Fast start to a new cycle. Rationale for report : Sector update

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1 PLANTATION SECTOR Fast start to a new cycle Gan Huey Ling, CFA gan-huey-ling@ambg.com.my Investment Highlights Rationale for report : Sector update OVERWEIGHT (Upgraded) CPO price estimates raised; Sector upgraded to Overweight. After a sharp and swift correction in the CPO pricing cycle in 2H08, we are seeing growing signs of a sustained recovery in prices that started from December We do not think that the recent recovery in CPO price is seasonally-driven ahead of the Chinese New Year festivities. We are raising our CPO price assumptions to RM2,000/tonne for 2009F (from RM1,800/tonne previously), rising further to RM2,300/tonne in 2010F and RM2,500/tonne in 2011F respectively. Accordingly, we are upgrading the plantation sector to a non-consensus OVERWEIGHT and reinstating the big-cap sector proxies IOI Corp, Kuala Lumpur Kepong (KLK), Sime Darby and Wilmar International, in our BUY list. We put forth several reasons to underpin our bullish conviction. Peaking CPO production and inventory levels. From our recent company visits, we sense that production may soon peak with the passage of time. Planters have been adjusting their planting and agronomic practices due to the plunge in CPO prices. These proposals such as replanting and reducing the usage of fertiliser, may lower FFB (fresh fruit bunches) yields and production. We understand from a major local fertiliser supplier that demand has been weak as planters are adopting a wait and see attitude in anticipation of a lower price for fertiliser before committing to orders. As it is, we have already seen industry experts revising down production growth estimates to reflect the rapid adjustments o the supply-side. Production growth in Indonesia has been slashed from 13% to 8%, while Malaysia s production is now expected to remain flat at 18 million tonne for 2009F. Based on our estimates, CPO production in Malaysia is expected to peak by 3Q2009F before leveling-off. We expect CPO inventory to decline to 1.9 million tonne (November 2008: 2.3 million tonne) by year-end due to a combination of a recovery in exports and peaking production. There is also risk of dry weather threatening soybean production in South America. Brazil s National Commodities Supply Corp recently revised its forecast for 2008/09F soybean production by 2% to 57.7 million tonne. Soybean production of 57.7 million tonne for 2008/09F is 4% lower than 2007/08F s soybean crop of 60 million tonne. Like Malaysia, Brazilian soy farmers have been complaining about the high costs of fertiliser, which is restraining them from planting more soybean. CPO defaults overplayed. News of default in CPO shipments appears to have been significantly overplayed. Major plantation companies under our coverage have indicated that they were not significantly affected by the defaults. News report had placed the amount of CPO defaults at 1.5 million tonne or about 8.6% of Malaysia s 2008F CPO production. Recovery in demand from China and India appears imminent. We expect exports of CPO to China and India to reaccelerate from firming demand trends, and the price of substitutes to rise. Stockpiling of corn and soybean by the provincial governments in China should underpin rising soybean prices. To support local farmers, Heilongjiang a major soybean region, needs to buy 4.5 million tonne of corn by April 2009 to boost its reserves. The Chinese Government s policy is to stockpile 2 million tonne of soybean, 7.1 million tonne of corn and 5 million tonne of rice in Heilongjiang. Demand from India is also expected to increase due to expectations of an import tax on vegetable oil in the coming months. This is a populist measure by the Indian Government to help farmers ahead of the elections in May Narrowing price discount between CPO and soybean oil: Based on the last CPO price cycle, we find that the price discount movements between CPO and soybean oil are a leading indicator of CPO pricing cycle. Since reaching a peak discount of 41% in November 2008, the price discount has narrowed to 38% in December 2008 (10-year average discount: 16%). There has been some switching between CPO and soybean oil. Industry players also said that the widening discount in the past year was partly supply-driven as soybean inventory peaked ahead of a peaking in the CPO inventory. Going forward, the price disparity between the two commodities should decline further on the back of softer CPO output and firming demand, providing a kick to CPO prices. Plantation stocks are under-owned ; a weak US$ may also lift sentiment. IOI s foreign shareholding stood at 26% as at November 2008, 12-percentage points lower than the high of 38% a year ago. Sime Darby s foreign shareholding fell from 21% as at end-march 2008 to 13% as at November With analysts still clustering at the negative end of the PP12246/4/2009 (021280)

2 Plantation Sector market, we expect growing evidence of a sustained CPO price recovery to soon trigger a consensus rating upgrade on the plantation sector; rejuvenating the inflow of foreign portfolio funds given its under-owned status. A weak US$ should also accentuate the return of foreign buying on plantation stocks. IOI, KLK and Sime Darby upgraded to BUYs. We are upgrading the big-caps sector proxies IOI, KLK and Sime Darby to BUY. They are the earliest beneficiaries of a sustained CPO price upcycle and the most liquid. We have assigned PE multiples of between 12x - 15x to our fair value estimates to reflect the recovery scenario where earnings are rising from the lows. For IOI, however, earnings risk in FY09F (June) is still high but will improve significantly looking into FY10F. There is a likelihood that IOI would record provisions for diminution in value of its landbank in Singapore and continued forex losses if the US$ strengthens. FY09F is a kitchen-sinking year for IOI but the group is expected to be on much firmer footing in FY10F. We also like Wilmar International as it is a proxy to an economic rebound in China. Wilmar s