Investment Highlights

• Maintain NEUTRAL on the sector. Average spot price has been roughly RM2,900/tonne year-to-date. Assuming average CPO price is RM2,400/tonne in 2H2017, average CPO price would be RM2,650/tonne in 2017F. As this is only 3.9% above our assumption of RM2,550/tonne for 2017F, we are not revising our forecast. The catalyst would be a severe El Nino, which would throw production forecasts for palm oil and soybean out of the window. We are neutral on the plantation sector as there is a balance between positive and negative factors.

• The positive factors are:
  • Soybean and soybean oil prices have bottomed. We believe that the downside for soybean prices is limited as the 13.2% decline in soybean prices since the peak in January 2017 has already reflected the risk of a glut. In addition, the latest demand and supply forecasts for soybean by the USDA are not bearish. The USDA has forecast global soybean production to fall by 1% to 344.68mil tonnes in 2017F/2018F and world soybean inventory to ease by 1.5% to 88.8mil tonnes. The caveat is that the USDA's forecasts are inconsistent sometimes.
  • Short-term softness in CPO production. Seasonal reasons and the fasting month are expected to result in palm oil production softening in Malaysia and Indonesia in May and June 2017. This is expected to support CPO prices as palm inventory may not reach the critical level of 2mil tonnes in Malaysia immediately. We expect CPO output to resume its upward trend from July or August 2017 onwards.
  • Weather could lower production estimates. As at 9 May 2017, Australia's Bureau of Meteorology said that there is a 50% chance of an El Nino in the coming months. Caveat is that weather is difficult to forecast. Weather experts predicted El Nino in 2013 and 2014 before it took place in 2015. Another issue is the strength of El Nino. A weak El Nino is unlikely to have a significant impact on palm yields. The severe El Nino in 2015 resulted in a 13.2% drop in palm oil production in Malaysia in 2016.
• The negative factors are:
  • China and India's demand for palm oil may soften in 2H2017. We believe that China has re-stocked sufficient palm oil reserves. Also, demand is usually weaker during the winter season. Hence, China's palm purchases may ease in 2H2017 compared with 1H2017. Palm inventory at major ports in China rose by 97.1% from 0.29mil tonnes as at end-October 2016 to 0.58mil tonnes as at 12 May 2017. China's palm imports surged by 26.4% YoY in 4M2017. India's demand is weak as reflected in the 36.2% YoY fall in Malaysia's palm exports to the country in 4M2017. However if CPO prices fall further, Indian buyers may return into the market. In April 2017, traders in India indicated that demand is soft as there is not much difference between CPO price and soybean oil price. Inventory of edible oils in India stood at 2.1mil tonnes as at 1 May 2017. India's inventory of edible oils ranged from a low of 1.2mil tonnes to a high of 2.4mil tonnes in the past six years.
  • EU's non-trade barriers against palm oil are a long-term concern. If there is a ban on palm-based biodiesel in the EU, biodiesel producers would have to use rapeseed and soybean as feedstock for biodiesel. This is expected to result in a shortfall of rapeseed or soybean oil for the food industry. However, palm oil may not benefit from this. Food producers in the EU may be reluctant to use palm oil due to the negative campaigns on palm oil. Use of palm oil in the food industry in the EU fell by 22.4% from 3.1mil tonnes in 2010 to 2.4mil tonnes in 2014. About 45% of palm oil were used in the biodiesel industry in the EU in 2014 while another 34% were used in the food industry. Malaysia's palm oil exports to the EU have been flat since 2010. Indonesia's palm oil exports to the EU grew by 2.6% in 2015 and 3.2% in 2016. The EU accounted for 12.8% of Malaysia's palm exports and 17.4% of Indonesia's palm exports in 2016. EU lawmakers plan to pass the law on a single certification scheme for palm oil and ban on palmbased biodiesel by year 2020.
  • No increase in biodiesel quota in Indonesia in 2017F? We think that Indonesia's subsidised biodiesel consumption may be flat at 2.6mil tonnes in 2017F. According to an industry player, Pertamina may release another biodiesel tender to maintain the amount of volume achieved in 2016. Recall that the biodiesel quota dropped by 10.2% from 1.53mil kiloliters (1.33mil tonnes) for the period of November 2016 to April 2017 period to 1.37mil kiloliters (1.2mil tonnes) for the period of May to October 2017. Previously, industry experts predicted that Indonesia's subsidised biodiesel consumption would rise from 2.6mil tonnes in 2016 to 3mil tonnes in 2017F.
  • Palm oil production to be healthy in 2H2017. So far this year, the recovery in palm oil production in Malaysia and Indonesia has met expectations. CPO production in Malaysia rose by 18.3% in 4M2017 compared with industry experts' forecasts of a 12.1% to 14.7% increase for 2017F. In Indonesia, Oil World estimates CPO output to grow by 9% in 2017F vs. 7.8% in 2016. CPO production is expected to pick up further in 2H2017 as oil palm trees move towards the high productivity season. Peak output is expected to take place in either September or October 2017. In 2016, Malaysia achieved the highest CPO production level in September. 2H usually accounts for 55% to 60% of full-year's CPO production.
• KLK is top pick. Although we are neutral on the plantation sector, we would recommend Kuala Lumpur Kepong (KLK) for investors who would like exposure to the plantation sector. We like KLK for its young oil palm trees in Indonesia, well-managed plantation operations and low net gearing ratio. We have a fair value of RM25.70/share for KLK, which implies a FY18F PE of 25x.

Source: AmInvest Research - 22 May 2017