27 - Substitutability – A key driver of brand value for Australian grain exports

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Peter Elliott - Manager - Strategy & Market Analysis, AEGIC

In terms of market competition, the biggest change seen in Australian grain export markets in recent years has been the inroads made by low-cost producers such as Russia, Ukraine and Argentina.  The most prominent impact to date has been in Indonesia – Australia’s key wheat export market – where Australian wheat has faced an increasingly competitive environment in recent years.  While this doesn’t change our view of the market potential that Indonesia’s rapidly growing economic status represents, it does highlight the importance of producing grains that either reliably attract a premium over cheaper, generic alternatives or that have desirable characteristics that help insure against loss of market share.

One approach could be to scan the various crops and grades we produce to identify those that enjoy “default” position in the minds of buyers.  In other words, the customer’s first preference is “Australian Grade X” (or Australian Grain X), as long as the spread between our price and the next best option is less than or equal to the perceived spread in value.  Let’s call this substitutability. This is typically driven by the degree to which the quality characteristics of Grade X differ from the next best options. Some of the specific drivers of substitutability might include the following –

  • In the absence of Grade X, does the end product change enough that processors or consumers notice (and even complain in some cases)?

  • In the absence of Grade X, do manufacturers need to amend labelling?  This could include – country of origin, nutritional data or even product names.

  • Does the absence of Grade X require changes to the manufacturing process? For example – rollers calibrated to the thickness of Grade X, which is noticeably thicker or thinner than the backup option. This could impact at either the first stage (milling) or second (baking, noodle making etc.)

  • In the absence of Grade X, how many alternatives are there and is there usually sufficient volume available?

  • Geographical factors – For example - Is there a processing operation located where Grade X is grown?

  • During the period of peak demand for Grade X, what is the seasonal availability of alternatives? For example – when Grade X is usually shipped, competing alternatives have only just been planted (I.e. – Northern v Southern Hemisphere or Winter v Summer crop misalignment).

Compared to generic alternatives, some crops, grades or varieties have accrued a certain degree of “brand value” and have, to some extent, been de-commoditised – an exceedingly rare feat in commodity trading.  Each of these “brand” products typically commands a price premium over alternatives and a key driver of this premium is substitutability

In the absence of Australian Grain X, how easy is it for buyers to switch to another source?

Looking at the range of crops and grades produced in Australia, some examples might include –

  • Australian Prime Hard (APH) for yellow alkaline Chinese-style noodles in Asia

  • Australian Noodle Wheat (ANW) for soft white noodles in Japan and Korea

  • Lupins and Oats for specialty feeds

  • Australian milling oats for health-conscious Asian markets

  • Non-GM canola

For today’s piece I want to focus on two wheat grades - APH and ANW. 

APH

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Despite being Australia’s premier wheat “brand” that makes the world’s best ramen noodles, the value of the APH brand in Australian export markets has been eroded somewhat due to a number of weather related supply disruptions.  We have even experienced a double-whammy where drought has affected production of both APH and other feed grains, which has seen APH redirected from the export market to be repurposed as animal feed.  This has meant that flour mills, noodle makers and bakeries have had to look at other ways they can maintain a consistent product for consumers.  In the case of APH, patchy availability forced buyers to switch to alternatives such as USA DNS and Canadian CWRS, and noodle manufacturers became more familiar with how best to use these grades.  As a consequence, compared to 15 years ago, APH is today perceived, rightly or wrongly, as being significantly more substitutable than it was previously. 

Not only does this scenario undermine the premium that products such as APH can attract, sometimes these markets don’t come back at all.  This is particularly so in the Japanese market.  Japan’s low self-sufficiency in food means that they are particularly exposed to any food import disruptions, leading them to place a premium on stable supply.   Moreover, their concern for reliability can create a “one-two punch” scenario where firstly Australia loses an important market, and then secondly this impacts our ability to claim other new market with wary customers

In the case of APH, recurrent droughts led to an additional adverse effect.  Asian markets were already buying significant quantities of DNS and CWRS for their baking (bread etc.) segment.  So, even before they started using these grades for noodles, due to the droughts in Australia, they already benefited from significant economies of scale, with a steady stream of large vessels shuttling back and forth between PNW (Pacific North West) ports and Asian import markets.  When the increased flow of grain enables vessel upsizing (e.g. – from “handymax” vessels to the larger “panamax” boats), while pushing down other supply chain costs, it can become increasingly difficult to reclaim lost market share and even more difficult to claim new markets.  In particular, the cost of shipping by panamax versus the cost to send in containers can be significant.   

