Weaker average CPO price in 2013. We expect CPO price to average RM2,800 based on West Malaysia price versus an estimated RM2,870 this year. Although weaker on a y-o-y basis, it represents a significant recovery from currently depressed levels, and will be dependent on the following:
1. Reduction in Malaysia's CPO export duty, thus freeing up the outflow of CPO from the country. At the current price, CPO export duty will go down to zero come January 2013;
2. Nationwide rollout of biodiesel in Malaysia to use up 0.5m tonnes of CPO;
3. Surge in new refining capacity in Indonesia will reduce the bargaining power of Indonesian refiners versus CPO producers, while the erosion of downstream margin will discourage the dumping of prices in the export market, thus resulting in the operating environment normalising in 2013; and
4. Seasonal production downcycle, which should pare down Malaysia's inventory by 0.4 to 0.9m
tonnes by mid-2013.
Another year of healthy production. Given the friendly weather in the past 24 months, 2013 production will continue to be healthy. Indonesia should register another year of robust growth, amounting to some 1.6m tonnes, compared with an estimated 1.8m-tonne increase in 2012. Malaysia will also chalk up higher production growth although the quantum will be rather marginal. The question really is whether global demand can absorb Indonesia's rising production. Should global demand continue to grow at the normal 5m to 6m-tonne rate, the increase in Indonesia's production would easily be absorbed. Otherwise, the strong supply will continue to weigh down on CPO prices.
Trade may normalise in 2013. Indonesia's will be seeing a significant increase in annual refining capacity throughout 2013 to about 40m tonnes by early 2014. Currently, due to the lack of refining capacity in Indonesia, Indonesian refiners have been able to buy CPO at a discount to the international market price. Given their lower raw material cost relative to their Malaysian counterparts, Indonesian refiners are able to sell at more competitive prices. This had directly given risen to an inventory build-up in Malaysia throughout 2012. As more refining capacity comes on stream in Indonesia, the discount at which Indonesian refiners buy CPO will narrow, thus affecting their ability to sell cheaply. This along with Malaysia's lower CPO export duty come January 2013, will help to remove trade distortions and facilitate the free flow of CPO. As such, inventory should normalise from the current record levels and Malaysian refineries should see some improvement in margin although we have not factored this into our forecasts.
Weather concerns linger but nothing serious, as soybean production is still on track tomeet demand. On the soybean front, while there continues to be worries over potential delays in planting in Argentina due to heavy rainfall and some dry spots in Brazil's soybean planting areas, any impact arising from the patchy weather would only be known later, ie when the planting period comes to a close and harvesting begins sometime in 1Q2013. According to Oil World, South America's soybean production needs to increase by 28m to 30m tonnes in 2013 in order to ensure a sufficient supply of global oilseeds until the North American crop arrives in 3Q2013. At this point of time, we believe this is still achievable despite the potential weather impact. Recently, Argentina's "Sociedad Rural" (the Rural Society of Argentina), projected that 3m-4m ha of Argentina's crop areas will be unplanted this year, and that the country's soybean crop would only reach some 50m tonnes in 2013 (+23.5% yoy from 40.5m tonnes in 2012). This is still an increase of 9.5m tonnes. Recently, Brazil's "CONAB" (the Agriculture Ministry's crop-forecasting agency), raised its soybean crop estimate for 2013 by 4.7% to a record 82.6m tonnes (+30.3% y-o-y from 63.4m tonnes in 2012), due to more soybean planting at the expense of cotton and grain. This implies an increase of 19.2m tonnes. It also means that Argentina and Brazil alone would already be producing an additional 28.7m tonnes of soybean in 2013, which according to Oil World estimates, is enough to meet demand. This does not even include the soybean crop coming from other South American countries like Paraguay, Uruguay etc, which are projected to produce an additional 5m tonnes of soybean in 2013.
