REFORM OF THE ISRAELI DAIRY SECTOR: THE EXPERIENCE OF QUOTA REMOVAL AND PRICE VOLATILITY IN THE EU

ENPARD-IAMM Seminar Exploring potentially useful lessons from the EU experiences Tel Aviv, 18-19 May 2016

Trevor Donnellan Principal Researcher Teagasc (The Agriculture and Food Development Authority) Ireland trevor.donnellan@teagasc.ie

Overview

• Brief summary of EU dairy sector

• Evolution of Dairy policy in the EU

• Motivation for milk quota removal

• Critical factors influencing outcome of milk quota

removal

• Experience of milk quota removal to date

• Volatility in Dairy Price and Dairy farm incomes

• Mechanisms to deal with Price and Income volatility

2

Global perspective on Dairy over the next decade

• Strong consumption growth trends

– population

– incomes

– increasing meat and dairy consumption (outside EU)

– limited range of consumption substitutes for dairy

• Consumption of dairy growing globally

– regions globally where production is not traditional

• Continuing export opportunities for regions with

surplus milk production

– EU, US, Oceania

3

Complexity of EU dairy sector

• EU dairy sector quite diverse across the Member States

– in terms of both farm sector & processing sector

• Member State milk prices span a wide range

– 25 to 40 cent/kg in 2014

• Member State production costs differ

– And of course costs differ within member states also

• Strong variations in Member State average farm size

– between 3 and 141 dairy cows

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Share of EU27 Milk Production 2013

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DE FR UK NE PL IT ES IE DK BE AT SE CZ FI PT HU LT RO SK LV ES EE SI BU LU CY MT

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75% of EU milk production in just 6 countries FR, DE, UK, IT, ES & PL

Contrast in scale and intensity of dairy farms across the EU

• EU-15 average

– 54 dairy cows milk yield of 7,337 kg/cow

– 385,000 litres milk/year

• EU-10 average

– 19 dairy cows milk yield of 5,695 kg/cow

– 105,000 litres milk/year

• EU-2 (BU & RO) average

– 5 dairy cows milk yield of 3,445 kg/cow

– 15,500 litres milk/year

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EU dairy processing sector

• 91 % of milk production is delivered for processing

– But share is much lower in parts of Eastern Europe

• Specialised dairy products vs generic commodities

– High value added and lower value added dairy products

– eg. specialist cheeses vs commodity butter

• EU15 modern, larger, more efficient milk processing facilities

that rest of EU28

• All of these factors suggest that quota elimination would not

have a uniform impact across the EU

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The EU Dairy Market: A few important things to remember

• Mainly dependent on concentrate feed, with

cows housed for much/all of the year

• Except where grass is main portion of the diet

– Such regions typically have lower production costs

– Since grass is a cheaper feed than concentrates

• Production to expand where costs are lower

– i.e. regions that favour grass production

– But the milk price farmers receive is also a critical

consideration

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EU Policy (1968-2003) Price Stability in Dairying

• Stated objective of Treaty of Rome 1957 – “to stabilize markets”

• Stable price policies established in 1960s – dairy, beef, grain, etc

• EU prices substantially above world market price

• Target Price for Milk

• Intervention stocks and Private Storage Aid

• Export Refunds

• Import Tariffs

• Subsidised Consumption

• Milk Production Quotas (introduced in 1984)

EU Policy (reform of 2003) Enter Price Volatility

• End of explicit EU price stability policy

– global market volatility permeates EU market

• Much lower “safety net” intervention prices

– reduced from 2004 to 2006

– unchanged since 2007

• Change of emphasis in EU Agricultural Budget

– introduction of direct payments for dairy farmers

– much less emphasis on price stability

Changing times for EU Dairy Sector

• Removal of EU Milk Quota System in 2015

• Created mixed sentiment across the EU

– growth opportunity in some Member States (MS)

– a threat for dairy sector in some MS

• Concern for international market volatility

– Volatile milk prices and volatile farm production costs

– Some concern that quota elimination could exacerbate

volatility

• Voluntary production restraint 2016?

