Bottom's Up at Fosters

An article in today's (9/27/07) Wall Street Journal suggests that the era of wine surpluses, both in the world and especially in Australia (see previous blog entry below) may be coming to an end. The world's second largest winemaker has started to raise prices on its premium wine after a long period of discounting and drastic bulk sales. Maybe this market cycle has finally hit bottom and prices are on their way up.

Most people I talk to assume that Gallo is the world's largest winemaker and have no firm notion of who could be number two. But in this era of growing brand power the #1 winemaker is Constellation Brands and Foster's is number two. Fosters makes a lot of wine, but it is really a "drinks" company more than a wine company (to use a distinction that Craggy Range winemaker Steve Smith once explained to me). Fosters manages a long list of brands, only a small sample of which are shown in this photo. They sell branded wines, beers, spirits and even Oragina soft drinks and various juices and sparkling waters. If you are thirsty and want a drink, Foster's is ready to serve your needs.

Foster's lager beer is the brand you might most obviously associate with this company, but its list of wine brands is long and includes Australian wines such as Penfolds, Rosemount Estate, Wolf Blass and the Little Penguin as well as Beringer and Stag's Leap from the U.S., Matua Valley from New Zealand and Fonsecca Port and Gabbiano Chianti. More than 60 wine brands are distributed internationally, reaching from the budget bottom shelves of the wine display clear to the top.

The WSJ article reports that Foster's raised its wine prices by between 4% and 11% in August and the higher prices have stuck -- they haven't hit strong consumer resistance or been undercut by competitors. I think it might be too early for Foster's to declare victory, but rising prices do suggest that the wine glut has come to an end and some shortages may be emerging.

Foster's has apparently finished selling off its inventory of surplus unbranded wine stocks, which are called "cleanskins" in Australia in reference to an international espionage term for an agent of unknown origin. (See this website for an example of Australian cleanskins marketing.) These discount sales dragged down Foster's earnings.

Now, with the prospect of a drought-reduced 2008 vintage following drought problems in 2007, the trend of falling prices may finally be coming to an end. I am skeptical, however, because it seems to me that Australian wines face a lot of competition around the world and it may be difficult to raise prices in this market environment, with surplus stocks still available, for now at least, from other parts of the wine world.

A Tale of Three Brands

I was asked to give a talk at a university wine event recently and my colleague Amy Ryken selected the wines: three New Zealand Sauvignon Blancs, all from Marlborough: Monkey Bay (2006), Nobilo (2006) and Kim Crawford. The Kim Crawford was the first 2007 vintage I have tasted and it made me realize why people like this wine. I like it for its distinctively pungent tropical fruit flavors, which displayed themselves very well in the young, fresh wine. But winemakers must like it because of its distinctively favorable economics. Some wines spend years in the barrel before they can be sold, but not this one. You harvest the grapes in March or April in New Zealand and the wine's already on sale in the U.S. in September. That's Chateau Cash Flow!

The three wines were different and each had its champions, but all three were unmistakably Marlborough products. They had something else in common: all three were sold by Constellation Brands, the world's largest wine company. This fact made me appreciate how very important branded wine products and distribution clout are in the wine business today. How did theses wines come to belong to Constellation Brands and to arrive at our local stores. Here are three stories.

Nobio wines was founded more than 60 years ago by Nikola Nobilo, a Croatian migrant to New Zealand (most of the famous names in New Zealand wine are of Central or Eastern European origin and came to that island country attatched to migrants fleeing poverty and war). Nobilo prospered and was acquired a few years ago by BRL Hardy, the big Australian drinks conglomerate. When BRL Hardy merged with Constellation Brands, Nobilo came along in the deal. So Nobilo benefits today from its access to Constellation's powerful distribution system and its expertise in marketing branded goods.

Kim Crawford's story is a little different. Kim Crawford is a famous New Zealand winemaker who made his reputation at Cooper's Creek and Saint Clair Estate and opened the first Marlborough "virtual winery." He purchased grapes from contract growers, leased production space from other wineries, and made great wine. Kim Crawford was so well known for making great wine that he became an iconic brand, sort of like Martha Stewart (and that's a good thing). "Kim Crawford" on the label as winemaker or winery owner is a sign of quality.

But even brands need distribution, especially for the export market, so Kim Crawford cut a deal with Hogue Cellars of Washington state that brought their wines into the U.S. and Canada. The distribution relationship continued when Hogue was purchased by Vincor, the Canadian wine giant, which was itself eventually bought by Constellation Brands in 2006. Kim Crawford still makes the wines, as near as I can tell, but Constellation owns the "intellectual property," which must mean the brand rights.

