Investors are neutral to overweight. Most investors are largely in agreement with us and are neutral to overweight on the sector. Some are looking to add to their positions as they are bullish on the medium-term prospects for CPO price. However, others are concerned about the recent volatility of crude oil price and the potential de-rating of the plantation sector following its strong YTD outperformance.
Maintain OVERWEIGHT call. In the short term, we are turning a bit cautious on the sector in view of (1) the high volatility in the oil market, (2) possible demand dent from economic uncertainty and near-record CPO prices, (3) biofuel policy risks, and (4) weak market sentiment. However, we remain upbeat on the sector’s long-term fundamentals and maintain our OVERWEIGHT call given: (1) the strong prospects for CPO price, (2) the sector’s relatively defensiveness against political risks, and (3) the sector’s resilience against an economic slowdown as 80% of crude palm oil is processed and used in edible products. We continue to believe that there is potential upside to our CPO price forecasts given the current tight edible oil supplies and volatile global weather conditions of late.
Top picks in the region. There is no change to our top big-cap picks, which are IOI Corp for Malaysia, Wilmar for Singapore and Astra Agro for Indonesia. Among the mid-cap planters, we like Asiatic in Malaysia, IndoAgri in Singapore and Sampoerna Agro in Indonesia. Key re-rating catalysts for the sector are higher CPO prices, adverse weather, further biofuel incentives and rising crude oil price.
Feedback from regional plantation roadshow
We recently completed a one-week roadshow on the regional plantation sector. During our trip, which covered Singapore and Hong Kong, we met up with approximately 50 fund managers and buy-side analysts from 41 investment management firms. The purpose of the trip was to update investors on: (1) our outlook for CPO price as well as the sector; (2) recent changes in palm oil taxes in Malaysia; and (3) highlight our top picks in the region. Judging from our tight schedule, we believe that interest in the Asean palm oil sector remains strong.
Our message. We highlighted to investors that we remain optimistic on the sector as CPO price is well-supported by strong fundamentals. However, we are turning a bit cautious due to concerns over a potential correction in crude oil price in the event of (1) a major unwinding of funds out of commodities into other market instruments, and (2) a global recession. These events may drag down sentiment on commodities including CPO despite its strong fundamentals. However, we remain upbeat on the sector’s long-term fundamentals and maintain our OVERWEIGHT call given: (1) the strong prospects for CPO price, (2) the sector’s relatively defensiveness against political risks, and (3) the sector’s resilience against an economic slowdown as 80% of crude palm oil is processed and used in edible products.
In terms of strategy, during our roadshow, we recommended that investors opt for highly liquid, big-cap, efficient planters with solid corporate governance track records in view of the poor market sentiment and volatility in the commodity market. For longterm players, we drew their attention to our mid-cap plantation picks, which offer cheaper P/Es than their big-cap peers. We also voiced our preference for the Malaysian-based planters over the Indonesian players due to regulatory concerns.
Feedback from investors. Most investors are largely in agreement with us and are neutral to overweight on the sector. Some are looking to add to their positions as they are bullish on the medium-term prospects for CPO price. However, others are concerned about the recent volatility of crude oil price and the potential de-rating of the plantation sector following its strong YTD outperformance.
Bullish factors supporting the sector
A resilient sector for exposure in the current environment. The palm oil sector stands out as a resilient sector against the current backdrop of economic uncertainty and high commodity prices. We believe the upstream palm oil players are set to enjoy record profits this year as higher palm oil prices more than offset operating cost increases due to rising fertiliser, fuel and labour costs, and higher taxes. Average CPO price for the first five months rose 65% yoy to RM3,451 per tonne. Downstream oil palm players, from refiners to oleochemical and speciality fats players, are also reporting higher earnings, thanks to higher sales volumes and better profit margin per tonne of refined products. Following the consolidation of several big palm oil groups over the past year, the plantation sector has become a more significant component of the market indices – 21.3% for KLCI, 4.96% for FSSTI and 4.2% for JCI.
