Supply management : nobody is getting the facts right. Here are some examples.

Apparently, neither proponents nor opponents of supply management are able to present their figures in an unbiased rigorous fashion.

Consolidation of dairy farms has been faster in Australia than in Canada. Well, it depends on the period you want to consider. For instance, between 1970 and 2014, consolidation has been faster in Canada. Over this period, the number of Canadian dairy farms decreased by 78%, 71% in Australia. For the period 2008-2014, the rate slowed significantly in Australia to 16% (8% in Canada). Production wise, between 1970 and 2013, Australia experienced a 23% increase while production in Canada barely grew (+1%). Between 2008 and 2013, production grew by 3% in both countries. However, there is one common dynamic: the five to ten-year period following a significant policy change (introduction of supply management in 1970 in Canada, deregulation in 2000 in Australia) saw a rapid consolidation and a drop in production in both countries, which is to be expected as farms have to adapt to a new environment and delayed changes are accelerated. Besides, it is interesting to see that nobody talks about the extreme drought experienced by many Australia regions between 1995 and 2009 (especially between 1995 and 2003) and how it has affected dairy farms, most likely magnifying the effects of deregulation. Similarly, since the introduction of a price cap on quota in 2007, quota markets in Canada are feeble and the recent consolidation rate in Canada has been slowed somehow artificially.

I also find a bit misleading the comparison of milk retail price used by Dairy Farmers of Canada, especially in the case of France, a country I know very well. Unlike Canada, most of the consumption of fluid milk in France is made of UHT ½-skimmed milk (about 70% of fluid milk retail market). The average price per liter of UHT ½ skimmed milk in France was 1.15 CAD according to official statistics, not 1.81 (the price of fresh whole milk). I have not checked yet any such discrepancies for the other countries used in the comparison. Any relevant comparison of milk price must account for the differences between milk consumption patterns.

Talking about price, I took a look at egg prices in Canada, at the farm gate and on the retail shelf. It was very instructive. First, farm gate prices in Canada are in line with wholesale price in the US. This means that Canadian egg producers could be competitive on the North-American market, especially considering the strength of biosafety protocols in Canada. However, the most interesting thing is the differential between farm gate and retail prices which has been growing for a decade or so (see figure below).

egg data

Regarding economic contribution of the dairy industry, the proponents of supply management tend to forget to outline that about a third of contributed jobs and GDP, half of fiscal revenues come from the induced effect, which is the most tenuous one and is widely debated in economists’ circles as to its relevance. Besides, they do not highlight how Saputo and Agropur are the cornerstones of the industry nor do they show what would be lost in phasing out supply management (perhaps they want us to believe that all would be lost).

We could fight over these figures forever and forget what the real issues are.

The real issues for the dairy industry are that strengthening forces are weakening the three pillars of supply management: import control, production discipline and price fixing. I have discussed them in a previous post. Like any public policy, supply management has an expiry date, and my guess is that it is before 2030. By then, supply management could well be about 6,000 dairy farms, a handful of dairy processors, and a few retailers fighting over a dormant market, triggering at some point a major crisis originating in a spat between Ontario and Quebec. The dairy industry itself will ask for dismantling supply management, but it may well have lost any political goodwill – the fourth pillar of supply management – to fund the transition by that time.

Some people should really think honestly about the two following questions: how long can we expect to make supply management work in the interest of most of its stakeholders? Are we sure we can get enough political support for massive assistance funding when time comes?  Right now, there is an apparent consensus on the fact that phasing out supply management requires financial assistance for dairy farmers and processors. The industry should take advantage of that to develop a vision and a strategy, and start investing in its future.

Phasing out supply management in Canada is not that simple

In a previous post, I have highlighted that supply management will likely be phased out within the next 15 years, either because of trade agreements or because of internal tensions which could morph into fault lines. I have been quite critical of some of the arguments used by the proponents of supply management because they don’t pass the test of facts. I will be equally critical of some of the arguments of the adversaries of supply management.

Martha Hall Findlay and Jack Mintz recently published an opinion piece in the Globe and Mail in which they outline a possible scheme to phase out supply management in Canada. Their proposal is to transpose to Canada what was implemented in Australia following the deregulation of the dairy market in 2000, namely a temporary levy on fluid milk sale to finance a quota buyout to help dairy farmers transitioning to an open market. However, one key element seems to be missing there : geography matters to trade patterns.

The Australian domestic market for fluid milk is, well, quite insulated from any competition. Therefore, substitution by cheaper imports was not a threat to Australian dairy farmers on that specific market.

