Despite current short-term challenges facing the dairy sector, the medium to long-term outlook is robust, according to a new Rabobank report.

With the market for dairy moving into a fundamentally changed time, the report, “The Global Dairy Industry – Reshaping in a New Market Era,” states that global demand for milk — at any price point — has increased. This is based on global income growth, and favorable demographic and cultural trends that have increased the number of people who are aware of dairy, have access to dairy, want to consume it and can afford to do so.

Additionally dairy analyst and Rabobank Food & Agribusiness Research and Advisory Managing Director Deborah Perkins said, “we believe that the medium-term price for dairy products has increased from its long-term average, and that economic growth and cultural changes have substantially increased the price the market will pay for milk.”

Short-term challenges

However, prevailing negative forces have been at play in late 2008 weighing on the previously buoyant dairy industry.

“The global dairy market has entered the closing months of 2008 in a bearish mood,” said Perkins. “Fundamentals on all sides have appeared to be weakening, with retail dairy inflation still building, United States milk supply growth only slowing modestly, financial market turmoil and a damaging milk contamination scandal in the Chinese market.”

After an extraordinary boom in global dairy prices in the past two years, which culminated in a phenomenal peak in late 2007, international dairy prices – in U.S. dollar terms – have fallen during most of 2008.

Expected turnaround

Global dairy demand is likely to remain below trend level through the first half of 2009 assuming continued weak economic conditions. However, it is hoped that a turnaround will occur later in the year brought on by an eventual improvement in the global economy, increased consumer demand from more competitive pricing and continued demographic and cultural trends favorable to dairy consumption.

There is also likely to be a moderation of recent supply growth as farmers in many key export regions rein back investment in response to lower milk prices and an increase in the cost of production caused by higher input prices.

Increased production costs

Dairy producers around the world face significantly higher production costs than in recent history, the report warns.

“The cost of producing milk has significantly increased for all farmers due to the structural increase in the prices of feed grain, fertilizer and fuel,” Perkins said.

In addition, there are constraints on growth in traditional low-cost dairy regions, due to limited land or natural resource (water) availability.

“This means that for additional export supply, the market will eventually need to turn to regions with higher costs of primary production, less efficient supply chains or greater structural impediments – such as Latin America and the US,” Perkins said. “Extreme volatility in the dairy market is likely to remain.”

Volatility

Even with a recovery in prices, the industry must expect significant prices swings, the report warns.

“Within this higher trading band, price volatility will be high,” according to the report.

“Global dairy stock levels are low and, in the medium-term, it is expected that there will be frequent shocks to the demand and supply side of the market, which are expected to unleash the latent volatility inherent in dairy product markets due to the short-term unresponsiveness of demand and supply to price.”

New strategies for key players

The new dairy market era is expected to significantly reshape the sector in the years to come and heralds the need for all players involved in the industry to reconsider their strategies, the Rabobank report finds.

“As the global dairy industry contemplates life in this new market era, players all along the supply chain will need to re-evaluate their strategies,” according to the report. “Those who adjust best will be well placed to reap the benefits that market change will bring.”

Even with higher dairy commodity prices, farmers in most regions will not necessarily see margin improvements due to the increased cost of production, while those in export regions must be prepared to manage volatility on all sides of their business.

Domestically oriented dairy processors also face a battle to restore margins in very difficult conditions (with the focus on areas such as input sourcing, product range and brand) while export dairy processors will need to adjust their strategies and develop competencies to suit changed conditions, such as huge increases in export volumes.

Traders, meanwhile, face the prospect of limited volume growth from the traditional heartland of the European Union, but will need to be ready to diversify their sourcing base as other regions develop increasing milk surpluses.

Dairy ingredient users also need to reconsider the manner in which they will be able to secure supply and manage the volatility in price, while balancing the costs of reformulation and recipe flexibility with savings from substitution.

And all players, the report says, will need to consider the implication of increased credit risk and capital shortages in the current financial environment.