Investment Highlights

• Structural changes in the sector. In this report, we highlight the structural changes that are taking place in the plantation sector. We also highlight the changes in the CPO price cycle. We believe that most of the changes are negative for the sector in the long term. In spite of this, we are keeping our average CPO price assumption of RM2,300/tonne for Malaysia for 2019F (2018: RM2,235/tonne). Average CPO price (MDEX price) was RM2,014/tonne in 1Q2019.

• CPO price cycle has changed. Comparing CPO prices for the period of 1996 to 2011 with prices from 2012 to 2018, the cycle (from trough to peak) has become shorter. After 2012, the CPO price upturn lasted for only slightly more than a year. In comparison from 1996 to 2011, the CPO price upcycle lasted for two years, at least.
  
  The recent recovery in CPO price from November 2018 to February 2019 lasted for only four months.
  
  Also, the highest level for CPO price in each cycle is falling lower while the lowest prices have been consistently below RM2,000/tonne. During the recovery period from December 2008 to February 2011, the highest monthly CPO price (MPOB price) was RM3,811/tonne. From December 2012 to March 2014, CPO’s monthly price was the highest at RM2,855/tonne. In the recent upturn in CPO price, the highest monthly level of CPO price was RM2,101/tonne. We attribute the change in CPO price cycle to changing demand and supply dynamics.

• Biggest structural demand changes. First, China’s consumption patterns are changing. According to the USDA, China is transitioning from “eating full” to “eating well”. As such, middle-class consumers are choosing snacks and foods perceived to be healthier rather than the traditional snacks and instant noodles of the rural and older consumers. We believe that more than 20% of palm oil are used to fry instant noodles in China while another 30% are blended with other vegetable oil to make cooking oil.
  
  Also, during the Palm Oil Conference in KL early this year, an industry expert said that in spite of the increase in disposable income, China is consuming more meat instead of vegetables. This has increased China’s imports of soybean, which are used to produce feed meal for the poultry and hog industries. China’s soybean imports rose by 67.2% to 88.03mil tonnes in 2018 from 52.6mil tonnes in 2011. In contrast, China’s palm imports fell by 16.1% to 5.3mil tonnes in 2018 from 5.9mil tonnes in 2011. We believe that even if China increases its palm imports, the level of imports would not return or exceed the record high of 6.3mil tonnes in 2012.
  
  Second, the EU is phasing out diesel cars. Automobile companies have said that they would be introducing more electric car models by 2025. This would affect the biodiesel market in the EU even if the EU does not impose a ban on palm biodiesel. According to Oil World, about 49.5% of palm imported into the EU are used to produce biodiesel while another 29.8% are used by the food industries. The balance 20.7% of palm oil are used in the electricity, heating, oleochemical and feed meal industries.

• Biggest supply risk. The biggest risk is if China successfully produces CPO on a big scale. This would reduce China’s demand for palm oil from Malaysia and Indonesia, and this will affect CPO prices. Recently, China’s news agency Xinhua  reported that the Chinese Academy of Tropical Agricultural Sciences has selected the first palm tree species for mass production in China. The tree species realised an oil yield of 2.8 tonnes per ha in trial plantation. The academy has plans to expand cultivation of palm oil in the southern provinces of Yunnan and Guangdong.
   
• In spite of this, palm oil does not face an existential crisis. In spite of the sombre prognosis, we believe that the palm oil sector does not face an existential risk as cooking oil is a food staple. Although there are anti-palm oil campaigns in the EU, which may affect demand from the food segment, we reckon that there are new markets to explore such as Africa. 
  
  India will also remain as a key consumer of palm oil as it is unlikely that the country’s consumption patterns will change like China. Finally, palm oil is the livelihood of smallholders in Malaysia and Indonesia, accounting for 40% each of the two countries’ CPO production. In the worst-case scenario, we believe that there will be some form of government support.
   
• Global supply may slow down but timing is uncertain. We conclude that the long-term outlook for CPO may not be as exciting as 10 years ago. However, a silver lining is that global palm supply may slow down due to the decline in new plantings of oil palm in Indonesia.
  
  The issue is the timing. It is not known when CPO production in Indonesia would start to stagnate. In the coming two years, we think that CPO output in Indonesia would still continue to rise on the back of increases in mature areas. The exception is if there is a supply shock from El Nino.
   
• For now, we are keeping our UNDERWEIGHT stance on the plantation sector. We believe that CPO prices will continue to be weak as FFB production is expected to rise in the coming months ahead of the peak output period in 3Q2019. Nevertheless, for investors who would like exposure to the sector, we would recommend integrated companies as downstream earnings would help cushion the fall in upstream earnings. As such, we would recommend IOI Corporation for its stable oleochemical earnings and high gross cash reserves of RM2.8bil.

Source: AmInvest Research - 3 May 2019