In the case of Canada, the situation will be very different. If a levy was imposed on any fluid milk sale in Canada while the market is totally open, the retailers would have many incentives to substitute Canadian milk by cheaper US milk. One fact to remember here: the US states neighbouring our border produced in 2014 about 5 times more milk than Canada in its entirety (Wisconsin alone produced more than Canada). The threat of substitution will be very real in the aftermath of a brutal end of supply management. Moreover, such substitution by retailers would happen very quickly, much faster than any adaptation at the farm level.

While operating costs are fairly similar on average between dairy farms in these US states and Canada, capital and labour costs are quite higher in Canada, partly due to unrealized economies of scale. Consequently, to have a chance to compete against US dairy farms, Canadian dairy farms must be given time to transition and realize their economies of scale.

In these conditions, I think that an Australian-style levy on fluid milk would have dire consequences on the Canadian dairy industry.

The current debate has been painting supply management as the last Canadian obstacle standing in the way of the TPP agreement. Obviously, this is not true as many other issues are contentious but too often perceptions are stronger than reality. In the meantime, the dairy industry contributes significantly to the Canadian economy. So, we could say that the stakes are high.

Unfortunately, the public debate is rather poorly informed and too many arguments – for or against supply management – are weak, resorting to wishful thinking, twisting facts. What is particularly missing is foresight. Fortunately, the federal government has a group dedicated to such exercise, Policy Horizons Canada. Perhaps, it could be mandated to lead a foresight study of Canadian supply-managed industries, allowing scenarios with and without supply management in different forms.

The phasing-out of supply management in Canada will be initiated before 2030, regardless of TPP.

The current debate about the TPP negotiations and their consequences for the future of supply management in Canada is not about the merits and benefits of supply management themselves. It is about Canada’s bargaining power in negotiations it has been invited to and to which it may not be an essential party. As of now, it seems that Canada has a rather weak hand and will have to commit to open its dairy market somehow or risk being sidelined. I’m not privy to the negotiations and my opinion has been forged on what has been publicly disclosed.

Supply management has undeniably served the Canadian dairy industry very well, allowing among other thing dairy farmers to increase their income and wealth over the years and two dairy processors (Saputo and Agropur) to develop into major global players. Over the period 1998-2014, the number of dairy farms has been almost halved. Production has increased only by 4%, following a sleepy growth in consumption of dairy products driven by demographics and changes in food consumption pattern. Today, the three largest dairy processors control about 80% of the market. The Canadian dairy industry could be said to be relatively mature. However, even if supply management survives the current TPP negotiations, its future is uncertain as adverse forces are gathering strength, threatening the three pillars of supply management (import control, producer pricing and production discipline) from within.

The strongest force is the weakness of growth potential in the domestic market which, because of supply management, will translate into a marginal production increase. On the processing side, maintaining or increasing margin will then require to lower supply cost, which will result in a downward pressure on milk price and concomitantly in an increased use of imported ingredients which in turn will reinforce the former. In the meantime, and considering productivity gains and labour shortage in dairy production, there will be tremendous pressure to realize some economies of scale at the farm level to limit the ongoing deterioration of profitability in many dairy farms. Even so, more voices getting louder may call for increasing market potential by making it possible to export Canadian dairy products, which would antagonize import control.

Now the second significant force, quota mobility. Pressure to further consolidation at the farm level will certainly build up as previously shown. This will require that quota is made available for purchase. However, the quota exchange market has become rather illiquid over the last seven years or so. This change has been most remarkable in Ontario and Quebec after new regulations of quota exchange were introduced in 2007. A trigger is needed to incentivize the sale of quota. Will it be sufficient to decrease milk price? Shall we lower the existing price cap? Shall we let the price be set freely? Shall quota move unhindered between province? All this in a context where there are expectations to maintain as many dairy farms as possible in as many regions as possible. Quite a catch 22, isn’t it. Some unruly producers may end up challenging production discipline.

