For our 4Q16 sector outlook, we maintain a NEUTRAL outlook with a trading view as we expect volatile CPO prices given mixed catalysts. FY16E CPO price is upgraded to RM2,500/MT on tight stocks level, while FY17E CPO price maintained at RM2,400/MT on a bearish 2H17 production recovery. 4Q16 production should continue picking up, though earlier production setbacks could cut full-year production by 11-12% YoY, supporting near-term prices. On biodiesel, we expect a limited impact from the recent OPEC crude oil production cut, while mandate announcements could provide brief price boosts. Demand should remain robust on stock drawdowns, though soybean oil may absorb some demand given limited palm oil stocks. Year-end La Nina odds are fading, but could still provide a catalyst. Given mixed catalysts, we expect volatile 4Q16 CPO prices between RM2,400-2,900/MT. We downgrade KLK to MARKET PERFORM with an unchanged TP of RM25.00 on fair valuations, while we upgrade FGV (MP call) TP to RM2.65 (from RM2.10) on improving CPO prices and fading M&A risk. We prefer TAANN (OP; TP: RM3.94) and UMCCA (OP; TP: RM6.50) on above-average production prospects due to their young tree age. Our other calls and recommendations include: NEUTRAL on SIME (TP: RM7.90), IOICORP (TP: RM4.60), IJMPLNT (TP: RM3.60), TSH (TP: RM1.95), CBIP (TP: RM2.15), and UNDERPERFORM on PPB (TP: RM15.00) and GENP (TP: RM9.80).

Limited 2QCY16 improvement. Of our 11 stocks, only SIME beat the consensus on oneoff tax benefits and better Motors/Industrials performance. Only 3 (IJMPLNT, PPB, UMCCA) performed within our forecast, while the remaining 6 missed on below-expected FFB recovery amid 1Q16 setbacks. This slightly improved over 1Q16 with 3 above and 9 below forecasts. Despite decent QoQ FFB recovery in Malaysia, we noted flat-to-weaker growth in Indonesia, which indicates a stronger drought impact in Kalimantan and a high likelihood of delayed peak production (c.October/November). Yearly growth was generally weaker (avg. -8%) with TAANN the only exception (+9%) due to its Sarawak concentration and young age profile of its trees. Moderate production pickup in 4Q16. We expect FFB production to continue its monthly increasing trend to peak in Oct-Nov 2016, later than the last two years’ peak in Aug 2016 due to production setbacks on 2015 droughts. Year-to-date production has continued to track 5-year lows, indicating that full-year production could drop to c.17.58-17.76m metric tons (MT), or by -11-12% YoY. Poor production figures should continue suppressing 2016 stocks up to late-4Q16, supporting near-term prices.

Stronger production recovery from 2H17. Beyond 2016, we expect strong production recovery from mid-2017 onwards once the third stage of production impact kicks in 22-24 months after the mid-2015 droughts. Recall that FY15 production at 19.96m MT was an all-time high for Malaysian production. We think that monthly production rates could well recover to 2015 levels from mid- 2017 onwards on post-drought recovery and new maturing area in Sarawak. Based on historical average production levels, we expect production to rebound, most likely to 19.3-20.2m MT, representing 9-14% against 2016, or -3 to +1% against 2015. This will likely be bearish to prices from 2Q17 onwards as investors start pricing in the production pickup.

Unsustainably low SBO premium. As noted in our monthly production outlook report (published 14-Sep-16), the recent run-up in CPO prices had sharply narrowed the soybean oil (SBO) and CPO price premiums in mid-September, and we deemed this unsustainable, at -1.5SD from the long-term historical average of c.USD150/MT. Indeed, since a brief equalisation of SBO-CPO premiums on 13thSep 2016, the SBO premium has since widened substantially to trade at USD60/MT as of 29th Sep 2016. Nevertheless, we think the SBO-CPO premium has some room to widen further – as higher production season kicks in for both palm oil and US soybeans, and the additional supply could provide better bargaining power on the buyer side.

OPEC announcement to have limited impact on biodiesel production – mandates a bigger driver. Despite the 29thSep 2016 OPEC announcement of a planned production cut, the market appears sceptical as prices have remained relatively flat c.USD49/barrel for Brent as of 30th Sep 2016. With a limited crude oil/gasoil price impact from the announcement, the price gap of c.USD220/MT between CPO and gasoil means that discretionary biodiesel blending will remain very slow, with total biodiesel production largely mandate-driven. We continue to believe biodiesel will not be a major price catalyst in 2H16, though newsflow on the planned B10 implementation in Malaysia over 4Q16 could provide temporary price boosts.

Decent demand from India & China. On the demand side, we think Indian and Chinese demand should be supportive to prices in the near term, although incoming soy supplies could pose risks. For India, the recent 5% reduction in palm oil import duties (CPO: 7.5%; processed palm oil: 15%) improves purchasing power on the buyer side. We note that year-to-date Indian demand has been fairly robust, at 2.04m MT as of Aug-16. This is -6% below 2015’s record high (2.17m MT) on account of lower production and tight stocks, but a substantial 64% above the 8-year average of 1.24m MT. With the import duty reduction and upcoming festival season in end-October, we expect short-term demand to be sustained in early 4Q16. Meanwhile, for China, demand has picked up in recent months as palm oil stocks fell 62% from 786k MT to 296k MT as of end-Sept 16. With the sharp drawdown in demand, we expect palm demand in China to normalize closer to 200-250m MT/month (the 3-year average monthly demand). However, according to Oil World, US farmers are about to harvest a record soybean crop, within the latest USD estimate of 114m MT. This may absorb some Indian and Chinese edible oil demand.