other plus points are its economies of scale, good track record in reading the financial and commodity markets and global positioning in Europe, China and Russia. Although our top picks are the big-caps, the smaller plantation companies also have their appeal due to their pure exposure. We estimate that for every RM100/tonne change in CPO price, the net profit of the smaller companies would increase by 5% to 9%. We are also initiating coverage on IJM Plantations and Asiatic Development with a BUY rating, joining TH Plantations and Sarawak Oil Palms. TABLE 1 : VALUATION MATRIX Share price FD EPS (sen/cents) FD PEs (x) Target Prices Upside FY09F GDPS FY09F Div yield (RM/S$) FY09F FY10F FY09F FY10F (RM/S$) (sen) IOI Corp % % Sime Darby % % KLK % % Kulim % % Sarawak Oil Palms % % TH Plantations % % Asiatic % % IJM Plantations % % Wilmar % % Indofood Agri % % Source: AmResearch 4,000 CHART 1 : CPO PRICE CYCLE (RM/TONNE) 3,500 3,000 2,500 2,000 1,500 1, Jan-87 Jan-88 Jan-89 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Source: MPOB (monthy prices) 2

3 Plantation Sector UPGRADE TO OVERWEIGHT We are upgrading our recommendation on the plantation sector from UNDERWEIGHT to OVERWEIGHT due to the factors below. We have divided our report into two main sections i.e. what has changed following company visits and our downgrade report six months ago and what will change in the coming quarters. In line with the upgrade in our sector recommendation, we have raised our CPO (crude palm oil) price assumption from RM1,800/tonne to RM2,000/tonne for 2009F. For 2010F, we are now assuming an average CPO price of RM2,300/tonne versus RM1,800/tonne previously. What has changed? 1. A broad-based sentiment- driven recovery in commodity prices triggered by recent weakness in the US$ and perception of a further US$ depreciation. 2. Is the recovery in the price of CPO sustainable? Feedback from company visits have revealed the following: (i) (ii) (iii) Some cutbacks in fertiliser application; Selling on spot; Breakdown of correlation with crude oil price; (iv) Replanting mainly by smallholders; (v) CPO contract defaults are not a major concern and the trend is reversing due to the recent price recovery; (vi) Low foreign shareholding; and (vii) Biodiesel policy in Indonesia will take time to implement. What will change in the coming quarters? 1. Supply-demand dynamics pointing to further price recovery 2. Narrowing of price discount between CPO and soybean oil IS THE RECOVERY IN CPO PRICE SUSTAINABLE? FEEDBACK FROM COMPANY VISITS In summary, feedback from company visits revealed that plantation companies expect CPO prices to recover on the back of slower production growth from a reduction in fertiliser application and replanting by the big players and smallholders. Also, one of the companies believe that at a certain level, the price of CPO has finally broken away from crude oil price. CPO prices should stabilise once the problem of defaults of shipments by Chinese and Indian importers is cleared up. Some cutback in fertiliser application There is a good mix of companies, which plant to reduce fertiliser application because of higher costs and some, which would not be. As a gauge, the usage of fertiliser is about 8kg to 12kg per tree per year for young oil palm trees. Based on a Malaysian Palm Oil Board (MPOB) study in 2002, reducing fertiliser by 25% would reduce the FFB (fresh fruit bunches) yield of a 12-year old oil palm tree by 0.4% in the first year, 2% in the second year and 3% each in the subsequent two years. Companies, which plan to reduce fertiliser application include Asiatic Development (Asiatic) and Kuala Lumpur Kepong (KLK) while Wilmar International has said that it would not be. Sime Darby is still reviewing its fertiliser policy but has said that it would not be reducing its fertiliser for the sake of doing so. As for IOI Corp (IOI), the group has already locked-in its supply of fertiliser for the coming six months. Although in November, it was reported that the big six plantation companies would be holding back fertiliser purchases for the next six months, we understand from KLK that the actual amount of the reduction in fertiliser would have to depend on recommendations from its inhouse agronomist. We believe that some of these companies might have bought more than a sufficient supply of fertiliser in the previous year, which allows them to hold back purchases for the coming six months. For instance, Asiatic plans to reduce its fertiliser tender by 15% in FY09F as it still has an ample supply of fertiliser carried forward from FY07 and FY08. The group did not apply all of its fertiliser fully due to the rainy season in FY07. Other companies like Wilmar International (Wilmar) has said that it would not be reducing its use of fertiliser. Interestingly, Wilmar has a different fertiliser policy from Malaysian plantation companies. In Malaysia, plantation companies lock-in their fertiliser supply for six to 12 months whereas Wilmar buys its fertiliser for a shorter period of three to six months depending on its view on the price of fertiliser. Wilmar also has another advantage in that it owns a 450,000 tonne/year fertiliser plant, which accounts for less than 50% of its annual fertiliser requirements. We understand from Asiatic that fertiliser costs have declined but not by as much as what the plantation companies are hoping for. As CPO prices have declined by 50%, plantation companies are expecting fertiliser costs to fall by a similar magnitude as well. 3