The third force is indebtedness arising from the cost of capital which in turn stems from the price of quota. Indeed, one must not forget that acquiring quota is just the first step but a costly one. Additional investments (buildings, equipment, farmland, herd genetics, etc.) are needed to maintain consistent dairy production systems. This will be especially critical in Quebec where almost all dairy barns are of the tied-stall type, which is ill-fitted for the automation of milk production processes. Besides, these barns are ageing, which combined with work overload could make it more difficult to maintain good herd health status and consistent milk quality, both being key to the farms’ competitiveness. Consequently, heavy investments will have to be made over the next ten to fifteen years in order to achieve a full-scale modernization of Quebec dairy production. Meanwhile, the sources of capital available to the Canadian agriculture are essentially restricted to debt. Already indebted farms will thus have to carry on more debt, pressuring their profitability further. Quebec dairy farms will be particularly exposed to that risk. Here, it is worth remembering that, for instance, if the current dairy crisis in New Zealand has indeed been triggered by a sudden drop in price, one of the main structural fault lines has been excessive indebtedness. So, the very economic sustainability of many dairy farms will hinge on higher milk price while the most efficient ones may still prosper in this lower-price environment. Consequently, producer pricing will become even more conflictual as increasingly diverging interests are expressed along the value chain and within different groups of stakeholders.

These conflicting dynamics may give enough strength to centrifugal forces,  make one of the, or all three pillars of supply management crumble. Quebec may well be at the epicenter of this quake.

This is why I think the phasing out of supply management will be initiated before 2030, regardless of any trade negotiations.

Supply management as such is a sound policy. However, it cannot pretend to remain unquestionably relevant forever. This is why I think it is time to engage in a comprehensive review of supply management, followed by an open debate over its future, over the why and how of supply management.

About the future of supply-management and the difficulty to debate it.

After some discussions, it appears that my previous post on supply management (here) has been understood as a manifesto for dismantling supply management. Yet, nowhere in that post, did I convey such opinion. What I wrote is that current dynamics, if not addressed, may lead to the implosion of supply management. So, let me just rephrase my rationale and clarify some of its elements.

Before anything else, we must acknowledge the successes of supply-management for the Quebec economy. The average income of Quebec dairy farmers’ families is now above the average Canadian family, as is their net worth (see table below). Saputo and Agropur have become world-class dairy processors with a global footprint. The milk is of the highest standards of quality and safety. But when looking at the future, one can see some clouds gathering.

income and wealth dairy farmers QC

First, the quota market is currently not allowing any meaningful investment to fulfil the potential productivity and efficiency gains at the farm level. For Quebec, this means that the efficiency gap with other provinces will increase. In the meantime, although there has been a unique opportunity to deleverage, debt is still growing in dairy farms as excess liquidity is directed to non-dairy investments such as farmland. So, we see, on one hand, assets that are accumulating within farms waiting for the right time to exit and, on the other hand, farms turned towards the future that are investing in non-dairy assets and taking on more debt.

When the time will come to re-invest in dairy production, the scale of investment will likely be large (modernization, farm transfer, etc.). Do we know for sure that the farms we think will take on most of these investments will be able to do so ? I do not have a definitive answer to that question but I’m sceptic because, from my time in banking, I remember that the most efficient farms have been among the most leveraged. While they will certainly have some spare capacity to invest, I question the adequation of their aggregate investment capacity to the scale of the investment that will be needed.

That inadequation would become apparent if a major event was to happen, resulting in a significant increase in cost (major drought leading to insufficient feed availability) or fall in price (major disease outbreak linked to popular dairy products). Then, the number of exiting farms may jump dramatically requiring the farms left to take on the missing production capacity over a relatively short period of time. Consequently, I think there is a risk to see production below demand long enough that the processors would have no choice but to import from other provinces (the least damaging to supply-management at the national level but not for the Quebec share of quota) or from the US (once the gates are open…).

Leaving the worst-case scenario aside and considering a more gradual exit of the less efficient farms, the capacity of dairy farms to invest will still be mainly determined by their capacity to take on more debt. And that could happen in a context where there will be pressure to temper milk price increase and where interest rate will increase in all likelihood. It is also worth remembering here that any decrease in quota value may make it more affordable but it also may also markedly decrease the net worth thus limiting the borrowing capacity of farms, especially in cases where the quota had been leveraged a bit too much.

Perhaps all this is far-fetched and I may end up completely wrong. Yet, I have not read or heard anything to convince me there is no risk.

If I had to suggest a way to reform supply management in the dairy industry, I would choose one based on the deregulation of the quota market along with the creation of regional markets and with a cost-of-production benchmark excluding a greater proportion of the less efficient farms. I would add another measure to prevent any lasting overpricing of quota (and the related risk of over-indebtedness) that is to set up limitations in the use of quota as a collateral in credit structuring.

Supply management needs to be reformed and that rethinking might also extend to the objectives of supply management themselves. Quebec, Canada and the world have changed, the dairy industry has changed and so will supply management. This is not a question of ideology ; this is a question of being realistic.