CPO price may not have peaked yet. Although spot CPO price is currently 14% below its year’s high of RM4,203 per tonne, we believe it is not conclusive that palm oil price has peaked for the year. This is because CPO price may scale new heights in the event of the perfect storm, i.e. record crude oil price, poor weather in major planting areas and export curbs by major edible oil exporting countries. We believe one cannot discount these possibilities as crude oil price recently reached a new high and the key US corn planting areas was reportedly affected by flooding in the Midwest while southern China was also hit by heavy flooding recently. Lastly, governments may resort to drastic measures to secure domestic supply in the event of shortages in the global edible oil market. This may exacerbate the tight conditions, leading to a price rally.
Current price cycle to last longer than previous cycles. We are also of the view that the current uptrend in CPO price will last longer than its historical cycle due to a structural change in demand. Historically, a high portion of the rise in demand went to the food sector, which takes up the bulk of the edible oils. However, this has changed in view of the increase in demand for biodiesel driven by fiscal incentives or mandatory biodiesel blend usage policies implemented by the US, Europe and other governments. This, coupled with the strong demand growth from China and India, has lifted global edible oil demand above its historical average growth of 3-4% by 1-2% pts, evident from the stronger demand growth posted over the past few years. On the supply front, it is taking farmers longer to raise supply despite the high prices. This is mainly because of palm oil’s expanded market share in the global edible oil market. Also, it takes three years for oil palms to reach maturity and expansion into new oil palm areas is affected by local issues and environmental groups, the ongoing fight for acreage between soybean and corn in US due to rising demand for corn for ethanol production in US and high export/windfall taxes imposed on farmers.
Higher oil prices lift floor price for palm oil. The recent sharp rise in crude oil price has improved the economic viability of biodiesel. We understand that some biodiesel producers are taking this opportunity to raise their biodiesel production, thus boosting demand for edible oils. Also, the current high crude oil price acts as a floor price for CPO in the event of excessive supply. We estimate that at a crude oil price of US$130 barrel, the CPO biodiesel breakeven price or floor price for CPO is around RM3,529 per tonne, assuming an exchange rate of RM3.25 per US$. We are also of the opinion that the CPO price is well supported as it currently trades at a wider discount of US$208 per tonne to soya oil than the historical 8-year average of US$100 per tonne. This will increase substitution between palm and soya oil.
Potential upside to our CPO price projections. There is upside to our CPO price projection of US$1,105 (cif) or RM3,350 (fob) per tonne for 2008 and US$1,090 per tonne or RM3,000 per tonne for 2009 as we have conservatively assumed normal weather in key planting areas and an average crude oil price of US$110/barrel. We will review our CPO price in due course to account for these developments if they turn out to be significant. Also uncertain is the outcome of Argentinian farmers’ standoff with the government on the 44% export tax on agriculture products such as sunflower and soybean. If not resolved, this may affect soybean plantings in the upcoming season and will seriously impact the already tight global soybean market. Argentina accounts for 19% of total global soybean oil output and 54% of global soybean oil exports.
Figure 6: Breakdown of soybean oil output and exports by countries
Clarifying changes in Malaysia’s palm oil taxes. We reiterated to clients that the recent move by the Malaysian government to replace the cooking oil cess scheme with a windfall tax is net positive for the East Malaysian planters and slightly negative for planters in Peninsular Malaysia. We also highlighted to investors that the Malaysian planters are still better off than their Indonesian peers as total palm oil taxes (windfall and sales tax) in Malaysia of around 7-11% on CPO selling price is less than Indonesian planters’ current export tax of 15%. We are also of the view that clarification on the palm windfall tax in Malaysia will help lift the uncertainty overhanging the sector. Furthermore, our opinion is that the sector is unlikely to face additional taxes for the next year or so, under the current administration.
Concerns raised by investors
Sustainability of record crude oil prices. Investors voiced their concern over the sustainability of crude oil prices and a potential sharp correction in oils and other commodities on concerns over weaker demand. We agree that this scenario will be negative for CPO price, which is indirectly linked to crude oil price. However, our regional energy analyst believes that the fundamentals for crude oil remain strong and predicted in a report on 14 May 2008 that crude oil should average US$110-120/barrel in 2008-2010. At these crude oil prices, CPO should be firmly supported at RM2,800- 3,000 per tonne over the next three years at the current exchange rate.