4 Plantation Sector CHART 2 : CPO PRICE VS CRUDE OIL 1,200 1,200 1,000 Crude oil (US$/tonne) CPO (US$/tonne) 1, Jan-05 Jun-05 Nov-05 Apr-06 Sep-06 Feb-07 Jul-07 Dec-07 May-08 Oct-08 Source: MPOB IOI Corp KLK Kulim TH Plant Asiatic Sime Darby TABLE 2 : HEDGING/FORWARD SALES Sold forward 6 months of FY09F output at prices above RM3,000/tonne Sold forward 40% of 1QFY09F output at RM2,000/tonne Sold forward 11% of FY09F output at RM2,100/tonne Policy is 30% forward, 30% long-term and 40% spot Spot Spot A report by the American Soybean Association on 29 December 2008 said that after a six-year increase, wholesale fertiliser prices in US were falling. Retail prices, however have yet to follow suit. The report quoted the American Farm Bureau Federation as saying that wholesale prices for ammonia in the Corn Belt have decreased by 50% while prices for urea have fallen by 60%. The decline in U.S wholesale fertiliser prices was attributed to lower crop prices and weaker natural gas prices. Natural gas is the main input used to manufacture ammonia. Selling on spot Source: Company Fertiliser companies in Malaysia have pledged to reduce fertiliser costs by 15% although according to one of the bigger plantation companies, prices of different types of fertiliser have fallen more than that. We understand from Golden Agri-Resources (Golden Agri) in December 2008 that the price of urea had declined by 50% from its peak with phosphate 40% and potash between 30% to 40%. Back in November 2008, Asiatic had said that the cost of potash had fallen by 25% from RM3,600/tonne in July 2008 to RM2,700/tonne. Currently, the Malaysian Government is mulling making imported fertiliser a controlled item i.e. placing a ceiling on its price. The Government is also exploring the option of bulk buying and selling fertiliser to palm oil and rubber planters at lower prices. We believe that it is a matter of time before fertiliser costs start to decline. But if crude oil and commodity prices start to inch up, the fall in fertiliser costs would be short-lived. Plantation companies are expecting CPO price to recover on a combination of factors. IOI s view is that CPO price would rise to RM2,000/tonne by 1Q2009F due to slower production growth. KLK thinks that CPO price would rise to RM1,700/tonne to RM1,800/tonne by 2Q2009F underpinned by expanding Chinese demand. Due to their positive outlook for the sector, these two companies have stopped selling forward and are currently selling at spot. When CPO prices fell in 3Q2008, the bigger plantation companies in Malaysia such as IOI and KLK had already sold forward some of their FY09F production (see Table 2). IOI sold forward six months of its FY09F production at prices above RM3,000/tonne while KLK sold forward 40% of its 1QFY09F production forward at about RM2,000/ tonne. KLK believes that its average selling price for FY09F should not be lower than RM1,600/tonne because of an expected recovery in CPO price. 4

5 Plantation Sector CHART 3 : IOI S AGE PROFILE TABLE 3 : REPLANTING Past Prime 6% Due 1% Immature 7% Young 10% Due for replanting (% of planted areas) IOI Corp 1% KLK 4% Sime Darby 3% Source: Company, AmResearch Prime 76% We attribute the declining relationship between the two commodities to a few reasons. Source: Company Most of the other companies under our coverage are also selling at spot prices. These include medium-size ones like Asiatic Development and Sarawak Oil Palms and the larger ones like Sime Darby and Indofood Agri-Resources. We understand that these companies prefer to follow existing market trends and not take a view on CPO prices. Also, one of the companies i.e. Sime Darby recorded trading losses of RM120mil in the past, resulting in a more conservative selling policy currently. Among the smaller plantation companies, TH Plantations is the only one with a formal hedging policy. The group s policy is to sell 30% of its full year production forward, 30% at long-term prices and the balance 40% at spot prices. Wilmar also hedges because of the scale of its operations. But the group prefers not to disclose its policy. Wilmar s track record in hedging in CPO and foreign exchange seems to have been pretty accurate so far. The group recorded a US$300mil fair value gain on derivative financial instruments in its 9MFY08 results. Breakdown of correlation with price of crude oil KLK has said that the price of CPO has stopped moving in tandem with crude oil. This appears to be true. Looking at Chart 2, the correlation between the two commodities has been declining of late. Although crude oil prices fell to as low as US$31/barrel on 22 December 2008, CPO prices continued to hover between RM1,500/tonne to RM1,800/ tonne. We believe that the direct relationship halted when the prices of crude oil were between US$45/barrel to US$50/ barrel. This implies that if the price of crude oil falls below US$45/barrel, CPO price would stop declining but if the price of crude oil rises above US$50/barrel, then CPO would follow suit. The weakening relationship started in the last two months of We estimate the daily correlation coefficient between crude oil and CPO was 0.1x from November to December 2008 compared to October s 0.9x and September s 0.5x. From January 2008 to December 2008, the correlation coefficient between the two commodities was 0.8x versus January 2008 to October 2008 s 1.0x. First, the Chinese government s proposed purchases of physical corn and soybean to support vegetable oil prices and domestic farmers. When this piece of news first broke out in late-december 2008, soybean, soybean oil and palm oil surged by the daily limit on the Dalian Commodity Exchange. Second, it appears that there could be a risk of soybean supply disruptions in Argentina because of dry weather. Bloomberg quoted the Buenos Aires Cereals Exchange in December 2008 as saying that the lack of rain had slowed soybean planting in Argentina. Planting was projected to cover 18.2 million ha but so far, only about 76% has been planted. A report from the Chicago Board of Trade (CBOT) also said that there is potential for lower soybean yields in South America as the current financial crisis has affected farmers credit and cash requirements to purchase and apply fertiliser. Third, vegetable oil prices are still partly driven by demand from the food segment. CBOT quoted an agricultural economist from Purdue University as saying that even if China s growth rate were cut by 2% to 3%, the Chinese would still eat the same number of calories but they may shift from animal protein to vegetable protein. This implies that there would still be demand for soybean. Also, we estimate that more than 30% of palm oil imported into China, are used as cooking oil. We reckon that the weakening relationship between crude oil and CPO brings the cycle back to pre This was when prices of crude oil were averaging at about US$56/ barrel and before biodiesel came into picture. We believe that at current crude oil and CPO prices, biodiesel may not be feasible. Weak crude oil prices would exert downward pressure on biodiesel selling prices while steady CPO prices would result in rising feedstock costs and eat into margins. 5