I’m asking these questions because I see a risk that could be managed. I would not mind coming to the conclusion that there is a trajectory for supply management to last and be able to support prosperous dairy farms and processors for another generation. But I maintain that these issues need to be investigated more thoroughly in order to better anticipate the coming of the black swan that will provoke the demise of supply management. Here comes to mind the Titanic, unsinkable until it met an iceberg.

Sometimes it feels as supply-management is a dogma and not a public policy that could be debated and reformed. We should remember that history offers plenty of examples of such dogmas relegated to the museum of ideas.

Will supply management of dairy production crumble under its own weight ?

Over the last few years the debate about the relevance of the supply management policy for the dairy industry has intensified. A majority Conservative government has given hope to the traditional foes of supply management, bolstered by the demise of the Canadian Wheat Board. This has made them more vocal in their request for a complete end of supply management in Canada in the name of free trade and consumer protection. Meanwhile, major trade negotiations with the European Union and countries of the Pacific Rim (Trans Pacific Partnership) have shown a shift in attitude towards supply management, from quota abolition to increased market access for dairy products. Some external stakeholders have thus built an environment of almost constant challenge to supply management which has not, yet, weakened the multi-partisan political support it has enjoyed for so long.

Simultaneously, the supply management system is cracking from within. The fault lines have grown over the last decade and are coming to light through a dysfunctional quota exchange market, a growing efficiency gap among dairy farmers and high indebtedness.

From 1994 to 2006, quota price saw a significant increase, going from $15,000 to more than $30,000, with some difference between provinces. With fears of a bubble, growing debt in dairy farms and difficulties to adequately transfer farm assets to the next generation, Ontario and Quebec, soon followed by the Atlantic provinces, introduced new regulations in 2006 aiming at controlling the quota market (introduction of a price ceiling and of restrictions to transactions). As a result, the quota exchange market has come to a standstill, most notably in Quebec and Ontario, as exiting farmers are postponing their actual exit expecting some quota price increase. For instance, in December 2013, in Quebec there were 22 sale offers for 263 units and 2,017 purchase offers for 11,254 units.

With a dysfunctional quota market, excess liquidities allowed by supply-management pricing scheme are mostly directed to assets not directly related to dairy production, such as farmland. Yet, as per tradition, farmers tends to use leverage. Consequently, we do not see any real deleveraging in dairy farms that would free capital for future growth or development of dairy production. Besides, this is spilling over to the whole agriculture by contributing to the rapid increase in farmland prices.

The following figures will give an idea of the current weight of dairy supply management in Quebec. In 2011, dairy farms in Quebec owed 5.2 billion of dollars, compared to 3.9 billion ten years before. In 2002, the average quota holding was 36 BF kg / day. In 2011, it was 51 BF kg / day. Over the 2002 – 2011 period, quota transactions amounted to a total of 2.4 billion of dollars. The current (2013) market value of the whole dairy quota is just shy of 8 billion of dollars. In terms of income, and to maintain a relatively stable level of average profitability, the price of milk at the farm has had to increase by 31% between 2002 and 2011, clearly outpacing consumer price inflation (18% for CPI excluding food items). Besides, the farm price difference between Quebec and Vermont and New-York has grown from $13 to $27/ HL over the 2002 -2011 period (US price adjusted for exchange rate). This hints at a system on a detrimental positive feedback loop.

One key figure giving an idea of the scale of investment needed to modernize dairy farms over the next decade is 92% of barns in Quebec are tied-stalls (88% of the dairy herd). With animal welfare regulations covering hens and sows, I do not see how dairy cows would be able to escape much longer such regulations especially when most of the cows elsewhere enjoy free-stalls (I will not enter here the debate about the actual relevance of tied vs. free stall to the welfare of cows but to say that image matters a lot).

Other key figures worth keeping in mind :

–          27% of the dairy farm operators in Quebec were 55 or older in 2011

–          12% of  Quebec dairy farms had in 2011 a net operating income (i.e. income left for debt repayment, remuneration of farmer’s labour and capital) of $25,000 or less, meaning that there is in fact just enough money to remunerate farmers’ work.

–          the 25% best performing dairy farms are almost twice as efficient as the 25% worst performing ones when considering the operating margin.

The combination of all these figures is implying several things :

i)                    for some dairy farmers, exit cannot be postponed indefinitely ;

ii)                   consolidation of dairy production will likely accelerate abruptly at one point within the next decade ;

iii)                 modernization will be costly ;

iv)                 pressure on capital and milk price will be significant.

