palm oil(棕油网): Rising downside risk for CPO price

Rising downside risk for CPO price
UNDERWEIGHT Maintained (CIMB)
8 August 2008

Steep fall in CPO price. Since our last regional plantation report on 18 Jul, CPO spot price has dropped by 20% to RM2,785 per tonne. We attribute the price weakness to: (1) a 10% slide in crude oil price since our last note; (2) improved prospects for edible oil supplies and (3) concern over a slowdown in edible oil consumption.

Sentiment outweighs fundamentals. The unexpectedly big drop in CPO price in just a short span of time has rattled sentiment in the palm oil market. It could lead to forced selling by brokers in the CPO futures market, sending CPO prices below its fundamental-support price. Some palm oil traders may also renege on their forward contracts. We may also see some redemption of commodity funds by investors. This could aggravate the fall in the prices of edible oils and related products.

Downside risk to 2009 price. For 2009, we believe there could be downside risk to our CPO price forecasts if oilseed crop prospects in key planting areas continue to improve and there is no spike in oil price or unforeseen disruptions to grain and oilseeds supplies due to government intervention or weather developments. That said, we retain our CPO price forecast for 2009 as it is supported somewhat by our house view of an average crude oil price of US$120 per barrel.

Some earnings revision and flagging CPO price risk. We have adjusted our earnings forecasts for Astra Agro and Sampoerna Agro by a range of –8% to +3% to account for higher fertiliser costs, better seedlings earnings and higher third party FFB purchases. We maintain our earnings forecasts for the rest of planters but in view of the downside risk to CPO price, we scale back our target P/Es to align them with their historical 3-year average forward P/Es. As a result, our target prices are cut by 11-34%.
Recommendation changes. With the downward revision in our target prices, Sime Darby is reduced from outperform to NEUTRAL while Asiatic, Sampoerna Agro and Hap Seng Plantation which used to be neutrals are relegated to UNDERPERFORM.

Maintain UNDERWEIGHT. We think that the recent share price correction has removed the P/E premium accorded to the sector but does not factor in the rising downside risk to CPO price. Our UNDERWEIGHT stance on the sector is reinforced by the key de-rating catalysts of increasing volatility of CPO price and emerging concern over the unwinding of funds from the commodity market and planters’ rising operating costs.

Sector comparisons

Background
CPO price fell sharply over the last few weeks. Since our last regional plantation report on 18 Jul, CPO spot price has dropped by 20% to RM2,785 per tonne while CPO futures has fallen 19% to RM2,830. This means that CPO price has given up all the gains made during the year and is now at a 10-month low. CPO futures price is 8% below the 1 Jan 08 level and 34% below the year’s high of RM4,315 (see Figure 1).

Why the concern? What caught our attention in the recent movement in CPO price are: (1) The magnitude and pace of decline in CPO price. It has dropped 20% in just three weeks after trading within a steady price band of RM3,300-3,600 per tonne. (2) Our key fundamental support level of RM3,000 per tonne of CPO, which is based on the breakeven price for CPO conversion to biodiesel, has caved in. This is unlike the sharp decline in CPO price seen in May 08 after a bout of speculative buying on the back of supply worries which sent CPO price up 22% in two weeks before the correction (see Figure 2).

Breaking the RM3,000 psychological support. We were surprised by the recent plunge in CPO price to below the RM3,000 level. In our earlier note, we had projected a price range of RM3,000-3,600 for 3Q08 as we expected stronger festive demand for edible oils to offset the higher palm oil production in Malaysia. The recent price slump has also caught several industry observers by surprise. What sparked the decline? In this note, we analyse the factors that contributed to the sharp drop in CPO price. In a nutshell, the convergence of a few negatives – weaker crude oil price, improving edible oil supply prospects and lower CPO consumption from major buyers – are the main reasons behind the price decline. We also look at recently announced plans by the Malaysian and Indonesian governments to support CPO price.

Figure 1: Recent price movement of various related commodities to CPO price

Figure 2: Comparing the two sharp declines in CPO price in 2008

Figure 3: CPO price movement since 2007

Outlook
What has changed? We attribute the recent decline in CPO price to the convergence of a few negative developments: (1) the decline in crude oil price by 10% since our last note; (2) improved prospects for edible oil supplies; and (3) concern over a slowdown in edible oil consumption.

