy marketing and came up with some recommendations for those dairy farmers who are searching for advice and direction.
In the period from 1949 to 1981 farm milk prices were largely determined by a federal support program operated by the USDA, which set farm milk prices to inflation through the parity price concept. This period was marked by a remarkable increase in the production level of dairy cows outstripping production costs making dairying increasingly profitable. This period of increased production was not met by an increase in demand, which forced the government to buy surplus dairy products to support the price of milk. This program came to an end in 1981 by which time government warehouses were overflowing with surplus butter, cheese and nonfat dried milk. Dairy economists call this 32-year period the “parity period.”
The post parity period represented a most difficult time for many involved in the industry. Many producers went out of business with the herd buy out program a major factor in convincing many operators to do so. One factor that economists use to measure the profitability of an operation is Return on Equity (ROE). During the period 1981 to 1996 the ROE on the average farm was 0.7 percent. It took 15 years for the industry to level out and come to terms with the need for greatly reduced level of production. Cow numbers and the number of farms were greatly reduced as the reality of the situation took hold.
In 1996, the post parity era transitioned into a market-oriented era, in which the number of cows and the number of farms fell into equilibrium with the true needs of the marketplace. Here the very basic economic principle of supply and demand came into play.
By 2007, the market was focused on exports, with major markets for U.S. dairy on foreign soil beginning to emerge. During this dairy export era, China came into the market on several occasions as a major buyer of dry milk products. It will be remembered that this period also marked the beginning of a sharp economic downturn in the general economy but the agricultural component continued to enjoy a period of strong prices across most major basic commodities. During this period New Zealand and other significant dairy product exporters were suffering weather-related issues impacting their production levels to the advantage of U.S. producers.
One might ask what happened to that all-too-brief period of market highs. Since mid-2014, the value of the U.S. dollar has risen sharply against most other foreign currencies making U.S. product less affordable in overseas markets. China has greatly reduced its importation of dairy products in part due to their own economic difficulties and its continuing efforts to expand its own dairy industry. The European Union ended its long-standing dairy production quotas, which resulted in a marked increase in production and New Zealand had recovered from its weather-related issues.
In recent years, it appears the milk market has been in a three year cycle; one year of moderate prices, the next one of very strong prices followed by one of weak prices. The year 2014 was a highly profitable one for the industry followed in 2015 by a sharp reduction in the price per cwt with even lower prices this year. The supply of milk world-wide is at an all time high and forecasters are unsure when a significant price increase will occur. To take this unpleasant forecast a step forward there may never be a return to the three-year cycle. If this is indeed an accurate forecast then some rather drastic restructuring will need to be done for the industry to remain viable.
Another major factor to be considered in the overall picture is the net cost of production (NCOP) or how much does it cost a given producer to produce a cwt of milk. The increase in the level of production of the average cow is indeed a remarkable one, from about 11,000 lb. in 1977, to over 22,000 lbs. in 2015. There are few industries that can show that sort of increase in production over a span of 38 years. When farms with a high NCOP discontinue production this makes the overall average lower. Those farms at the cutting edge of the industry must continue to adopt the most efficient dairy technology and management practices. Larger operations have the advantage relating to the economies of scale, which should translate into lower net cost of production.
The dairy industry is moving into a new phase. This period will be marked by existing farms becoming more efficient and those with high NCOP leaving the scene. It will come as no surprise that there is a strong relationship between the price of milk and the net cost of doing business. Producers are price takers, thus must adjust to changes in the price of milk. When the price of milk is good, producers tend to do more discretionary spending and the NCOP goes up.
Conversely, when the price is weak, they quite predictably attempt to cut the costs of production. When milk prices are strong relative to the NCOP, this signals producers that expansion is favorable and increases in cow numbers and improved facilities normally follow. Ultimately, this leads to more milk being produced and the predictable market-correction in the form of lower milk prices. When milk prices are low, expansion is restrained compared to NCOP ultimately leading to a market correction whereby supply is in better aligned with demand. This up and down movement of is one that takes time and has been a major driver of the three-year cycle.
Since milk prices peaked in 2014, the forces in effect during the three-year cycle no longer seem to hold true. During the 2014-2016 period, the size of the national dairy herd has increased by 53,000 head with no decrease in production, which means continued low milk prices. This factor would suggested that the industry is entering a new era and those who remain need to adjust their overall planning accordingly. Managing farm debt is critical if an operation is to remain viable. Economists use a measuring factor called earnings before interest, taxes, depreciation, and amortization (EBITDA) to assist in determining the efficiency of a given farm. As an example of how this works in the period 1996 to 2006, the so-called market oriented era, EBIDA per cow was $760, the debt per cow was $2485 for a debt to EBIDA ratio of 3.44.
Guidelines to insure the continued success of any operation include managing and understanding a farm’s net cost of production. The average NCOP for farms in the northeast is $18.36 and it is suggested that a target of $18.00 is achievable. It is also critical accurate financial records are kept and reviewed to achieve such targets. If any of the resources presently in use are under-performing, then they should be carefully re-evaluated and put out to pasture. During a period of expansion it is possible that a couple of the segments were expanded while other supporting elements remained unchanged making for an imbalance that needs to be corrected if such activity does not impact the financial picture too much. It is important to take advantage of outside professional advisors. The picture for the immediate future and beyond is that farm milk prices will be under far greater pressure than in the recent past. Farm business rates of return will be lower during this period of adjustment. The size of the national dairy herd will continue to shrink as will the number of farms. Low cost dairy producers will continue to make money but at a lower level while high cost producers will be under intense pressure to improve or exit the industry.
As is usually the case those farms with excellent management will continue to do well while those a peg lower on the scale have the opportunity to make necessary adjustments to bring their operations up to a higher level.