Tag Archives: supply management

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

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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 ?

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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.