– Currently a hot topic in Brussels

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EU Milk Price trends 2001-2016 Source: European Milk Market Observatory

Causes of Dairy Price Volatility

• Characteristics of the demand for food – inelastic demand

• Combined with unanticipated variation in supply – due to weather, disease, etc.,

• Small changes in supply can cause large changes in price

• Policy change in EU – Low dairy inventory levels in recent years

• Biology of dairy – Production responses small in short run (yield adjustment)

– Greater in long run (herd size adjustment)

Consequences of Price Volatility

• Low prices cause financial problems – e.g. low margins, cashflow management and debt servicing

• High prices lead to substitution away from dairy – difficult or impossible to reverse (want stable ingredient prices)

– Buyers favour fixed price contracts or lower levels of price variability found in price of other food ingredients

• Extreme volatility leads to procrastination – slows investment, innovation and R&D decisions

– wait and see mentality takes root

– culture of (empty pipe) minimal stockholding, which itself contributes to volatility

Forward Contracts

• Agreement to purchase/sell specific quantity at a specific price at a certain point

• Counterparty risk is an issues – farmer defaults on delivery (due to production problem) or – buyer defaults on payment

• Risk to farmer of default can be reduced – only lock in a share of production in the contract

• Conflict of counterparty interests – sellers want to lock in high prices /buyers want to lock in low prices

• Education required – necessary to underpin adoption of tools – for both processors and farmers

• Now available for milk production in Ireland – Glanbia and 5 other milk processors

Futures Market

• A future is a forward contract that is traded on an exchange – Quality, quantity, time and location

• A solution more suited to processors than individual farmers

• The contract’s delivery price changes as the real commodity market price changes

• Buyers and sellers must have a margin account – Positive or negative payments to/from the account

• Market can include participants from outside sector – Speculators – Widens pool of market participants

Dairy Futures Markets in the EU

• Growing demand for futures based risk management solutions in dairying

• In Europe primarily driven by demand from the dairy buyer or customer side – Already used for their non-dairy ingredient purchases

• Reluctance on dairy seller side – Could rely on EU policy to stabilise market in the past

– Unfamiliar with futures markets trading as a result (need to hire expertise from other sectors)

– no milk contracts listed on the EU exchanges

Production risk and insurance

• Weather, disease, flooding, fire, accident require insurance

• But insurance is not mandatory (and this pushes up prices) – leads to adverse selection problem

– those insured are a higher risk group than whole population

– higher insurance premiums result

• Moral Hazard – Where insurance affects the behaviour of the insured

– Leads to the requirement for an insurance excess

• Government (taxpayer) – provider of “free” insurance? – Crowding out of private insurance

• Subsidised insurance premiums – Can make insurance look more attractive

Dairy Insurance in the US

• US has moved from product price support to income support and latterly insurance tools

• Livestock Gross Margin for Dairy (LGM-Dairy) insurance program – launched in 2008 – protects against loss of gross margin (market value of milk - feed costs) – pay out is insured gross margin minus actual gross margin

• Margin Protection Program for Dairy (MPP-Dairy) – launched in 2014 – offers protection when margin falls below a certain dollar amount – producer can pick the margin dollar amount – cover a specific percent of historic production (up to 90%) – premium depends on level of cover chosen

Other tools to address Income Volatility (1)

• Tax Income Smoothing – Tax system is used to make after tax income less

volatile than pre-tax income

– Tax liability is calculated over several years rather than over an annual basis

– Good years compensate for bad years

• Now available to farmers in Ireland – Farm profits in years 1, 2 and 3 can be added together

for tax assessment purposes

– Recently changes now allow averaging over 5 years

Other tools to address Income Volatility (2)

• Voluntary Supply Constraint

• Collective action to limit production – where producer organisations (POs) and interbranch

organisations (IBOs) agree to limit production

• Allowed by EU legislation under limited circumstances – voluntary & temporary (Art. 222 of CMO Regulation)

– limited in order to prevent anti-competitive behaviour

• Issue of how to regulate such agreements – potential free rider problem

– those that do not limit their production stand to derive greater benefit

EU Post Quota: Likely Outcomes (1)

• Volatility is likely to continue

– milk prices, production costs and farm margins

• Quota elimination to have relatively minor

implications at EU28 level

– EU milk production will grow slowly beyond 2015

• At MS & regional level within MS impacts could be

more appreciable

– Milk production will reorientate towards regions to better

reflect comparative advantage

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EU Post Quota : Likely Outcomes (2)

• Expansion in milk production needs management/oversight

– the milk quota will be replaced by other limiting factors

– issues at the farm level and beyond the farm

• Difficulties with access to land, labour, water and capital

– will impede expansion for some producers

• Processing, storage, distribution, marketing

– Needs forward planning

– e.g. 3 year time horizon required to commission, design and build new

processing plant

– Need to secure new markets for additional product

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Conclusions (1)

• EU dairy sector is quite diverse

• Quota removal means that other constraints limit production

• Quota elimination will lead to differing outcomes across the EU member states

– More efficient dairy producers to benefit

– in regions where alternative farm enterprises are not particularly profitable

• Volatility is not going away

• Price based income volatility is one of a number of risks farmers face

Conclusions (2)

• Tools exist to limit the adverse impact of price volatility – available for processors and dairy farmers

• Education is required to understand how these tools work

• Diversity of EU dairy sector at farm level – makes the design of effective incomes support

instruments more difficult

• Market solutions more advanced in US than EU – for price and income volatility mgt.

