Tuesday, July 30, 2013

BC Milk Supply Management System (SMS)

BC Milk Supply Management System (SMS)


Full Disclosure


If you believe in free markets, as I do, the presence of market control mechanisms administered by government is offensive. As an entrepreneur interested in utilizing milk production to bring value to a given land base, my encounter with the system was disappointing, to say the least – they simply refused to grant “permission” for me to do business; even when it was clearly demonstrable that no impact would accrue to incumbent producers and processors. So, in the interest of full disclosure, the comments to follow will be offered with inherent bias and a good measure of disgruntlement fueling the discourse.
  

What I wanted to do.


I've spent a considerable amount of time contemplating how to bring maximum value to a given land-based, that is to say perhaps more accurately, how to make farming/ranching pay. The key observation of the industry is that, from crops to livestock, it is a commodity environment, for the most part. This reality requires one to seek improved operating efficiencies relative to the norm or to occupy more of the supply chain so as to access the greater margins that accrue to business action closer to the consumer.

In acknowledgement of this key observation and others, I designed a business model that would, in my judgment, best address the contemporary realities that flow from capital costs, production realities and the “new food market”. I made market observations; that the functional food market was growing and that functional beverages with an appropriate macro-nutrient mix targeted to specific human action was ineffectively represented in the market. I combined these observations in the design of a the business model with efficiencies that emanate from an integrated supply chain to create the concept of Mid Fraser Agro -  a business concept – that included a 3000 head dairy, an UHT processing and packaging plant, and a nationwide marketing initiative for functional beverages with the base ingredient of milk.

I prepared a business concept document and initiated due diligence processes which began with a regulatory review, that’s when I encountered and came to comprehend the nature of SMS(s) and their effect on the industry and accessing the industry.     

Relevance of the Present SMS System


One understands the impetus for the creation of the SMS; the desire to effect price stability in a production space that has as components highly perishable product and a nearly emotional societal attachment to the product as a right to have for children. My father was a dairy farmer in the Fraser  Valley in the 60s and was active in garnering the SMS for himself and other dairy farmers.  The fact is that the Dairy farmers do garner a higher price for their milk than they would absent the system, in the present operating environment affected by the SMS. It is my sense that the latent capital that as a product of licensing costs that are as much as 1/3 of net worth, administrative costs, the inefficiencies that now exist due to regulatory restraint in pursuit of an optimal operation regime, regulatory errors which result distortions that increased transportation costs and a number of other realities, all conspire to effect a less profitable circumstance than if the market was left to function on its own. Add to this the challenges that SMSs have on implementing trade deals, in recent talks with Europe, SMS’s have weighed heavily on the process. One needs also to consider the advances in technology with respect to refrigeration, production methods, processing methods, and information systems and their ability to distribute information, in the context of the milk industry. Clearly, the ability for farmers to market their product is better now; the SMS has been overtaken by events in many ways rendering it defunct or at least of increasingly dubious value.

Complex Bureaucracy 


The most striking thing that becomes to light when examining the SMS universe is the weight of the administration on the industry. The supply management complex represents a tremendous transaction cost to the industry itself; additionally these sorts of cost tend to amplify as their effect works its way through the system; by way of example, the milk producers pay for people to administer the system and so when the product gets to market, mark up is added to these costs. 

The Softdrink industry has no SMS overhead, it is bigger, more dynamic; people just do business and the market takes care of itself. The BC  Milk Marketing Board (BCMMB), that exists by government statute, employs a large number of people, manages directly the transportation of milk, determines the nature and scope of milk products processed and sold in the province, determines the nature and configuration of production and processing facilities, controls access to the industry – this is a massive undertaking. The people working at BCMMB are excellent people who seek to fulfil their mandate, the challenge is their mandate or perhaps their presence in their capacity, it is inherently obstructive. In the pursuit of accessing a better price for milk for producers, the cost of doing so harms the efficiency of the supply chain, curtails innovation, effects stagnation in market share and impairs needed consolidation in the industry.

Over and above the BCMMB there exists another organisation called the Farm Industry Review Board (FIRB). The FIRB’s function is to provide a quasi-judicial body to manage disputes that arise between marketing boards, processors, producers and the public at large.  Another excellent group of people, well-educated bright people, employed to interface on behalf of the government with organisations created by the government who manage a market that can manage itself. It is difficult to measure the FIRB’s affect on milk prices for example, as the administrative costs are paid by the provincial government; there are costs, however.

