We expect neutral impact from the upcoming budget to be tabled on 25th October. While some allocations may be provided to encourage biodiesel production, the impact to the potential beneficiaries (SIME and FGV) should be minimal at less than 1% accretion to their bottom lines. Even if the much talked-about Goods and Services Tax (GST) is introduced, we think the cost of production may only increase by about 2%. Budget aside, we believe CPO prices should have bottomed out helped by the swift Indonesia biodiesel policy implementation which spurred higher usage. This will ensure that any significant palm oil supply increase can be converted into biodiesel and hence keeping inventory level in check. However, CPO prices upside is also limited in the near term as we are entering seasonally higher production months in September and October. We maintain our NEUTRAL call on the sector with our current CY13-CY14 average CPO price forecasts of RM2,400/mt-RM2,700/mt unchanged. Although we are NEUTRAL at this juncture, we believe investors should look at these two factors which we believe will lift CPO prices significantly: (i) if the current dry weather in South America persist till end-Nov as this will increase CPO substitution demand due to insufficient soybean oil (“SBO”) and (ii) if Brent crude oil surge above USD120/barrel as this will increase biodiesel demand and subsequently palm oil.

Our top pick is CBIP (OP; TP: RM3.18) as we expect it to benefit from global palm oil mill construction demand and its good EBIT margin at more than 20%. We also have OUTPERFORMs on PPB (TP: RM15.20) and TSH (TP: RM2.56). Maintain MARKET PERFORM on SIME (TP: RM9.80), IOICORP (TP: RM5.40), KLK (TP: RM21.50), FGVH (TP: RM4.55), GENP (TP: RM9.35), IJMP (TP: RM3.00) and UMCCA (TP: RM7.55). Maintain UNDERPERFORM on TAANN (TP: RM3.55) due to its high cost issue.

Expect minimal impact from upcoming Budget 2014 on 25th October. The only impact may be some allocation provided to encourage biodiesel production locally in Malaysia. Recall that the Malaysia Government has targeted to implement B5 program nationwide in July 2014 upon which palm biodiesel consumption will be increased to 0.50m mt annually (from 0.25m mt in 2012). Although SIME and FGV should benefit (should this materialize), the impact to their net income would be small (<1%). We also also believe some allocations will be made for oil palm replanting program which are aimed to increase FFB yield to 26.2mt/ha by year 2020. However, public-listed planters would not benefit as these are mainly targeted at smallholders.

What if GST is announced? If this scenario materializes, it will increase the overall CPO cost of production (CP) due to expected rise in transportation cost (~15% of total cost). However, fertilizer cost (~30% of total cost) and labor cost (~25% of total cost) should not be affected. Hence, we think the increase in total CPO CP should be manageable at about 2%. We also expect no impact on CPO prices which is influenced more by global demand and supply (instead of local factors).

Budget asides, CPO prices should have bottomed helped by the swift Indonesia biodiesel policy implementation. Recall that Indonesia announced in end-Aug that it plans to raise its biodiesel plan to B10 (from 7.5% currently). Additionally, the requirement will be extended to non-subsidized fuel and industrial users in Jan-2014 while power plants will be obliged to use bio-diesel with a 20% blend. Based on the latest data gathered from MPOB on the significantly lower palm imports in Aug-2013, we believe that the Indonesian biodiesel policy has been effective in absorbing its additional supply. Our estimates shows that Indonesia’s local consumption should increase by 1.57m mt in 2014 due to the higher biodiesel usage which should absorb about 87% of the additional supply of 1.80m mt expected from Indonesia in the same year. Overall, we think CPO prices are already near its bottom as any significant supply increase would be converted mostly into biodiesel and hence keeping inventory level in check.

Waiting for these catalysts to lift CPO prices. Although short-term CPO prices upside should be limited as we are entering seasonally high production months in September and October, we wish to highlight several factors that may cause CPO prices to surge. Firstly, we gather from Oil World that South America’s weather has been too dry recently. While it is still not too late for the rain to arrive, we believe the situation may develops into a supply shock if the dry season continues into November as it will affect South America soybean and soybean oil (“SBO”) production significantly. Under such a scenario, demand for palm oil should increase as it is commonly used as a substitute to SBO. Another factor to watch out for is Brent crude oil price movement in which we think any significant increase above USD120/barrel will lift CPO prices significantly. 

Source: Kenanga