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12 January 2009

Fonterra flunks milk powder flak test


Fonterra’s introduction in July last year of an internet auction system, globalDairy Trade for whole milk powder (WMP) was a lightning rod for critical comment from farmers, commentators, competitors and media. Expect more criticism in 2009, especially if milk powder prices continue their slide.

For a business that has a focus on brand and added value product development, the decision to auction your product seems counter-intuitive.  Certainly, it is hard to imagine our meat exporters going back to wharf-side auctions of carcases in the UK to “determine the true market price” of lamb – the rationale Fonterra has given for its auctions.

Traditional auctions are attractive to speculative middlemen who profit from large price swings – in contrast to those at the production and selling ends of the marketing chain who want price stability. Also they tend to reduce everything to a price on the day – distorting or eroding margins for quality, service and appellation – the exact opposite of what brand development is designed to achieve.

It is for these reasons that commodity auctions have a bad rep in the NZ primary sector. While auctions are still used to dispose of both wool and deer antler velvet, the new PGG Wrightson joint venture with sheep farmers looks likely to diminish the importance of the wool auction. For their part, the deer antler pools are widely discredited and also appear to be on their last legs. In both cases, many growers are convinced that their future lies in creating a seamless production and marketing supply chain under producer control.

That said, commodity auctions can be made to work, especially in circumstances where there are multiple producers selling virtually identical bulk commodity staples to multiple buyers. The former Wool Board did this successfully through the 1970s and 1980s, using intervention bidding and floor prices to smooth price fluctuations and in the event of a market crisis, to act as buyer of last resort. The system fell apart only when farmer politicians decided to push its intervention prices above the long-term price trend line.

WMP meets many of the criteria for successful selling through an auction, especially one that is as sophisticated as the one devised for Fonterra by CRA International, an international consultancy that has organised auctions for things as diverse as radio spectrums, natural gas and electricity supply, and the sale of shares in government-owned companies.

Basically, the monthly auctions involve buyers offering to buy quantities of product for future delivery at prices set by the trading manager in a succession of bidding rounds. In each round, each bidder enters the volume they wish to purchase at the announced price.  In each successive round, the trading manager raises prices and bidders enter new volumes and this continues round-by-round until the available volume is cleared.

The process has many advantages over traditional spot market auctions for wool, fresh produce or deer antler velvet.

All customers have equal opportunity to secure supply and winning bidders pay the same base price for the same product and contract maturity  They can choose their desired mix of contract maturities and hence their own exposure to commodity price risk. And because the volumes on offer and the timing of the auctions (Fonterra calls them trading sessions) are published up to 12 months ahead, customers know when and how much product is being offered.

Most importantly, the system is designed to make it almost impossible to ‘game’. Partly because of this, it will tend to dampen down the wild price fluctuations and distortion of margins for quality – major downsides of traditional auctions.

Fonterra expects to sell approximately 200,000 tonnes of NZ-sourced WMP on globalDairy Trade during its first year of operation.  Other commodity products like skim milk powder (SMP) and products from other suppliers will be added later.

We have gone into this detail here, because none of it has been highlighted by critics. They all blame the globalDairy Trade auctions for the decline in WMP prices from a peak of US$5000 a tonne in 2007 to around $2000 a tonne now. But they fail to point out that milk powders traded in a US$2000-2500 a tonne range for more than a decade before spiking at the much-quoted $5000 level.

The critics can’t have it both ways. If the globalDairy Trade auctions cause price instability, how do they explain the hugely disruptive 2007 price spike that occurred more than a year before globalDairy Trade started business? The reality is that prices are returning to the long-term trend line – something that is not only inevitable – it’s in the interests of everyone in the marketing chain from producer to consumer.   

So why the criticism?

For competitors – Dairy Australia, Westland Milk Products, New Zealand Dairies and independent exporter Global Dairy Network – criticism comes cheap. But there’s no substance to it. Prices for skim milk powder – which is not auctioned – mirror those for WMP. Indeed, there is a scary match between the Brent oil price and prices for WMP and SMP (see graphic at bottom of link web page).

The criticism of the globalDairy Trade auctions builds on long-standing negative rural perceptions of commodity auctions in general. While business and farm editors had the system explained to them by Fonterra when it was launched, it is clear from their comments than many critics don’t (or don’t wish to) understand what’s involved.

But by failing to stay in contact with the media and leaving its critics in the media and blogosphere unanswered, Fonterra is allowing the public perception to grow that its milk powder marketing is incompetent and destructive of prices. If Fonterra wants globalDairy Trade to realise its potential and for its own reputation as a responsible trader to remain intact, it needs to manage this debate with much more professionalism than it has to date.


- Trevor Walton

What do you think?

Sam Poa
That's easy for you to say. If Fonterra acted along the lines you recommend, it would be all hui and no dooey.

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