Dollar Daze on the Wine Wall

You know that wine economics has become mainstream when you find yourself listening to it on the car radio.

The Dollar and the Wine Wall

Marketplace, a program of American Public Media that is broadcast by many National Public Radio stations, recently featured a story called U.S. Winemakers Toast a Strong Euro. Go ahead and click on the link to listen to the story or read the transcript.

The basic idea, which my International Economics students will recognize immediately, is that exchange rate changes create many direct and indirect winners and losers. This is particularly true in the increasingly integrated global wine market. The Euro has appreciated from about USD 1.35 per Euro to about USD 1.55 in the last year, which means that a wholesale €10 bottle of French or Italian wine’s dollar cost has increased from $13.50 to $15.50. This pushes the retail price from about $20 to $23 or $24, assuming a full cost pass-through, which puts it at a different price point on the supermarket shelf. Higher shipping costs will nudge the dollar price a bit higher still. Basically, you’re looking at a $20 wine selling for as much as $25. U.S. wines are corresponding cheaper in Eurozone countries.

U.S. winemakers hope that the falling dollar will be their ticket to higher sales abroad. I wrote about this in January when a group of Washington and Oregon wineries organized an export event in London. It is difficult to get traction in foreign markets, but the dollar’s weakness should help.

In the meantime, rising import prices here give domestic wines an advantage. Wine buyers tend to make most of their purchases around particular “comfort zone” price points and rising import prices should create some advantageous substitution effects. This comes out in the Marketplace interview. One wine professional puts it this way

Say if they used to enjoy a Sancerre for $20 and now their favorite producer is $25, they’re going to look for a comparable producer in that same price range that they originally purchased.

And the idea is that the “comparable producer” might be from the U.S., although this isn’t always the case.

Now Things Get Complicated

A falling dollar encourages exports and discourages imports — so far we are following the textbook pretty closely. But real world economics, and wine economics in particular, is seldom so simple. Foreign wine producers and distributors obviously have an incentive to keep from losing their market and there are many strategies to soften the exchange rate effects. The New Zealand producers, for example, seem to have been pretty successful in finding new markets for their wine and strengthening their reputation in response to the rising New Zealand Dollar. So far NZ wine seem to be defying gravity — higher quantities and higher prices too. But not everyone can pull of this bit of magic (or necessarily do it forever in New Zealand’s case).

One way to retain market share is for European exporters, distributors and retailers to absorb some of the exchange rate effects themselves, limiting what economists call the “pass through effect.” Canadian wine columnist Anthony Grismondi wrote about this in April in the Vancouver Sun.

I think European winemakers will be under a lot of pressure this year as container shipping costs continue to rise and the Euro’s strength persist. Not all of these higher costs can or will be passed along immediately in the form of higher dollar prices. The biggest effects will probably be felt on low cost wine, where the shipping cost effect is proportionately greater and price sensitivity is higher, too. Look for foreign wineries to go upmarket if they can and to absorb costs or adjust in other ways if they can’t.

But high end wines are not immune from exchange rate problems. Decanter reported in March that the strong Euro was expected to depress prices for Bordeaux en primeur sales.

Winners & Losers

The dollar hasn’t fallen uniformly relative to all currencies. A dollar buys 3.1 Argentine pesos today, for example, which is about the same as a year ago (Argentina’s compounding economic problems have caused a run on the currency in recent days). The Chilean Peso has not appreciated as much as the Euro and the South African rand is actually cheaper in dollar terms than a year ago.

One well known Australian brand, Lindemans, has been sourcing wine from Chile and South Africa to keep costs down as the Australian dollar has risen — a controversial but not uncommon practice in today’s small world of wine. Look for the Lindemans “Country of Origin” wine series.

This suggests that the Dollar Daze on the Wine Wall might feature some interesting shifts, from France and Italy (and Australia and New Zealand) to Argentina, Chile and South Africa. Is it my imagination or are the wine critics and magazines already riding this wave by featuring these New World regions more prominently in their publications?

The Future of Wine?

What will the world of wine look like in 50 years? A look in the crystal ball.

What if the Chinese were French?