6 Plantation Sector Source: Company TABLE 4 : FOREIGN SHAREHOLDING % level Period % level Period IOI Corp 26% mid-nov % peak as at Sept 2007 KLK 13% mid-dec % Feb-2008 Sime Darby 13% end-nov % end-mar 2008 Asiatic 9% Nov % early-sept 2008 Kulim 21% Oct % end-jun 2008 Replanting - for smallholders; not significant for larger plantation companies Although replanting was touted in November 2008 as one of the initiatives, which would reduce the production of CPO and inventory in Malaysia and Indonesia, we believe that this would not be a major agenda in most of the plantation companies plans for 2009F. We reckon that most of the 200,000 ha in Malaysia, which are supposed to be replanted would involve smallholders. It is estimated that smallholders account for 35% to 40% of the country s CPO output. Generally, replanting involves chopping down trees above 25 or 30 years old and planting new trees again. This would affect companies with older oil palm trees. Companies with large hectarage of young trees such as Wilmar and Golden Agri would not be affected. Most of the companies under our coverage have young trees. As at end-june 2008, only 1% of IOI s trees are due for replanting while another 6% are past their prime of 15 years old (See Chart 3). KLK plans to replant about 5,000 ha in FY09F (about 4% of planted areas) while Sime Darby s replanting policy is 4% of its planted areas. Currently, however only 3% of Sime s trees are due for replanting (See Table 3). Replanting cost in Malaysia would be subsidised by the Government via its RM200mil Oil Palm Replanting Incentive Scheme. Based on the reported area to be replanted of 200,000 ha, the replanting subsidy would be about RM1,000/ha. This is 8% to 10% of the replanting cost of RM10,000/ha to RM12,000/ha. The replanting scheme is supposed to reduce CPO production by 700,000 tonne (4% of the country s 2008F output of 17.5 million tonne). In Indonesia, the areas to be replanted are not as sizeable as Malaysia as most of the trees in Indonesia are younger than in Malaysia. It was reported that Indonesia would replant approximately 50,000 ha of trees, which would reduce production by about 100,000 tonne. This is small compared to Indonesia s projected output of 19 to 21 million tonne for 2009F. But if CPO prices rebound, it is likely that the smallholders would stop replanting and start selling fruits from the older trees. Trees older than 25 years old can still be harvested although it would be more difficult because of their height. Also, older trees generally produce less fruits. CPO defaults - trend reversing given recent price recovery In November 2008, news reports placed the amount of palm oil defaults at an alarming 1.5 million tonne or 8.6% of Malaysia s 2008F CPO production. We understand that shipments of palm oil, which were defaulted were sold to other companies at lower prices. According to a CBOT report in October 2008, palm oil prices were being renegotiated several times before being shipped. Apart from renegotiation of contracts, shipments were also deferred. Based on company visits we found that the major plantation companies had not been significantly affected by defaults in palm oil shipments. The smaller plantation companies did not face this problem as they sell their palm oil in crude form to the refiners. The main players in the refining industry in Malaysia are Wilmar, which commands a capacity of 4.5 million tonne/ year and IOI, which has an annual capacity of 3.2 million tonne/year. According to IOI, only about 10,000 tonne of its palm oil shipments were defaulted. Most of IOI s products are sold to its subsidiaries in Johor and Rotterdam and reputable companies such as Cargill. IOI also has back-to-back arrangements with its endcustomers, meaning that the risk of defaults by its own subsidiaries are minimised. Similarly for Wilmar. The group was not adversely affected by the defaults as about 40% of its palm products are sold to joint ventures in China and India. Additionally, Wilmar sells to established companies like Proctor and Gamble and Cargill. KLK was also not affected by the problem of defaults as most of the group s refined palm oil are sold to its oleochemical subsidiaries in China and Europe. Like IOI and Wilmar, KLK also sells its palm products to large customers like Cargill. According to Sime Darby back in August 2008, it was not affected by the issue of defaults as less than 3% of its products are sold directly to Chinese and Indian importers. Most of the group s refined products are sold via trading houses. We believe that the problem of palm oil defaults would ease as CPO prices have been showings signs of stability recently. The same CBOT report in October 2008 quoted an industry player as saying that once the palm oil transactions - which were struck at high prices - were adjusted or cancelled and more sales take place at current prices, then the market would recover on fresh demand. 6