The third wine was Monkey Bay. Monkey Bay is the best selling brand of New Zealand wine in the United States. As near as I can tell there is no "Mr. Monkey Bay" in the same way there is a Mr. Nobilo and a Mr. Kim Crawford. And I am not completely convinced that there really is a Monkey Bay, although one is indicated on the company website.

You see, Monkey Bay is a created brand, like most of the "critter wines" are. The name is created and the wine designed to appeal to a particular market niche or lifestyle segment. "Monkey" suggests that the wine is fun and doesn't take itself too seriously. "Bay" suggests an island locale, which is appropriate, and perhaps will remind some of Cloudy Bay, the famous (and much more expensive) high end Marlborough wine, which is owned by the French luxury goods conglomerate LVMH. Constellation Brands invented Monkey Bay because they thought they could market the brand and the wine -- and they seem to have been immensely successful. The grapes apparently come from Nobilo vineyards.

Why not call it Nobilo wine? Apparently the Money Bay moniker appeals to a different market segment. And by segmenting the market, Constellation Brands can attract buyers with different buying preferences at different price points.

Should we be concerned about so many Constellation Brands wines on the shelf? Well, these wines showed that market consolidation does not necessarily produce homogeneous wines. But that's only the beginning of an answer. More to follow in future posts.

Vineyard Economics: Boom and Bust in the Global Wine Market

Anyone who studies the economics of the wine business eventually comes to realize that wine is fundamentally an agricultural product with the boom and bust market cycles that ag markets are prone to experience because supply cannot quickly adjust to changes in price and demand.

Here’s what I mean: When demand for Pinot Noir (PN) rises growers must decide whether to pull up Chardonnay and plant more PN. They may delay doing this, creating a short term shortage of PN (and rising prices), because they are unsure whether the Pinot Noir boom is real. If they do switch, it takes maybe five years before the new vines are ready to make wine. By that time the PN craze may be ended and so the market will collapse under the weight of the extra wine. Even if demand stays firm all the extra PN coming to the market at once may result a surplus of wine and falling prices. Then growers have to decide whether to stay in PN or switch to something else (Pinot Grigio?) and so the cycle begins again. Rising price, rising production, surplus, falling price and so on.

The winemakers in Oregon are currently worrying about this cycle. Oregon Pinot Noir has been hot in recent years, which has been good for their businesses. But what’s going to happen when the new vineyards they’ve planted begin to produce in a couple of years. Will Pinot Boom be followed by Pinot Bust?

(Economics students will recognize the vineyard boom-bust cycle as a market cobweb, one of my favorite examples of economic dynamics. Cobwebs can be stable and converge slowly, or they turn unstable and explode.)

Pinot Noir aside, most of the talk in wine markets these days is about surplus, not shortage. Australia is still stuck with large surpluses of bulk wine. California is in surplus, too. And the European Union has been forced to introduce a new wine regime in an attempt to drain its wine lake and reverse the structural forces that created it.

It is very interesting, therefore, to read about the coming wine shortage. This is the message of recent studies by the people at Turrentine Brokerage, a Novato, California firm that does wine market research and also brokerage services (go to their Marketplace section to get a real feel for supply in the bulk wine market!). I’m very impressed with their analysis of wine market dynamics.

Turrentine Brokerage has created the Wine Wheel to describe the boom-bust cycle of the wine markets. According to their analysis, we are currently in the stage called Emerging Shortage for many wines where supply is stagnant or falling (no one’s really planting much Cabernet Sauvignon in California right now) but demand is slowly growing. There isn’t a shortage yet, but there could be or will be in the future and the market isn’t taking action now to deal with the problem when it comes.

Moving around the wheel, Emerging Shortage is followed by Acute Shortage, with rising prices, which stimulate new plantings and new vineyards and wineries. This large scale expansion leads inevitably to and Emerging Surplus and then Acute Surplus. And then we start again. If you think of wine as a tiny craft industry or as a giant industrial business, these cycles don’t make much sense. But when you realize that fundamentally agricultural nature of wine, it all falls into place.

