Over the last ten years the global dairy industry has experienced several supply and demand shocks that have impacted the fortunes of dairy farmers and dairy processors around the world. The effect of these shocks has varied by geography, and, indeed, by individual player, driven by regulatory actions, market niche, and even company structure. In the face of these shocks, dairy processors need to rethink traditional business models to remain competitive.

A Decade of Upheaval

The first half of the past decade was marked by a series of food safety scandals in China from 2008 to 2012 that drove explosive demand in that country for imported infant formula and milk powders. Then came Russian sanctions on the import of food products in 2014, which dried up a key export market for the European dairy industry. Following quickly on the heels of that, in 2015 the European Union (EU) lifted decades-old milk production quotas, exacerbating the global oversupply problem (although that has been tempered somewhat by a recent slump in EU dairy production).

On the positive side, while demand for white milk, shelf-stable ultra-heat-treated (UHT) milk, and milk powders is flat or declining, consumer health trends continue to drive demand for, and industry innovation in, high-margin products like yogurts, whey protein concentrates, and high-protein milk. Butter, too, is enjoying something of a renaissance with fat no longer regarded as a dietary evil. (That dubious mantle has now passed to sugar and other simple carbohydrates.)

These are on top of the industry’s perennial challenges of perishability, variability in herd productivity (biology isn’t entirely controllable), and the vagaries of weather (neither is nature).

An Expensive Conundrum

The underlying issue that makes it hard for dairy processors to deal with large swings in supply and demand is structural. Dairy processing is an exercise in mass balance. Simply put, whole milk is separated into a solid (butter or cheese) and a corresponding liquid (skim milk or whey, respectively). The liquids are then often converted into powders, by essentially blasting them with heated air.

Many dairy products – cheese, butter, whey, milk powders – are traded on global commodity markets, where most individual players are price takers. Dietary trends over the past decade have driven up demand (and prices) for certain products – butter, for example, which is at a record high – and simultaneously driven down demand for its complement (skim milk powder, in this instance).

So, what’s the problem?

It turns out that drying skim milk or whey into a powder is a very expensive operation. The capital cost of a dryer can run into the hundreds of millions, and the ongoing production costs are high as well, requiring significant operating scale to be profitable. So, for dairy processors to profit from a high-value product, they must sink a lot of money into processing its low-value complement.

Co-opetition or Bust

So, what can dairy processors do to address the mass balance conundrum? Three strategies come to mind, all of which call for them to separate the high-value and low-value parts of their business, much like they do with the end products themselves.

First, dairy processors should carefully review their asset bases to make sure they have the flexibility to respond to changing commodity prices and consumer trends.

Second, dairy processors should explore ways to co-invest in capital-intensive operations, allowing them to realize economies from their combined scale while reducing their individual capital burdens. Given the exorbitant cost of transporting liquid milk products, this would likely require co-location of processing facilities, which in turn demands careful structuring of joint ventures and mechanisms to protect each player’s intellectual capital in the high-value portions of their businesses.

And finally, processors should explore partnerships with downstream players such as major grocery retailers, for example by promising exclusive access to, or rebates for, new high-margin products in exchange for “subsidizing” their low-margin complements.

Given the challenges in this structurally dichotomous market, dairy processors that are open to business model innovation as well as product innovation are best positioned to succeed.