Speech by Teagasc Director, Professor Gerry Boyle at the National Dairy Conferen
What can the Irish Dairy Industry do to resuscitate the Irish Economy?
I was asked to outline my medium-term vision for Ireland’s dairy industry. This is a tall order. But in simple terms I hope I live to see the day when Ireland’s dairy industry will realise its full potential as one of the world’s most efficient producers and exporters of dairy products. As long as the quota exists that vision cannot be realised. I don’t propose to address the question of whether or not we should seek to dismantle the quota system. The economics of quota dismantlement from Ireland’s perspective versus its retention hinge on whether it is believed that, due to our relative cost efficiency and degree of technological change and spare capacity for expansion, we can acquire sufficient additional market share to offset any reduction in milk prices that might follow the abolition of the quota2. This question is essentially the same one that we were confronted with in the early 1980s prior to the introduction of the quota. It is undoubtedly an interesting and important question but as of now, all of the indications are that the quota dismantlement train has left the station and that we are on track to its abolition by 2015. The relevant question in these circumstances is how to position our dairy industry to not only cope with the challenge of abolition but to plan for exploiting the opportunities that will arise, especially for young milk producers.
On the eve of the quota’s introduction Ireland’s milk production trend growth was on average about 6% per annum and substantially in excess of international norms (Chart 1). Over the last 25 years, or so this gives an indication of the potential annual ‘loss’ due to the quota system in terms of foregone milk output and exports. My vision is that this loss can be recovered in a relatively short period following the removal of the quota. Given the buildup of technological change since the introduction of the quota, together with the structural change that has already taken place, it seems reasonable to me that we can anticipate an even faster trend rate of growth in production following the abolition of the quota than which prevailed prior to 1984.
Trend growth (%) in milk production prior to the introduction of the EU quota
Teagasc has a role in supporting its industrial partners to realise the potential that the sector has for expansion. In particular, we accept our responsibility to lay out the mitigation strategies for the risks that inevitably accrue to any significant expansion programme.
Medium-term commodity price outlook
What a difference a year makes! Who would have thought one year ago that the world was on the brink of being plunged into the depths of an unprecedented crisis in its banking system? Closer to home, who could have envisaged the catastrophic deterioration in the public finances that, was precipitated by the collapse in the housing market? On the energy front, oil prices have yo-yoed throughout the year. Farmers are only too aware of the impact that energy price inflation has had on fertilizer prices (Chart 2). Prices of CAN have soared to just under €400/tonne this year compared with a trading band of between €210 and €230 for the last three years.
Fertiliser prices (CAN 27.5%N),€/tonne, 2005-2008 (August)
Almost a year ago the mood within dairying was exceptionally positive, possibly to an excessive degree. The positive mood was of course driven by the prevailing historical record prices for dairy products (Chart 3). As we meet this year the mood is the exact opposite and, possibly, just as the optimism may have been overdone last year, the pessimism may be overdone this year (Chart 4).
Milk prices, €/litre, 3.7% fat, 1976-2007
But expansion will not be driven by this year’s price or indeed by the price that is likely to obtain next year. Rather the issue is the expected price that is likely to prevail over the period of a planned expansion. Based on my appraisal of the evidence on the global supply and demand trends over the medium term there is no basis, in my view, for us today adopting a fundamentally different view of medium-term developments in prices to that which obtained this time last year. Medium-term prices in real terms are expected to be significantly higher than they were in the 10-15 years before last year.
Monthly milk prices €/litre, 3.7% fat, 2005-2008 (August)
Of course what has been definitively borne out by our experience over the last several months is that price volatility is now a fact of life.
Up to recent years agricultural prices were considered to be driven by the so-called ‘Treadmill’ theory whereby agricultural supply persistently outstripped demand resulting in a relentless downward trend in agricultural prices that has persisted for over a 100 years (Chart 5). In recent years this view has been overturned by a wide range of authoritative commentators. The three main drivers of global demand, namely, population growth, income growth and bio-energy demand comfortably outstrip any potential supply growth over the medium term.
Real international food prices, 1900-1990, index 1977-1979=100
The world’s population is anticipated to grow to about 9.5 billion over the next 40 years or so (Chart 6). Within the next decade the global population is expected to grow by just under 800 million and nearly 470 million of this increase will occur in Asia (Von Witzke et al, 2008). Per capita income growth will also drive food consumption, especially for livestock and livestock products. Over the next decade income growth in Asia is expected to grow by around 5%, while in the developed economies it is likely to be well less than half of these levels. These anticipated trends take into account the emergent global recession and financial crisis as well as the slowdown in activity that appears to be occurring in China at present.
These trends in global population and income will be reinforced in terms of their impact on the demand for food by an intensification of the global trend in urbanization which inter alia can be expected to lead to a significant growth in the consumption of livestock and dairy products. The third key demand factor is the relentless drive in the production of first-generation biofuels in both the US and the EU. By 2015 global biofuel production is likely to be in excess of 150 billion litres or double current levels. Within 10 years or so it is anticipated that over 30% of US corn production will be earmarked for the production of biofuels. The EU is likely to switch from being a net exporter of grains to a net importer as demand for biofuels continues to grow.
