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* Farm gate prices sharply down due to oversupply, static demand
* New Zealand competition fierce for depressed EU market
* Sheep farmers could reduce flocks or quit entirely
By Natalie Huet and Nigel Hunt
LONDON, Feb 22 (Reuters) - Sheep farmers in Britain and Ireland fear for their future as oversupply of lamb in Europe drags farm-gate prices to three-year lows while production costs soar, giving efficient New Zealand exporters a vital edge.
Most British sheep farmers have been selling at a loss since November because an influx of cheap imports coincided with the delayed sales of home-grown lambs that had been held up by wet weather causing poor feeding conditions.
Meanwhile, much of the European Union, the biggest market for British lamb, is in recession.
Lamb prices at British farms were down 24 percent year-on-year in early February while Ireland recorded a 20 percent drop.
Britain and Ireland are the EU's top lamb producers and major exporters alongside world leaders New Zealand and Australia.
But farmers and analysts say falling incomes could push hundreds to leave the business and thousands more to reduce their flocks, making the animal that shapes much of the current landscape of the islands, through its grazing, a rarer sight.
"If this trend continues, and producers are forced to sell lambs at less than the cost of production, then ultimately they will look at alternative ways of making a living," said Charles Sercombe, a sheep breeder in central England in charge of livestock issues for Britain's National Farmers Union (NFU).
The drop in farm gate prices - to 3.40 pounds per kg ($2.35 per lb)- has yet to show on British supermarket shelves, where lamb fetches between 7 and 15 pounds a kg. According to the NFU, while December wholesale prices for legs of lamb slid 17 percent from a year ago, retail prices edged down only 2 percent.
"Farmers' costs are rising, but retailers' costs are too," said Richard Dodd, spokesman for the British Retail Consortium, adding that the country's supermarkets regularly ran promotions on lamb but that higher costs for processing, transport and running stores needed to be reflected in headline shop prices.
Input costs for British and Irish sheep farmers have increased by around 30 percent in the past five years, with feed, fuel and fertilisers biting particularly hard.
"Those are the three things that have really put the guys under pressure here with the reduction in (lamb) price," said Gabriel Gilmartin, president of the Irish Cattle and Sheep Farmers' Association.
The situation for producers could get worse as New Zealand has leeway in its export quotas to further increase shipments to the EU, where appetite for lamb remains solid but incomes are squeezed.
FROM SHORTAGE TO OVERSUPPLY
Despite a strengthening currency, export-driven New Zealand farmers can produce lamb more cheaply than those in Britain and Ireland, largely through economies of scale.
In Ireland a large farm might have 500 to 600 sheep, compared with 3,000 to 5,000 in New Zealand, Gilmartin said.
"There is too much fragmentation of land in Ireland and the holdings are too small," he said.
Britain has been importing lamb from the Southern Hemisphere for over a century to guarantee supply at any season, with peak shipments traditionally arriving in the first half of the year, when domestic supply is lowest.
But the heavy rain of 2012 delayed Britain's peak of production by two months because lambs do not thrive on soaked grass, as they get less nutrients and are prone to diseases.
When these lambs came to market late last year, New Zealand imports had increased by over 30 percent from the previous year, according to data shared by trade body the English Beef and Lamb Executive (Eblex).
This increase came after extremely tight global supplies in 2011 sent prices to record highs and prompted a jump in output.
But consumer expenditure on lamb in Europe has since remained roughly static and the higher volumes sold fetched lower prices per kg, said Eblex senior analyst Paul Heyhoe.
Mike Petersen, chairman of New Zealand's trade body for beef and lamb, said average lamb prices were expected to drop by a quarter in the country this year.
"There is no doubt that with a soft market, and a number of carryover UK lambs from the wet winter, pricing has been softer than all of us would like," he said.
The agriculture ministry forecast last month that average incomes for English farms with grazing livestock would fall by up to 52 percent in 2012/13 to between 14,000 and 18,000 pounds.
The ministry cited lower sheep values and higher feed costs.
Phil Stocker, chief executive of Britain's National Sheep Association, warned that if farm gate prices did not pick up within six months, 2 to 3 percent of the country's 65,000 sheep farmers could decide to leave the business entirely, while a majority may shift activity towards crops, cattle or dairy.
"We could see the confidence that's built up in the last two or three years come to a halt, which would be a real shame, especially when global signals are still fairly strong and when, for environment and landscape purposes, people are saying we need grazing animals," he said. ($1 = 0.6555 British pounds) (Writing by Natalie Huet, additional reporting by Mantik Kusjanto in Wellington; Editing by Veronica Brown and Anthony Barker)