Thank you!

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Gradual Price Convergence and Greater Volatility

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Agenda for change in EU Dairy Policy

• EU dairy consumption is flat

– contrasts with the growing demand globally

• EU wanted a share of global dairy growth

• MS milk quotas were increased in run up to 2015

– Series of 5 annual 1% quota increases in 2009-2013

• But production static or declining in some MS for several years

– BU, HR, EL, HU, PT, RO, SK, SI, SE

• Failure to fill quota due to:

– dairy farmer exits,

– lack of new entrants to dairy farming,

– limited production growth from the remaining dairy producers

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Cap Reform 2013 – to present

• End of the EU milk quota

• But other policy levers were retained

– public intervention

– support for private storage costs for butter

– export refunds can be used in cases of market imbalances

– specific ad-hoc measures in case of emergency/ significant market disturbances

Post Quota Milk Production Levels: What factors are important?

• Farm milk price in the Member State

– and the range of milk prices within the Member State

• Costs of production at farm level: influenced by

– the production system in the MS (concentrates vs grass)

– rate of tech adoption by farmers

• Farm size (in terms of milk volume)

– Small farms will remain under pressure

• Milk processing industry

– modern plants can process milk at lower costs

– can farmers benefit from these efficiencies ?

– higher farm milk prices vs additional processor profits ?

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Post Quota Milk Production Levels: What factors are important?

• Economic performance of dairy sector vs agricultural sectors and

vs wider economy

– In some regions of EU dairy faces competition

– competition for land/water from other agricultural sectors

– competition for labour from other sectors of the wider economy

• Dairy will persist in some higher cost regions

– Where no other agricultural or non agricultural opportunities exist

• Environmental constraints

– Intensification limited by GHGs/nitrates policy

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European Dairy Sector in “Crisis”

Causes of Price Volatility over last decade

• 2007/8 Peak: Strong demand due to growing world economy, combined with modest scarcity due to drought in Oceania and low to zero stocks

• 2008/09 Low: Weak demand due to global recession, combined with a modest surplus due to increased output in Oceania, US and growing stocks

• 2013/14 Peak: Strong demand, China, other Asia, etc., milk output static NZ

• 2015/16 Low: Weak demand from China, Russian embargo, removal of EU quotas, Oceania/USA increased output

Price Volatility is a reality

• Price variation desirable and inevitable in all free markets – Flags up supply and demand imbalance – Highlights competitive position – Leads to resource reallocation

• Significant increase in price volatility EU dairy sector – expected to persist (may even increase) – EU dairy policy continues to become more market focused

• Exceptional price volatility brings numerous challenges – increased risk for all participants in the dairy supply chain – creates many problems for processors, farmers and other

supply chain participants

Price Volatility Defined

• Not easily defined

– common to think of volatility as increased risk

– but risk is subjective

• “Price volatility is a directionless measure of the extent of the variability of a price” Gilbert and Morgan (2010)

• Volatility is about highs as well as lows

– Speed and degree of change in prices constitute volatility

• Price volatility is one of a number of risks

– Others include financial risk, asset risk, policy risk, legal risk and currency risk

Low level of trade contributes to volatility of world prices

• Only 8% of world milk production is traded – Milk is mostly consumed in country of origin

• Structure of world dairy trade differs from grain market – more grain traded internationally

• Small changes in world milk production or world consumption can have a large impact – Can lead to large changes in volume available for world

dairy trade

• Makes international dairy prices prone to volatility

Challenges associated with dairy and risk management tools

• Mix of traditional and new (higher value added) products

• Processor price differentials may result – Different levels of farm milk price due to differing product mix

• Possible to Increase production through yields in short term

• Herd increase allows further increase over medium term – Today’s decision can have impact on supply well into the future

• Cutting production (culling) is a last resort – Farm operates below capacity, loss of progress in herd genetics

• Long supply chains represent an information problem – Delayed transmission along the chain

– Changing market sentiment can take a long time to reach the farmer

– Falling prices and rising production can be observed at same time

Market based solutions

• Farmers are price takers – so can’t control prices or price risk

• But risk can be transferred to 3rd party

• Broad range of instruments to manage price/income volatility – Market instrument – derivatives

– Hedges a farmer’s prices risk

• Derivative value increases as price falls

• Forward contracts, Futures Market

Volatility in input costs

EU Post Quota : Likely Outcomes (3)

• Processors moving up value chain

• Reflect fact that EU dairy market is mature

– Growth cheese, fresh products and specialist dairy products

(e.g. infant formula, athlete performance drinks)

• Sector needs export opportunities outside the EU

• Commodities a bargain basement business?