A journalist with a Brazilian newsweekly called me on Thursday to ask for help with a story on China. The magazine is doing a sort of “worst case scenario” report on the potential impact of China’s economic growth on world markets. What would happen to oil prices, for example, if the Chinese used as much fuel per capita as Americans do? Yikes, that would be a lot of drivers using a lot of gas and it would send oil prices through the roof. What would happen if Chinese consumers generated as much waste and pollution per person as people in the West? Once again, the global effects would be dramatic.

What would happen, the journalist asked me, if Chinese tastes changed and they drank as much wine per capita as the current world champtions, the French? Well, that is a very interesting question, even if it isn’t a very realistic one. Annual Chinese consumption of wine is about a half-liter per capita and rising, according to my copy of The Global Wine Statistical Compendium (and a lot of that wine isn’t grape wine, as I wrote in The China Wine Syndrome). Wine consumption in France, on the other hand, is 55 liters per person and falling (it was more than 120 liters per capita in the early 1960s). The figure is about 8.5 liters per capita for the U.S. and 20 liters per capita for Great Britain.

It is hard to imagine how Chinese wine consumption could rise to the current French level. Heck, it is unlikely that the French will sustain their current level for long. But isn’t entirely out of the question that Chinese consumpion could rise to the world average, which is about 3.5 liters per capita per year. That’s a lot smaller increase than the Brazillian reporter was concerned with, but it would still have a huge impact on global wine markets. Much of the increase would probably be met by higher Chinese production; China is already a major wine producer — smaller than Chile but larger than Portugal in total production. But the global effects would be substantial and prices would surely rise.

We can already see some indication of the potential “China Effect” in the market for fine wine. Everyone seems to think that at least some of the rise in Bordeaux prices in recent years is due to Asian and especially Chinese purchases. This trend seems likely to accelerate now that Hong Kong has eliminated its high tax on wine transactions so that it can become the auction hub of the Asian wine market. The latest Wine Advocate reports prices of 2005 Bordeaux that reach stratospheric levels — $500, $1500, $2500 per bottle! This is what happens when a global market focuses on an object of speculation — huge rents (excess returns) are created. As China (and India, too) become more completely integrated into global markets for products like fine wine, these rents will likely rise higher still.

The View from London

The Brazilians are not the only ones interested in the future of wine. Berry Bros. & Rudd (BBR), the London fine wine house, recently celebrated its 310th anniversary with the release of the Future of Wine Report written by four of their top wine buyers (Alun Griffiths MW, Jasper Morris MW, Simon Field MW and David Berry Green). It makes pretty interesting reading if you are interested in what wine markets might look like in 2058.

I say wine markets (plural) because BBR correctly recognizes that there is not one wine market but many interrelated ones. The fine wine market, BBR predicts, will see the rise of China and India as important factors in terms of both demand and supply. “I absolutely think China will be a fine wine player rivalling the best wines from France,” writes Jasper Morris. Britain will become an important producer of fine wines, too, perhaps especially Champagne-like sparkers.

Wine prices will soar even higher, according to the report. “If values increase by 15% per annumn, as they have been doing recently, a case of 2005 Ch. Lafite-Rothschild, currently available for £9,200. could be worth just shy of £10 mllion by 2050,” according to Simon Staples.

The forecast changes are more dramatic in the volume wine market. China will be the world’s largest wine producer. Global warming will shift wine production from France to Eastern Europe and from Napa Valley to Canada. Australia, the report speculates, could see a collapse of its volume wine industry if recent droughts persist. Goodbye Yellow Tail. Hello boutique producers in cooler, wetter areas like Tasmania.

Brands will become even more important in the volume business, BBR suggest. “In 50 years, consumers will ask for wine by the brand name or flavour and won’t know, or care, where it has come from. Grapes will be genetically modified to change a wine’s taste,” according to Jasper Morris, “and producers will add artificial flavourings to create a style wanted by consumers.” Wait — OMG I think I drank those wines back in the 1970s when I was in grad school!

Bottles and corks? They’re history. Corks will disappear because they are inefficient — the contamination rate is too high. Bottles are heavy and environmentally problematic. Tetra pak containers (like the ones used in today’s French Rabbit wines) and other sustainable packaging systems will prevail for volume wine.

The Future of Wine?

So what should we think of these visions of the future of wine? Economists like to say that prediction is difficult, especially about the future, so long range forecasts need to be taken for the educated guesses that they are.