7 Plantation Sector Low foreign shareholding Foreign shareholding of the major plantation companies in Malaysia are currently at their lows, indicating a strong likelihood that foreign selling has abated and hence, the limited downside risk. IOI s foreign shareholding stood at 26% as at November 2008 (See Table 4), 12-percentage points lower than its high of 38% a year ago. IOI s average foreign shareholding is normally about 35%. KLK s foreign shareholding has also taken a tumble. At its peak in early in 2008, foreign shareholding was 23%. This has since shrunk to 13% currently. Sime Darby s foreign shareholding fell from 21% in March 2008 to 13% as at end-november In line with the decline in foreign interest, Sime Darby s share price has weakened almost 55% from a year ago. Smaller planting programme for 2009F Most plantation companies have reduced their planting programmes for 2009F because of the current financial crisis and high fertiliser costs. We understand that planting costs have increased from a range of RM10,000/ha - RM12,000/ha to RM15,000/ha currently. The reduction in the companies new plantings would help lower the supply of CPO coming out from Indonesia in the medium-term compared to the scenario based on original planting programmes six months ago. Wilmar has scaled down its planting programme in Indonesia from 40,000 ha to about 25,000 ha per year. Indofood Agri- Resources has also brought down its planned new plantings from 35,000 ha to 30,000 ha. Golden Agri plans to plant between 10,000 ha to 20,000 ha in FY09F versus FY08F s estimated 20,000 ha. Among the Malaysian-based plantation companies, IOI has also reduced its size of new plantings in Indonesia from a range of 10,000 ha to 15,000 ha to 5,000 ha to 7,000 ha. But KLK is different from its peers. The group plans to maintain its planting programme of 10,000 ha per year in FY09F as it had never been as aggressive as the other plantation companies to begin with. Lower capex for 2009F Partly due to the reduction in planting programmes mentioned above, most plantation companies have scaled back their capex. But Wilmar has said that the current downturn provides opportunities and that it is open to acquiring landbank. Also, we understand from a mill manufacturer that plantation companies may switch from commissioning new mills to converting or refurbishing their existing mills as this would be a cheaper option. Originally, Wilmar s FY09F capex was US$1bil. This has been lowered to US$800mil to US$1bil. The reduction in capex is mainly due to smaller areas being opened up for plantings. Similarly, IOI has reduced its FY09F capex by 15% to a range of RM400mil to RM500mil because of lower new plantings. Its FY09F capex includes the RM600mil construction of new specialty fats plants in Johor and Rotterdam, which would be spread over two years. As for KLK, capex is estimated at RM500mil for FY09F compared to FY08 s RM400mil. This is due to higher cost of new plantings. KLK has not reduced the number of areas it plans to cultivate in Indonesia in FY09F as its planting programme was never as aggressive as the other plantation companies to begin with. Sime Darby has said that it would be reviewing and prioritising its capex. For instance, new property launches have been deferred while the number of new showrooms for the motor division would not be as high as before. Sime Darby would also be reviewing some of its proposed acquisitions. But if the pricing is right especially for landbank purchases, then the group would not hesitate to pursue the opportunity. Sime s original capex is RM1.8bil to RM2.0bil for FY09F. But, we have forecast RM1.2bil to be conservative. Biodiesel policy - will take time Biodiesel in Indonesia A CBOT report in October 2008 said that Indonesia would be starting trials of 1% biodiesel use in the transportation sector while the blend for industrial users would be 2.5%. Indonesia s biodiesel policy is expected to become mandatory in 2009F. By 2010F, biodiesel use will increase to a blend of 2.5%-3% for the transportation sector and 5% for industrial users. Like Malaysia, however, Indonesia s biodiesel policy is accommodative to changes in the price of CPO. According to an Indonesian Government official quoted in the same CBOT report, the mandatory percentage use of palm oil in biodiesel may be lowered when CPO price is high and vice versa. Despite news reports on Indonesia s biodiesel plans, we understand from plantation companies with operations in Indonesia that biodiesel has not taken off in the country. These industry players believe that it would take time for the Indonesian Government to execute the biodiesel policy. Biodiesel is supposed to absorb about 2.5 million tonne of CPO or about 12% of Indonesia s 2009F projected output from the system. Among the companies under our coverage, Wilmar is the most prolific in biodiesel. The group plans to increase its biodiesel production capacity by an additional 600,000 tonne/year to 800,000 tonne/year from its current capacity of 1.05 million tonne/year. The increase in production capacity would likely be used to tap the Indonesian market where the major offtaker would most probably be Pertamina. 7

8 Plantation Sector TABLE 5 : FFB YIELD FORECASTS Source: Company, AmResearch Currently, Wilmar s biodiesel plants are operating at more than 50% utilisation rate and its biodiesel are sold to Europe and US. Biodiesel in Malaysia FY07 FY08 FY09F FY10F FY11F IOI Corp KLK Sime Darby Kulim Sarawak Oil Palms TH Plantations Asiatic IJM Plantations Wilmar Indofood Agri Due to the recent decline in vegetable oil prices, biodiesel has cropped again as one of the ways to reduce palm oil inventory in Malaysia and Indonesia. We are not excited over biodiesel as once CPO prices recover, it would be difficult for biodiesel to be commercially feasible. Even at current price levels, we believe that margins are thin as the selling price of biodiesel would have fallen in line with lower crude oil prices. But at the same time, feedstock cost of CPO has stopped declining. Hence, the current strong growth in biodiesel exports from Malaysia may not sustain. According to MPOB, biodiesel exports from January to November 2008 grew 76% YoY to 161,921 tonne. At US$40/barrel, crude oil is cheaper than CPO. Based on a conversion rate of 7.26 barrels to 1 tonne and an exchange rate of US$1.00:RM3.50, the cost of US$40/ barrel translates into RM1,016/tonne compared to current CPO prices of RM1,900/tonne to RM2,000/tonne. As for the legislative-driven use of biodiesel, the Malaysian Government has said that the country s biodiesel policy would not be a hard-and-fast policy i.e. if feedstock prices escalate, the Government may choose to defer the policy. The Government plans to roll-out