Crude Palm Oil - A Price Storm Is Brewing 28 04 12 11 31

Global Research | 30 April 2012
Crude palm oil A price storm is brewing

Contents
Summary Hedging and trade recommendations Building blocks Declining CPO yields CPO supply forecasts Higher industry costs Fungibility and demand CPO balance sheet CPO price outlook Conclusion Appendix 2 3 5-7 8-13 14 15-19 20-25 25-26 27-29 31 32-35
Highlights
A severe structural slowdown in palm oil output is under way. The downtrend will worsen over coming seasons and is one the market can no longer afford to ignore. The deceleration in palm output is caused largely by the ageing profile of estates in South East Asia, which accounts for over 90% of the market, as well as suboptimal farming practices across much of the region. Our conservative estimate is that more than 20% of trees in Malaysia are over 25 years old. In reality, this could be more. US prospective plantings for 2012 suggest soybean output will remain tight for the rest of the year. The resulting decline in palm yield alongside a production shortfall in the soy complex will necessitate strict demand rationing in the edible oils sector. As before, we continue to see upside momentum building in 2012, but contrary to consensus, we expect Q4-2012 to be mostly bullish. Despite current enthusiasm, markets are likely to rally to even higher levels in 2013. Our long-term bullish view on crude palm oil (CPO), relatively accommodative global interest rates and a deteriorating age profile of trees in Malaysia should help to convince owners, particularly in Malaysia, that the replanting decision is best not delayed. We recommend shorting the September 2012 BMD crude palm oil futures at the current price of MYR 3,450/tonne (t), with a target of MYR 3,250/t. From Q3-2012, we recommend looking for any reversal in prices to the upside with a target of MYR 3,700/t.
Abah Ofon, +65 6596 8651
Abah.Ofon@sc.com
Koun-Ken Lee, +65 6596 8256

KounKen.Lee@sc.com
SCout is Standard Chartereds premium research product that offers Strategic, Collaborative, Original ideas on Universal and Thematic opportunities
Important disclosures can be found in the Disclosures Appendix All rights reserved. Standard Chartered Bank 2012
research.standardchartered.com
Summary
Why we are bullish on CPO
Productivity and supply, substitutability and import demand are important factors determining the CPO price. In this report, we focus largely on supply and leverage off historic fundamental data that shows supply has a material impact on price trends in the CPO industry. We highlight the crucial decoupling between weather events and CPO output; wet weather in SE Asia will not, as in the past, lead to higher CPO output We believe there is a price storm brewing in the industry due to a deceleration in yields, the severity of which will be bullish for the market. First, we highlight the crucial decoupling between weather events and CPO output, which suggests that La Nia (wet weather in South East Asia) will not, as in the past, lead to higher CPO output (see Chart 1). We believe this phenomenon has been exacerbated by the sub-optimal profile of some plantations in South East Asia. We estimate that more than 20% of oil palms in Malaysia are already over 25 years old (Chart 2), after which yields plummet and trees generally have to be replanted. We recommend that estate owners not delay replanting. We find evidence to suggest that a large proportion of estate owners in South East Asia have underinvested in their estates, largely to limit overhead costs. Yields have been adversely affected as a consequence. Further yield erosion can be halted by replanting schemes, using higher-yielding seedlings, through the application of more fertiliser, the use of a more efficient and motivated work force or a combination of all three. Whatever the strategy employed, these essential investments will raise the cost curve for palm and provide a higher price floor. On the other hand, CPO consumption has been trending higher in an almost linear manner relative to global edible oil consumption, driven in part by population growth. CPO consumption has been enhanced by its fungibility across a wide range of applications, as well as its price competitiveness versus other vegetable oils. We assume this ratio will continue through the forecast period. We believe the market is entering a period of demand rationing; initially this will be felt most acutely in Q42012 We believe the market is entering a period of stringent demand rationing. We model CPO prices based on our CPO balance sheet estimates and, factoring in external market risks, arrive at a price forecast of MYR 3,450/t for 2012, MYR 3,620/t for 2013, MYR 3,228/t for 2014 and MYR 3,456/t for 2015. Our annual average forecast for 2012 is unchanged, but now adequately reflects upside risks further along the curve (Table 1). Chart 2: Age profile of oil palms in Malaysia We estimate over 20% of trees are over 25 years old, mn ha
6 5 4 3 2 1 0 2000 2002 2004 2006 2008 2010 Mature area < 25 yrs 10% 5% 0% Mature area > 25 yrs % >25 25% 20% 15%
Essential investment in the CPO industry will raise the cost curve for palm and provide a higher price floor
Chart 1: Correlation between the SOI and change in CPO output in Malaysia has broken down
70% 60% 50% 40% 30% 20% 10% 0% -10% Jan-84 Jan-88 Jan-92 Jan-96 Jan-00 Jan-04 Jan-08 Source: Standard Chartered Research
30 April 2012
3.5 3.0 t-stat 5% (RHS) Corr Corr t-stat 2.5 2.0 1.5 1.0 0.5 0.0 -0.5
Sources: MPOB, Standard Chartered Research