The financial costs of administering SMS here are one consideration. The costs of the opportunities forgone in deploying people to a task that is superfluous are another. In my interface with these organisations I encountered people of significant capacity who’s talents, if directed toward promoting and developing market and product, would be effecting growth and dynamism rather than industry decadence.

Industry Situation Analysis


The Canadian Dairy Industry is well established. The SMS, given its monopoly, has facilitated an established product environment and processing industry. The incumbent operators have enjoyed constraint on competition, producers on new entrants to the industry and processors on the obstruction of new entrants in some circumstances. As they were able to do to me by participating in the FIRB appeal process (see transportation).

Consolidation / Scale


There is presently a culmination of events which are forging the industry in a manner that makes consolidation an inevitable trend, responding to that trend it is an imperative to be maximally efficient and hence profitable. Scale is an entrenched trend supported by fundamentals rationalized to the contemporary operating environment. Demographics of the participating human resource in the agricultural industry are driving consolidation – more people are leaving than entering. The capital requirements to participate are driving a different type of industry participant and require greater asset utilisation to support these increased capital requirements.

Consolidation is occurring industry wide, internationally as well as domestically, and consolidation is occurring at a more rapid rate in countries where dairy operations are exposed to the rigours of an open market system. Consolidation has been a trend found in every facet of the agricultural industry as the family farm makes the transition to a family agricultural enterprise or just an agricultural enterprise. In the USA where access to milk industry is unfettered by government intervention, average heard sizes are higher, approximately 900 head compared to 200 head in Canada.
  
“Large dairy farms have substantial cost advantages over smaller farms, derived from the ability to take advantage of economies of scale. On average, farms with at least 1,000 cows realize costs, per hundredweight of milk produced, that is 15 percent lower than farms in the next largest size class (500–999 head) and 35 percent lower than farms with 100–199 head. Other evidence suggests that costs may continue to decline as herds increase to and above 3,000 head. “ USDA Report

There is a mass of literature supporting larger scale, however, the supply management program limits access to the industry and limits scale. For example, in British Columbia, the herd size is limited to approximately 3000 head. It is nearly impossible to acquire the quota to get to that level, worse is the reality that the BCMMB is beginning to limit the ability to buy farms and consolidate the cattle and quota to a large operation. There is an insistence on the part of the BCMMB that upon the sale of quota that it be committed to the BCMMB quota exchange for purchase; this precludes the ability to consolidate the heard to optimum scaled operations.   

Other Comments Regarding Consolidation – The Free Exchange of Assets


Inherent in consolidation is the reconfiguration of the assets contributing to the milk supply. If left unfettered, assets will configure themselves to best satisfy a given operating environment. Herd mobility is a critical element to permitting consolidation to occur in a manner most advantageous to both the people entering the industry and those seeking to exit the industry – cattle and quota (as the quota system now exists) will gain the most value when being purchased with the intent of being directed toward the most profitable use.

This reality stands juxtaposed to another present reality, where the sum-value of all assets is greater than the sum-value of the segregated asset components in many dairy operations. The gestalt that is formed by the operations component parts, quota, cattle, equipment, land … etc presently holds an elevated value as a turnkey operation – as many of the assets associated with a dairy are as much a drag on value, as a contributor to value, in the absence of an ongoing dairy operation. The functional unit provides cash flow valuation that adds to the primary assets value – so as a unit the farm is more valuable at sale. One may also attribute a liquidity premium, driven by an accessible smaller asset base supported by a business with cash flow. Industry incumbents need to be able to maintain this premium situation to maximise their asset value at the time of sale.

A paradoxical situation exists with the free exchange of cattle and quota, whereby, allowing the small farming units to exist in a manner which provides for them to be marketed as a whole enterprises, gives rise to a circumstance that permits the extraction of the most benefit for industry incumbents wanting to exit, and yet provides a mechanism for consolidation. Policies which impair the free purchase of cows and quota and their subsequent free movement, would have the effect of both damaging industry incumbent asset value and retarding the consolidation that is happening in response to new operational realities.

The writer’s interactions to date have found no opposition to consolidation being allowed to occur. The limiting of the sale of quota or its transfer in anyway, however, seems to have a chilling effect on the trading of dairy related assets – both CDQ directly and related farm assets. One may expect to see, if CDQ transfer is curtailed or limited to the present exchange indefinitely, decadence effected on the industry – where consolidation or regional adjustment is curtailed or operational transformation is retarded.