B5 biodiesel in the transportation sector by January 2010F and this is supposed to absorb 500,000 tonne of CPO or 22% of November s palm oil inventory of 2.3 million tonne, from the system. Subsidies for biodiesel are expected to be funded from the RM250mil cess collected for MPOB s price stabilisation fund. Currently, biodiesel is being used by government bodies such as Kuala Lumpur City Hall, Selangor s Jabatan Kerja Raya and the Royal Malaysian Armed Forces. The absorption of CPO from these usage are expected to be small as Kuala Lumpur City Hall s requirement is only about 66 tonne of biodiesel per year. US policy on biofuel following the change in administration Currently, the US Department of Agriculture (USDA) forecasts 17% of soybean output in US. would be used in biodiesel production in 2008/09F. This is almost the same as 2007/08F. The US biofuel industry is driven by the non-binding Renewable Fuel Standard (RFS). The standard stipulates the minimum amount of ethanol that must be blended into gasoline every year. Under the latest RFS, the blending target for 2010 is 13 billion gallons of ethanol and 36 billion gallons of ethanol in The biofuel industry in US is subsidised via tax credits. Legislators in the US. recently voted to continue with the US$1.00/gallon (US$305/tonne) tax credit for biodiesel production until end-2009f. But, the tax credit would not apply to biodiesel imported into US to be re-exported to another country. So far, President-elect Obama has not announced any changes to the biofuel policy in US. Based on the Comprehensive Energy Plan proposed during his election campaign, it would appear that Obama is supportive of biofuel. Under the plan, Obama wants to develop the next generation of sustainable biofuels and infrastructure. The requirement would be at least 60 billion gallons of advanced biofuels by Advanced biofuels include cellulosic ethanol, biobutenol and other technologies, which can produce fuel from sustainable feedstocks. Biodiesel policy in EU The European Union (EU) is not as supportive as biofuel as before. Lawmakers have voted to indirectly reduce vegetable oil-based biofuel targets for 2020 from 10% to 6%. This is mainly due to reports showing that the surge in food prices in 2007 and the start of 2008 was attributed to the use of vegetable oils as feedstock for biofuel. Although EU lawmakers have kept the biofuel target of 10% of transport fuel by 2020, they have voted that at least 4% should come from electricity, hydrogen or secondgenerations biofuels from waste. The use of biodiesel in Germany, which historically consumes the most in EU is also expected to decline because of higher taxes. Germany started imposing a tax of 9 cents/litre on biodiesel in By 2012, the tax would increase to 45 cents/litre. Due to the protectionist nature of EU, we reckon that the main market for biofuel is likely to be only US. 8

9 Plantation Sector CHART 4 : CPO PRICE (RM/TONNE) VS CPO PRODUCTION (MILLION TONNES) 4, , , , , ,500 1,000 CPO price CPO production Jan-01 Jun-01 Nov-01 Apr-02 Sep-02 Feb-03 Jul-03 Dec-03 May-04 Oct-04 Mar-05 Aug-05 Jan-06 Jun-06 Nov-06 Apr-07 Sep-07 Feb-08 Jul-08 Source: MPOB WHAT WILL CHANGE IN THE COMING QUARTERS? 1. Supply-demand dynamics pointing to further price recovery Palm oil inventory and production adjustment Our main basis for downgrading the plantation sector six months ago was because of a potential increase in palm oil supply, which would outstrip demand. But, since then CPO prices have plunged and the credit crunch has affected working capital of importers, resulting in defaults of CPO shipments by Chinese and Indian buyers. These circumstances coupled with rising production costs have forced Malaysian plantation companies to react in ways that would have an impact on the supply imbalance situation. These include reducing fertiliser application and planting programmes in Indonesia. Bigger plantation companies like Sime Darby have also said that they would be embarking on replanting. We believe that the reduction in fertiliser application could be more prevalent among the smallholders, including FELDA (Federal Land Development Authority) settlers. Based on MPOB statistics in 2005, we estimate that Malaysia s FELDA planters account for nearly 20% of the country s CPO production of 15 million tonne. As a whole, it is estimated that smallholders account for 35% to 40% of the country s CPO output. Feedback from plantation companies indicate that it would take between six to 12 months for FFB yields to be affected by the cut in the use of fertiliser. Based on a MPOB study in 2002, reducing fertiliser by 25% would reduce the FFB yield of a 12-year old oil palm tree by 0.4% in the first year, 2% in the second year and 3% each in the subsequent two years. Hence, supply or palm production could surprise on the downside. So far, plantation companies in Malaysia have not imputed any impact from the reduction in fertiliser use on their output forecast for 2009F. At the very least, FFB yields are expected to be flat. IOI believes that its FFB yield can exceed 28.5 tonne/ha although we have conservatively forecast 28 tonne /ha for FY09F. This is the same as FY08 (See Table 5). As for KLK, the group reckons that its FFB yield would remain flat at 24 tonne/ha for FY09F (See Table 5). Timing of CPO price recovery Based on past cycles, the CPO pricing cycle turns positive way before CPO production and inventory decline. We find that on average, CPO prices react eight months in advance before MPOB s monthly statistics showed peaks and subsequent contractions in palm oil production and inventory. During the 2001/2004 upcycle (See Charts 4 and 5), the first inflection point in CPO prices came in October 2001, four months before CPO production touched its cycle-low and also eight months before palm oil inventory reached its low. In the 2006/2008 upcycle (See Charts 4 and 5), CPO prices swung positive seven months before output declined to its trough and 11 months prior to palm oil inventory s reaching its low. 9