Some forecasts, will be wrong because they are more or less simple straight line extrapolations (How much wine would the Chinese drink if they were French? How much will fine wine costs if its price compounds at the current rate?). It seems to me that simple projections are usually wrong because they are sensitive to initial conditions. Who is to say if long term trends will match those of the recent past?

Some predictions, like the £10 million case of wine, are extreme, but others are probably too conservative. The wine world has a way of surprising us — who in 1958 would have predicted the importance of Chile and Argentina today or the decline of consumption and production in France? People matter, too. People and their ideas are powerful forces that do not always respect historical trends, as refelction on the recent death of Robert Mondavi remind us.

Kenneth Boulding, the great 20th Century social scientist, once wrote a history of the future. He looked back to see what people in the past had said about the world just ahead. What he learned, he told me, was that when the future eventually rolled around, it never matched the predictions, it was always unexpected. The best way to prepare for the future, he concluded, was to prepare to be surprised. I expect this rather general advice applies as well to wine.

Grubbing Up

Grubbing up is one of my favorite wine economics terms. It means to pull the vines up by the roots and replace them with other agricultural crops. I It is a harsh term, just as it sounds, because it is the opposite of wine — it is anti-wine. Grubbing up isn’t something that a wine lover contemplates with ease, but sometimes it is necessary. The European Union’s Council of Ministers has recently finalized a grubbing up scheme for the EU and it is probably a good idea, even if it may not work.

Watering Down the Wine Lake

The problem is that EU wine production vastly exceeds demand with the result that thousands of liters of wine must be bought up by the EU each year and distilled into alcohol to prevent prices from dropping through the floor. The distillation price support only encourages continued production, waste and expense. It is a mess — a wine lake, as people say — and it has to stop.

A fairly radical plan was introduced a few years ago, one that would have paid farmers to grub up thousands of hectare of vines and introduced market reforms to allow (by deregulating) and to encourage (through supporting programs) European winegrowers to compete more effectively with New World winemakers who are taking their markets.

The package that the Council of Ministers agreed last week is significant even if it is less radical than the original initiative (Decanter magazine called it “watered-down” — never a good thing when you are talking about wine). The program called for subsidies to encourage winegrowers to eliminate up to 175,000 hectares of vines (versus 400,000 hectares in the original proposal), limit chaptalisation (the addition of sugar in the wine-making process) rather than eliminating it, and market-based reforms that encourage and enable winegrowers to compete on world makets (through varietal labeling of wines) rather than hide behind protective barriers.

I’ve been reading up on the details of the final EU plan and it is pretty interesting — the best analysis I’ve seen so far comes from the USDA Global Agriculture Information Network, which you can download in .pdf form at this California Wine Export Program website. The program includes money for grubbing up, of course, and deregulation of wine labels, removal of some vine planting restrictions (so marketable grape varieties can replace uneconomic grubbed up varietals), funds for wine promotion abroad, and so forth. Like any EU program, it is a complicated balance of economic reality, fiscal feasibility and political necessity.

The idea is to help the European wine industry transition to a new market environment, where export markets are growing, domestic markets shrinking and competition is fierce. It is not unreasonable to think that policies like this could work. They worked in New Zealand in the 1980s, for example.

Lessons from Kiwi Wine History

New Zealand today is famous as one of the great success stories in the world wine market. A small nation in an unlikely location, it punches above its weight in the global wine market, holding the title as champion exporter. Not in quantity, obviously, but in price. New Zealand has the highest average export price of any wine producing country.

But such was not the case 25 years ago. New Zealand suffered from a surplus of mediocre wine that could only be sold domestically behind high protective barriers. The industry collapsed with many failed firms from a combination of bad wine and surplus production. The government paid to grub up vines and then opened the market to international competition. Cheap but better wines from Australia flooded in to fill the domestic bulk wine market, leaving New Zealand producers only one choice — make better wine for export. They have done so brilliantly. Their success inspires the EU reforms.

It would be a mistake to think that what worked so well in New Zealand in the 1980s will work equally well in Europe today. It is unlikely that the EU would be willing to let its wine sector reach the sort of crisis that New Zealand experienced and that motivated the dramatic reforms implemented there. If big change comes from big crisis, as I believe (I wrote a book on this theme), then Europe is unlikely to see big change. The social cost of crisis is just too great. The guiding principle of EU policy is to prevent crisis, which makes change that much harder to effect.