The SMS prevents the free flow of assets and the adjustments that would occur in its absence if assets were permitted to trade freely.  The discussion above offers recognition of the overall distortion due to the mere presence of the system and brings resolution to the “sub” distortions that occur as various policies are actuated. This is demonstrated repeatedly as one examines the SMS, below you will be exposed to policy related to the sale of quota (CDQ) that retards its accent in value, there are just endless examples of things occurring under the SMS that would never occur absent the system; distortions abound.

Continuous Daily Quota Review

BCMMB Consolidated Order

Calculation of the Market Clearing Price


10.          1)The market clearing price for the first Quota Exchange after July 31, 2010 shall be the average of the market clearing prices for the preceding 22 exchanges, namely, $38,000.00 per kilogram.
(2) If, for three consecutive Quota Exchanges:
(a) The volume of Continuous Daily Quota subject to offers to buy has
Exceeded the volume of Continuous Daily Quota subject to offers to
Sell; and
(b) The offers to buy have been filled to 50% or less; the market clearing price shall be increased by $500.00 per kilogram for the next exchange.

This mechanism is disconnected from the functioning dairy industry and natural market influences on the value of CDQ. The three month wait to increase price and an immediate response to reduce price may represent a mechanism prone to reduce CDQ value. CDQ finds its value as a product of the returns it can generate in the context of a given market circumstance, there exists the maximum possible price for CDQ, which is a function of its carrying costs relative to other operational factors, other capital cost, input costs and revenue. There is then likely to be a degree of cyclicality associated with CDQ prices absent interventions, cyclicality mostly influenced by input values. The more rapidly CDQ can be transferred from one dairy producer to another, the more accurately the price equilibrium (value) arrived at will represent the realities of a given operating environment. The manner in which the CDQ exchange functions now may be less optimum than if a transparent bid ask process facilitated immediate transfer. A transparent bid ask exchange would generate more price volatility, but at any given point in time, the value would be a fair representation of the market value of CDQ derived from industry operational realities. It is apparent that the CDQ Exchange as it functions under these regulations may retard the price of CDQ over time, and prevent quota from reaching equilibrium in a manner that is representative of present market conditions – market conditions of input costs and capital carrying cost related to dairy production.


  
The calculations above offer approximations, I am sure the BCMMB has better data; they do however, serve to support and demonstrate an appreciation trend in the ownership of CDQ. When CDQ ownership is presently considered, one can view it as an appreciating paper asset, with an appreciation rate of approximately 4% per annum above an assumed average 3% generalised inflation rate. The “real” appreciation is beneficial to operators as it represents a reduction in the cost of ownership than would otherwise occur in a stagnate or descending CDQ Value circumstance. Policies that retard CDQ valuation effect a substantive reduction in income to incumbent producers. The freer the transfer of CDQ, the more likely that CDQ value will ascend along with other asset values like land.

The Consolidated Order is the document that governs the BCMMB Conduct.

10 - (3) If the volume of Continuous Daily Quota subject to offers to sell exceeds the Volume of Continuous Daily Quota subject to offers to buy, the market clearing price shall be reduced by $500.00 per kilogram for the next Quota Exchange.
9 - (2) If the volume of Continuous Daily Quota subject to offers to sell exceeds the volume of Continuous Daily Quota subject to offers to buy, the Quota Exchange will be cancelled and re-run within two weeks using a market clearing price that has been adjusted in accordance with these Rules.

The combination of Section 10 – (3) and 9 – (2) offers an impediment to quota reaching a price equilibrium that reflects its value in the context of operator’s ability to generate revenue by owning quota at any point in time. Circumstances may be such that people are willing to pay more, and a transparent bid ask process would provide an immediate response in CDQ price to operating conditions – when input and carrying cost are high CDQ price will fall, when input cost and carrying cost are low CDQ price will rise – this is a healthy circumstance for several reasons, perhaps the most important of which, is it gives operators the ability choose to exit the industry at the point of maximum benefit to them – when CDQ prices are favourable.


11 - (2) Subject to section 12, if there is insufficient Continuous Daily Quota subject to offers to sell in any monthly Quota Exchange to meet all offers to buy Continuous Daily Quota on that Quota Exchange, then the available Continuous Daily Quota will be Transferred to each buyer on a percentage basis - i.e. if there is enough Continuous Daily Quota offered for sale to fill 95% of the offers to buy, then each offer to buy will be 95% filled.