2
Hedging and trade recommendations

Producers
Producers should take advantage of the current market near MYR 3,500/t to lock in some profits. Although we are bullish on CPO, we expect significant volatility at current prices. Risk-averse clients should consider buying put options, which will give them the right but not the obligation to sell at an agreed price, thereby protecting against price drops.
Consumers
We have a bullish long-term outlook on CPO on account of tight global edible oil stocks and an anticipated deceleration in CPO yields. However, we believe the market is approaching a near-term top and will dip briefly in Q3-2012. Consumers should look to buy dips on the basis that any weakness is likely to prove short-lived.
Trading (short-term)
We recommend shorting September 2012 BMD crude palm oil futures at the current price of MYR 3,450/t, with a target of MYR 3,250/t, below our average Q3-2012 price target of MYR 3,350/t (prices above Q3-2012 price target will need to fall below target to ensure our average is met). MYR 3,241/t represents the 61.8% Fibonnacci retracement level and also appears to be significant since it has served as a support and resistance level for the past year. We place our stop-loss at MYR 3,590/t. After the northern hemisphere summer months, yields are expected to decline, but to lower levels than usual, which is a reflection of the sub-optimal profile of plantations in South East Asia. From Q3-2012, we would recommend looking for any reversal prices to the upside, with a target of MYR 3,700/t (about a 10-15% gain).
Table 1: Standard Chartered CPO forecasts We see significant upside risks in Q4-2012
New forecast MYR/t Q2-2012 Q3-2012 Q4-2012 2012 annual average 2013 annual average 2014 annual average 2015 annual average 3,500 3,350 3,700 3,450 3,620 3,228 3,456 Previous forecast MYR/t 3,400
Chart 3: BMD CPO futures, MYR/t We recommend shorting September futures

4,100 3,900 3,700 Daily Qtr Fcst
3,600 3,500 3,600 3,450 3,800 3,900 3,950 3,300 3,100 2,900 2,700 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Sources: Bloomberg, Standard Chartered Research
3
Fwd Qtr avg
Source: Standard Chartered Research

30 April 2012
Chart 4: A graphic introduction to CPO, its value chain and applications UPSTREAM Plantation
Fresh fruit bunches (FFB)
Milling Crude palm oil/ Palm kernel oil
MIDSTREAM Trading/transport
DOWNSTREAM Refining
Applications
RBD palm oil
Food (75%): Cooking oils and frying fats
Fractionation
Margarine and spreads Shortenings Stearin (20%) Confectionary and bakery fats (specialty fats) Vanaspati (vegetable ghee)
RBD Olein (80%)
Double fractionation/ palm mid fractionation
Hydrogenation/ Oleo chemical interesterification processing
Ice cream, coffee creamers and filled milk Emulsifiers Vitamin E supplements
Splitting Non-food (25%): Glycerol/fatty acids Soap , shampoo and detergents Animal feed Reduction Energy generation, biodiesel and lubricants Cosmetics Pharmaceuticals Organic fertilisers and biomass Amidisation Paints Plasticisers, stabilisers for rubber and PVC
Fatty alcohols
Fatty nitrogen
Sources: MVO, Standard Chartered Research

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Three building blocks productivity, fungibility and demand

An important starting point in our discussion on the outlook for CPO prices is to introduce building blocks we will use to formulate our CPO price forecast. Oil palm productivity (yield), its fungibility with other vegetable oils and import demand are key elements that shape the price outlook. To demonstrate this view we analyse the CPO markets evolution in 2011 where these three factors contributed to generate significant price volatility. We believe these three factors will continue to shape CPO prices over the long term and we develop this argument further in our report to arrive at our CPO price forecasts. CPO prices started 2011 on a bullish note, rallying 9% in mid-January to close at a peak of MYR 3,990/t on 10 February 2011. Thereafter, the market traded lower, slumping nearly 30% to reach a floor around MYR 2,800/t on 7 October. Three key events helped to shape the outlook for CPO prices in 2011, as well as set the platform for events in 2012.
An unprecedented increase in CPO yields in South East Asia

Lower CPO output in Q4-2010 provided the market with a bullish platform; nearby CPO futures subsequently rallied 38% This was most evident in Malaysia, where fresh fruit bunch (FFB) yields rose significantly between March and December 2011. It is important to put the improvement in Malaysian FFB yields into context. Overall, FFB yields declined counter-seasonally in 2010, with the trend persisting until it reached a floor in February 2011. This tightening in output prospects was particularly prominent in Q42010, when yields were around 14% lower than the average yield in the same period in 2006-09. Lower output in Q4-2010 provided a bullish platform for markets, with nearby CPO futures rising 38%. The drop in yields in 2010 coincided with an intense La Nia, the worst in over 35 years. Monsoon flooding caused by La Nia tends to limit harvesting, particularly in low-lying areas near riverbanks. Flooding can significantly distort the palm oil supply chain in the short term, but boost yields in the longer term. The sharp improvement in yields in South East Asia after La Nia subsided had an inverse effect on market prices. FFB yields in Malaysia improved significantly in Q2-2011, with average yields 14% higher than the five-year average for the same period. Yields peaked seasonally in September at 1.95t/ha and have since trended lower (Chart 5).
FFB yields in Malaysia peaked in September 2011 and have since trended lower
Chart 5: 2011 CPO yields vs. the five-year average Malaysian yields saw unprecedented growth in 2011, t/ha
2.0 1.8 1.6 5 yr average yields 1.4 1.2 1.0 Jan Mar May Jul Sep Nov 2011
Chart 6: High yields boosted inventories in Malaysia Month-end closing stocks, mt