Comparing New Zealand to Europe is problematic in other ways, too. New Zealand’s wine production is tiny — a drop in the bucket, really — whereas European producers account for well more than half of all the wine in the world. New Zealand’s grubbing up program may have been difficult, but only 1500 hectares were uprooted rather than the “watered-down” 175,000 set for the EU.

Changing the Rules of the Game

The principle of the EU wine reform scheme is sound, yet many reports that I have read are pessimistic. I think this is mainly because the final reforms are so much more timid that the initial proposal. But there are other reasons for concern.

One thing that economists have learned over the past 25 years is that institutions matter. This is another way of saying that economic forces do not always produce the same results. If the “rules of the game” are different the laws of economics will produce different results. Institutions are the rules of the game in life. Dani Rodrik, my favorite development economist, makes this point in his recent book One Economics, Many Recipes. The nature of local institutions, public and private, formal and informal, shapes the economic landscape in important ways.

This idea applies to the EU reforms in particular. Take the grubbing up scheme, for example. An incentive to repurpose large but unprofitable vineyards in Australia, for example, might well meet with an enthusiastic response because the institutions of wine growing there are different, with large vineyards and a consolidated industry. But European vineyards are much different and represent a completely different model.

Many vineyards (where much of the inferior surplus wine originates) are tiny inherited plots of a hectare or so, frequently on sites with few viable alternative uses. The rules of the game here are much different. A hectare might produce 20-30 tons if badly overcropped and, at perhaps $500 per ton at the local cooperative, gross revenues are too small for a family to live on but too great (compared to alternative uses) to give up. It’s an institutional trap that might be solved by consolidation, but making large vineyards out of these scattered small plots is necessarily costly and difficult.

Under these circumstances growers are likely to hang on to their vines for years rather than accept a modest one-time payment. Grubbing up might need to be forced, not voluntary, to have much effect.

New regulations to allow wines to be labeled according to grape variety (rather than the traditional local geographic designation) might be attractive to a large and distinctly commercial wine producer, but much wine in Europe is still produced by cooperatives that have little to distinguish their wines from others apart form the local designation. What advantage would they have as simple varietals in a world awash with good varietal wine?

A Certain Vision of Wine

It is possible to envision a future where the reforms can work, where the marginal vineyards have gone out of production, where consolidation has increased efficiency and where branded varietals can compete with the world market. (I have even seen some early attempts at EU branded varietals in the discount bins of a local store — more about this in a future posting.) I think it is possible that this vision may be realized — eventually.

But oh, it is such a big jump. The institituions of the small family vineyard and the local wine cooperative seem to me to make these reforms much more difficult. New Zealand’s success will be difficult to repeat.

The Most Profitable Wine in the World?

Following the Money to New Zealand

2128.jpgWhat’s the most profitable wine in the world? Not the most expensive single wine (like Chateau Pétrus or Screaming Eagle), but the most profitable type of wine? Guardian wine critic Tim Atkin raised this question is a recent article called “Bottle Banks” and it is interesting to think about what the answer might be.

Profits, of course, are all about the difference between price and cost. So which country gets the highest average price for its wine exports? Most people are surprised to learn that it is New Zealand (see footnote below). New Zealand is unusual among wine producing countries in that its exports are almost entirely premium and super premium wines. The domestic Kiwi market for low cost bulk wines is filled by imports from Australia and Chile, leaving NZ producers free to focus on higher value export markets. This nearly single-minded concentration on upmarket wines results in high average export prices.

New Zealand would therefore be a prime suspect for the most profitable wine-making country – if higher production costs don’t offset the price advantage.

Easy as 1-2-3?

I was not completely surprised, therefore, to read Atkin’s conclusion that the most profitable wine is probably Marlborough Sauvignon Blanc from New Zealand, which is by far that country’s leading wine export. Atkin writes that

I was sitting talking to the owner of a top New Zealand Sauvignon in Australia recently when he proudly took out his mobile phone and showed me pictures of his bespoke Maserati. ‘Kiwi Sauvignon is cheap and easy to make and commands a premium,’ he explained. ‘And by the time I have to pay my growers for their grapes, the wine is already on the market.