The supply of food products will be driven by the capacity of the world’s agricultural regions to mobilize its underused and unused land resources for food production as well by the future potential for productivity gains. While there are substantial areas of land available throughout the world that could be used successfully to produce food, most notably in South America and Eastern Europe, because of constraints pertaining to the availability of water, poor infrastructure, lack of capital etc., it is estimated that only modest additional production can be expected form this source over the medium term, probably substantially less than 0.5% per annum (Von Witzke et al, 2008).
In the absence of a 2nd Green Revolution, or more likely, the widespread adoption of GM technology, it is unlikely that improvements in productivity will bridge the global demand needs. Global grain yields are likely to grow by a little over 1% per annum over the next twenty years in contrast with an annual growth of about 4% in the period 1961- 1990 (Von Witzke et al, 2008).
Climate change will also have a negative impact, especially in developing countries, while in global terms it will result in relatively modest overall production effects. Climate change, however, is likely to be a factor underlying price volatility.
There is a consensus among international forecasters that, despite the down turn in world economic performance this year and the relatively poor outlook for the next 18 months or so, the fundamental structural shortage of food will be the global experience over the next 10-20 years. This means that the price of food will be under upward pressure in all major export markets. But Rabobank (2008) point out that volatility will be more prevalent and that cost-push factors will also be responsible for keeping prices firm. The latter implies that for high-cost producers, and especially producers that rely heavily on grain diets, margins will also be tight. This of course provides a competitive opportunity to be exploited by low-cost, grass-based dairy systems and places an imperative on securing ever greater technologically-generated efficiencies in our grass-based system.
While the price outlook for the medium term is relatively benign, the next 12-18 months is more uncertain. Prices this year when weighted by monthly deliveries won’t be far off their 2007 levels, although because of the substantial inflation in input prices margins have suffered considerably. Next year we can expect a further squeeze in milk prices but we may see a deceleration in fertilizer and energy prices which could help to prop up margins. All-in-all milk prices could be back about 5 cents on this year’s average, with only a two per cent or so decrease in input prices likely. Over the next decade milk prices in Ireland are likely to be in the range 27 to 29 cents per litre which is considerably below the levels achieved in 2007 and 2008 but substantially ahead of the trend average prior to 2007.
The economics of expansion for the farmer and the country
The farmer’s view
When farmers have the opportunity to expand they will do so as long as it makes economic sense. Irrespective of the price a farmer receives for his milk it always makes sense to push production costs as low as possible. Farm profit is a function of productivity and the ‘price-cost squeeze’:
PROFIT = ↑(PRODUCTIVITY) X (‘PRICE-COST SQUEEZE’)↓
Farmers have no influence over the ‘price-cost squeeze’ but they can influence the productivity of their enterprise. Productivity is enhanced whenever fewer inputs are used to produce the same or a higher level of output. Productivity is in turn driven by the application of useable technology.
Prices of course matter. The closer prices get to unit production costs, the greater the prospect that economic activity will become uneconomic. Ultimately the incentive to expand activity will cease as soon as marginal production costs equate with milk prices. In other words if farmers have spare capacity in terms of capital assets (including cows) expansion makes economic sense as long as the milk price exceeds variable costs. On Curtin’s farm there is considerable scope for expansion as variable costs are only a little over 7 cents per litre3. Where there are capital constraints on expansion then the relevant cost variable is total production costs and depending on the target level of expansion (e.g. 150 cows +) additional labour requirements may arise. Thus in Chart 7, I show the relationship between different milk prices and total production costs on Curtin’s farm. It is apparent that expansion makes economic sense as long as the price level is not less than about 24 cents per litre.
Total milk production costs, Curtin's Farm, and various milk prices, c/litre
The basic message is simple. As long as unit costs are under control and kept comfortably below expected prices then expansion makes economic sense. Clearly where expansion involves fixed capital investment, especially where it is funded by borrowing, farmers have to be alert to the risks involved, especially regarding the ‘pricecost squeeze’ and they may need to adjust their plans accordingly. Risk-minimization strategies need to become a central feature of farm planning.
The economics of expansion from the perspective of the sector and indeed the economy depend on the potential additional production and export growth that is likely over the medium term due to the expansion of the quota up to 2015 and its subsequent abolition. A number of scenarios are possible in terms of prices and milk production. In Chart 8, I show a conservative expansion scenario for Irish milk production between now and 2020 that implies a growth in the volume of production of 23% between 2007 and 2020. I assume a price of 27 cents per litre. The value of milk output is shown to grow from about €1.5 b. to €1.8 b. Dairy exports are expected to grow from about €2.5 b. to just under €4 b.
Milk Output Value and Dairy Exports Value 1997 - 2020
Riordan (2008) has shown that for every €100 of agricultural exports about €50 is added directly to GNP compared with only €19 for non-agricultural exports. This higher GNP effect is due to the fact that agricultural exports require much fewer imports per unit of exports and also they induce positive EU transfers (Chart 9) in the form of direct payments, etc. Based on these estimates the expansion scenarios over the period to 2020 would be worth around €750 m. to the economy’s GNP. Based on the estimates of the potential expansion of production following the removal of the quota made by my Moorepark colleagues the actual impact could well be double this amount.