So don’t be surprised if wine prices start to rise back up as the surpluses disappear. But don’t expect prices to go through the roof, either (except for those high end collector wines that you read about in the magazines – their prices are already stratospheric). The world wine market is very small these days and this may keep prices from getting out of hand. Boom and bust cycles happen everywhere, but I’m not sure that they are entirely synchronized, so shortages in one part of the world may still be partially offset by surpluses elsewhere. This cushions the cycle somewhat as far as consumers are concerned – for now at least.

But what about the future? I wonder if the cycles will become more or less severe in the future? That’s a question for a future essay!

Big Trouble Down Under: Crisis in Australian Wine

Most people find it hard to imagine that the Australian wine industry could possibly be in trouble. Isn't Australia the great success story of wine's current globalization era? Australian wines are the #1 imports in Great Britain, having overtaken the French, and they may soon replace Italy as the #1 wine import in the United States. Where is the trouble in this?

And aren't Australia's best wines, like the iconic Penfolds Grange shown here, recognized as among the finest wines in the world? Australian Shiraz has set a high standard and its popularity has ignited interest in Shiraz and Syrah around the world. What's wrong with that?

And yet big trouble there is for Australia's wine industry and it is important to understand the situation both to appreciate the forces at work in Australia and to recognize their impact on the rest of the wine world.

First, however, we have to understand how Australian wine really works. Although famous brands like Penfolds Grange established Australia's reputation for fine wines, they are a small and limited segment of the market. The evolution of Australian wine during the 1990s has produced an industry dominated by a small number of very large producers focused on branded products for export to Great Britain and the United States (about 75% of Australian wine exports are aimed at these two markets).

The bulk of Australia's exports are inexpensive bulk wines, like the Yellow Tail brand that sells so well in the U.S. In fact, Yellow Tail wines account for nearly one-third of all Australia's exports, making the industry incredibly dependent upon market conditions at the bottom end of the market. And those market conditions are not favorable: price competition is fierce. Penfolds Grange is the sophisticated image of Australian wine, but Yellow Tail, with more than 10 million export cases per year, is the inexpensive "critter wine" that pays the bills.

Or doesn't pay the bills. Three years of rising harvests from 2004-2006 left Australia awash in bulk wine and the market worked just like the textbook says: prices dropped. The fact there is surplus wine, at least for now, in many parts of the world made the situation worse, of course. Bulk wine export prices are now less than 85 cents per liter, an unsustainable level.

I have read some reports that suggest that cheap French wines are part of the problem. The wine industry in the South of France,the Languedoc, is badly fragmented, with tiny family vineyards that can undercut new world wines because they do not count the cost of inherited capital (the vineyards) or family labor. And, of course, there are those EU subsidies, at least for now.

The wine world has become very small and Australian bulk producers compete head to head with those from Chile and France in the main global markets. And this creates a problem, too, because there is only so much demand to go around at any given time. If Australia exports a bit more to the U.S., for example, it pushes that extra U.S. wine into an export market, where it undercuts existing Australian sales. The result, once again, is falling price. Australian wine producers are on the lookout for new markets, focusing on Russia, China and South Korea. I would guess that these are not the easiest markets to enter except through the undesirable bulk wine route.

The problem is compounded by the fact that Australia's big brands seem to have hit a wall in the export markets. Everyone has "critter" wines, now (or haven't you noticed) and the competition among branded wine products has become positively frenzied. Sales of some of the Australian "popular premium" brands have actually declined for the first time, with these wines pushed down into the bulk market, pulling prices even lower there. More and more, Australian wines compete in a single category and market conditions on that part of the wine rack have deteriorated.

There is good news, but even the good news is bad. The good news is that the Australian wine surplus is shrinking and supply is becoming more closely aligned with demand. The bad news is that this isn't because demand is rising, but rather because 2007 was a disastrous vintage. Grade production fell by 30% due to disease, frost and especially drought. Drought conditions are projected to continue into 2008, so there is not much hope of a quick recovery. Bad news is sometimes good news in agricultural markets, where bad crops push up prices and make people rich. But Australia's bad crop won't do much to push up global bulk wine prices. The only good news is that the surplus stocks that Australian producers have been holding can be used up at last.

What can be done? The Australian Wine and Brandy Corporation (a government marketing agency) has released a study titled Wine Australia: Directions to 2025 that presents a plan to turn the troubled industry around without ripping out vines the way that they did in Canada and New Zealand during their wine gluts in the 1980s and the European Union proposes to do to shrink their wine lake now. The key to the plan is to "re-brand" Australian wines using a market segmentation scheme described in the report and then to move up market and away from bulk wines with more innovative brands and an attempt to focus on distintive regional terroir.

