It’s not an exciting time to be a dairy farmer.

Barnaby Joyce is angry. Waleed Aly is angry. Petitions are circulating. Dairy farmers are screaming about being paid 15 cents a litre.

How did it come to this?

 

 

A race to the bottom

Remember 2010 when, in the race for market share, Coles (ASX:WES) dropped the price of milk to $1.00 per litre? It was a classic ‘loss-leader’ strategy that is employed by plenty of other companies - McDonald’s 50c cones being a longstanding example.

Plenty of analysts saw as a harbinger of doom for the dairy industry. Simply, there was no way that price could be sustainable or, while Coles promised to honour existing price contracts for primary producers and processors, that the behemoth wouldn’t arrive at the table for the next negotiations carrying a big stick – one worth about half a billion litres per annum.

 

 

China falls in love with Australian dairy

Take, for example, Warnambool Cheese and Butter Factory (ASX:WCB). Two years ago, the company was pottering around with a consistently growing business. News that some New Zealand dairy farmers were valuing their cows at around AU$10,000 was based on potential demand from China, and the little dairy was a sudden takeover target, and its share price almost trebled in the last six months of 2014.

This growing and expected demand came as a result of the perception that Australasian dairy was clean and trustworthy – important assets following the 2008 malamine baby formula incident that destroyed confidence in China’s domestic dairy industry after 58,000 infants were hospitalised.

Between 2009 and 2015, prices for milk and milk solids jumped almost 50% on the back of export demand – a factor that staved off the impact of Coles’ $1.00 per litre prices on the farm gate.

 

 

China quickly falls out of love with Australian dairy

Fast forward to 2016 and the party is well-and-truly over. Australian and New Zealand dairy farmers are sending their cattle to the slaughterhouse in volumes never before seen as the price for milk solids hits unprecedented lows.

The two biggest desks for milk dairy sales – Fonterra (ASX:FSF) and Murray Goulburn (ASX:MGC) – can no longer compete against European products and a resurgent domestic Chinese industry. Also, the demand expected from Chinese buyers has failed to materialise, and the two big guns are shoring up their positions in order to survive the downturn.

The major casualty is the farmers. Those who have been through the boom-bust cycle before will have made hay while the sun shone. Now, with China out of the picture and prices pushing well below cost, who is going to be the main customers for Australian milk?

 

 

Shut the gate

Well, you guessed it. Coles and Woolworths (ASX:WOW).

Having spent the last five years utterly devaluing the product, the supermarket duopoly is here as the last surviving major customers for Fonterra and Murray Goulburn.

By riding out the last five years of higher farm gate prices, the major players are in the box seat to push down their cost of goods at least a break-even point.

The big question will be how the producers can sustain supply at that price, and whether the domestic industry can survive at all as international supply continues to grow and prove increasingly competitive against the high costs of Australian milk.