Contribution of every €100 of gross exports to GNP
Faced with the turnaround in milk prices that has occurred this year and the equally unpalatable escalation in fertilizer and energy prices, it is understandable that some farmers would be in the grips of a deep pessimism about the future. But if we can stand back from the recent experience and look ahead, all the indications still are that the agricultural sector has escaped from the ‘Treadmill’ of continuously declining real food prices. The medium-term outlook still presages that the trend future prices for food will be higher than their historical levels. Of course even if we accept this perspective, what this last year’s price experience has underlined in such stark terms is that volatility is now a fact of life.
The economics of expansion for the individual dairy farmer come down to ensuring that production costs are driven as low as possible for whatever price levels that are likely to prevail over the expansion period. Teagasc research has shown that with ‘best management practices’ expansion will be profitable as long as the average milk price doesn’t fall below 24 cents per litre.
For the industry as a whole and indeed the entire economy, the potential for expansion following the abolition of the quota is obviously difficult to determine and several scenarios could reasonably be put forward. My ‘conservative’ expansion scenario implies a growth in dairy production and exports up to 2020 of €300m and €1.5b respectively. The addition to the economy’s GNP of this scenario amounts to €750m. These are very significant numbers and probably significantly understate the true potential. Given the likelihood that the non-agricultural economy will perform sluggishly for the next few years the expansion potential of the dairy sector is all the more significant.
What are the potential constraints on realizing the expansion potential? Assuming that profitability is not a constraint, there are several concerns that need to be addressed.
The implementation of various environmental policies could put a serious brake on the sector’s expansion potential. It is going to be impossible to achieve the targeted 20% reduction in Green House Gases in the agricultural sector without a catastrophic cull of suckler cows. This outcome, should it materialise which is admittedly most unlikely, would however provide some scope for a compensatory expansion in dairy cows.
A potentially more serious environmental constraint could follow from the implementation of the Water Framework Directive. This Directive requires a draft plan to be produced before the end of this year for each river-basin district. These plans will outline appropriate measures to ensure adherence to stringent surface, ground and estuarine water-quality standards. It is conceivable that measures could be proposed that could severely limit the dairy sector’s potential for expansion. In this context it is important that the sector plans now for a derogation from the application of measures that are considered likely to impose a disproportionate cost burden on the sector.
As noted earlier, price volatility or risk is now a fact of farming life. Farmers will need to implement strategies for dealing with this volatility if expansion is being contemplated. Clearly relentless cost containment will be a critical element of any strategy. But I can envisage in time various insurance-type products being employed as was suggested recently by Franz Fischler4. Futures markets and other hedging instruments may well also emerge for dairy products in the next few years and it is even conceivable that some of these mechanisms could become an integral feature of the CAP.
At last year’s conference we also identified ‘mindset’ as a key obstacle to expansion. Each farmer will have to make up his or her own mind as to what makes most economic sense in their particular circumstances. But farmers will expect guidance on the best logistics and technologies that will minimize the risks associated with expansion. Teagasc will continue, through its research and advisory services, to provide sciencebased innovation support. In particular we intend to shortly establish a BETTER Dairy Farm Programme that will be designed to demonstrate the various challenges and solutions to expansion for different initial conditions on farms. Some of these farms will comprise ‘green-field’ situations. As far as technology is concerned we will continue to emphasize the primary role of the grass-based system and top-quality animal genetics.
Finally, the ability of the processing sector to handle the additional output cannot be taken for granted. Up to 2015 the sector will have no difficulty in processing the relatively small increase in the quota but following its abolition significant investment in additional processing capacity will be required. We estimate that if milk production were to increase by say 25% between now and 2020, with an unchanged product mix, an additional 30,000 tonnes of cheese-processing capacity would be needed together with 40,000 tonnes of extra butter. If all of the additional milk were to be processed as cheese, a 100% increase in cheese-processing capacity would be needed, amounting to an extra 140,000 tonnes.
Tim Hunt, Hayley Moynihan and Mark Voorbergen (2008), The Global dairy Industry: Reshaping in a New Market Era, Rabobank International, Food and Agribusiness Research and Advisory, October.
Riordan, Brendan (2008), The Net Contribution of the Agri-Food Sector to the Inflow of Funds into Ireland: a New Estimate, report Commissioned by the Department of Agriculture, Fisheries and Food, Dublin, May.
Harold von Witzke, Stefan Noleppa and Gerald Schwark (2008), Global Agricultural Market Trends and Their Impacts on European Union Agriculture, Working Paper Number 84/2008, Humboldt University Berlin.
1 I would like to thank several of my colleagues who assisted me in the preparation of this paper: Pat Dillon, Eric Donald, Trevor Donnellan, Matt Ryan and Laurence Shalloo. None of these is in any way responsible for any extant errors.
2 This cannot be taken as given as the price impact will depend critically on global developments in supply and demand and the pace at which the quota is dismantled.
3 Data supplied by Laurence Shalloo.
4 Cited in the Irish Farmers Journal, November 13th 2008.