The logic is simple: move from the bottom shelf in the supermarket, where prices are unsustainable in any case, into the middle and top shelves, where consumers are willing to pay higher prices. The problem? Well, changing consumer expectations isn't easy, although it is possible. But isn't everyone trying to do that? It seems like every winemaker is trying to move upmarket. Gallo and Constellation have dozens of brands in these market segments, with more coming every day. (Just this week, as it happens, Gallo announced a partnership with Martha Stewart to produce a Sonoma-sourced Martha Steward Vintage brand wine to sell for $15 in select markets!)

The Wine Australia report is a good beginning. They recognize the current crisis and they know what to do. But can they do it?

The Fall and Rise of the British Wine Market

People are always surprised when I tell them that Great Britain is the most important import wine market in the world. How is this possible? Britain is so much smaller than the U.S. and the British are known to prefer beer and spirits to wine. How can they be an important wine market?

One part of the answer is that most countries that consume a lot of wine actually produce a lot, too, and so are not necessarily large net importers. This is obviously true of France, Italy and Spain and it's even true of the United States. Countries that consume in large quantities but aren't also major producers are rare. Britain's wine production until recently has been tiny, so most wine is imported wine and that makes their market very important. British wine production is creeping up now, however, driven by global climate change. Rising temperatures are making it possible to produce good and even exceptional wines in Britain. It is said that some British sparkling wines already rival the best of Champagne.

A second piece of the puzzle was revealed to me recently in an excellent book by George Mason economics professor John V.C. Nye called War, Wine, and Taxes: The Political Economy of Anglo-French Trade, 1689-1900 (Princeton University Press, 2007). Professor Nye deals with many interesting topics in this book; I'm going to focus on the wine story here and not try to cover everything.

Britain was not always a beer and spirits culture. Wine was cheap and plentiful in Britain in the middle ages and Britain did in fact have its own vast vineyards for 300 years starting in 1152 because Bordeaux was British territory! The loss of those vineyards and then war with France caused Britain to turn away from French wines to those from Spain and Portugal and then, finally, from wine generally.

Faced with the need to generate war revenue, Britain imposed tariffs on wine imports. Significally, these were not excise tariffs (10% or 20% of value), but specific tariffs (x number of pence per bottle or gallon). Excise tariffs would have had an equal proportionate impact on wines of all prices, but specific tariffs introduced a bias against cheap wine. Suppose that the tariff is $10 per bottle, for example. The effect on a $100 bottle of imported wine is relatively small -- the price rises by 10% and demand probably declines somewhat. The impact on a $5 bottle of wine is enormous, however. Its relative price rises prohibitively. Who will pay $15 for a $5 bottle of wine? Its market evaporates.

(Note: Transportation costs , which are more or less the same regardless of price, have something of this same effect. This helps explain why that cheap but lovely bottle of local wine you enjoyed in Provence never shows up on your grocers' shelves here in the U.S.. By the time the transportation costs are paid it would no longer be cheap and you might not find it quite so lovely.)

The British drinks market was thus split in two. Elites continued to drink and collect fine red Bordeaux wines that they called "claret." The masses switched from wine to now relatively less expensive beer. And Britain acquired its reputation as a beer drinking nation.

Professor Nye argues that British brewers were able to take advantage of technological innovations that allowed for large economies of scale in beer production. Once they had a near monopoly on the British drinks market, they could build huge factories to satisfy the captive demand at low production costs.

An interesting "invisible handshake" arrangement evolved, according to Nye, between the brewers and the revenue-hungry British state. The brewers permitted themselves to by taxed at fairly high rates in return for tariff protection from wine imports, which gave them a large captive market. The economies of scale in brewing were so significant as to make it profitable both for the brewers and for the taxman -- so long as cheap wine was kept away.

Britain's entry in to the Common Market combined with Margaret Thatcher's later market reforms broke up this nice arrangement and established an environment where British wine demand could return. Britain was required to "harmonize" its wine tariffs with European partners, which removed the bias against popularly priced wines. And the market reforms allowed wine to be sold more widely and competitively, especially through supermarket chains. With wine available and at good prices, Britain's thirst for the vine returned.

Thus did Britain, once the most important export wine market in the world, become so again because of the cost of war, the nature of specific tariffs, the economics of brewing, Britain's entry into the Common Market and Mrs. Thatcher's market reforms.