The Challenges Posed by Price Volatility in the EU Dairy Sector.

Declan O Connor, Dennis Bergmann & Michael Keane

Agrarian Perspectives XXIV.

and

25th Annual Conference of the Austrian Society of Agricultural Economics

September 16th 2015, Prague1

•Price Volatility– What it is?

•Price Volatility–Causes and Consequences

•Some challenges

•The Response

Public policy

Private Risk Management

•Conclusions

Overview

2

Definition of Price Volatility

Price volatility is a directionless measure of the extent of the variability of a price.

(Gilbert and Morgan 2010)

Note that sustained high or low prices (inadequate) do not constitute volatility.

Volatility - implies unstable prices that are hard to predict

3

EU Dairy Commodity Prices (€/tonne)

Jan-

90

Sep-9

2

May

-95

Jan-

98

Sep-0

0

May

-03

Jan-

06

Sep-0

8

May

-11

Jan-

140

500

1000

1500

2000

2500

3000

3500

4000

4500

Butter SMP

4Source USDA.

EU Butter One Month % Change

Jan-

90

May

-91

Sep-9

2

Jan-

94

May

-95

Sep-9

6

Jan-

98

May

-99

Sep-0

0

Jan-

02

May

-03

Sep-0

4

Jan-

06

May

-07

Sep-0

8

Jan-

10

May

-11

Sep-1

2

Jan-

14

May

-15

-20

-15

-10

-5

0

5

10

15

20

5

EU Butter One Month % Change

-20

-15

-10

-5

0

5

10

15

20

6

±5%

±10%

EU Butter Three Month % Change

-40

-30

-20

-10

0

10

20

30

40

50

7

±7.5%

±20%

1500200025003000350040004500

1990-2006 2007-2015

€/Ton

neMid 90% Range Butter

€2,596 to €3,443

€2,214 to €4,070

Seasonal and Cyclical Behaviour of Farm Gate Milk Prices

• Much of the huge price volatility in recent times is attributed in large part to the seasonal and cycle components. Bergmann, D., O’Connor, D. & Thummel, A. (2015)

• This means that volatility can nearly be fully explained by these model components which suggests that much of milk price volatility is endemic to the dairy industry.

• Suggest that policy interventions and strategies should be countercyclical.

9

Consequences of Increased Price Volatility

• “Normal” volatility is desirable. It reflects changes in supply, demand and policy and provides price signals to facilitate efficient reallocation of resources.

• Extreme volatility is undesirable with many adverse consequences

10

Extreme Volatility – Adverse Consequences

• Cashflow/Planning (leads to variances)• Investment• R&D• Substitution/ Supply Reduction

Buyers (ingredient and retail) prefer to do business with suppliers providing stability, price and volume (retail prices are sticky)

11

Causes of Price Volatility

• Economic Fundamentals, - Demand, Supply

• Policy Change- E.g. Luxembourg Agreement (2003)

• Market Speculation- Hedge Funds, Index Traders

Who are the biggest speculators today?

12

Causes of Price Volatility – Economic Fundamentals

• Unique Characteristics of demand for Dairy (and Food) Commodities i.e. Inelastic Demand– Modest scarcity causes prices to be bid up to very high levels– Modest surplus causes prices to fall to very low levels to clear

market– Modest scarcity or surplus are frequent occurrences (weather,

disease etc.)

• Impact further accentuated by low stocks

• Production takes a considerable time in agriculture and dairy in particular

13

The Role of Public Policy in Dairy• The “Old” CAP

– Intervention Buying – Export Refunds– Import Levies– Subsidised Consumption– Aids to Private Storage

• 2003 Fischler Reform – Reduced intervention (price & volume)– Direct Payments

• 2008 Health Check – Phasing Out of Milk Quotas

• 2012 Milk Package (apply until mid-2020 with 2 reviews)– Written Contracts– Producer Organisations– Interbranch Organisations– Milk Market Observatory 14

The CAP Towards 2020

15

• The end of the quota regime (April 2015). • Provision of a safety net (“public intervention" private

storage aid). • Export refunds can be used in cases of market

imbalances.• Access to crisis fund (€400 million p.a.)• Specific ad-hoc measures in case of emergency or

significant market disturbances such as the so-called School Milk Scheme.

