While headwinds remain, palm oil prices have recovered from subMYR1,900/tonne levels. Production has likely peaked for 2015, allowing the market to start factoring in upcoming production concerns. 4Q is seasonally a good quarter and prices may continue to be lifted by the El Nino factor in 2016. We expect El Nino to hit across the oil palm region eventually, although the impact is uneven so far.

Production has peaked. Malaysia’s palm oil production may have peaked in August, especially for West Malaysia. We suspect it is the same for Indonesia, as severe haze (with the Air Pollution Index (API)approaching 2,000) is likely to affect productivity. We understand that 3Q production for Kalimantan is disappointing due to the dryness experienced between July and October last year.

El Nino strengthening. The sea surface temperature (SST) anomaly is now more than 2 degrees Celcius above normal, which indicates astrong El Nino. In comparison, 2014 was just 1 degree Celcius above normal. Weather authorities think the current episode will last into 2Q16.

Still early days. As we are more than two quarters away before El Nino ends and the production impact will last into 2017, there is still plenty of room for palm oil prices and plantation stocks to move higher. We expect them to peak in 1Q17, taking into account the 12-month lag effect (see our report Quantifying El Nino dated 20 May 2015 for details). Our base case is for the price of palm oil to rally to MYR2,900 per tonne, but will likely be exceeded as effects become more widespread.

Soybean factor. Soybean is the major overhang for the plantation sector at the moment, as the US crop is sizeable. However, with itsharvest progressing faster than normal, being 42%-complete, full completion may be as early as end-October. This would allow the price of palm oil to resume its recovery.

Stock picks. First Resources (FR SP, BUY, TP: SGD2.54) is still our top sector pick. We also like Genting Plantations (GENP MK, BUY, TP: MYR10.40), and Astra Agro Lestari (AALI IJ, BUY, TP: IDR28,337)

4Q tends to be a good quarter for the price of CPO and the plantation sector, and we do not believe that there will be any difference this time around. From 1996 to 2014, palm oil prices produced a median return of 9.9% in the 4Q, compared to flat or negative returns for all the other quarters. In terms of probability, the price of palm oil rose two-thirds of the time in the 4Q. What tends to bump up the sector in the 4Q is a fall in seasonal production. The production seasonal upcycle, which tends to weigh on 3Q CPO prices, would have peaked in September or October.

The market has been concerned about palm oil inventory rising to dangerous levels, as it has already grown to 2.5m tonnes by end-August. However, it appears that production has already peaked for Malaysia in August. The first 20 days of September saw Malaysia’s production declining by 5.3% MoM, while exports rose by 13%. This suggests that inventory could have peaked in August. Without the overhang of a rising stockpile, the palm oil market can turn its attention to El Nino’s impact on production, especially in 2016.

We believe 4Q palm oil prices could turn out to be better than usual given the El Nino weather phenomenon, which the market has been ignoring, given the rising palm oil stockpile and burdensome soybean inventory. With peak palm oil inventory no longer an uncertainty in 4Q, palm oil prices would start to factor in the adverse dry weather driven by El Nino – especially since l Nino is expected to strengthen further by early October. Note that the SST has been rising steadily since the start of 2Q this year and the SST anomaly now stands at 2.13 degrees Celcius. That is about 1 degree warmer than 4Q last year when there were El Nino fears.

India’s monsoon season this year has been disappointing, with cumulative rainfall being 12% below average. In its crop-producing region, the rainfall deficit is said to be even more serious. That partly explains why India’s edible oil imports have been so strong this year (+25% YoY). In terms of quantum, India’s imports rose by 1.9m tonnes in the first eight months of this year, which more than offset China’s 0.48mtonne decline in imports.

With the price of palm oil averaging MYR2,166 per tonne based on the West Malaysia price and on a recovery path, our average price assumption at MYR2,200 per tonne for 2015 is within reach. Our average palm oil pr ice for 2016 stands at MYR2,500 per tonne – which appears to be a big jump, relative to the 2015 average– but is really just USD20 per tonne higher, compared to more than USD200 per tonne higher in 2010.

The discount of USD97 per tonne against soybean oil is still good enough to encourage buyers to opt for palm oil over soybean oil. We expect the discount to narrow in the year ahead to around USD50 per tonne, as palm oil supply deteriorates faster than soybean oil supply.

Despite the delay in implementation due to economic and policy hurdles, we still expect Indonesia’s biodiesel demand to kick in in 4Q, as all the various issues have been taken care of. Indonesia started charging an export levy of USD50 per tonne for CPO and up to USD30 per tonne for refined products in July, the proceeds of which would be used to fund its B15 biodiesel programme.

Fertiliser prices have eased slightly in the recent two months, mainly due to the slide in urea and potash prices. The composite fertiliser cost per ha stood at USD305 vs an average of USD311 in 1H. We expect these levels to be sustained going into 2016, unless energy prices recover significantly from here. The US crop progress report indicated that 64% of soybean crop is in good or excellent condition, compared to 73% last year. Harvesting is 42%-complete, which issharply faster than 32% for the past five years. While US soybean crops will undoubtedly still be big this year, early completion of harvest will mean the earlier removal of the soybean overhang factor.

We remain OVERWEIGHT on the Singapore and Indonesia plantation sectors whilestaying NEUTRAL on Malaysia. We are reviewing our CPO price assumption for 2016, given that the average CPO price for 2016 looks easily achievable. First Resources remains as our top sector pick. We also like Genting Plantations (TP under review) and Astra Agro Lestari.