Falling crude oil price dampen floor price for CPO. The recent slide in crude oil price has dented sentiment on CPO and edible oils as it lowers the floor support price for biodiesel conversion. The lower crude oil price, coupled with recent reports that biofuel may have contributed to the sharp rise in global food prices, may also reduce governments’ interest in promoting biofuel, thus crimping edible oil demand for fuel usage. We note with interest the steeper drop in CPO price vs. the fall in crude oil price. This has improved the economic viability of CPO-based subsidised biodiesel. However, CPO price is still trading above the CPO-biodiesel breakeven level if one excludes government subsidies of US$150 per tonne we assumed for biodiesel producers. This implies that the market may be imputing a cutback in government incentives for biodiesel following the recent newsflow on the potential reduction in biodiesel target/subsidy.

Figure 4: CPO biodiesel price breakeven chart

Improved prospects for edible oil supply… We believe the market may also be increasingly concerned about a potential rise in the current record palm oil inventories as both Malaysia and Indonesia are now in the peak palm oil production season, which will end in Sep-Oct 08. The recent repeal of Argentina’s soybean export tax hike has improved the availability of soybean supplies to the export market while reports of improved weather in the US have raised prospects of better soybean harvests. There is also an increasing perception that the United States Department of Agriculture (USDA) will raise its corn and soybean output estimates as the improved weather in the planting region may boost yield potential. Also, a recent report by Oil World indicates better-than-expected rapeseed supplies from Europe and Ukraine, which will ease the current shortage. Lastly, China National Grains and Information Center revealed two days ago that soybean output in China will rise by 37% to 17.5m tonnes from a year earlier. This exceeded last month's forecast by 1m tonnes and may reduce demand for imported edible oils in the coming months. All of these newsflows point to an easing of the supply tightness in the coming months, which will help to satisfy consumption and replenish stocks.

Figure 5: Oil World projects rising global rapeseed oil stocks in 08/09

Figure 6: Oil World projects global palm oil output to increase by 3.9m tonnes in 2008

…. and worries of weakening demand. Recent reports suggest that high prices have curbed demand for edible oils. We understand from market players that the increased demand for soymeal in China may have raised consumption of soyaoil in the country at the expense of palm oil. Palm oil exports to China may slow down ahead and during the Olympics as the country has reportedly stocked up. Also, edible oil demand for biofuel usage could slow if governments pull back their biofuel incentives as biofuel is viewed to have contributed to the rising global food prices. There is also fear that the slowing global economic growth will rein in edible oil demand growth in the coming year.

What about plans by governments to support CPO price? Malaysia and Indonesia recently agreed to use the surplus from their palm oil stockpiles to produce biodiesel for local usage as part of the mechanism to boost palm oil price. While the idea of increasing usage of palm oil through the production of biodiesel is good, there are many challenges in terms of implementation. Firstly, the biodiesel programme will need funding and considerable support from the governments given that diesel in both countries is subsidised by the governments at below market price. Secondly, distribution of the products may be hampered by logistic challenges. For example, in Malaysia, it is unclear which party will be in charge of producing or blending the biodiesel for local usage. Thirdly, as it is a new product, the biodiesel may not be widely accepted by consumers unless the government makes biodiesel usage mandatory. We believe the market is discounting this news due to lack of details on funding and implementation. If successfully launched, it could provide some support for CPO price.

Figure 7: Share of biofuel in edible oil consumption
Biodiesel 6%
Food and others 94%

Sentiment outweighs fundamentals. The unexpectedly big drop in CPO price in just a short span of time has rattled sentiment in the palm oil market. It could lead to forced selling by brokers in the CPO futures market, sending CPO prices below its fundamental-support price. Some palm oil traders may also renege on their forward contracts in view of the sharp drop in selling price, which could delay shipments of palm oil to destination markets if it gets out of hand. We may also see some redemption of commodity funds by investors, which is evidenced from the lower volume of open interest futures contracts for palm oil-related products traded on CBOT (see Figure 8). This could aggravate the fall in the prices of soybean, wheat and corn products. Given the price volatility, buyers, on the other hand, are likely to run down inventories and buy only what they need in anticipation of buying at lower prices later. Overall, these factors could push CPO price below its fundamental support price until some positive re-rating catalysts for CPO price emerge, for example, a resurgence of crude oil price and a weather-induced shortfall in edible oil supply.