6 - (2) Subject to subsection (3), the maximum amount of Continuous Daily Quota which may be contained in an offer to buy is the greater of 13.7 kilograms or 10% of the Producer’s current allotment of Continuous Daily Quota, up to a maximum of 109.6 kilograms.

From the perspective of Inverine Developments and the creation of West Fraser Agro, where an objective assessment of the industry drives operational scale of up to 3000 head, the application of these sections impede the ability to gain scale through the purchase of CDQ at a rate that permits viability. Please consider, that assuming an entrant could purchase CDQ at the full rate these clauses dictate, it would take four years to garner sufficient CDQ to operate at capacity – if my assumptions are correct – please see CDQ Analysis matrix below.

The following matrix is an approximation of the operating outcomes in a circumstance where MFA was able to garner full quota purchases as per the CDQ Exchange rules, as the writer’s present state of awareness perceives them to function. It is the belief of MFA’s developers that maximum efficiencies are achieved at or around the 2500 to 3000 head mark. In the pursuit of this scale, it is required to invest in the infrastructure to support this herd size at the outset and carry the cost of ownership of those assets through the period of acquiring cattle and quota. Full quota, even under ideal circumstances, is only reached at the close of four years, operational break even takes a full 23 months achieve and overall return on invested capital is only .8% over the cattle and CDQ acquisition period of four years. Compare this to a fully operational year where the return on invested capital exceeds 10%.

Some modification to the CDQ Exchange rules is required to provide for entrants to manage this dynamic associated with purchasing quota for a stand-alone dairy operation. The functioning of the Exchange as the rules now provide for; impairs, entry, the natural trend toward consolidation and the pursuit of scale efficacies. There are several means to address this issue, simply increasing the maximum CDQ purchase amount in conjunction with the section 12 – (1) provision for new entrants would offer a considerable improvement. Optimally, however, the transfer of CDQ would be facilitated through an open and transparent exchange in a typical bid ask functionality; allowing CDQ value to respond to demand for the privilege to produce milk, as influenced by the market dynamics external to the Supply Management System. By allowing people to enter the dairy industry purely on the basis of their ability to satisfy licencing requirements and apply their capital to the challenge, the general health of the industry, at least its vibrancy, would be enhanced.

CDQ Entry Analysis

 

The present configuration of the CDQ Exchange in conjunction with the suspension of the direct sale of CDQ between farms, absent any other means of transferring quota, may offer risk of the value of CDQ – relative to BCMMB precedential operation – experiencing less favourable appreciation in the future absent other means of transferring quota that allows for “natural market dynamics” to determine the price of CDQ, some of which were at play in the BCMMB’s previous actions. The writer is not aware of the events that precipitated the reported suspension of non-exchange transfers and trusts they were perceived as necessary by the BCMMB administrating body. The above observations are offered from a lay person’s perspective and the perspective an entrant wishing to gain scale and viability as quickly as possible.

NOTE: The writer, at the time of writing, has only received verbal notice of a suspension in non-exchange transfers and as yet has been unable to verify through documentation this is in fact the case.

Market

At present, under the SMS and related marketing efforts, the milk market is effectively stagnating. There are areas of improvement, however, the decline in per capita consumption of fluid milk offsets these advancements.

One is unable to attribute this stagnation entirely to the SMS system; there are counter convention consumer groups in place that have boycotted the consumption of milk products; their effect is substantive, however, it is the righters sense that the SMS is mostly the cause.

Innovation


One of the key determining factors in advancing the use of a product with market penetration to the degree milk has, most households have a milk product of one kind or another, is innovation in production, processing and product design. The government recognized this to be the case and in 2006 mandated SMS sectors to put in place “innovation” programs. In the none SMS sectors, think cars with similar market penetration, innovations are what the industry lives on, in any given year there are literally hundreds – that's innovation. Since the government mandated innovation in about 2005, at the time of the writer's review of the system in 2010, there had been one “innovation” organic milk. Organic milk is really the same as none organic milk, the production process is on altered slightly. 

Once the milk finds its way into the hands of the processors, who under the umbrella of the SMS are required to compete, innovation is quite brisk. One encounters in the market place variations on a theme, yoghurt, for example, has a thousand incarnations.

