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2 Palm Oil Stocks That Will Rise With Crude Palm Oil’s Price
Corporate Digest | 23 October 2015
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By: Louis Kent Lee
Articles (199) Profile

The commodities scene has seen its fair share of punishments. This is amid the market volatility we are seeing worldwide.

With the all too familiar haze in Singapore, the research team has found impending value to be recognised, if you look beyond the smoke and mirrors in the plantations sector.

Let’s give you a quick run through of the plantations sector. The thing about plantation companies, is that it is crucially dependent on the prices of Crude Palm Oil (CPO) because it is a direct component to the average selling prices of their palm oil products which affects their revenue, and which further flows into their net profits.

However, things are seemingly changing, and fast.

Let’s go into basic economics to take a look at this sector in pure simplicity; Supply and Demand.

In a nutshell, an oversupply of anything without the corresponding increase in demand will cause the selling price to drop, and an overdemand of anything with unmatched supply will cause the selling price to rise. The equilibrium price, is always the hardest to match, and constantly changes.

We’ll now go into one major factor that we think is going to impact on the production of palm oil, and hence the supply of its products.

El Niño, The Bad Weather Effect To Cut Palm Oil Supply

According to the Climate Prediction Center (CPC) of the US National Weather Service in partnership with the International Research Institute for Climate and Society of Columbia University, a strong El Nino is in full swing.

The El Nino event is predicted to be competing for one of the three strongest events since 1950.

The El Nino effect, basically brings forth superior dry weather, directly on regions such as Indonesia and Malaysia, which alone accounts for more than 90 percent of global palm oil production.

We are now four months into an El Nino, and this is expected to intensify and extend into early 2016.

Based on their climate data, this El Nino, once it unfolds, would likely make it one of the longest and strongest El Ninos of the past 40 years and probably most comparable to the strong El Nino of 1997-1998.

Production of palm oil during that period fell four percent YoY, and caused CPO prices to spike 70 percent.

Although massive stock piles are still registered from Malaysia, data forecast expects the dry season to directly hit production prowess come 1Q16. Coupling this with El Nino’s full wrath, supply moving forward for these two big producers should reasonably decrease.

Imposition Of Demand Commitment From Indonesia

In Indonesia, an Estate Crop Fund, known as the CPO Supporting Fund was established earlier this year to administer the collection of levies imposed on palm oil exports which is to be used to support the country’s B15 biodiesel mandate.

Biodiesel contains a component of CPO in the blending process. In mid-July 2015, Indonesia came out with a new biodiesel pricing mechanism to tackle the subsidised transportation segment.

Indonesia slapped a US$50 per tonne CPO being exported and up to US$30 per tonne for refined products in July. The proceeds, which will be used directly to fund the B15 biodiesel programme shows commitment from the Indonesian government.

The long story short of this, is that this is expected to absorb 1.3 to 3.6 million metric tonnes of CPO.

This is essentially more than 60 percent of what China normally consumes on a yearly basis. (*Note that China is one of the top 3 consumers of CPO globally.)

This amount range is also 33-66 percent of Indonesia’s own annual CPO intake. We believe this to reduce stock inventory levels and lift the global CPO average price.

2 Picks Poised To Rise With The Sector Lift

First Resources (FR) – Good Growth Profile and Valuation

We think FR is poised nicely to be lifted together with the rising tide of CPO price.

Firstly it is among one of the few companies with the youngest plantation estate at just about nine years. Most of its peers’ plantation age ranges between 12 years and onwards.

The key benefit of younger plantations is primarily from stronger and better production yields generated from the estate. Apart from driving volume growth from its strong production via a young estate, this can be done with minimal capital expenditure compared to players with significantly older plantation estates.

FR’s planting target of 12-15k ha/year should see it nearing the ranks of the industry’s top five planters in five years.

On numbers, its production costs is somewhat relatively low compared to its peers in the industry. This is surprising because a younger age estate most often than not require more upkeep and costs to maintain the estate.

2Q15 Results Showed Good Margins Despite Industry Rout. Although many of its peers’ results for 2Q15 was largely bleak at best, due to the lower CPO price affecting their average selling prices and hence revenue and other big items, FR’s core net margin of 24 percent was 16 percent better than its peers’ average.

FR exhibited prudent cost control in both cost of goods sold and selling, general and admin expenses, alongside strong production growth.

An interesting point to also note was that FR revealed in recent meetings with clients that they have forward sold an undisclosed amount of CPO. This suggests a possible scenario where FR might have already avoided the CPO price weakness in 3Q15. Lastly, FR’s revenue is denominated in US$, while costs is in Indonesian Rupiah. Should the US$ rise in the face of a rate hike, it is more than being shielded and might even benefit more from it.

The five year range of FR’s price to earnings (PE) ratio is between 8.5x to 16.19x. At the time of writing, FR’s PE ratio of 11.9x is somewhat on the lower end of this range, suggesting an inexpensive valuation that offers a window to the rising tide in the sector, and a worthy beneficiary.

Golden Agri Resources (GAR) – Direct Proxy With Highest Correlation To CPO Prices

GAR is the second largest palm oil refiner in Indonesia, with a total capacity of nearly 3.6 million tones per annum.

Albeit being punished by investors and the market for paltry financial results in 1Q15 and 2Q15, it is still undeniable that GAR is a key beneficiary of a higher CPO price.

Among its peers, GAR has a 91 percent correlation to the spot CPO price movement. Naturally as such, GAR’s earnings are highly geared to CPO price movements.

An off the bat five percent increase in the CPO price movements would see a probable increase of at least 18 percent in GAR’s earnings per share considering the high correlation GAR has to CPO price movements.

In addition, GAR is also going to be expecting contribution coming from a new biodiesel plant that will be driven by cheaper feedstocks. As biodiesel usually has a higher margin than conventional refined palm production, the commencement of the new biodiesel should further enhance GAR’s refining margin.

Lastly, as GAR’s new 300,000 ton per annum biodiesel plant starts pumping in 2016, it could participate in the Indonesian Biodiesel program, which in the earlier part of the article, is one of the key things set to prep up demand, plus lift overall CPO prices for the industry.

The five year range of GAR’s PE ratio is significantly wide, between 3.27x and 154.0x. A better frame would be to use the average PE ratio for the past five years as a benchmark instead, at 21.24x.

At the time of writing, GAR has risen quite a bit and is now trading above the average PE at 30.0x.

Louis is a qualified accountant with the ACCA, and is the Research Editor at Shares Investment magazine.

Please click here for more information about this author.

First Resources  1.550 -0.020 -1.27%   
Business: Co engages in the cultivation and maintenance of oil palm plantations. [FY18 Turnover] Refinery and processing (95.5%), plantations & palm oil mill (4.5%).

Insight: Feb-19, FY18 revenue dipped 2.1% due to lower aver... Read More
Golden Agri-Resources  0.215 +0.005 +2.38%   
Business: Co is engaged in cultivating & harvesting oil palm trees, processing fresh fruit bunches (FFB) into crude palm oil (CPO) & palm kernel (PK), & refining CPO into industrial & consumer pdts.

Insight: May-19, 1Q19 revenue fell 11% due to softer crude ... Read More

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