Potential U-turn on biofuel subsidies/targets by key countries. We were also asked about the possibility of a U-turn in biofuel targets in the US and European Union (EU), which are increasingly blamed for pushing up food prices globally. Our view is that a complete removal of current biodiesel incentives or targets is unlikely. However, governments may be pressured to reduce the current biofuel targets. Between the US and EU, we believe the latter is likely to make concessions on this front in the near term. However, we do not expect a substantial change. That said, a drastic cut in the EU’s current biofuel target for transport of 5.75% by 2010 and 10% by 2020 would be negative for edible oil prices as it reduces the demand growth prospects for edible oils. We also stated our opinion that the US is unlikely to change its biofuel incentives in the short term, judging from the recent statement by Edward Schafer, the US secretary of agriculture, that renewable biofuels is one of the ways to deal with the high oil prices. He indicated to the media that analysis by his department indicated that biofuel production is responsible for only 2-3% of the increase in global food prices and had reduced consumption of crude oil by a million barrels per day.
Widening valuation gap between planters and market. Other concerns raised are the widening P/E gap between the plantation sector against the market as the sector has outperformed the market YTD. We argued that the valuation gap might narrow over time as there are potential earnings upside to planters’ earnings if CPO price exceeds expectations, in contrast to earnings downside risk for other sectors, which are affected by global economic uncertainty and high commodity prices.
Addressing concerns over high palm oil stocks. Malaysia’s palm oil stock level rose by 0.8m tonnes yoy to a record 1.91m tonnes in May, as exports grew at a slower space than output. On an absolute level, the stock level may appear high relative to historical standards but we believe this is partly due to structural changes in palm oil trades and government policies. Firstly, consumers have been keeping lower stocks due to higher working capital costs following the sharp rise in CPO price. As a result, the key producing countries, in particular, Malaysia, are holding more stock. Secondly, due to the monthly variation in Indonesia’s export tax rate for palm oil according to the monthly average CPO price, the Malaysian refiners have seen an increase in imports of palm oil from Indonesia. This is evident from the 142% yoy jump in palm imports by Malaysia in the first five months of 2008 to 258,951 tonnes. Lastly, the higher stock level represents only 1.6 months of exports coverage, which is not high considering the above factors as well as the fact that refined edible oils can be stored for at least six months. We also pointed out that Malaysia’s palm oil exports increased by 14% yoy in the first five months of the year, which suggests that demand remains healthy and is likely to stay high in view of CPO price competitiveness relative to other edible oils.
Valuation and recommendation
Maintain OVERWEIGHT call. Overall, we remain bullish on the sector’s long-term fundamentals and maintain our OVERWEIGHT call on the sector. However, we are turning a bit cautious in the short term due to (1) the high volatility in the oil market, (2) possible demand dent from economic uncertainty and near-record CPO prices, (3) biofuel policy risks, and (4) the sector’s outperformance YTD. Our views are shared by most investors who are less bullish on the plantation sector compared to a year ago. On a more positive note, we believe our CPO price assumptions are conservative and there is potential upside to our price forecasts given the current tight edible oil supplies and volatile global weather conditions of late. Also, this sector offers the best relative defensive play in the current uncertain market environment.
No change to our recommendations and top picks. There is no change to our top big-cap picks, which are IOI Corp for Malaysia, Wilmar for Singapore and Astra Agro for Indonesia. We like IOI Corp for its share liquidity, capital management and transparent management. Its share price is well supported by its ongoing share buyback programme. Wilmar is our top pick in Singapore for potential merger synergies, M&A possibilities and unique global agribusiness exposure. Indonesia’s Astra Agro boasts strong management, large asset base, attractive valuations and share liquidity. Among the mid-cap planters, we like Asiatic in Malaysia, IndoAgri in Singapore and Sampoerna Agro in Indonesia. Key re-rating catalysts for the sector are higher CPO price, adverse weather, further biofuel incentives and rising crude oil price.
Ivy Ng Lee Fang CFA +60(3) 2084 9697 - ivy.ng@cimb.com
filed: roadshow harvest 24 June 2008.pdf
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