Malaysia June palm oil output of 1.448m MT fell 10% short of Kenanga’s forecast and came in 4% weaker than consensus. Exports of 1.172m MT was muted, coming in 3% lower than our estimate, but 8% above consensus. Consequently, inventory closed just 1% above our estimate but 8% short of consensus. Average CPO price for June was RM3,525/MT (-7% MoM, -45% YoY) but for the full-year to 2023, we continue to expect average CPO prices of RM3,700/MT. A severe El Nino can push prices up but thus far CPO prices are still trading within our expected range. Maintain NEUTRAL as the threat of El Nino is not a foregone conclusion. Meanwhile, the sector’s cash flows and balance sheet remain defensive, while cost pressures should ease in the 2H of 2023. Ratings are not demanding either; hence, an opportunity to selectively accumulate in the event of stronger CPO prices and earnings from a severe El Nino. KLK is our sector choice.

Although Malaysia’s end-June inventory inched up, the level is not excessive and remains below the historic average for the month. Looking ahead, FFB output should improve seasonally in July to peak in Sept or Oct 2023. However, an El Nino is looking likely come the end of 2023 or early 2024. If serious, our current expectation of a small 2024 global edible surplus can turn into a deficit even with a small fall in palm oil output of just 2% in 2024. Hence, current expected CPO prices of RM3,700/MT for 2023-24 may end up stronger. So far, the threat of El Nino seems to have provided some support to edible oil prices from easing further but yet to raise prices above our expected range of RM3,500-4,000/MT for CPO.

Cost pressures are still high but easing. Fertiliser prices have fallen by about 35% from the peak in 2Q CY22 but are still more than 50% above the 10-year average. Likewise, diesel cost has eased but still not cheap while wages are still trending up only that the increment is now slower. A side product of FFB after CPO is extracted, palm kernel (PK) is sold to offset the cost of producing CPO. Whilst CPO is largely consumed as food, palm kernel oil (PKO) is used more in personal care, cosmetics and industrial products such as coatings or greases. Therefore, PKO prices can react more to economic slowdown as recently demonstrated - trading close to CPO prices instead at the usual 20%-30% premium. This should reverse as PKO inventory adjusts to the new demand environment but this transition may stretch beyond 2023 so the benefit of higher PK prices to lower CPO cost and lift margin may have to wait till then.

Maintain NEUTRAL as a serious El Nino is still not conclusive. However, given that the sector is already trading at 1.1x PBV with plenty of negative news reflected into the sector’s equity prices, investors may want to consider some selective accumulation in the event CPO prices and earnings are lifted by a severe El Nino. In any case, the market for palm oil should stay robust, underpinned by demand from the food and biofuel sectors. Moreover, many players in the sector own land banks with market value worth far higher than their reported book value. Gearing is also low to moderate with several in net cash position. While CPO selling prices can be volatile, efficient operators with good cost control can generate healthy cash flows along with decent returns. We like: (i) KLK (OP; TP: RM24.50) for its strong track record, regional upstream operations and growing downstream operations, (ii) PPB (OP; TP: 19.30) for its exposure to Wilmar and strong market position in Southeast Asia’s growing consumer essential segment and (ii) HSPLNT (OP; TP: RM2.30) which offers upstream exposure with cash surplus to sustain a decent dividend yield.

Source: Kenanga Research - 11 Jul 2023