The elevated price of dairy products, driven by imports by China, when milk output may have slumped by 20%, is at risk of causing long-term damage to demand by encouraging buyers to explore alternatives.
Dairy Australia said that high dairy product prices, many of which are close to record highs, were already driving some buyers to replace milk-based fats with alternatives derived from oilseed plants, "to be able to sell at more affordable prices".
"Ongoing strength in dairy commodity prices means substitution of dairy remains a concern," the Australian dairy industry group said.
"The risk of longer-term demand reduction grows over time as commodity prices remain too high, and thus unaffordable for large populations in developing markets."
The warning comes amid continued buoyancy in dairy prices, which have risen 42% over the last year at the benchmark New Zealand-based GlobalDairyTrade auctions, putting pressure on buyers.
Earlier this week, shares in Dean Foods, top US milk processor, tumbled after it flagged the dent to its profitability prospects from domestic milk prices already at a record high, and seen rising further next month.
Meanwhile AarhusKarlshamn, or AAK, the Swedish-based producer of vegetable-based fats, last week unveiled record operating profits for the October-to-December quarter of SEK328m, up 12%, with growth fuelled by a quest for alternatives to dairy products.
Sales, by volume, of its dairy replacement products "increased significantly", AAK chief executive Arne Frank said.
Dairy Australia stressed the extent to which dairy market buoyancy was being underpinned by demand from China, whose own milk output is reportedly "tracking as much as 20% below recent years".
"As long as China remains short of dairy product, either via demand growth or struggling local milk production, [dairy] commodity prices should remain elevated," the group said.
Output has been undermined, besides by soaring feed costs and a hot summer last year, by a "timing mismatch" in a policy of encouraging larger enterprises, at the expense of smaller operators, large numbers of which have quit dairy, often in favour of the increasingly profitable beef industry.
"As many as 1m-2m dairy cows are believed to have been culled over the past year," Dairy Australia said.
The impact of China's huge demand for dairy has been to boost profits for dairy producers, who in Australia the European and Union have seen 10-25% rises in farmgate milk prices, with their New Zealand peers enjoying a 40% increase, Dairy Australia said.
However, it has also created the potential for huge profits in China too, spurring a rash of investment from foreign groups from Danish-co-operative Arla Foods to US private equity titan KKR.
On Tuesday, French giant Danone revealed it was spending E486m ($666m) to raise to 9.9%, from 4%, its effective shareholding in China Mengniu Dairy, China's top dairy group, through supporting a rights issue priced at HK$42.5 per share, a 15.3% premium over the stock price at the time.
China Mengniu's Hong Kong-listed shares hit a record high of HK$40.45 on Thursday.
Separately on Thursday, RRJ Capital, a private equity firm run by former Goldman Sachs partner Richard Ong, plans to invest 1.52 billion yuan for a 45% stake in Shanghai Bright Holstan, a dairy farming joint venture with Shanghai-listed Bright Dairy & Food.
And on Friday, Sunny Verghese, the chief executive of agricultural trader Olam International, highlighted the cash to be made from dairy.
"If you look at all the dairy companies now out of China, they are trading at 50 and 60 times multiples because there's a real shortage of supply, growing demand and the shift in diet," he told investors.
However, the dependence of dairy markets has also made them vulnerable to Chinese economic setbacks, Dairy Australia warned.
"Some measure of caution still needs to be applied given a fragile [world] economic recovery, and that no one really knows the extent of possible shadow-banking issues in China.
"Concerns over China's financial stability have heightened."
By Mike Verdin