That certainly sounds easy enough. Atkin continues

He’s got a point. Marlborough Sauvignon generally produces heavy crops (partly a result of fertile soils, but also of vineyard practices). Once it’s in the winery, all the average producer has to do is crush the grapes, add yeast and ferment it at a cool temperature in stainless steel. A matter of days later the wine is ready for bottling.

Nothing could be simpler really, although I didn’t know you could make wine in just a few days. I wonder why everyone doesn’t just get up and go to Marlborough to make Sauvignon Blanc? Since economists are trained to be suspicious of easy money stories like this, I thought it would be interesting to talk to someone in the New Zealand industry about profitability.

Hidden Complexity

So I wrote to Neal Ibbotson, managing director of Saint Clair Family Estate Wines in Blenheim (Marlborough). I met Neal in 2004 when I was doing research for a book on globalization. Neal was a pioneer winegrower in the Marlborough region — Neal and Judy planted their first vineyard there in 1978 —  and someone whose knowledge and opinion I value a lot. The 2003 Saint Clair Wairau Reserve Sauvignon Blanc that I sampled on that visit was the most memorable NZ wine I have ever tasted.

Neal didn’t comment on the Guardian article directly, but what he had to say helped me understand the hidden complexity of the situation.

Marlborough Sauvignon Blanc can in fact be a pretty profitable wine, but that doesn’t mean that everyone is rolling in cash.

Neal writes that

It is very profitable for the best grape growers on the best soils where they can combine relatively high yields and high quality. Say 5% of Marlborough’s growers. These growers deservedly reap the benefit from having out laid the capital and taken some risk and are very fortunate that the grapes they grow are a unique product, in strong demand.

It is less profitable and is in some cases unprofitable, for those growers who are in more marginal areas on less productive soils where yields and often quality are not as good

It can also be quite profitable for the very best wine companies who produce a high quality product and have good access to the markets. Say 10%. There are however both Marlborough Sauvignon Blanc grape growers and wine companies that are unprofitable. {It’s worse in some other parts of NZ.}

There are also a number of cases of new labels that have been produced, by would-be winemakers, that are sitting in the bottling halls, or on retail shelves, gathering dust whilst interest accrues in their bank accounts. In addition there is the huge capital requirement to take a small producer, normally profit marginal, to a medium or large producer where profitability is more likely

This is clearly a more realistic picture of the NZ wine industry. There some firms that are very profitable due to cost advantages or because they are able to leverage unique assets, like reputation or special vineyard characteristics. But there are other firms that, lacking these advantages, scrape by or lose money. Distribution is the big bottleneck in the global wine business, and wineries with access to efficient distribution have a head start towards profit goals. Inevitably in any industry with heterogeneous inputs and outputs, the profit profile is complicated.

Not only are Marlborough profits not uniformly high, according to Neal, they are also not certain. High prices require high quality and the ability to maintain a reputation for exceptional wines (I will talk about what Saint Clair is doing in this regard in a future post). But there are other factors to be considered. Neal writes that …

Most wineries are struggling to some degree with the increasing cost of buying in Sauvignon Blanc grapes, and the high value of the NZ $ which increases the cost of NZ wine in the market place and makes any additional increase in price from the wineries extremely difficult. Because of increasing prices for Marlborough Sauvignon Blanc grapes and the high NZ$ at present most wineries are caught between a rock and a hard place

This reminds me of a discussion I had with Jane Hunter of Hunters Wines in 2004. (Hunters was one of the first NZ Sauvignon Blancs to break into the key British Market and establish the region’s reputation there). What is the biggest threat to your industry, I asked her. The appreciation of the NZ dollar, she replied without hesitation.

Tim Atkin might be right about Marlborough Sauvignon Blanc, but he’s also wrong. I think it must be a very profitable wine for some (I wonder … was he talking to someone from Cloudy Bay?), but making wine and then making money making wine isn’t as easy as he suggests, even in Marlborough.

(Footnote: Here is an interesting fact: Canada actually earns higher per liter revenues from its bottled wine exports than New Zealand, according to my copy of The Global Wine Statistical Compendium, but comparing it to New Zealand is like comparing apples and oranges. Or table wine to ice wine, to be more specific. Canada’s wine exports are tiny compared to New Zealand, but the per-bottle revenues are high because it is mainly expensive ice wine - sweet dessert wines made from grapes left on the vine so that freezing weather can concentrate the juice and flavor.)


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