10 Plantation Sector 4,000 CHART 5 : CPO PRICE (RM/TONNE) VS PALM OIL INVENTORY (MILLION TONNES) 2.5 3,500 CPO price CPO stocks 2 3,000 2, , , , Jan-01 Jun-01 Nov-01 Apr-02 Sep-02 Feb-03 Jul-03 Dec-03 May-04 Oct-04 Mar-05 Aug-05 Jan-06 Jun-06 Nov-06 Apr-07 Sep-07 Feb-08 Jul-08 Source: MPOB CHART 6 : CPO INVENTORY (MILLION TONNE) VS SOYBEAN INVENTORY (MILLION TONNE) Soybean ending stock CPO ending stock / / / / / / / / Source: MPOB, Oil World How much should palm oil production and inventory fall before price of CPO price improves? We believe that CPO production and inventory would peak in 3Q2009F before softening towards the end of the year underpinned by effects from lower fertiliser application and replanting programmes. We also think that CPO inventory would most likely inch down to 1.9 million tonne by the end of the year. Although this is not an exciting figure, it is still lower than the sevenyear high of 2.3 million tonne recorded in November In 1H2008, CPO production showed good growth after being affected by dry weather and haze in the previous year. In 2H2008, CPO output started recording slower growth after a robust 1H. Since August 2008, the YoY rate of production growth has ranged from a negative 1.4% to a positive 4.6%. The highest YoY increase recorded in 2008 was 25.9% in June. Based on past cycles, before CPO prices recovered, the decline in palm oil production was 36% on average. Although CPO production is usually weaker in the first half of the calendar year, it was different in 2008 because of the cropping pattern. The palm oil cropping pattern for 2008 was the opposite of previous years because of the haze and dry weather, which affected FFB yields in Last year, the country enjoyed strong harvest in the first six months and slower output in the second half of the year. Looking at the 2001/04 and 2006/08 upcycles, both CPO production and inventory adjustments were about the same quantum, 36% on average. 10

11 Plantation Sector Source: USDA TABLE 6 : USDA PROJECTIONS (AS AT 11 DECEMBER 2008) (million pounds) 2006/ / /09F Soybean oil Beginning stocks 3,010 3,085 2,483 Production 20,489 20,568 19,550 Imports Total supply 23,536 23,718 22,083 Domestic 18,562 18,327 18,000 - For methyl ester 2,762 2,981 3,100 Exports 1,877 2,908 2,050 Total use 20,439 21,235 20,050 Ending stocks 3,085 2,483 2,033 Average price (cents/pound) (million bushels) 2006/ / /09F Soybean Planted area (mln acres) Harvested area (mln acres) Yield/harvested area (bushels) Beginning stocks Production 3,188 2,676 2,921 Imports Total supply 3,646 3,260 3,133 Crushing 1,808 1,801 1,715 Exports 1,116 1,161 1,050 Seeds Residual 69 (1) 72 Total use 3,073 3,054 2,927 Ending stocks Average price (US$/bushel) In the 2001/04 cycle (See Chart 4), CPO production peaked in October 2001 and took about four months to decline 32% to its low. Palm oil inventory reached the cycle-high of 1.34 million tonnes and fell 32% after eight months. During the 2006/2008 cycle, CPO output took five months to fall 39% from its peak while palm oil stocks shrank 38% after reaching its cycle-high of 1.8 million tonnes. What drove the recovery in CPO prices and the decline in production in the past two cycles was unfavourable weather conditions. The Asian region experienced El Nino in 2001 and in 2006/ 07, the main producing countries faced dry weather and haze. Structural change such as biodiesel also contributed to the CPO price upturn in late CPO inventory vis-a-vis soybean inventory CPO inventory have been trending upwards over the years in contrast to soybean ending inventory, which have been declining (See Chart 6) after peaking in 2006/07 (based on Oil World numbers). We believe that the increase in CPO inventory partly contributed to the wide price discount between the two commodities. Currently, CPO and soybean inventory are still above their long-term averages. Based on MPOB statistics (from ), the longterm average palm oil inventory is roughly 1.4 million tonne. For soybean ending inventory (based on Oil World s numbers from 2000/01 to 2007/08), the long-term average is about 51.8 million tonne. Going forward, soybean production is expected to increase in 2009F as US farmers switch from planting corn to soybean and Argentina recover from the strike by farmers in In contrast, world palm oil output growth although still positive in 2009F, is envisaged to be slower. China s demand for soybean is still resilient although the recent decline in the price disparity between CPO and soybean oil indicates some switching to CPO. Export trend - Chinese demand expected to pick up due to stockpiling by provincial governments In contrast to the situation six months ago when industry players indicated that demand was slowing because of high commodity prices, we now expect demand from China to pick-up. This is due to three reasons. First, the wide price discount between palm oil and soybean oil. Attractive commodity prices coupled with the festive period in the first half of 2009F are expected to spur demand for palm oil. In January, China celebrates Chinese New Year while in May, the country honours Labour Day. 11

12 Plantation Sector CHART 7 : CPO PRICE (RM/TONNE) VS DISCOUNT B/W CPO AND SOYBEAN OIL (%) 4, % Price discount b/w CPO and CSO CPO price 3, % 3, % Jan-96 Jun-96 Nov-96 Apr-97 Sep-97 Feb-98 Jul-98 Dec-98 May-99 Oct-99 Mar-00 Aug-00 Jan-01 Jun-01 Nov-01 Apr-02 Sep-02 Feb-03 Jul-03 Dec-03 May-04 Oct-04 Mar-05 Aug-05 Jan-06 Jun-06 Nov-06 Apr-07 Sep-07 Feb-08 Jul-08 2,500 2, % 1, % 1, % % Source: MPOB Second, the Chinese Government s proposed US$584bil or 4 trillion yuan stimulus package on bridges, housing and tax breaks are envisaged to result in trickle-down effects to domestic consumption. According to Bloomberg, since September last year the People s Bank of China has gradually reduced its key lending rates to boost spending. Third, farmers in China have been facing challenging times because of plunging commodity prices. As such, China has ordered state reserves to increase purchases of crops to protect farming income. This measure is expected to support soybean and subsequently palm oil prices. Last December, a CBOT report