2.4 2.2 2.0 1.8 1.6 1.4 1.2 1.0 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11

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5
Markets quickly unravelled in Q2- and Q3-2011 as major support for prices was undermined
The impact of the improvement in yields and as a consequence, output had a noticeable effect on Malaysian stocks. According to data from the Malaysian Palm Oil Board (MPOB), month-end closing stocks averaged 2.02mt in 2011, compared with 1.61mt in 2010 and 1.66mt in 2009 (Chart 6). Between April and September 2011, stocks in Malaysia were, on average, 25% higher than the previous year and 40% higher than in 2009. The improvement in yields was facilitated by the waning of La Nia conditions, particularly between Q2 and Q3-2011. Markets quickly unravelled as tight production, which provided major support, was undermined. A narrowing of the price premium of soyoil over CPO from July 2011 increased the competitiveness of soyoil (SBO) as a substitute edible oil. CPO traded on par with soyoil in September and December 2010 and at a premium to it in January and February 2011. Using market data spanning five years, our analyses show that a narrowing of the price differential between soyoil and CPO is followed by a drop in CPO prices (Chart 7). This is caused by a drop in demand for palm oil from pricesensitive importers, particularly in Asia. We have two observations. We do not see CPO trading at a premium to soyoil. Also, it appears that as this floor is reached, soyoil prices move rapidly higher and at a faster rate than CPO price gains, with the latter creating a natural springboard for soyoil prices. As seen from the CPO point of view, soyoil prices appear to provide a ceiling to CPO prices. CPO industry fundamentals aside, we believe soyoil prices will continue to be key in determining the outlook for CPO prices in 2012 and beyond. This important relationship between soyoil and CPO was a core element influencing CPO price volatility in 2011; it is therefore imperative to have a view on soyoil in order to have a more rounded view on CPO prices.
A narrowing in the price differential between soyoil and CPO is followed by a drop in CPO prices
CPO has to trade at a discount to soyoil to stay competitive in key markets such as India
The trend in CPO imports in Asia, and particularly India, had a strong impact on the CPO market in 2011. India produces soybeans (but not CPO), so consumers there have traditionally consumed soyoil and other locally sourced edible oils including peanut, cottonseed and mustard oil. To attract demand from India, now the largest CPO importer, it is important for CPO to offer a price incentive. Additionally, Indias import policy favoured soyoil until 2008, which meant that CPO also had to trade at a discount to stay competitive, as an increase in the price of CPO would quickly trigger substitution demand for soyoil.
Chart 7: CPO usually trades at a discount to SBO A narrowing in the spread is followed by a drop in CPO prices
4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 Jan-06 Dec-06 Nov-07 Oct-08 Sep-09 Aug-10 Jul-11 CPO prices, MYR/t (LHS) SBO/CPO spread monthly avg USD/t 400 350 300 250 200 150 100 50 0
Chart 8: Monthly CPO imports slumped in Q4-2010, kt (RHS) Key importers are price-sensitive to changes in CPO prices
1,400 1,200 1,000 800 600 400 200 0 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 SBO/CPO spread, USD/t (LHS) India China 500 400 300 200 100 0 -100 -200
Sources: Reuters, Standard Chartered Research

30 April 2012
Sources: SEA, Reuters, Standard Chartered Research

6
The past four years had three significant periods in which a narrowing of the SBO/CPO spread was followed by a sharp slowdown in CPO imports and, as a consequence, a sharp drop in the price of CPO. The sharp improvement in CPO demand in Q2-2011 coincided with a larger soyoil premium over CPO Using data from January 2004 in China and from January 2007 in India, we find some correlation between the average monthly SBO/CPO spread and the volume of imports. This relationship is more established in India, which mainly imports crude CPO, but we also see a similar pattern in China, which mainly imports refined CPO (Chart 8). The sharp improvement in CPO demand in Q2-2011 coincided with a larger soyoil premium over CPO. Conversely, the recent decline in CPO demand coincided with a tightening of the soyoil premium over CPO. The soyoil premium hit its lowest level in nine months in January 2012, and now looks to have reached a floor. The improvement in the SBO/CPO spread reflects bullish momentum in the soybean complex (see Special Report, 31 October 2011, Soybeans The case for a bull market in 2012), which has so far provided significant upside impetus for CPO prices in 2012. Over all, the impact of these three key events (the trend in CPO yields, the trend in the SBO/CPO spread and CPO import dynamics in Asia) set the stage for CPO prices in 2011. These events, along with significant fiscal changes in Indonesias CPO market and energy prices, will continue to drive the outlook for CPO prices in 2012 and beyond.
30 April 2012
Productivity A protracted decline in CPO yields is in sight