ANW noodle wheat

Growers in Western Australia have also experienced their fair share of droughts over the past decade, so why hasn’t ANW gone the way of APH in Japan?  Firstly, noodle wheat is purchased as a blend, including 20-40% of APW, which can be ratcheted up or down depending on ANW availability – thereby acting as a buffer against fluctuating supply.  However, at a basic level, the main difference between APH and ANW is the fact that Australia’s competitors, the USA and Canada, produce wheat that performs almost as well as APH, while being unable to breed anything that even vaguely approximates Australian ANW noodle wheat.  They face several impediments that act as a kind of ‘protective moat’ around Australian supply to the udon noodle market.  Firstly, across much of North America, red wheats are considerably more prevalent than white or “club” wheats.  While red wheats are ideal for making bread, they are ill-suited to white salted noodles. Secondly, compared to WA’s sandy soils, wheat in North America is produced on heavier, more fertile soils.  As a result, WA growers often struggle to consistently produce high-protein baking wheats, while North American growers face the opposite problem – being able to keep protein low enough for products like cakes and softer noodles.

Sometimes there’s only one chair…

Sometimes there’s only one chair…

Lastly, from the perspective of breeding and growing ANW varieties, the white salted noodle market is like a game of “musical chairs” with only one chair.  Due to some astute thinking by the Australian industry many years ago, Australia claimed the only available chair, effectively blocking North American competition.  This is because ANW to Japan and Korea for white salted noodle is essentially a 1 million tonne specialty niche market.  If you grow ANW-type wheat, outside of these two markets, there is a notable absence of other demand sources willing to pay anything close to the prevailing ANW price. As with just about any parcel of grain, the challenge isn’t finding a buyer – the challenge is finding a buyer willing to meet your price.  Outside of white salted noodles, ANW wheat has not yet demonstrated any specific functional traits proactively sought by buyers.  So, at best, in non-udon markets, ANW would attract only “generic wheat” values, which is significantly less than the prices paid by Japan and Korea.

Japanese-style udon noodles - A consistent, premium niche market for Australian wheat.

Japanese-style udon noodles - A consistent, premium niche market for Australian wheat.

The 1mmt ceiling on demand in Japan and Kore reduces the incentive to North American wheat breeders to develop wheat varieties for such a small market, especially as Australia already has a breeding program constantly improving the yield of ANW varieties whilst ensuring maintenance of the required quality traits of ANW. Therefore, unless an American or Black Sea-based breeder happens to accidentally produce something suitable for this market ANW should continue to enjoy low substitutability – notwithstanding the effects of Japan’s rapidly aging population.

Considering the abovementioned factors, ANW wheat is unlikely to face any substantial competitive threat from North American wheat any time soon.  In fact, the most likely source of new competition for Western Australian noodle wheat growers will be South Australian growers.

Lastly, I think it is worthwhile addressing a couple of important questions that may arise in reading this piece.  The overarching point is that, all other things being equal, a specific grade is more likely to generate premiums over other grades if there is a lack of functionally-comparable alternatives.  However, it is important to point out that this claim says nothing about the other factors that determine whether an individual grower should grow a particular grade.  ANW for Japan and Korea provides us with a useful example of this.  The decision whether an individual grower should grow an ANW variety or not takes into consideration factors such as –

  • The relative yield compared with a logical alternative (such as an AH variety)

  • The relative grower price

  • The likelihood of hitting the protein window and the size of the cliff-face if this window is missed

  • Whether breaking rain comes earlier or later than usual

This example holds for any number of different crops across Australian. Sometimes the variety that ticks all the boxes in terms of market demand is, to borrow an expression a grower recently used, an “absolute dog” on farm!  Until InterGrain released their Supreme noodle wheat variety, which is now widely seen as the best quality noodle wheat Australia has produced, if market evaluation was the only consideration, WA would produce nothing but Cadoux and Victoria would be producing a million tonnes of Rosella wheat.

Secondly, this piece should not be interpreted as an exhortation to put the customer over a barrel.  Any commercial arrangement with an inherent power disparity or any other factor that creates lingering resentment is doomed to fail.  Likewise, there are very few grades or varieties that are completely irreplaceable.  Sometimes, all it takes is a supremely motivated end-user to find a workaround.  Whether your product is substitutable or not doesn’t change the importance of fostering a respectful, flexible and co-operative relationship with your customer.  Commercial arrangements don’t need to be “zero-sum” games, where the seller only benefits at the buyer’s expense.  Sometimes, for value to be created (not transferred) all it takes is identifying grain with a unique property and a customer who is able to leverage this property for commercial gain.

Stay tuned for Part 2 in the coming weeks, where I look at two non-wheat examples of grades and grains that are able to leverage comparatively low substitutability to generate a premium over generic alternatives.