quoted Xinhua news agency as saying that the Chinese government will be buying 4.5 million tonne of corn for reserves by April 2009F to stabilise prices. A Bloomberg report in December said Heilongjiang province, a major producing region, had been authorised to buy one million tonne of soybean and 4.5 million tonne of corn. According to the China National Grain and Oils Information Center, the government s intended purchases of corn will amount to 30 million tonnes in total. The same CBOT report said that purchases of vegetable oils is part of the Chinese government s policy to stockpile 7.1 million tonne of corn, 5 million tonne of rice and 2 million tonne of soybean in Heilongjiang. Heilongjiang province is estimated to account for nearly half of China s soybean production in China is the world s largest importer of soybean and biggest consumer of palm oil from Malaysia. Although palm oil exports from Malaysia to China were flat YoY from January to November 2008, China still accounted for a sizeable 25% of Malaysia s exports. How does the current cycle differ from previous cycles? The current cycle started in late-2006 and ended in mid From July 2006, the price of CPO surged 165% to a monthly average high of RM3,681/tonne in April 2008 before plunging to a low of RM1,517/tonne in November. The first difference between the current cycle and past cycles is the speed of the retracement in the price of CPO. While it took almost 21 months for CPO prices to reach its peak in April 2008, it only took seven months for prices to fall to its trough of RM1,517/tonne (based on monthly average prices). In the past, it took between 11 months in 2001/2004 to as long as 30 months in 1998/2001. We attribute the speed of the rise and correction in the price of CPO to the role of speculators. As an indication, statistics provided by Bursa Malaysia revealed that domestic and foreign retailers accounted for 67% of the trading volume in the CPO futures market in November 2008 versus 22% in January The second difference is CPO s correlation with crude oil. Due to the use of soybean and palm oil as feedstock for biodiesel, vegetable oils have been viewed as an alternative to renewable fuels. In the past, there were no impetus for biodiesel as European Union and the U.S did not have legislative mandates for biofuel. Hence, as crude oil price rallied towards US$147/ barrel in 2008, the price of CPO also followed in tandem and vice versa. The third difference is the broadening of supply-demand dynamics. Since 2002, China has overtaken India as the largest importer of palm oil while Indonesia replaced Malaysia as the biggest producer from 2007 onwards. - 12

13 Plantation Sector CHART 8 : FFB YIELD CYCLE (TONNES/HA) Source: MPOB Also, in spite of environmental protests against palm oil in US., the country s imports of Malaysian palm oil have shown an impressive growth of 201% since The emergence of China makes demand for palm oil more resilient compared to India, which has a tendency to change the import tax system for vegetable oils every now and then. The increase in US role as the fourth largest importer of Malaysian palm oil is also a positive as US importers are better paymasters. So far, there has been no reports of defaults by US customers. Indonesia s growth in the plantation sector over the past few years was driven by aggressive expansion of plantings. This was partly prompted by the Government s moves such as opening up of areas for cultivation in Kalimantan. Based on our coverage of companies with operations in Indonesia, we forecast Wilmar International s CPO production to increase 9% to 1.7 million tonne in FY09F compared to a 13% increase estimated for FY08F. Indofood Agri s FY09F output growth of 5% is not a good gauge due to the high base effect in FY08F s, which incorporated the full-year impact of the acquisition of PP London Sumatra. Oil World projects softer palm oil output growth in 2009F Latest projections by Oil World indicate that palm oil output in Malaysia is expected to stagnate between 17.5 to 18 million tonne in 2009F while production in Indonesia is estimated to increase 8% to 20.8 million tonne. This is lower than the 13% growth projection by Oil World six months ago. According to the December 2008 Oil World report, Indonesian producers expect slower productivity in the coming months from the above-average performance registered in Globally, palm oil production are envisaged to inch up by 1.9 million tonne in 2009F versus 2008 s increase of 4.9 million tonne. Driving production growth in Indonesia are mainly increased planted areas. We understand from an industry player that companies owned by the Indonesian Government account for 50%- 60% of the country s output. Smallholders account for 20% while the private sector account between 20%-30% of the country s CPO production. USDA projects flat soybean inventory in 2008/09F, barring unpredictable weather conditions Soybean production in US is envisaged to increase 9% to 2,921 million bushels in 2008/09F on the back of 17% rise in planted areas resulting from farmers switching from corn to soybean (See Table 6). In spite of the positive production growth, the USDA has forecast the country s soybean ending stocks to remain flat at 205 million bushels in 2008/09F (See Table 6). Underpinning the stagnant number is a lower carry-over inventory from 2007/08, which is envisaged to compensate for higher production. Biodiesel is expected to account for 17% of soybean oil usage in US. For Brazil, USDA has projected soybean production to soften 3% to 59 million tonne in 2008/09F. However, recently Brazil s National Commodities Supply Corp revised its estimate for the country s 2008/09F soybean production down by 2% from 58.8 million tonne to 57.7 million tonne. Soybean production forecast of 57.7 million tonne for 2008/09F is 4% below 2007/08F s estimated output of 60 million tonne. The downward revision in soybean output estimates is due to unfavourable weather. According to a CBOT report early this month, the south of Brazil has been facing a prolonged dry spell since November