Malaysia's CPO inventory level for May-12 was reported at 1.76m mt, below the consensus estimate of 1.78m-1.79m mt. It was also 3% below our estimate of 1.81m mt as the tree stress effect caused a worse-than-expected production decline. With total demand increasing 6% MoM against a flat total supply (+0.3% MoM), the stocks-to-usage ratio declined to 9.2% in May-12 (from 10.2% in Apr-12). On the supply side, although CPO production showed a higher production of 9% MoM, it still lags behind the 14% MoM improvement shown in May-11. As a result, May-12 CPO production registered a 21% slump YoY as the tree stress effects intensified. On the demand side, exports increased 5% MoM in May-12 to 1.40m mt as demand growths from Pakistan and European countries were more than enough to offset the lower demand from China and India. Lastly, China's easing monetary policy and the increasing chances for a return of El Nino are bullish for CPO prices. We are maintaining our OVERWEIGHT call on the plantation sector with an average CPO price of RM3,200 per mt as the fundamentals of the sector  remain  healthy.  We  have OUTPERFORM  calls  on  SIME  (TP:  RM10.80),  GENP (TP: RM9.90) and IJMPLNT (TP: RM4.00) on valuation grounds. To leverage on their  double  digit  FFB  growths,  we  also  have  OUTPERFORM  calls  on  TSH  (TP: RM2.50), UMCCA (TP: RM8.00) and TAANN (TP: RM6.10). We are maintaining MARKET PERFORM calls on KLK (TP: RM22.10) and IOICORP (TP: RM5.35).

May-12 stocks level lower than expected.  The CPO inventory level of 1.76m mt was below the consensus estimate of 1.78m-1.79m  mt. It was also 3% below our estimate of 1.81m mt as the tree stress effect caused a deeper production drop than expected. As total demand increased 6% against a flat total supply, the stocks-to-usage ratio declined to 9.2% in May-12 (from 10.2% in Apr-12). On the overall, the sustained drop in the stocks level below 2.00 mt is positive for CPO prices.

Tree stress effect was more severe than expected. We believe that the data confirmed that tree stress effect has intensified as the drop of 21% YoY in May-12 was worse than the YoY decline of 17% YoY in Apr-12. After a strong  production  year  in  2011,  oil  palm  tree  will usually go through a low production period, which can last up to 2.5 years.  Still resilient demand from Pakistan and Europe. Exports increased 5% MoM in May-12 to  1.40m  mt  as  the  demand  growth  from  Pakistan  and  European  countries  was  more  than enough to offset the lower demand from China and India. Among the key CPO consumers, the highest growth was seen in Pakistan (+80% MoM to 175k mt) and Europe (+11% MoM to 226k mt). The strengthening CPO exports to Pakistan were probably caused by CPO purchases ahead of the Ramadhan month (fasting month), which will begin around 21-July-2012. European demand for palm oil may have increased due to a higher usage of palm oil as a cheaper feedstock for biodiesel after the its season ended.

China's reduction of interest rate positive on CPO prices. After Australia cut its interest rate by 25bp to 3.5% on 5 Jun, China also unexpectedly reduced its interest rate by 25bp to 6.31%. We understand that this was the first  interest rate cut since 2008, and hence we believe  that  more  monetary  easing  policy  may  follow  suit.  In  addition,  the  other  major economies such as United States and Europe may introduce further easing policies to support the global economic growth. Generally, CPO prices will benefit from this trend as easing policy usually will result in a better economy growth going forward, hence higher CPO demand. 

CPO prices should surge if El Nino returns in 2H12.  According to Australia Bureau of Meteorology, all seven models surveyed indicate that conditions are likely to approach, or possibly exceed El Nino thresholds during the Australia late winter to early spring period. In addition, US Climate Prediction Center mentioned that there is a 50% chance that El Ni''o conditions will develop during 2H12. To conclude, there are increasing chances for El Nino to return as the 30-day Southern Oscillation Index (SOI) values have remained on the negative side of neutral over the past two weeks. Sustained SOI negative values below '8 will confirm the  return  of  an  El  Nino  event.  We  expect  CPO  prices  to  surge  if  El  Nino  is  confirmed  as  FFB production may be reduced by a staggering 30% depending on the severity of the El Nino.