Figure 8: Open interest future contracts movement palm oil-related commodities at CBOT (volume)

Some good news. On a more positive note, the plantation companies that we spoke to recently remain positive about the long-term prospects of CPO price and believe that fundamentally, CPO price should trade above RM3,000 per tonne in view of rising consumption for food and energy usage. This is broadly in line with our view that CPO price should rebound towards the later part of this year when palm oil production enters the low season in 4Q08 and China increases its edible oil purchases ahead of the Jan 09 Chinese New Year festivities.

Rising CPO price risk. We are keeping our CPO price forecasts of US$1,105 (RM3,350) for 2008 and US$1,090 (RM3,000) for 2009. In the first seven months of 2008, CPO price averaged RM3,474. CPO price would need to average RM3,178 over the next five months to meet our CPO price forecast of RM3,350 for the full year. Despite the recent CPO price plunge, we remain optimistic that our price forecast can be met as we expect a recovery in demand in 4Q and think there may be setbacks in the US soybean harvest due to earlier weather concerns. Furthermore, CPO price still trades at an attractive discount of US$400 per tonne to its key competitor, soybean oil. Also, lower Indian palm oil import duties will help boost palm oil demand by the country.

Downside risk to 2009 price. For 2009, we believe there could be downside risk to our CPO price forecasts if oilseed crop prospects in key planting areas continue to improve and there is no spike in oil price or unforeseen disruptions to grain and oilseeds supplies due to government intervention or weather developments. That said, we retain our CPO price forecast for 2009 as it is partially supported by our house view of an average crude oil price of US$120 per barrel. However, a removal of biodiesel incentives may lead to a downgrade of up to US$150 (RM450) per tonne for our current CPO price forecast of RM3,000 per tonne. We maintain our view that CPO price will most likely peak in 2008 as the high price in the past three years has spurred new plantings of oilseeds and curbed demand growth in low-income countries.

Figure 9: CPO price forecasts

Valuation and recommendation
Revising earnings for two companies. We have adjusted our earnings forecasts for Astra Agro and Sampoerna Agro by a range of -8% to +3% to account for higher fertiliser costs, better seedlings earnings and higher third party FFB purchases. There is no change to our earnings forecasts for the rest of plantation companies under our coverage as we are not changing our CPO price forecasts and have already factored in higher fertiliser costs.

Flagging downside risk to our 2009 CPO price forecast. However, we caution investors that there is downside risk to our 2009 CPO price forecast stemming from further weakening of crude oil price or an improvement in edible oil supplies. Our sensitivity analysis of earnings to CPO price changes (see Figure 10) reveals, as one would expect, that the pure planters are affected most by changes in CPO price assumption. Every US$100 per tonne change in CPO price would change our EPS forecasts by 6-15%, depending on the companies’ exposure to plantation earnings.

Cutting target prices. In view of the downside risk to CPO price, we scale back our target P/Es to align them broadly with the 3-year average forward P/Es that planters with a three-year share price record have traded at. Overall, we are reducing our target P/Es by 1-5 multiple points (Figure 11). As a result, our target prices are cut by 11-34%.

Recommendation changes. With the downward revision in our target prices, Sime Darby is reduced from outperform to NEUTRAL while Asiatic, Sampoerna Agro and Hap Seng Plantation are relegated from neutral to UNDERPERFORM. We reiterate our UNDERPERFORM call for IOI Corp and KL Kepong. In Singapore, there is no change to our UNDERPERFORM call on Indofood Agri and NEUTRAL call on Golden Agri and Wilmar. In Indonesia, we are keeping our UNDERPERFORM call for Astra Agro, London Sumatra and Bakrie Sumatra.

Maintain UNDERWEIGHT. Although share price of plantation stocks have corrected by 7-34% following our last report, we continue to rate the sector an UNDERWEIGHT owing to concerns over the increasing volatility of CPO price, emerging concern over the unwinding of funds from the commodity market, planters’ rising operating costs, the potential U-turn in biofuel policy and slowing earnings growth momentum (see Figure 12). We think that the recent share price correction has removed the P/E premium accorded to the sector but does not factor in the rising downside risk to CPO price. Share prices may see short-term rebound after the recent steep decline. We advise investors to use any rebound to reduce their exposure to the sector. Key de-rating catalysts are the softening CPO price outlook, lower crude oil price and higher-than-expected operating costs.

Figure 10: Earnings sensitivity to CPO price changes