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Tuesday, September 30, 2014

Low fine wool premiums – cyclical or structural?

By Andrew Woods  |  Source: Harries, BAE, AWC, WI, AWEX, ICS

Key points

  • Fine wool premiums are volatile, with the latest run of low premiums appearing to be cyclical rather than structural.
  • Sentiment seems to be turning against fine wool production, implying that rent low premiums are permanent.
  • The history of fine wool premiums from the past 30 years is probably our best guide to premiums in the next thirty years.

Sentiment continues to turn against fine wool production following three years of low and falling fine wool premiums. The key difficulty with breeding decisions is the long timeframe involved. This article takes a long look backwards as an aid for when we need to peer into the foggy future.

In risk management, the rule of thumb is that you use historical data that matches the length of time you are looking forward. How much science is involved in that rule of thumb is questionable, but there is a large slab of common sense.

The further forward we look, the more we need to base decisions upon our best guess of market structures/fundamentals rather than the sentiment of the time (be it meat is the future in the late 1970s or micron is all in the late 1990s). In a 2008 article about political predictions, Owen Harries talks about the trap of being a slave to fashionable thinking, or running with the mob, and agriculture is no different.

In agriculture, an extreme price signal that persists for 3-5 years generally has a significant effect on production. It generates a reaction at the farm level that flows into decisions about enterprise mix. This, in turn, shows up in changing commodity production. Fine wool premiums have had their longest run at low levels since the early 1990s, and a production reaction appears to be building.

A reaction to changed price relativities by farmers is logical. Price pushes supply up or down, which helps to bring supply and demand closer together.  The hard part is to determine whether the changed price relativity is a more permanent structural change or a cyclical one, which by its nature will revert to a more sustainable level.

Figure 1 shows the premium (in proportional terms) for the merino micron category 2 microns finer than the median micron for the past 60 years. The premium is basically divided into two parts, before the early 1980s and after the early 1980s.

Is the market reverting back to the pre-1980s structure? This seems most unlikely because the factors that allowed the rise in value of fine wool (containerisation, objective testing of greasy wool and fabric weights falling to low levels) remain with us. Has supply risen markedly in recent years? Yes it has, and this factor explains a lot (not all) of the low premiums we see today.

The peak in premiums seen in the late 1990s was, in hindsight, an anomaly caused by stable fine wool prices and depressed medium/broad merino prices. If we assume the late 1990s high premiums are not likely to be repeated, and that the current low premiums are mainly a cyclical phenomenon, then the premiums of the past 30 years (less the late 1990s peak) is our best picture of the next 30 years.

What does this mean?

The hard part about breeding decisions is that you need to make decisions that will take a decade to bear fruit. The rule of thumb from risk management of looking back as far as you are looking forward is not a bad one when you are trying to disentangle cyclical and structural changes in markets and the consequent effects on price. The best guide to the next decade of fine wool premiums is probably the past decade and the best guide to the next thirty years is probably the last thirty years.

Mecardo information is provided to assist in your marketing decisions. It contains a range of data and views on the current market. It is not intended to constitute advice for a specific purpose. Before taking any action in relation to information contained within this report, you should seek advice from a qualified professional. The information is obtained from a variety of sources and neither Mecardo nor Ag Concepts Advisory will be held liable for any loss or damage whatsoever that may arise from the use of information or for any error or mis-statement contained in this report. 

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