Last Updated: 24 May 2017

Fonterra announced an updated Milk Price Forecast of $6.15 for the 2016/17 season. That’s $0.10 below the last Dairy Analytics median price ($6.25/50) and so it’s worth looking into the cause.

In our models, there are number of causes of uncertainty:

- The USD:NZD exchange rate
- Fonterra’s cash and capital costs
- Fonterra’s product mix
- Fonterra’s sales curve
- Changes to the Milk Price Manual.

Let’s step through each of these in turn.

We don’t know the average exchange rate achieved by Fonterra. In last season’s Farmgate Milk Price Statement, they include the line

As at 31 July 2016, Fonterra had foreign exchange contracts in place in respect of approximately 70 per cent of the USD equivalent operating cash flow exposure expected to impact on the Farmgate Milk Price for the 2017 Season. If the balance was hedged based on a spot exchange rate of 0.7069, the average USD:NZD conversion rate would be 68 cents.

Since September (when they wrote that), GDT prices increased ~20%. That means Fonterra needs to convert more USD to NZD, and so the percentage they have hedged is less than 70 per cent. Let’s revise the assumption so that maybe now it’s only 40 or 50 per cent. Now we just have to estimate the average rate at which they convert the remaining 50 or 60 per cent from USD to NZD.

In our models, we assumed this was around 0.70 – 0.72 USD:NZD. However, all else being equal, to get our median forecast to be $6.15, Fonterra would have needed to convert their remaining USD to NZD at an average spot price of 0.74USD:NZD. According to the Reserve Bank, there were only three days when the exchange rate exceeded 0.74 (7th – 9th September 2016).

It seems unlikely then, that the exchange rate is the reason for the difference.

According to the Milk Price Manual, Fonterra is able to incorporate a number of costs into the Farmgate Milk Price. These don’t vary much between seasons. AgriHQ currently estimate the total cost (cash, capital, and lactose) to be $2.05/kgMS. That’s pretty close to a fairly naïve guess based on historical figures. If Fonterra’s cost is closer to $2.15/kgMS, then that could be a reason for the difference between our forecast and Fonterra’s latest forecast.

In order to calculate the total revenue under the Milk Price Manual, we need to estimate the proportion of milk that is turned into each of the Reference Commodity Products (RCP’s) by Fonterra (the Product Mix). Due to the lower peak in production, Fonterra had a greater ability to switch milk between product streams to maximise revenue. This season also saw a divergence in prices between different RCP’s, so that Milk Fats were trading at a significant premium to Skim Milk Powder on GDT. In theory, this should have led to a slight increase in the Farmgate Milk Price compared to the average season (and therefore led to our models underestimating the Farmgate Milk Price). It was one reason we were slightly bullish. Therefore, even if we estimated the product mix wrong, it probably isn’t to blame for the difference in forecasts.

We also need to estimate the proportion of total production that gets attributed to each GDT auction. The flatter milk curve may have led to more milk (as a percentage of total production) being sold on the shoulders of the season. Overestimating the quantity of milk sold during high GDT prices, and underestimating the quantity of milk sold during low GDT prices could be a reason for the difference between our forecasts.

In their latest Market Update, Fonterra announced that the changes they made to the Milk Price Manual (including the ability to incorporate “off-GDT” sales) led to a 6 cent increase in the Farmgate Milk Price.

We never explicitly accounted for this in our models. Without the change, their forecast would have been $6.09 (or ours would have been $6.30) and the difference between our forecasts would have been even larger.

As a side note, we’ve always been a little sceptical of this change. Introducing “off-GDT” sales means that Fonterra can factor in the prices it gets for products in closed door deals (i.e. the prices are not released publicly). That makes the process less transparent and harder to forecast which goes against the ethos of the transparency that the Milk Price Manual and GDT were meant to introduce in the first place.

On the other hand, 6 cents isn’t that much of a difference. So why go to the effort of changing the Milk Price Manual and reducing transparency if it has a minimal impact on the Milk Price?

The May forecast that Fonterra releases isn’t the final Farmgate Milk Price. In the table below, we’ve listed the Forecast as of the end of May, and the Final Farmgate Milk Price for the last six seasons. In the past, the Farmgate Milk Price has differed from the May Forecast by up to $0.10, although in the last three seasons there hasn’t been any change.

Season | May Forecast | Final | Difference |
---|---|---|---|

2010/11 | $7.50 | $7.60 | $0.10 |

2011/12 | $6.05 | $6.08 | $0.03 |

2012/13 | $5.80 | $5.84 | $0.04 |

2013/14 | $8.40 | $8.40 | - |

2014/15 | $4.40 | $4.40 | - |

2015/16 | $3.90 | $3.90 | - |

Therefore, it’s not without precedent that the Farmgate Milk Price might end up different to $6.15. In fact, based solely on these numbers, $6.25 wouldn’t be unexpected.

We still have reason to believe that Fonterra are underestimating their final Farmgate Milk Price. We’ve revised down our forecasts to account for the new information, but we think a small increase is on the cards. Unfortunately, we’ll have to wait until September to see how close to the truth we are.