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 16 th 2015, Prague 1

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) 4 Source USDA.

EU Butter One Month % Change 5

6 ±5%±10%

EU Butter Three Month % Change 7 ±7.5 % ±20%

Mid 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 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

The Challenges Cont. A long supply chain –Who takes the risk? –Transfer it to third party? Farm Processor Further Processor Retailer Consumer 19

The Challenges Cont. Back to Back Contracts Farm Processor Further Processor Retailer Consumer 20

The Challenge Price is only one element of income/profit –Yield –Inputs Milk Processor Further Processor RetailerConsumer 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 content Protein content Apparent Yield (kg/head) Apparent milk output per farm (tonnes) Bulgaria , Denmark , Germany , Ireland , Latvia , Lithuania , Netherlands , Poland , Romania , Slovenia , United Kingdom ,

Is Margin Insurance Feasible? 24 Dairy Farm Gross Margin with Coupled Payments per Member State 2011 Source: 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 ) Totals: Butter 7,879 SMP 2,229 and Whey 1, : Butter 1,425 SMP 362 and Whey

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). 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 32