– Possibly not, strong demand in developing countries

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German Milk Production to 2020

• Largest milk producer in EU – 30 million tonnes, over 4 million dairy cows.

– Production concentrated in North West & Bavaria

– Mix of bulk commodity & specialised local products

– Growing trend towards housing cows in some regions

• Cows number rising in last couple of years

• Positive outlook

• Expectations of 1 per cent increase p.a. – Strongest growth rate in coastal regions and in the lower

Rhine and in mountain areas

French Milk Production to 2020 • 2nd largest milk producer in EU

– 24 million tonnes milk, 4 million dairy cows

– Strong tradition of mixed farms

• Average dairy herd size is slightly smaller than Ireland – Drive to increase farm size, particularly herds > 100 cows

• Profitability suggest expansion in some regions – but competition from the crop sector for land

• Parts of processing sector uninterested in processing additional volumes of local milk – Multinational food businesses content to grow internationally

• Jury out on whether French production will expand – but some experts reckon that expansion of 2% p.a. is possible

UK Milk Production to 2020 • 3rd largest milk producer in EU

– 13.5 million tonnes (10 percent below quota)

– Driven by rapidly contracting producer numbers

• Feed use increasing due to land constraint

• Evolving two tier milk price system – those with contract to supply supermarkets directly

– and those without

• Two tiers of milk price and profitability – Margin over cost vs market determined price

• Stable to slightly contracting production outlook

Dutch Milk Production to 2020 • 4th largest milk producer in EU

– 12 million tonnes milk production, 1.5 million dairy cows

– densely populated & intensively farmed

• High productivity and low feed prices – but very high land prices – shift towards housing

• Strong export orientation (~ 70% exported) – efficient highly concentrated processing sector

• High profitability suggest expansion possible – but environmental factors are an area for concern

– need to process animal manure

• Netherland to expand by about 1.5 percent p.a. – with environmental constraints hindering faster growth rate

Polish Milk Production to 2020

• 5th largest milk producer in EU – 10 million tonnes, 2.5 million dairy cows

– low yields and small farms

– but developing rapidly

– deliveries increasing as a share of production

• Consolidation improving the competitiveness of processing sector

• Farmer and industry sentiment is quite positive – Like Ireland well over quota in 2014/15

• Production to expand 2 to 4 % p.a.

Ireland

• 7th largest milk producer in EU – Production of 5.5 million

– Low yields

– Low costs

• Grassland based – But only 20-25% of grassland is currently dairy

• Very ambitious expansion plans – Production likely to increase by >10% in 2015

• Strong growth to continue over next decade

• Long term aim to become NZ of northern hemisphere

Other EU MS

• Represent ~ 25% of current production

– MS where national quota no longer filled

• Some increase in MS with small quota share

• Elsewhere future production static/declining

– Removal of quota will have no direct impact

• But these MS could face greater competition

– from MS which are expanding their production and their

export capacity

50 Source: Reuters

51 Source: Reuters

52 Source: Reuters

Other Measures to deal with price/income volatility

• Off farm income

• Farm diversification

• On farm technology choices

Role of Government in Risk Management

• Government risk-related policies can impact on farmers’ risk management strategies

– Crowding out of on farm and private market solutions (OECD 2009, Tangermann 2011)

• Important to evaluate

– effectiveness of policy in achieving its aim

– effect of policy on other risk management measures

Types of Risk

• Market/Price

• Production

• Financial

• Institutional/Legal

• Can be categorised as Micro, Meso and Macro Risk

Price Volatility Concerns

• Population and income growth • Use of crops for Biofuel • Oil Prices • Low Stock levels • Climate change? • Production growth in more marginal regions • Short term Gov Policy (limiting trade) • Long term Gov Policy reforms (trade liberalisation) • Currency movements

Different Risk require different solutions

• Many of the measures available are not new – But are not generally in use in EU

• Risk reduction, risk mitigation and risk coping

• Farm, Market and Government level

• Systematic risk can be dealt with at a higher level – Mutual funds/insurance (production risk)

– Market instruments (price risk)

• If the systematic risk is very high then the risk may need to be dealt with by government – Drought, disease, sustained low prices (residual risk)