We expect CPO output to grow in 2012/13, but at a slower pace Oil palms in South East Asia are showing signs of stress after bumper harvests in 2011 The relationship between CPO output and the weather has weakened Market consensus suggests output will fall in South East Asia as the industry is in a low cycle that will last until November 2012. However, we believe this low cycle will last even longer than estimated due to what we perceive to be a crucial decoupling between weather events and CPO output, a phenomenon that has been exacerbated by the sub-optimal profile of some plantations in South East Asia. This suggests to us that La Nia weather conditions will not naturally, as in the past, lead to higher CPO output. Forecasting supply, our core view is for global CPO output to grow by around 5.5% in the medium term. This captures our expectation for tighter global inventories, but also takes into account unpredictable upside risks. The decline in global soybean supply in the current season will lead to a loss of around 5mt of soyoil Crude palm oil (CPO) and soyoil prices have been buoyant since the start of the year, as the market comes around to the view that weather-induced supply disruptions will limit output in the current season. CPO and soyoil are the two largest consumed edible oils, accounting for around 60% of major edible oil consumption in the 2011/12 season (Chart 9). We believe the markets focus has been on the soybean complex, and with good reason. According to estimates from consultants Oil World, global soybean output is likely to drop from 265.76mt in the 2010/11 season to only 240.42mt in the 2011/12 season. For the first time ever, the global edible oil/oilseeds market is faced with a decline in soybean output in both the US and Latam where output is forecast to drop by 7mt and 19mt, respectively (Chart 10). This translates into a 5mt decline in soyoil output in 2011/12 (down 9.5% y/y) and which will trigger a considerable squeeze on edible oil markets. While we acknowledge tightness in the soy complex and its impact on the edible oil market, it is our view that the market has not fully grasped the risk of a supply
Chart 9: CPO and soyoil account for most edible oil consumption Making up around 60% of major edible oil use, mt
160 140 120 100 80 60 40 20 0 1990/91 1993/94 1996/97 1999/00 2002/03 2005/06 2008/09 2011/12 Sources: USDA, Standard Chartered Research
30 April 2012
Chart 10: Soybean output has dropped in both the US and Latam Global soybean output 2011/12, mt
300 250 200 150 100 50 0 1990/91 1993/94 1996/97 1999/00 2002/03 2005/06 2008/09 2011/12 Sources: USDA, Standard Chartered Research
8
Other major edible oils
CPO
Soyoil
Latam
US
Rest of World
shortfall in the CPO market. This is not to say there is not healthy interest in the supply outlook, particularly for the key producing regions of Indonesia and Malaysia, which together account for around 90% of global output (Chart 11). There is; which we noted at a recent industry conference in Malaysia, where on average the three key industry speakers estimated 2012 output in Indonesia and Malaysia at 26.5mt and 19mt, respectively. However, we advocate greater market focus on supply as this will be a key game changer in the industry in the near to medium term. Government estimates in Indonesia put 2012 CPO output at 25.7mt, up from 22.5mt in 2011 while in Malaysia official figures indicate that output will rise by around 2.3% y/y to 19.3mt as more trees enter maturity. Central to output projections is the age profile of trees in producing countries. Indonesia is expected to benefit from young trees (4-6 years old) entering their prime (7-12 years old). This will partly compensate for the slowdown in yield from older trees. In Malaysia, yield is likely to drop despite a larger mature area due, in part, to a planting campaign in 2008-09, particularly in the state of Sarawak on Borneo Island (Chart 12). Data and comments from industry consultants highlight the fact that the industry is in the middle of a down-cycle. Consultant, Oil World, forecasts CPO yield in Indonesia of 3.94t/ha in 2012, flat compared with 2011. In Malaysia, yield is forecast to drop to 4.36t/ha compared with 4.42t/ha in 2012. In both Malaysia and Indonesia, palm trees are likely to show signs of stress after strong production in 2011. The general market consensus is that output will fall in South East Asia but we believe the decline will last longer Globally, Oil World forecasts output at 52.3mt in 2012, up from 50.2mt in 2011, with global yields dropping marginally to an average 3.72t/ha, down from 3.73t/ha in 2011. Global mature acreage is forecast to rise to 14.1mn ha, up from 13.44mn ha in 2011. Comments from major industry player Godrej International supports the view that the industry is in a low cycle which will last from March 2012 until around November 2012. The occurrence of this low cycle, should it be realised, will be of particular significance because CPO yields usually start trending higher in March before peaking in October (we briefly discuss seasonality below). However, we believe this low cycle will last even longer than currently estimated due to what we perceive to be a crucial decoupling between weather events and CPO output, a phenomenon which has been exacerbated by the sub-optimal profile of some plantations in South East Asia.
Chart 11: Malaysia and Indonesia are top CPO producers The countries together account for about 90% of global output
60 50 40 30 20 10 0 1990/91 1993/94 1996/97 1999/00 2002/03 2005/06 2008/09 2011/12 Sources: USDA, Standard Chartered Research
30 April 2012
Chart 12: Output growth is slowing This is particularly true in Malaysia, % y/y
30% 25% 20% 15% 10% 5% 0% -5% -10% 1990/91 1993/94 1996/97 1999/00 2002/03 2005/06 2008/09 2011/12 Sources: USDA, Oil World, Standard Chartered Research
9
Indonesia
Malaysia
ROW
Indonesia Malaysia
Palm oil seasonality

