We upgrade the sector to MARKET WEIGHT. The CPO price weakness since Feb 17 could have factored in concerns over the increase in FFB production. More importantly, Malaysia plantation stocks are now trading at a sector PE of 22x (close to -1SD of 5-year mean). There is no strong catalyst to lift CPO prices way above RM2,600/tonne to trigger an upgrade to OVERWEIGHT for now. We maintain 2018 CPO ASP assumption at RM2,400/tonne.

WHAT’S NEW

• CPO prices could have hit the bottom. Crude palm oil (CPO) prices have been trending in the range of RM2,350-2,550/tonne in Dec 17-May 18. We understand that downside risk for CPO prices is limited after the significant decline from the peak in Feb 17, but there is no strong catalyst to push CPO prices upwards amid high palm oil inventory levels.
• Biodiesel to buffer downside risk. Biodiesel demand could be higher than expected in 2H18 on the back of the current higher crude oil prices. The potential extra demand is set to come from non-mandated biodiesel blending. At the current gasoil price of US$650- 700/tonne, no subsidy is required for biodiesel blending in Indonesia. For 2018, Indonesia is expected to increase domestic biodiesel usage to 3.6m kilolitres (kl), up from 2.5m kl of biodiesel in 2017 (40% yoy or +1.0m kl). Coupled with the B25 mandate, biodiesel will make up 6% of 2018 global palm oil consumption or about 30% of 2018 palm oil inventory.
• But high supply and inventory may limit CPO price upside:
  • Palm data is more bearish with inventory above the norm, and CPO production expected to surge. Palm oil inventory has built up to a high of 2.73m tonnes from the low of 1.53m tonnes in Jun 17. Despite the recent fall in Jan-Apr 18, we expect the upcoming strong production to continue to boost the already-high inventory level. End-Apr 18 palm oil inventory in Malaysia was 2.17m tonnes. Global stock-to-usage (SU) ratio for palm oil as at end-17 was 18.9% vs 2016’s 16.1% or last five years’ average of 18.9%.
  • Global 8 major oils SU ratio is high, but severe soybean damage in Argentina prevents further inventory build-up. Despite the drought in Argentina, 2017-18 global oilseed supply is ample and oilseeds stocks are high. The 2017/18 8 major edible oils supply is expected to exceed demand by 2.68m tonnes, mainly due to strong palm oil production. The SU ratio for the 8 major oils is about 14.2%, which is higher than that of 2016/17 and above the last 10 years’ average of 13.6%. The peak of SU ratio came in at 17.2% for 2014-15.

ACTION

• Upgrade Malaysia plantation to MARKET WEIGHT as CPO prices could have hit the bottom. We upgrade Malaysia plantation to MARKET WEIGHT. The correction over the last one year could have factored in the lacklustre CPO price outlook. As we are not expecting further weakness in CPO prices, we reckon the sector is now trading at its near-term fair value. CPO prices are likely to trade sideways, and we are awaiting stronger re-rating catalysts eg much stronger biodiesel demand or disappointing production.
• There is no strong catalyst to trigger an upgrade to OVERWEIGHT but we see limited downside risk due to better gasoil prices of US$650-700/tonne and lower soybean supply.
• Malaysian plantation stocks are trading at a sector PE of 22x which is close to -1SD below its five-year mean. We maintain BUY on Kim Loong and have recently upgraded Sarawak Oil Palms as the latter’s share price has weakened significantly since Jan 18 (- 18.5%), and we believe the expected CPO price weakness for 2018 has been priced in. We recommend SELL on Sime Darby Plantation and IOI Corporation.

ASSUMPTION CHANGES

• Maintain 2018 CPO price assumption. To date, CPO ASP is RM2,437/tonne (-18.3% yoy). For 2018, we maintain our forecast at RM2,400/tonne as CPO prices could trend as low as RM2,250/tonne once production picks up in 2H18. We also maintain 2019 CPO price assumption at RM2,500/tonne.
• CPO prices could trend sideways in the near term. CPO prices are negatively correlated with palm oil inventory levels. As inventory is expected to increase in 2H18, CPO prices are expected to trend in the range of RM2,350-2,500/tonne in 2Q18 and RM2,250-2,600/tonne in 2H18. CPO prices could trend even higher in end-4Q18 due to the low production season.

RISKS

• Labour is main challenge facing sector. Oil palm cultivation is labour-intensive and mechanisation has its limits. The sector is facing two major issues with regard to labour:
  • Acute labour shortage. Hiring of foreign labour could get tougher under the new government. In its manifesto, Pakatan Harapan indicated that it would reduce foreign worker supply, which would pose a huge challenge to the plantation sector as it heavily relies on foreign workers. The labour shortage has resulted in wastage of crops that were not harvested and were left to rot. Progress has been made in mechanising field operations such as manuring, spraying, and loading of harvested fruit bunches onto vehicles to be transported out of the fields. However, mechanisation of the harvesting process continues to stump even the best minds after all these decades.
  • Cost pressure from rising minimum wage. East Malaysian planters face potential cost pressure as there is a plan to synchronise the minimum wages of Sabah and Sarawak (RM920) with that of Peninsular Malaysia (RM1,000). This could increase cost of production by 2-5% for planters with East Malaysia exposure. On top of that, Pakatan Harapan’s manifesto to raise the minimum wage to RM1,500 could add 5- 11% to cost of operation.

Source: UOB Kay Hian Research - 11 Jun 2018