The other challenge with the SMS is that programs directed toward product innovation are intended for, mostly, incumbent processors. A cumbersome aspect of SMS is that every product has to be defined in the context of regulatory requirements and permission given to sell it. Absent SMS, no one is worried about how a product is defined, save how it works in the market place. This reality places a whole other level of managerial concern on product development and in many cases, as it did in mine, stifles it all together.

Innovation needs to be considered with a broader scope than just product innovation - production and processing innovation needs to occur. The present modality of regulation by the BCMMB precludes many types of innovation from transpiring. The writer’s proposed business model would have accessed the full spectrum of innovation, innovations in scale, innovation in the degree of integration and innovation is product offering. The amalgam of these innovations would have generated a powerful means by which to address the market, with an anticipated expansion in overall milk product consumption. These sorts of obstructions to innovation of all sorts are likely to be putting downward pressure on customer consumption of milk as they are failing to access both more efficient production modalities and product innovation; so the consumer who is offered constant expansion of choice and price improvement from competing products, finds no reason to pursue milk products. Products competing with milk, or milk bases products, are subject to none of this type of obstruction and over time milk product market share will decline and opportunities for dairy farmers will decline with it.    

Stagnation

The reality is, in the case of milk, there is stagnation in the production sphere, the product sphere and overall market share is waning. One has to ask why is this the case, the types and varieties of other competing products, soymilk, ricemilk, sports drinks, juice beverages – the list is endless – are expanding and taking market share from milk.

It is the intent of SMS to reduce participation in the market to effect and increase in the price of products sold, that is the fundamental reason for it. What comes in tandem with this reality is the reduction in disruption - the creative destruction processes that fuel innovation, the ability for incumbents to impair others from access to production reduces access to the industry, distortions evolve in the producing and transportation of products. The rigours of an unfettered market discipline the industry so that it is rationalized to demand realities in the context of the market as a whole. The entrenchments that come with SMSs effect upward pressure on price. Please review the graphs below and note the price of Canadian Butter and Canada Skim Milk Power relative to world prices; decide for yourself the accumulated affect of the SMS.       


Transportation

The issue of Transportation as it relates to the BCMMB demonstrates the distortions that come into play in the administration of an SMS. I believe, in the interests of “fairness” the BCMMB has as a policy that the cost of transport for milk should be “equal” for all producers regardless of where they are located. The BCMMB actually, in a direct manner, manages the transport of milk from producer to the processor. Over the years of operation, as a result of this policy, there has been a disconnection between the location of producers relative to processors. If either processors or producers were responsible for transportation costs, the concern would be given to their relative location.

One of the key efficacies garnered in the at scale integration of producing and processing is the elimination of transportation costs in that section of the supply chain. At appeal under the FIRB, processors sited my absence of transportation cost as “unfair” and it appeared the tribunal gave weight to the assertion. So then it can be said, that the BCMMB impaired production innovation AND permitted the impairment of the implementation of a business plan that sought an elevated level of efficiency relative to the industry at large.

This is just one of many distortions that evolve when industries are shielded from, or regulated in a manner that prevents, disruptive influence or action rationalized to profit.     

Cost to the Consumer

The cost of milk products to the consumer are higher as result of the SMS; this reality extends beyond just fluid milk and milk products in general, milk products are a base ingredient in many products: all these products are affected by the price increase. In fairness to the administrators of the Milk SMS, provision to use cheaper skim milk from the world market for production of products intended for export is permitted.

Transition to an unregulated market

The government has put a system in place which dairy farmers have come to rely on, the government has a responsibility to ensure the interests of farmers upon dismantling the system. In many jurisdictions, governments have simply ended the system and farmers have been left marginalized and years of accumulation lost; a circumstance we must seek to ensure never takes place in Canada.

New Zealand facilitated the transition away from SMSs to an open market by facilitating what amounts to a farmers CO-OP. Literature indicates this was a relatively successful approach.  

The Government recognizes the value of Quota, it is measured in the billions, an approximation of $15 Billion would be a ball park number nationwide. The government will need to see the return of farmers money in some way, perhaps by a combination of cash payments and extended tax considerations for incumbent producers.

There are a number of potential strategies for the disassembly of SMSs from - declining monopoly to just a cash payment, the key is to ensure that government sees to the preservation and enhancement of the industry in the process of dismantling the SMS. As stated, farmers need to be wary, as other governments have been ruthless in their exists from SMSs.  


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