Seasonality in agricultural commodities is well known, and CPO is no different. Looking at the forward curve, we see signs of seasonality, with peaks occurring in the run-up to the summer (Chart 13). Seasonal troughs look as though they occur around September. As an exercise and to quantify our expectations, we analyse front-month futures prices for seasonality, using our multiplicative model (see Commodity Focus Quarterly, 21 June 2011, A season for everything). This assumes that prices can be broken down into three components: trend, irregular and seasonal. Simplistically, it takes the following form:
CPO prices are seasonally high around March to August and trough around September/October
We use S to refer to the average seasonal component for that time of the year. The irregular term I is the random noise component, while the trend term T captures, and ultimately removes, any price trends. Estimations of trend and removal of the irregular component allow us to isolate the seasonal component. The seasonality for palm oil, based on the last 10 years of data, is shown in Chart 13 and has been normalised to be between zero and one, with zero representing the seasonal low and one representing the seasonal high. What we find is that seasonal upward bias is seen in the run-up to the summer, peaking around April. Prices remain seasonally high around summer time and then descend to a trough in September-October. There is then an upturn at the end of the year. This is roughly what we expected from the forward curve (Chart 14). The reason prices exhibit this seasonality is linked to yields that start to trend higher in March and peak around October. Higher yields at this time would drive prices lower, as seen in our price seasonality. We calculate the normalised seasonal month average yield and overlay this with our price seasonality to demonstrate the relationship and show it inverted in Chart 13. While the relationship is clear, it is worth highlighting that seasonality in yields is largely a function of the weather. The North East monsoon weather runs from November through March, disrupting harvesting and production due to heavy rainfall.
Yield seasonality is closely linked to the disruptive impact of monsoon weather in SE Asia
Chart 13: Estimated relative seasonality CPO and average seasonal yield (inverted, normalised)
1.0 0.8 0.6 0.4 0.2 0.0 Price seasonality NE monsoon weather Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Sources: Bloomberg, MPOB, Standard Chartered Research
30 April 2012
Chart 14: BMD CPO forward curve, MYR/t 9 April 2012

0.0 0.2 3,650 3,600 3,550 0.4 3,500 0.6 0.8 1.0 3,450 3,400 3,350 Mar-12 Jun-12 Oct-12 Jan-13 Apr-13 Jul-13 Nov-13 Feb-14
Avg yield (inverted, RHS)
Sources: Bloomberg, Standard Chartered Research

10
Weather and CPO, a marriage gone sour

Oil palms thrive best in countries with high rainfall (minimum of 1,600mm p.a.) in tropical climates within 10 of the equator. According to the UNs Food and Agricultural Organization, low moisture is the most common reason for tree stress, which is why it is important to examine weather events over the last 24 months. Climate models by the Australian Bureau of Meteorology show a continuing weakening of La Nia Between June 2009 and May 2010, weather events were dominated by El Nio developments that led to moisture stress and occurrences of bunch failure, floral abortion and sex differentiation. In contrast, the weather over the last 24 months has been volatile, dominated by La Nia weather conditions stretching from July 2010 to April 2011. La Nia weather is associated with wetter-than-normal conditions in South East Asia, and El Nio with drier-than-normal conditions. La Nia weather conditions again gained momentum in July 2011, lasting until January 2012. Climate models surveyed by the Australian Bureau of Meteorology (ABM) show a continuing weakening of the event, with neutral conditions expected over the coming months. It is uncertain how sea temperatures will evolve after May 2012 There is some uncertainty over the outlook for the rest of 2012, a feeling echoed by the World Meteorological Organization (WMO) and consultants, Browning. In February, the WMO wrote that although historical precedence and the latest output from forecast models suggest that the current La Nia reached its peak in late 2011 and early 2012, after May there is a wide range in the model forecasts. Browning has a similar view while the Pacific is expected to be neutral by mid- to late spring, opinion is divided on whether the ocean will warm, remain neutral or cool again in the autumn. CPO yields rise following La Nia events For the purposes of this report, we will adopt the opinion of the ABM that sea surface temperature anomalies will likely return to a neutral state from March to May 2012 (temperate spring). We also assume conditions will remain neutral into December 2012. When we plot the Southern Oscillation Index (SOI) against annual output in Chart 15: Oil palms thrive in tropical climates within 10 of the equator
Sources: FAO, Standard Chartered Research