Diminishing weather factor. While drought impact continues to be felt on FFB production, fears of La Nina appear to be subsiding as forecasters are now expecting >50% probability of neutral weather heading into 2017. However, the possibility of La Nina should not be ruled out, as our study of previous ENSO patterns suggested a higher frequency of La Nina (>70%) following severe El Nino events. While the odds of La Nina occurring in late 2016/early 2017 is <50%, according to weather experts, a moderate-to-severe occurrence should provide a mid-4Q16price boost of c.RM150/MT above a ‘base case’ scenario based on our updated CPO pricing model.

Expect volatile pricesfrom 4Q16 to mid-17. Based on the current supply/demand environment, we expect prices to be volatile in light of multiple positive and negative catalysts. In the near-term, positives include tight stocks and decent export demand, with possible catalysts, including announcements on biodiesel implementation, or weather disruptions further weakening production and stock levels. However, headwinds include a strong soy harvest and palm oil production recovery toward mid-2017. With SBO continuing to be a major price factor, we expect volatile CPO prices of between RM2,400-RM2,900/MT in 4Q16, based on SBO premium ranging between USD20-150/MT.

3Q16 results to show mild improvement. QoQ, we expect stronger earnings driven by better production, as average prices have improved by only 1% to RM2,630/MT while we expect Malaysian production to rise 22% to 5.11m MT. However, YoY, 9M16 earnings could be only flat against 9M15 as production is expected to decline 15% to 12.70m MT. This is only partly offset by average price improvement of +17% to RM2,550/MT.

KLPLN fairly valued in short-term. The KLPLN is currently trading on par with the FBMKLCI as the KLPLN’s 2-year total return of -10.4% against the KLCI’s -10.8% represents a 0.4% premium, or -0.1SD against the historical average discount. We think this is fair as investors appear to have priced in production weakness affecting full-year earnings, which is offset by stronger prices arising from tight supply. Looking ahead, we think the KLPLN is fairly valued, as upside of 1.9% is slightly below downside of - 2.8%, based on a KLPLN-KLCI standard deviation between +0.5SD and +1.5SD. Accordingly, we expect the KLPLN to trade between 7,700 to 8,070 pts in the near term.

Updating CPO pricing model. We update our CPO price estimation model to a Monte Carlo model from a regression model, incorporating crude oil, SBO, Malaysian inventory, USD/MYR rates and weather impact (based on ENSO Indicators). Using historical data of key indicators, we formulate the relationship between the combined variables to CPO prices, with an aim of maximizing accuracy. This produced a pricing model with meaningful predictive power, given its R-squared of 87%. To forecast forward CPO prices, we apply our pricing formula and respective indicator averages/standard deviations to a Monte Carlo model and average out the resulting CPO price estimates.

Upgrade CY16E CPO forecast to RM2,500/MT. Based on year-to-date average values of our key indicators, our model returns an average CPO price of RM2,500/MT for CY16E. We concur with the results, as CPO prices have strengthened beyond our expectation largely in view of weaker-than-expected production data. Hence, we increase our CY16E average CPO price forecast to RM2,500/MT from RM2,400/MT.

Maintain CY17E CPO forecast at RM2,400/MT. Based on 1-year average value of our key indicators, our model returns an average CPO price of RM2,400/MT for CY16E. We agree that prices are likely to soften in CY17E as CPO stocks should normalise in 2H17 on strong production recovery. Hence, we maintain our CY17E CPO price expectation at RM2,400/MT.

Downgrade KLK to MARKET PERFORM (from OUTPERFORM) as we believe market valuations have caught up to fundamentals. We maintain our TP of RM25.00 based on CY17E EPS of 104.2sen and Fwd. PER of 24.0x, or mean valuation. We believe this is fair as KLK’s weaker FFB production outlook is offset by stronger downstream prospects.

Maintain MARKET PERFORM on FGV with higher TP of RM2.65. We upgrade our TP to RM2.65 (from RM2.10) as we upgrade our valuation basis to mean valuation (from -0.5SD) as we expect the improving 4Q16 production outlook and supportive CPO prices, as well as fading risk of unfavourable M&A, to improve market sentiment on the counter. However, we maintain our MARKET PERFORM call on FGV in view of its below-average FY16E production prospect of -10% compared to the sector average (+2%).

Maintain NEUTRAL and trading view. We reiterate our NEUTRAL view on the sector with a trading outlook as we expect a volatile 4Q16 given mixed catalysts. While tight stocks level and decent demand should prove supportive to short-term prices, a strong US soy harvest and narrow SBO premium could limit upside in the near-to-mid term. Hence, we expect volatile CPO prices of between RM2,400-RM2,900/MT in 4Q16. In view of 1H16 production weakenes, we upgrade CY16E CPO prices to RM2,500/MT (from RM2,400/MT), but maintain CY17E CPO prices at RM2,400/MT as post-drought recovery should lead to softer 2H17 CPO prices. Meanwhile, we lower our call on KLK (TP: RM25.00) to MARKET PERFORM as valuations catch up to fundamentals, and increase our FGV TP to RM2.65 (from RM2.10) on better short-term prospects and fading M&A risk. Of the stocks under our coverage, we like TAANN (OP; TP: RM3.94) and UMCCA (OP; TP: RM6.50) as their young average tree age supports solid FY16E FFB growth of 12% and 10%, respectively, which is well above the sector average of +2%.

Source: Kenanga Research - 6 Oct 2016