A 2023-24 El Nino is looking likely. The question now is more of severity. While harmless if weak or moderate, a serious El Nino is expected to swing a small 2024 global edible oil surplus into deficit. However, it is probably too early to incorporate such a deficit and raise CPO prices above our current assumptions of RM3,700 per MT for 2023-24. Current softness in edible oil prices also suggest that even the commodity market is more concerned about near-term supply and demand. Whilst a severe El Nino outcome may not be sufficiently conclusive to warrant an outright overweigh of the plantation sector, valuations are sufficiently low for investors to consider tactical accumulation so as to capture the potential upside in the event of a severe El Nino. Longer term, palm oil also offers exposure to the essential food (and fuel) market, growing emerging economies such as China and India as well as being Shariah compliant (12.6% of FBM Shariah Index, 12.1% of FBMKLCI). Maintain NEUTRAL with KLK as our sector pick (OP; TP: RM24.50) given its strong track record, upstream operations and regional presence.

Despite poor Argentinian soyabean harvest, 2023 edible oil supply is still expected to recover by 3% YoY. Brazil’s 2023 record soyabean harvest is virtually over. Sizeable US soyabean planting is near completion while better rapeseed and palm oil harvests are still likely. Our supply side concern is for 2024 as the US National Oceanic and Atmospheric Administration (NOAA) just declared an El Nino is here so a warmer end-2023 and early 2024 can be expected.

El Nino is a natural, recurring climatic phenomenon, marked by warmer-than-average sea surface temperature around the Pacific Ocean. It brings rain to the eastern front but dryness to western Pacific, including Southeast Asia. Eastern Sulawesi and Borneo as well as northwest Peninsular Malaysia which saw prolonged dryness during the last serious El Nino episode of 2015-16. Often categorised as weak, moderate, strong, or very strong - the impact on the oil palm sector in the past is often small unless a “very strong” El Nino occurs. Localised FFB yield can then drop by 10%-15% during such occurrences but smaller dips of 1%-3% is often registered at aggregated, industry-wide level because output from the additions of newly planted area coupled with younger trees maturing into more productive age help to compensate for the larger localised impact.

However, Southeast Asian oil palm sector is getting mature. Planted oil palm area has been declining in Malaysia while Indonesian expansion has slowed. Compound this with labour issues and ageing trees, FFB yields have already been on the downtrend since 2008. The 5% dip in palm oil output caused by the “very strong” 2015-16 El Nino can thus serve as a guide in the event of another similar-strength El Nino but a more pronounced impact should not be ruled out either.

Fragile supply-demand outlook. Despite improving supply, 2023 is still likely to end the year with flattish YoY inventory due to rising demand. Altogether, the global edible oil supply-demand balance remains delicate. For 2024, our base case is a small edible oil surplus of 1%-2% over global demand. However, this surplus can easily swing into deficit with a mere 2%-3% cut in 2024 palm oil production. A larger 5% reduction in 2024 palm oil output can even drag end-2024 inventory down by 10% YoY to a 10-year low when expressed as a percentage of demand.

Softer edible oil demand arising from an economic slowdown is possible but is more likely to be limited to the smaller biofuel segment. Thus far, biodiesel production remains robust while demand from the larger food segment is healthy with China and India switching from palm oil to soyabean and sunflower oils after sizeable palm oil imports in the preceding months, while buyers from Pakistan, Middle East and Africa are stepping in to take advantage of the current palm oil price softness - essentially, some switching between different types of oil but no noticeable demand dip overall.

Costs are easing but still high by historical standards. Fertiliser cost has eased by 35% from 2QCY22’s peak but remains high, at 55% above the 10-year average. Energy prices have also fallen, by about half that of recent peak in 3QCY23 and is now just 3% above the 10-year average. However, wage inflation is stickier and the 25% jump in Malaysian minimum wage which took effect in May 2022 will translate into a 7% YoY increase in 2023. Recovering FFB yields in 2023 among some Malaysian planters should also temper parts of the wage inflation.

However, PKO prices have fallen to CPO price level since mid-2022. This is unusual as PKO (palm kernel oil) often trades at 20-30% premium above CPO prices. Lower PKO (hence lower palm kernel or PK prices) raises the breakeven point for CPO as planters with mill typically offset their ex-mill CPO cost by netting out the proceeds from selling PK (this is referred as “PK credit”). Consequently, the recent fall in PK prices caused the net cost of producing CPO to increase. Overall, CPO production cost is estimated to have risen from RM2,000 (or even lower) two years ago to RM2,000-2,500 per MT currently including PK credit. If PK credit is excluded, current CPO cost would be closer to RM2,500-3,000 per MT.

PKO prices are likely to revert back to premium levels against CPO prices but current trading conditions may prevail for another 6-12 months as PKO demand can be more sensitive to economic slowdown than CPO. The demand for CPO is derived predominantly from the food sector while PKO is used to formulate personal care products, cosmetics, cleaning agents as well as industrial coating, grease and lubricants. As such, the demand for PKO can be more sensitive to economic slowdown when compared to CPO.

Resilient demand, defensive balance sheet with low PBV of 1.1x. Trading at close to book value, a lot of bad news is already reflected in the share rices of many plantation groups. Moreover, many own land banks with market value worth considerably higher than the value carried in their books. Gearing is also low to moderate with several having surplus cash. Demand for edible oil (which palm oil dominates) is also resilient, being an essential component in today’s food chain. While selling prices can be volatile due to supply swing, more efficient operators with good control over costs often generate healthy cash flows and decent long term returns.

High cost may be easing, after margin erosions for the past quarters. Nevertheless, margins are expected to stay under pressure for another quarter or two even as some input costs have started declining. FFB output is also improving; hence, easier unit cost is expected in the latter half of 2023. Meanwhile 2023-24 CPO prices should stay firm at RM3,700 per MT but, as discussed, a serious El Nino can push prices higher. Maintain NEUTRAL as a severe El Nino outcome is still inconclusive. However, investors should be tactical as 1.1x PBV for the sector is not demanding while a severe El Nino can cause CPO prices and earnings to strengthen. We like KLK (OP; TP: RM24.50) for its strong track record, upstream operations and regional presence, PPB (OP, RM19.30) for its exposure to Wilmar and strong business position in Southeast Asia’s consumer essentials businesses. HSPLANT (OP; TP: RM2.30) offers pure upstream exposure with strong net cash holdings and decent dividend yields prospects.

Source: Kenanga Research - 19 Jun 2023