30 April 2012 11
both Malaysia and Indonesia (Charts 16 and 17), we see that palm output y/y tends to rise during La Nia events and fall during El Nio episodes. Sustained positive values of the SOI are indicative of La Nia conditions. Assessing the current shape of the SOI curve, and taking into account forecasts for a drop in the SOI to neutral conditions, we expect yields will return to trend between May and October but, contrary to market expectations, we look for yields to fall below trend in Q4-2012. What reinforces our conviction that CPO yields will be tighter than expected beyond Q4-2012 is the noticeable decoupling in the relationship between CPO output and the SOI in both Malaysia and Indonesia (Charts 16 and 17). The recent de-coupling is noticeable; however, we look for more concrete evidence. We calculate the rolling correlation between CPO output and SOI for both countries (Charts 18 and 19). For each correlation we evaluate the accompanying t-statistic that tells us if the correlation is significantly different from zero for a particular confidence level (5%). A result above the t-statistic 5% level would mean the correlation was significantly different from zero.
Chart 16: SOI vs. change in CPO output in Malaysia Palm yields tend to rise during La Nia events
0.4 0.3 0.2 0.1 0.0 -0.1 Chg CPO output (% y/y, RHS) 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Sources: USDA, ABM, Standard Chartered Research SOI index 15 10 5 0 -5 -10 -15
Chart 17: SOI vs. change in CPO output in Indonesia More recently, this relationship has decoupled
0.4 SOI index 0.3 0.2 0.1 0.0 -0.1 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Sources: USDA, ABM, Standard Chartered Research 15 10 5 0 -5 Chg CPO output (% y/y, RHS) -10 -15
Chart 18: Rolling correlation between SOI and change in CPO output in Malaysia
70% 60% 50% 40% 30% 20% 10% 0% -10% Jan-84 Jan-88 Jan-92 Jan-96 Jan-00 Jan-04 Jan-08 Source: Standard Chartered Research
30 April 2012
Chart 19: Rolling correlation between SOI and change in CPO output in Indonesia
25% 20% 15% 10% 5% 0% -5% -10% t-stat Jan-84 Jan-88 Jan-92 Jan-96 Jan-00 Jan-04 Jan-08 Source: Standard Chartered Research
12
3.5 3.0 t-stat 5% Corr Corr t-stat 2.5 2.0 1.5 1.0 0.5 0.0 -0.5
2.5 t-stat 5% 2.0 1.5 Corr 1.0 0.5 0.0 -0.5
For Malaysia, we see a correlation ranging from 40-60%, which remained significantly different from zero until 2002. Beyond 2002, and particularly after 2008, we see a strong correlation decoupling, which backs up our initial expectations. Interestingly, when we do this for Indonesia, we see a much smaller and varied correlation, which statistically is close to zero for the whole period we studied (19842011). It would appear that the SOI, and hence La Nia/El Nio, has not had a significant effect on Indonesian CPO output in the past compared with Malaysias output. We attribute this to the younger profile of trees in Indonesia compared with Malaysia and the use of relatively improved seedlings in many parts of Indonesias CPO industry. However, since 2008, it would appear there has been a lack of influence from the SOI. Other factors have lessened the impact of the weather on yield outcomes in the CPO sector What this means to us is that La Nia weather conditions will not naturally, as in the past, lead to higher output. The impact of the weather will remain important, but the scale of its effect on output will depend on the severity of the weather event, as well as prior and subsequent weather conditions. In the near to medium term, output will depend even more on plantation management and practices, including the age profile of trees, labour, fertiliser and manure use, and planting procedures. These will have important cost implications for estate owners who may be inclined to stagger costly innovations and initiatives and, in the process, keep CPO yields depressed for longer.
30 April 2012
13
Our CPO supply forecasts

We assume global yields will stay on par with a three-year average, but with downside risks. We calculate that output will grow 7% and 3%, respectively, in Indonesia and Malaysia through the forecast period. Production in the rest of the world has been more chequered over the last three years, dropping 2% in 2009/10, stagnating in 2010/11 and forecast to grow 6% in the current season. We believe supply prospects outside Indonesia and Malaysia are good given increasing investment in oil palms in Latam and Africa. We believe growth of 6% can be maintained over the forecast period, particularly given the low output base. Our supply forecast is more aggressive than market conditions suggest. While our core view is for tighter global output in the medium term, we believe our forecast captures unpredictable upside risks. Our supply projections are shown in Table 2.
Table 2: CPO supply forecasts, mt (BASE CASE)

World production % growth y/y Of which Indonesia Of which Malaysia Of which rest of the world
2010/11
2011/12E 2012/13F 2013/14F 2014/15F
47.9 50.6 53.3 56.3 59.4
4.51 5.50 5.49 5.53 5.5
23.6 25.4 27.3 29.3 31.5
18.2 18.7 19.2 19.7 20.3
6.1 6.5 6.9 7.3 7.7
CPO supply forecasts, mt (HIGH CASE)

World production 2010/11 2011/12E 2012/13F 2013/14F 2014/15F 47.9 50.6 54.8 59.4 64.5 % growth y/y 4.51 5.50 8.30 8.39 8.59 Of which Indonesia 23.6 25.4 27.9 30.7 33.7 Of which Malaysia 18.2 18.7 19.7 20.8 21.9 Of which rest of the world 6.1 6.5 7.2 8.0 8.9
CPO supply forecasts, mt (LOW CASE)

World production 2010/11 2011/12E 2012/13F 2013/14F 2014/15F 47.9 50.6 52.7 55.0 57.5 % growth y/y 4.51 5.50 4.15 4.36 4.55 Of which Indonesia 23.6 25.4 27.5 29.2 31.4 Of which Malaysia 18.2 18.7 18.8 18.9 19.0 Of which rest of the world 6.1 6.5 6.7 6.8 7.1
Sources: USDA, Standard Chartered Research

