Canadian Dairy Farmers: Not Crying Over Spilt Milk
By: Quintin Tack
The Ivey Business Review is a student publication conceived, designed and managed by Honors Business Administration students at the Ivey Business School.
Quintin Tack
The North American Free Trade Agreement (NAFTA) showdown between Canada and the United States is a looming item on Justin Trudeau’s agenda in 2017. The interests of the American exporters against protected sectors like dairy, telecommunications, airlines, and banks will be major talking points. In particular, criticism of Canada’s dairy supply management system will spur plenty of debate. This regulatory system requires all dairy farmers to acquire fixed production quotas and subsequently, sell their raw milk through the provincial milk marketing board. Though initially established to guarantee minimum pricing on milk products, the milk marketing board has since created a monopoly on raw Canadian dairy products as all dairy processors are required to adhere to prices set by the marketing board.
Canadian dairy supply management has been vulnerable to various loopholes, which enable innovators and third parties to benefit at the expense of producers. Until 2013, pizza chains circumvented protectionist tariffs by sourcing their cheese from “pizza making kits” rather than traditional cheese suppliers. Tariff aversion has gone as far as giving rise to a black market for cheese that can net $1,000 per truck load from the U.S. to Canada. Without any meaningful change, the dairy industry is positioned to continue hemorrhaging value. Therefore, Canadian dairy farmers should diversify risk by developing ancillary revenue streams in the form of beef production. Aside from economies of scope between dairy farming and cattle ranching, there are several positive catalysts such as improved consumer perceptions and regulatory environment.
Disappearing Import Controls
Maintaining artificially high milk prices requires the Canadian government to place tariffs on incoming dairy products. In this manner, less expensive imported milk is marked up from 200 to 300 per cent to limit pricing shock in the Canadian milk market. The effectiveness of these import controls is being increasingly called into question by Canadian trade partners. In response, Canada has agreed on free trade amendments that reduce these tariffs. In particular, the recently signed Canadian-European Union Comprehensive Economic and Trade Agreement (CETA) allows the EU to export an additional 18,500 tonnes of cheese to Canada tariff-free, a figure that represents 4.3 per cent of the Canadian market. The net impact to the Canadian dairy farming industry will be a revenue reduction of $116-million, or two per cent of the $6-billion market. The Trans-Pacific Partnership (TPP) contains similar provisions; should it be ratified, the agreement will result in a similar revenue reduction for Canadian milk farmers.
President Donald Trump’s administration would to like change America’s previously non-existent role in the Canadian dairy market, a move that will further compress dairy farmers’ margins. At present, the Canadian dairy industry is excluded from the NAFTA, meaning that American dairy farmers have limited access to Canada’s captive dairy market. Should market access be granted, American farmers will pursue Canada vigorously as the American supply outpaces the domestic demand. In the first eight months of 2016, American farmers dumped 1.6 million hectolitres of milk due to lack of demand, enough to supply two per cent of Canada’s production.
Granting American farmers access to the Canadian market will undermine the supply management system and cause downward price pressure. American dairy farmers have 16 per cent lower costs of production on average compared to Canadian farmers. Aside from concerns over NAFTA, recent technological developments in the dairy processing industry provide an example of downward price pressure resulting from American market access. A particular example to scrutinize is diafiltered milk, a new milk “ingredient” containing 85 per cent protein. As a milk “ingredient”, the tariffs which apply to other imported dairy products do not apply to diafiltered milk. Diafiltered milk is imported into Canada and used to make cheese. Reducing the necessary amount of milk required for production will cost Canadian farmers $220-million in lost revenue per year. To combat the entrance of diafiltered milk and maintain market share, the Ontario Milk Marketing Board (OMMB) has created a new class of milk products. Instead of using their traditional cost plus pricing mechanisms, the OMMB has competitively priced this milk against the cheaper American diafiltered milk. Overall, this reduces the average price and profit of products sold by Canadian dairy farmers. Whether market access results from loopholes created by technological developments or renegotiations of NAFTA, Canadian farmers who have higher overall costs, cannot win a race to condense margins.
An Environment of Complacency
Since the introduction of supply management in the early 1970’s, dairy farming has been one of agriculture’s most attractive sectors. Dairy farms have agriculture’s lowest operating expense ratio on a cash basis at 0.73, in comparison to overall agriculture at 0.83. In addition, the industry has experienced steady revenue growth of two and a half per cent from 2008 to 2015, culminating with all-time high production in 2015 of 81.8 million hectolitres. In addition to being responsible for this profitability, many believe that rigid supply management by the federal government has resulted in complacency amongst dairy farmers. To outsiders, it appears that the industry has spent more energy trying to preserve the system rather than preparing for its inevitable erosion.
Limited Opportunities for Margin Increases
Dairy farmers could increase profitability through expansion of their operations. Taking advantage of economies of scale, the largest tertile of dairy farms have 12 per cent lower production costs compared to dairy farms in the smallest tertile. These economies of scale predominantly arise from labour savings. However, expansion is difficult to implement within the supply management system. In order to expand, producers must acquire increased production quotas, though these are in short supply and can be prohibitively expensive. In fact, the most recent Ontario quota exchange received bids for 10,465 units of quota; however, only 369 units were available for sale. This means buyers had a success rate of less than four per cent. Moreover, the quota price was also set at $24,000 per animal.
Continued import control erosion and its associated decrease in dairy farm profitability will eventually soften the quota market, meaning farmers expanding now may stand to lose a sizable amount of quota investments. On top of this, even the largest Canadian producers have 13 per cent higher costs than the average American producer, suggesting this solution will not adequately protect farmers from cheaper American imports.