Discount to soybean oil remains high. Palm oil price is trading at more than USD400 discount to that of soybean oil. The key factor to this is the ample supply of palm oil relative to soybean oil. Malaysia's palm oil stock to usage ratio is on the high side at 11.1% based on November data. Should the stock usage ratio remain at these levels, the steep discount to soybean oil will remain relatively high, unless the current South American soybean planting turns in a bumper harvest. We note that soybean supply tightness is perhaps behind us now as the South American season should turn out to be significantly better than the 2012 North American season, during which the region was hit by a worst-in-a-generation drought. That said, we note that the speculative net long positions for soybean have also fallen by more than 50% off its peak, indicating that the better South American harvest is already priced in.
Possible changes in EU biofuel policy could curb demand. Demand could be affected by possible changes in biofuel and trade policies in the EU. Recent media reports suggest that the EU is considering limiting the use of crop-based biofuel to 5% by 2020. The EU's original biofuel target was 10% by 2020, with the bulk of it supposed to have come from crop-based biodiesel made from rapeseed and wheat. Currently, as 4.5% of biofuel in the EU already comes from vegetable oils, this means that there would not be much more room for an increase in demand in the future. There are also reports that the EU is considering imposing anti-dumping duties on Indonesian and Argentine biofuel, as it is currently being sold for USD60-USD110/tonne lower than EU biodiesel, which has led to several bankruptcies Europe's biodiesel industry. If this is implemented, Indonesia's biofuel demand may also be affected, which will in turn curtail demand for CPO.
... thus, Malaysia's biodiesel demand needs to absorb supply surplus. With these risks emerging on the biofuel front, it is now crucial for the palm oil producing countries to have their own biodiesel mandate to absorb the surplus supply. Malaysia is rolling out its B5 biodiesel on nationwide basis, which will use up 0.5m tonnes of CPO per annum. Biodiesel was partly responsible for Indonesia's surge in palm oil consumption from 3.9m tonnes to 6.7m tonnes over the past five years; hence its effectiveness should not be underestimated. Meanwhile, the significant jump in Malaysia's monthly local consumption to more than 200k tonnes for two consecutive months suggests that conversion to biodiesel has started ahead of the nationwide B5 blend. The discount at which CPO is trading relative to crude oil also reinforces the case for biodiesel.
CPO price decline largely done. We believe the decline in CPO prices has largely reflected the rise in inventory, while the parity with crude oil will lend support to palm oil price. Going forward, we see Malaysia's nationwide B5 biodiesel rollout and the substantially lower CPO export duty as catalysts that could potentially help to bring down inventory levels, and in turn boost CPO prices. Our CPO price assumption of RM2,800 implies that palm oil price could surge to as high as RM3,000 - RM3,100 in 1H13, before settling below the RM3,000 level later.
But look out for another quarter of poor earnings. As CPO price only started on a steep decline in September 2012, the Sept quarter results did not reflect the full impact of the price decline. Instead, this weakness will show up in the upcoming December quarter results due to be announced in February 2013, whereby the 23% drop in average CPO price will be reflected. Investors looking to buy plantation stocks may best wait for the kneejerk reaction anticipated to follow when the December quarter results are released.
El Nino could come back. The Southern Oscillation Index (SOI) has recovered to neutral zone after briefly plunging into deep negative territory, rendering the El Nino signal a fake one. Nevertheless, we note that the SOI has been staying very close to the zero line and could swing back to El Nino zone. By next year, it will be 15 years since the last severe El Nino hit this region; hence investors should keep an eye on this potentially price-boosting event.
Neutral on Malaysian plantations. Overall, we are Neutral on the Malaysian plantation sector. Although CPO price is poised for some recovery in 2013, valuations are largely uncompelling; hence our Neutral stance. We accord target PEs of 15x-16x CY13 to the big cap plantation stocks and 12x-13x CY13 for the mid-cap stocks under our coverage. Our large cap top pick remains Sime Darby, an integrated player with stable contributions from its non-plantation related industries, which will provide an earnings buffer during a CPO price downturn, and whose valuations are at a 2x-3x PE discount to its peers. Among the mid-cap high growth stocks, we like Sarawak Oil Palms and TSH Resources. We may upgrade our fair values to incorporate higher target PEs of 20x - 21x should CPO price tick up and hang on to those elevated levels, especially coming off a low price base similar to what took place in 2009.
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