30 April 2012 14
Higher industry costs An indication of yield erosion

Low production costs in South East Asia are transient; the market should not get too comfortable High industry margins mask structural deficiencies The age profile of estates in Malaysia is sub-optimal; replanting will increase output costs We see evidence to suggest that a large proportion of estate owners in South East Asia have underinvested. In most cases, this is due to the relative cost of investing and long lead times between plantation establishment and profitability. Smallholders, particularly in Indonesia, have limited their use of fertiliser on properties that generally have inferior stock. As a consequence, yield has been adversely affected. Growth in yield can be remedied, but at a cost through planting higher-yielding seedlings, investing in fertiliser or both. These essential investments will raise the cost curve for palm and provide a more elevated floor for prices.
Malaysias headache is Indonesias, too

Malaysia and Indonesia find themselves at a crossroads. After years of buoyant output, yields are showing greater signs of stress. However, before exploring the resulting cost implications from the drop in yield in both countries it is important to note the following: 1. The cost structure of oil palm plantations is made up largely of labour, fertiliser and diesel on a per hectare (ha) basis. Oil palm plantations are extremely labour intensive and are costly to establish and manage. Fertiliser is the largest cost item for an immature estate, we understand. Once trees reach maturity, labour takes the No. 1 spot, with fertiliser dropping to No. 2. As a result, the price of fertiliser is a significant yield and profit driver. Palm trees typically begin flowering and producing fresh fruit bunches (FFB) after three to four years, with a substantial increase in yield three to four years later. Oil palm plantations generally remain profitable for 25 years, after which they need to be replanted. Yields are therefore central to profitability as they impact on the cost of CPO per hectare (or per tonne).
2.
3.
Chart 20: Typical yield profile of oil palms Trees peak at around 7-12 years, FFB yield in t/ha
30 25 20 15 10 5 0 4 8 12 16 20 24 28
Chart 21: Annual change in CPO import demand Indonesia now supplies over half the annual change in use
5 4 3 2 1 0 -1 -2 1991/92 1994/95 1997/98 2000/01 2003/04 2006/07 2009/10 Sources: USDA, Standard Chartered Research
15
World CPO exports ex-Indonesia, annual change, mt CPO exports, Indonesia, annual change, mt
Sources: Oil palm industry journal, Standard Chartered Research

30 April 2012
4.
Peak palm oil yields occur when trees are between 7 and 12 years of age, and gradually decline thereafter (Chart 20). As a plantation ages, it also tends to experience declining tree populations as a result of pests and disease. Newly established plantations might have 130-145 trees/ha, whereas an old plantation might be reduced to about 100 trees/ha.
The long lead time between plantation establishment and profitability are huge impediments to many plantation owners.
Growing pains in Indonesia and Malaysia

Indonesias remarkable CPO output owes largely to reforms in the industry between 2000 and 2009 Over the past decade, Indonesia has not only overtaken Malaysia as the top producer of CPO, but now supplies over half of the annual increase needed to meet growing demand global demand (Chart 21). Using data from the US Department of Agriculture (USDA), we calculate that Indonesias CPO growth averaged 12% p.a. between 2001 and 2010 compared with 6% p.a. in Malaysia. The primary reason for this remarkable growth in Indonesias CPO output was due to reforms in Indonesias CPO industry, which included the allocation and issuance of around 10mn ha of new land licences between 2000 and 2009. Land lease terms were also liberalised and extended from a limit of 25 years to a new limit of 95 years to motivate investors. What is fascinating about the growth in palm planted acres in Indonesia during this period is that the rate of growth was greatest among smallholders. The annual growth rate at smallholders was over 17.4%, compared to 4.6% at private commercial estates, according to the USDA and the Indonesia Palm Oil Commission (IPOC). By 2010, smallholders numbered over 1.5 million, with a typical farm size of two ha, compared with over 10 government companies operating around 185 plantations with an average farm size of 3,900 ha, and around 820 private operators operating 1,020 plantations with an average size of 3,500 ha. Consequently, smallholders now account for more than 40% of the planted area in Indonesia. This compares with around 14% in Malaysia (Charts 22 and 23). Evidence on the ground suggests that smallholders find labour to be a more manageable cost than other inputs required for an immature estate. As a result, smallholders apply minimal fertiliser to their land and genetic stock on their properties is generally inferior to that grown by government and private estates. Additionally, official data indicates that around a third of oil plantations, mainly smallholders, are Chart 23: Oil palm planted area by category Smallholders form a large part of Indonesias palm acres
60% 50% 40% 30% 20% 10% 0%
Private Independent estates smallholders Felda State agencies Felcra Risda Private estates Independent smallholders State agencies
Unlike Malaysia, smallholders in Indonesia form a sizeable proportion of oil palm areas
Tree stress from bumper production over the last decade in Indonesia is now coming to bear on estates
Chart 22: Oil palm planted area by category Private estates dominate Malaysias oil palm acres
70% 60% 50% 40% 30% 20% 10% 0%

