Box C: Implications of a lower milk price for indebted dairy farms
This page contains information on the implications of a lower milk price for indebted dairy farms from the May 2015 Financial Stability Report.
Between 2003 and 2009, dairy sector debt increased from $11.3 billion to $29 billion. Although this occurred alongside an increase in production levels, debt per kilogram of milksolids (kgMS) rose from $9.50 to $20.80 over the same period. Slower growth in dairy debt, reflecting significant reductions in farm investment and the value of farm sales, has since seen debt per kgMS fall to $18.90 (see figure 4.8). This box uses farm-level data from DairyBase, a benchmarking tool for dairy farmers operated by DairyNZ, to provide an updated assessment of the distribution of debt within the sector. The data includes approximately 2,000 farm financial statements, spanning the three most recently completed seasons (2011- 12, 2012-13, 2013-14).1
Consistent with previous work, debt remains concentrated among a relatively small group of indebted farms (figure C1).2 As at the end of the 2013-14 season, 10 percent of farms accounted for around one-third of the total sectoral debt. These farms tend to have higher levels of debt relative to output, leaving them more susceptible to worsening sectoral conditions. For example, the 10 percent of most indebted farms have average debt in excess of $25 per kgMS, compared to less than $10 of debt per kgMS for the least indebted 20 percent of farms. More generally, approximately 24 percent of dairy debt is owed by farmers with debt in excess of $30 per kgMS.
Figure C1: Distribution of debt in the dairy sector (by decile of debt, end 2013-14 season)
Note: Decile 1 refers to the least indebted 10 percent of farms.
With current milk prices near five-year lows, and a weak outlook for prices well into next season, it is likely that dairy farmers will face difficult conditions for two consecutive seasons. Fonterra’s payout for the 2014- 15 season is forecast to be approximately $4.75 per kgMS for a fully share-backed farmer, resulting in an effective milk income of around $5.70 per kgMS after including deferred payments from the strong 2013-14 season (see figure 4.7). Even if milk prices were to recover somewhat in the 2015-16 season, effective dairy income could remain around current low levels, as deferred payments are expected to be considerably lower than this season.
Figure C2 shows simulated cash flows for the 2014-15 season, after adjusting the farm-level data from 2013-14 in line with DairyNZ forecasts of effective milk income and working expenses.3 As the lower payout for 2014-15 was signalled well in advance, these forecasts allow for a fall in working expenses as farmers attempt to manage the decline in their cash flow. The dotted line shows ‘break even’ combinations of dairy operating margin and interest and rent costs, with farms below the line unable to service interest and rent costs out of their operating margin. Approximately 25 percent of farmers (representing around 32 percent of sectoral debt) are estimated to have negative cash flow on this basis. Unless these farmers are able to generate income outside their core dairy operation, this negative cash flow is likely to result in an increase in working capital borrowing. Farmers experiencing negative cash flow are also likely to cut back on farm development and reduce drawings.
Figure C2: Estimated farm cash flows (dollars per kgMS, 2014-15 season)
Note: Operating margin refers to milk and livestock income less working expenses. Farms below the dashed line (in red) are estimated to be facing negative cash flows in the 2014-15 season.
A key driver of weak profitability in the dairy sector is a low operating margin, primarily due to relatively high working expenses. For example, the least profitable 10 percent of farms have average working expenses around $2 per kgMS higher than the most profitable 10 percent of farms. Farmers who have less scope to reduce working expenses, including those reliant on imported feed, are likely to be particularly susceptible to low milk prices. High debt levels relative to output also create a further drag on cash flow in the form of higher debt servicing costs. On average, the most profitable farms have $14.90 of debt per kgMS (with associated interest costs of $0.70 per kgMS), compared with $23.50 (and interest costs of $1.50 per kgMS) for the least profitable farms.
Banks continue to have a largely positive view of the long-term outlook for the sector, and have been easing credit conditions for working capital borrowing. However, the availability of additional borrowing could be limited for some farms that already have elevated loan-to-value ratios (LVRs). As shown in figure C3, there is a significant crossover between farms estimated to have negative cash flows in the current season and farms with already elevated LVRs (above 65 percent). Around 11 percent of dairy debt is owed by such farms, while farms with relatively high LVRs account for 27 percent of sectoral debt. It is likely that the number of foreclosures among these indebted farms will eventually increase if weak cash flow persists for multiple seasons. Bank losses associated with these foreclosures would be exacerbated if land values fall alongside weaker farm incomes.
Figure C3: Estimated distribution of debt by LVR and cash flow (percent of dairy debt, 2014-15 season)
Note: Horizontal axis refers to loan-to-value ratio.
2 Previous Reserve Bank analysis found that more than half of sectoral debt was owed by the most indebted 20 percent of farms in the 2008-09 season. See Hargreaves, D and G Williamson (2011), ‘Stress testing New Zealand banks’ dairy portfolios’, Reserve Bank of New Zealand Bulletin, 74(2), June.
3 Estimated milk income is based on an average of $5.70 per kgMS, with farm-level income altered to reflect previous differences relative to the average farm. Working expenses are estimated by taking 2013-14 values and applying a random change according to a normal distribution with mean -$0.25 per kgMS and standard deviation $0.10 per kgMS. All farms are assumed to make $0.38 per kgMS from livestock income.