At present, the vast majority of Canadian dairy farmers sell a commodity product and accept the price the milk marketing board offers them. Also, dairy farmers store unprocessed milk in its raw form until it is shipped to large processing facilities. Under a marketing board pilot project, some dairy farmers have set up micro-dairies to process their own raw milk and create finished dairy products, including two per cent milk and cream which can be sold to consumers. Although these farmers have been successful in creating a distinct product, only a small market niche of consumers are willing to pay higher prices for a traceable local product. On the whole, milk will remain a commodity product from the farmer’s perspective and in the grocery store. As a result, opportunities for forward integration and its associated differentiation will remain limited for dairy farmers.
The Beefy Solution
Instead of expanding or attempting product differentiation, dairy farmers should develop ancillary revenue streams. In light of the predicted market trajectory, this strategy will allow farmers to maintain profit margins as the dairy industry adapts to decreased import controls. Dairy farmers only need to look at their operation and some of its by-products to find the solution: beef production.
Dairy farmers continually breed their cows in order to maintain a supply of milk production. A typical cow gives birth to its first calf at 2 to 3 years of age. Then, the cow is continually bred, giving birth approximately every 14 months. As with humans, 50 per cent of the offspring are male and 50 per cent female. Typically, dairy farmers keep and raise their female offspring in order to replenish and grow their herd. The male calves, on the other hand, are typically sold off the farm at birth to veal and beef producers.
Instead of selling the animals, dairy farmers can increase revenue and profits by keeping male calves and raising them to maturity. The average dairy farm, with a milking herd of 85 cows, produces approximately 37 bull calves on an annual basis. Adding an ancillary beef component to their existing dairy operation by raising bull calves will allow dairy farmers to take advantage of economies of scope between the two industries.
Economies of Scope Between Industries
Expanding into the business of raising beef cattle would only require a small capital investment from dairy farmers because they already possess most of the required machinery and infrastructure. For example, dairy farmers already have all the equipment required in a beef operation such as tractors, feed mixers, and manure spreaders. Capital expenditure is limited to the required barn and its associated fixtures including gates, feeders, and managers. For the average dairy farmer with a milking herd of 85 cows and 37 bull calves a year, the capital expenditure would represent an investment of approximately $25,000. Based on current market prices for feed and cattle, this project would net approximately $11,900 annually. In comparison to the average Canadian dairy farms operating income of $70,000 to 80,000, this plan represents a 15 per cent increase in income. It compares favourably to the dairy capacity expansion alternative discussed earlier. For every $24,000 investment in an additional unit of quota, operating income only increases by $1,700.The expansion will also allow dairy farmers to leverage their existing skillsets and human capital to diversify their businesses. Farmer expertise includes knowledge about keeping cattle healthy, treating them for various ailments, and developing food ration programs that will result in strong milk production. Many of these skills would be transferable to beef production. Also, looking after additional beef operations would require minimal operational changes on a dairy farm. Currently, dairy farmers split their time between looking after their milking herd and heifers, females being raised to become milking cows. The milking herd requires intensive care with frequent feeding and milking at least twice daily. On the other hand, heifers in milk production have similar requirements to calves in beef operations, namely feeding and barn cleaning. In this manner, caring for the beef operation could be easily added to the existing heifer routines.
Dairy farmers should also consider the merits of expanding this ancillary beef operation beyond raising just their own production of bull calves. Purchasing bull calves from neighbouring dairy farms would allow the beef operation to grow considerably, thereby generating additional income with minimal investment and operational changes.
The Attractiveness of the Beef Industry
The Canadian beef industry relies and thrives on free trade. In fact, 45 per cent of Canadian beef is exported. Free trade deals, such as CETA and TPP, have the ability to increase revenues and beef production in Canada. CETA, for example, has provisions for $600-million in tariff-free Canadian beef exports to the EU. In addition, Canada has recently won a longstanding World Trade Organization (WTO) proceeding against the U.S. over Country of Origin Labelling (COOL). This American regulation required U.S. processors to segregate Canadian cattle from American cattle within abattoirs. This segregation caused Canadian cattle to sell at depressed prices, costing Canadian producers one billion dollars annually in lost revenue. With these regulations gone, Canadian beef producers will see an increased demand and fair prices for their cattle in American markets. Coupled with recently repealed export bans to Asian countries, a growing market for Canadian beef exports has been established. Partly due to these reasons, the Canadian beef industry is enjoying some of its highest prices on record, with the 2016 average price at $141.9 per hundredweight. In comparison, the 10-year average is $108.7 per hundredweight. Forecasts predict price increases in 2017 and 2018 of 0.3 and 2.85 per cent respectively. Dairy farmers are uniquely positioned to take advantage of a stronger beef industry and counteract the dairy industry’s reduced profitability.
Raising Dairy Farm Profitability
Dairy farmers should consider developing an ancillary revenue stream by adding beef production to their existing operation. This expansion will require small capital expenditure due to economies of scope that exist between dairy farming and cattle ranching. Dairy farmers will be positioned to take advantage of the expected upswing in the Canadian beef industry due to increasing exports. Dairy and beef production are moving towards opposite ends of the regulation spectrum. Whereas beef production will have increased whitespace going forward, Dairy farmers will face weakening import controls as the Canadian government continues to negotiate and renegotiate free trade deals. Weaker import controls will result in downward price pressure and shrinking domestic market share. Dairy farmers who want to maintain their bottom-line have limited options available. Expansion within dairy is difficult due to the limited production quota available and lower cost structure of American producers. Downward vertical integration opportunities are limited by the size of the niche, premium dairy market.