“You can’t just turn cows on and off”

An article in the WSJ highlights how over optimistic expectations over Chinese demand growth helped contribute to the current lull in commodity prices we are seeing. In this article they show how strong Chinese demand growth for dairy products soared between 2008 and 2013 prompted farmers in New Zealand to ramp up production to to supply the growing demand.

“Chinese imports of whole dry milk powder soared to 619,000 metric tons in 2013 from just 46,000 in 2008, according to U.S. Department of Agriculture data. Farmers in New Zealand ramped up production to supply the growing demand, adding 450,000 metric tons of capacity during that stretch, an amount that is equal in weight to about one billion 16-ounce milk containers.”

Then when demand fell short, prices collapsed.

China’s imports of dry powder milk have since flattened. Its inventories of the product tripled between 2011 and 2014, and prices tumbled, according to the USDA.

Related article: Dairy price rebound looks unsustainable on weak Chinese interest

Since the start of 2014 whole milk powder prices have dropped from $5,000 per tonne to $2,300 per tonne (GlobalDairyTrade)

Expectations are vitally important to commodity markets. Indeed, their importance, particularly in agricultural markets has been recognised for almost 150 years.

“….A scarcity or abundance of crops affects the exchange of the world, and tends to forecast future prices, and to give some clue to future production…”

Samuel Benner, “Prophecies of Future Ups and Downs in Prices” (1876)

Cow face, Otago Peninsula, NZ

The observation was expanded on further through The Cobweb Theorem, developed in the 1930s. The theory shows how supply and demand responds in a market where the amount produced must be chosen before the price is observed. Agriculture is a great example of where the theory might apply, since there is a lag between planting and harvesting.

Suppose for example that as a result of unexpectedly bad weather, farmers go to market with an unusually small crop of wheat, resulting in higher prices. If farmers expect these high price conditions to continue, then in the following year, they will plant more wheat relative to other crops.

When they then go to market after the crop has been harvested, supply will be high, resulting in a drop in the price of wheat. And so it goes on. If they then expect low prices to continue, farmers will reduce planting of wheat for the subsequent year, resulting in a return to high wheat prices yet again.

Very short-sighted of those farmers, you might say.

Critics of the Cobweb Theory have argued that rational farmers should be able to work out what the equilibrium level of supply should be, given current information about supply and demand. The farmers, it is argued should base their price expectations on how they expect the market is likely to work, rather than just reacting blindly to price movements.

Back to those dairy farmers in New Zealand and their expectations of Chinese demand. Were they short-sighted too?

Well, may be a little.

When prices have been high and rising for some time (as it was for dairy prices as with many other commodity prices), it becomes an entrenched assumption that high prices will persist for the foreseeable future and vice versa. As much as you or I like to think of ourselves as forward-looking, the truth is that we are all backward-looking to some degree and update our perception of the world only gradually (something called adaptive expectations).

However, as with iron ore miners who reacted to strong Chinese demand growth in 2005 to bring on more iron ore supply, there is a time lag between the decision to increase supply and that supply actually materialising.

What will be interesting now is how dairy farmers in New Zealand respond. Will they now look to reduce the size of their herds, perhaps setting the stage for the next surge in dairy prices?

“You can’t just turn cows on and off”

See the FT 4th June 2015 “Dairy price plunge highlights hedging handicap”

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