• The Commission may grant aid for skimmed milk and skimmed-milk powder intended for use as feeding stuffs or to be processed into casein and caseinates.

• Income stabilisation Tool• Mutual Funds

Hammock to Safety Net to……

16

The Challenges• Milk is a complex product• How do we bridge the gap between milk and

product prices?

17

EU Farm Gate Milk Prices Jan-09 to June-15

18

60

50

40

30

20

10

60

50

40

30

20

10

Data

The Challenges Cont.• A long supply chain

– Who takes the risk?– Transfer it to third party?

Farm Processor FurtherProcessor

Retailer Consumer

19

The Challenges Cont.

• Back to Back Contracts

Farm Processor FurtherProcessor

Retailer Consumer

20

The Challenge• Price is only one element of income/profit

– Yield– Inputs

Milk Processor FurtherProcessor

Retailer Consumer

Note US dairy policy has moved from direct payments to margin insurance.

Inputs

21

Private Risk Management Options

• Forward Contracting• Futures Markets • Options • Over the Counter (OTC) Contracts• Insurance Products• Mutual Funds

22

Milk and Dairy Farmers are not Homogeneous

  Fat contentProtein content

Apparent Yield (kg/head)

Apparent milk output per farm (tonnes)

Bulgaria 3.68 3.28 6,924 46.0Denmark 4.26 3.52 7,592 1292.8Germany 4.12 3.41 8,963 367.8Ireland 3.94 3.39 7,882 290.0Latvia 4.08 3.26 5,438 64.5Lithuania 4.16 3.25 6,651 32.8Netherlands 4.40 3.53 7,265 630.1Poland 3.98 3.21 7,769 64.2Romania 3.79 3.27 5,532 2.6Slovenia 4.14 3.37 8,005 65.3United Kingdom 4.03 3.26 8,254 921.1

23

Is Margin Insurance Feasible?

24Dairy Farm Gross Margin with Coupled Payments per Member State 2011Source: EU FADN – DG AGRI

Insurance Cont.

• Data.• This will take time.• Do we want a “Common” Agricultural

Policy• Choice between direct payments and

subsidised insurance?• May distort market signals

25

EEX/EUREX Cumulative Volumes (as at July 31 2015)

0

2,000

4,000

6,000

8,000

10,000

12,000

Co

ntr

acts

Totals: Butter 7,879 SMP 2,229 and Whey 1,0062015: Butter 1,425 SMP 362 and Whey 232 26

Exchanges Comparison

• EEX 55,570 tonnes V NZX 273,200 (end July)

• EEX 5 Tonne contracts V NZX 1 Tonne• NZX WMP Options 59,305 (to Aug 21th)• NZX WMP ~ 80% (Futures and Options) • EU OTC Market • EEX hedging products not milk

27

Basis For German Farm Gate Milk Price (€/100 kg of milk).

Jul-0

9

Nov-0

9

Mar

-10

Jul-1

0

Nov-1

0

Mar

-11

Jul-1

1

Nov-1

1

Mar

-12

Jul-1

2

Nov-1

2

Mar

-13

Jul-1

3

Nov-1

3

Mar

-14

Jul-1

4

Nov-1

4

Mar

-15

-8

-6

-4

-2

0

2

4

6

8

€/10

0/ K

g

28

What is required?

• These options are based on risk sharing or risk transfer so they will require

–Data–Education–Support

29

Conclusions• Volatility in EU dairy is an established

phenomenon.• As well as being more volatile prices are

reaching new highs and lows and the nature of milk prices has changed.

• Volatility affects the entire supply chain.• Dairy farmers are heterogeneous.• Unlikely there will be a policy led solution

in the short term.

30

Conclusions• However there are gaps

– Data, Education, Critical Mass

• Solutions should be voluntary but nobody has a veto.

• There is a role for communication and co-operation.

• Reward is competitive advantage– Early mover advantage (GDT/NZX?).

• Learn from others (USDA subsidised trades, data, education).

31

Thank you

Declan O Connor

Cork Institute of Technology

declan.oconnor@cit.ie

32