According to many recent analyst reports, the sentiments towards Crude Palm Oil (CPO) prices have started to turn bearish, mainly attributable to expectations of higher CPO production in the next few months and a probable weakened Chinese and Indian demand in 2H09.

Bullish Drivers Gone
Earlier on in the year from January till mid May, the then bullish sentiment on CPO, notwithstanding the slump in the economy, was premised on low soybean and palm oil inventories, further aided by a poor Argentine soybean crop.

Faced with one of the worst droughts in decades, the world’s largest soybean oil exporter Argentina has seen its harvest volume of soybean being hit severely. As a result, the production of soybean oil, which is a close but premium substitute for CPO in terms of edible cooking oil and alternative energy, was affected as well, therefore sending CPO prices higher.

Bearish 2H09
Based on a UBS report in 2 June, global soybean production is expected to increase 14% to a record 242m tonnes in the October 2009-September 2010 season. The forecast hinges on two major crop events though: 1) the US soybean harvest in September-November 2009 (which is currently in the planting phase); and 2) a recovery of the South American soybean crop in March-May 2010. Both of these regions account for approximately 60% of the world’s soybean oil output. The boost in soybean supply could well suppress upward pressure on CPO prices due to the increased effect of product substitution.

The report also added that the strong demand in China and India (two largest importers of Asian palm oil) for edible oil during 1H09 may weaken in 2H09. This is because the Chinese stockpiling activity is expected to end while in India, it is believed that the strong imports seen since end-2008 were due to a change in the import duty for palm oil compared with soybean oil. Such momentum cannot be maintained for a prolonged period.

Other Unpredictable Factors
The forecast of CPO prices is not purely based on the exact science of a simple supply and demand equation. Other variables to consider include the weather and crude oil prices.

For instance, vagaries of the weather, personified in the form of El Nino, could pose considerably serious threat to crop production in Indonesia and Malaysia, which produce 90% of the world’s CPO output. On an anecdotal note, there were reports that the El Nino influence has strengthened in the Indonesian Basin during early June, causing reduced rainfall in these countries.

The volatility of oil price is usually closely tracked by CPO price as the latter is used as a feedstock in the production of biofuel, an alternative for the former. Exceptions do happen though when decoupling between the two occurs, as evidenced during mid-November 2008 when CPO prices were stabilizing at RM1,400 per tonne while crude oil was going down to US$49 per barrel.

Sector Looking Stretched
To date, share prices in the plantation sector have risen as much as 75% and their valuations may be looking stretched now. Should the sector stocks still pique your interest, one good way to separate the wheat from the chaff could be by looking at other criteria, for instance, the extent of diversification of core businesses in these stocks.