So, while supply management tends to project an image of a stable dairy production, there are complex dynamics at play that may lead to the whole system crumbling under its own weight, most notably in Quebec. Though imperfect, I’ll propose now a little foresight exercise in order to expose how some of these issues are critical for the dairy industry in Quebec, and consequently in Canada because of its relative size (38% of quota, 49% of dairy farms, 39% of dairy processing jobs).

We will assume the following over a 10-year period :

–          Quota allocated to Quebec will increase at a rate of 0.1% per year (over the last decade the rate was 0.3% but we will assume an increase in the importation of milk components and an increase of the relative quota share of Western provinces).

–          Productivity of cows will improve from 1.12 cow / quota unit to 1.05

–          The number of dairy farms will reach about 4770, holding on average a quota of 70 BF kg / day

–          The quota price ceiling will remain stable at $25,000 / unit

To allow the growth of the average Quebec dairy farm from 51 to 70 quota units, one can roughly estimate at 2 billion of dollars the value of quota transaction in Quebec over the next 10-year period.

Meanwhile to simply convert existing tied-stall barns to free-stall barns in order to have only 35% of the dairy herd still in tied-stall in 10 years, an investment of more than 500 million of dollars may be required. This does not include other investment for modernizing milking-parlour and other equipment and machinery, nor maintenance or land investments. All considered, the Quebec dairy farms active in 10 years will have had to invest probably between 2.7 and 3.2 billion dollars to get there. Assuming 70% of it is financed by debt, then dairy farmers will need to access credit worth between 1.9 and 2.25 billion of dollars over a decade. This may result in a net increase of the outstanding debt held by dairy farms of 1.3 to 1.7 billion of dollars. If the outstanding debt was indeed around 6.75 billion of dollars in 10 years, the debt per quota unit in production would have then reached over $20,000 ($16 300 in 2011).

As the debt load becomes heavier, the pressure on milk price at the farm will increase. Then, a key question would be that of the relation between the dynamics of dairy prices and of consumers’ purchasing power. I do not think that the political consensus will stand for long if : i) dairy prices increase significantly outpace purchasing power growth rate, ii) the public realizes that the high prices they pay make farmers millionaires and banks richer without significant improvements in production systems, and iii) dairy processors are making an increasing part of their profits from overseas operations.

This rough analysis needs to be refined by taking account the state and dynamics of the different type of dairy farms, namely by sorting them into types defined by productivity, profitability, and indebtedness. This would allow to more precisely grasp the extent of the challenges ahead, especially if that shows that the most efficient farms may not have the capacity to invest as much as necessary in the current conditions.

The paralysis of the quota exchange market is preventing any meaningful consolidation of dairy operations, delaying investments and leaving many competitiveness gain unfulfilled. Besides, the scale of the investments needed within a decade to keep dairy production competitive enough will require an access to large amount of capital that debt alone may not be able to satisfy, especially if interest rate are set to rise which they undoubtedly are.

The fault line of supply-management lies in the combination of increasing efficiency gaps among farmers, allowed by an inefficient system of quota allocation, with an over-reliance on debt as a source of capital. While supply-management is a perfectly legitimate public policy in principle, its modes of implementation must be consistent with the actual state of the industry.

I’m among the ones who think that unless supply management is thoroughly reformed within the next few years it will implode sometime in the next decade.

One avenue that could be explored is the liberalization of the quota market (no restriction to price nor transactions, national/regional marketing board as proposed by Prof Bruno Larue) along with the introduction of limitations to the collaterization of quota which would temper any inflationary pressure on quota prices.

Another avenue would be for the marketing boards to buy out all existing quota (through a bond issuance under a federal guarantee for instance) and then lease them back to the producers on 1, 3 or 5-year renewable contracts to be auctioned annually, with the contracts non-pledgeable to creditor. The proceeds of the auction of leasing contracts would then be used to service bond obligations, and eventually create an investment fund to prepare an eventual gradual phasing-out of supply-management.

I’ll add a comment concerning the capacity of Canadian dairy producers to benefit from the global growth of dairy products consumption which is at the core of the latest research report of the Conference Board on supply management (here). Considering the magnitude of the investments required to modernize and scale-up dairy production, most notably in Quebec and Ontario, a transition period of around 10 years may be necessary to reach the desired competitiveness. Besides, a quota buy-out may be much more complex and costly than what is envisioned in the report, the nexus of the complexity lying in the use of quota as a general collateral for credit structuring which has created an entanglement reaching the whole financial structure of dairy farms. The most efficient way to disentangle it would to have a buy-out extending over a 10-year period in order to allow for a smooth debt restructuring.