30 April 2012
Sources: USDA, IPOC, Standard Chartered Research

16
not planted with certified seed. We believe that the stress of strong production over the past decade is now coming to bear on estates where farming practices have been inadequate. Growth in yields can be remedied at a cost either through planting high-yielding seeds or investing in fertiliser. Underinvestment in fertility management is a theme that seems to run through many CPO plantations in Indonesia. This view is captured by a USDA study that shows the gap is much larger than it should be between yields on well-managed and highyielding private estates and the national average for their group. While some private producers have recorded 6.5-8.0t/ha average yields on individual plantations, the average for the group is only around 4.1t/ha (Chart 24). Indonesian output will be relatively depressed until better farming practices are employed The gap between yields on smallholder subsistence properties and private estates is inexplicably low, given the tremendous advantages that private estates have in capital, land-management ability, fertilisers and better high-yielding varieties. One reason why owners have not been motivated to invest adequately is still-healthy margins. Additionally, low palm seed sales during the financial crisis suggest that many producers reconsidered their decision to expand plantings (Chart 25). This means output in Malaysia and Indonesia will continue to be relatively depressed until better farming practices are employed or larger mature acreage comes onstream. In the interim, demand will have to be rationed via higher CPO prices. We believe that comparatively high yields have helped to contain CPO production costs in Malaysia. Like Indonesia, the recent slowdown in yields in Malaysia should raise serious concerns for the industry. Annual demand for CPO has grown by around 2.3mt over the past decade. Yield growth in Malaysia before 2008 averaged 4% p.a., but has since declined by around 13%.
The recent slowdown in CPO yields in Malaysia is also a significant and serious concern for the industry
Malaysian policy makers have a rigorous policy to keep 50% of the country forested. Considering the current pace of expansion (180k ha/year), this gives estates fewer than seven years before reaching the limit of Malaysias land bank. Most suitable areas for oil palms have already been developed and marginal land is scarce. Acreage in Sarawak, which reportedly has the most remaining development potential, is largely low-lying coastal peat land or degraded inland forest. Chart 24: Indonesia palm oil yield by owner, 2008 Smallholders are at the bottom of the pile, t/ha
8 Potential yield 6 Average yield 4
Chart 25: Sale of palm seedlings in Malaysia Yet to recover following the global financial crisis, mn
95 90 85 80 75 70 65 60 55 50
0
Smallholder Govt Estate Private Estate
2005
2006
2007
2008
2009
2010
2011
Sources: Directorate General of Estates, USDA

30 April 2012

17
According to our estimates, over 20% of palm oil trees in Malaysia are older than 25 years
Like Indonesia, the profile of oil palms in Malaysia is also damping output, although in Malaysia we are more concerned about the age profile of trees. Farmers have not been persuaded to replant in earnest, despite attractive international prices. According to USDA estimates, around 25-30% of Malaysian oil palms are 20-30 years old. According to our own estimates, more than 20% of oil palms in Malaysia are over 25 years old (Chart 26). To arrive at our estimate, we used data from the MPOC, and publicly available information on major replanting schemes over the last five years. We also use an industry assumption that 5% of stock in private estates is replanted annually. Industry officials indicate there is potential to boost yields with new higher-yielding varieties, but there is a need to replace up to 50% of the Malaysias current national crop. Labour constraints and high CPO prices are severely limiting replanting rates, so it may take time before a big replanting scheme can be undertaken. In the short to medium term, yield growth in Malaysia seems to have reached a plateau, with the possibility for output to stagnate (Chart 27). Indonesia has been a popular alternative for the expansion of Malaysian plantations, but there is increasing interest in Africa and South America. While land lease costs are more competitive in these regions, the investment required to integrate upstream and downstream operations will be significant. There are also other factors exacerbating the pressure on yields in Malaysia, including acute competition with Indonesia for labour, as Indonesia is also expanding its palm oil industry. This shortage of plantation workers, most of whom are from Indonesia, has adversely affected harvests and is creating wage pressures in the industry. Plantation owners we spoke to on a recent trip to Malaysia have been compelled to raise worker wages over the last 12 months. Labour costs on plantations estates now account for around 30-40% of total costs (depending on the level of mechanisation and location) and are likely to trend higher at a rate of 10-15% annually. This poses a significant cost challenge for estates where labour contributed only around 20% of total costs in 2002. The Malaysian government last year increased the minimum wage for workers by 10% y/y to MYR 850/month.
CPO investors are increasingly looking outside Malaysia and towards Africa and Latam for new acreage; the investment needed to integrate operations will be costly
Acute competition with Indonesia for labour is fuelling wage inflation in the CPO sector
Chart 26: Age profile of oil palms in Malaysia We estimate over 20% of trees are over 25years old, mn ha
6 5 4 3 2 1 0 2000 2002 2004 2006 2008 2010 area <25yrs old 10% 5% 0% area >25yrs old % trees >25 years old 25% 20% 15%
Chart 27: Malaysia CPO yields Yield growth seems to have plateaued, t/ha
4.6 4.4 4.2 4.0 3.8 3.6 3.4 3.2 3.0 2000 2002 2004 2006 2008 2010

30 April 2012
Sources: MPOB, USDA, Standard Chartered Research

18
Production costs in Indonesia have typically been lower compared to Malaysia, but the differential is no longer obvious
On our trip to plantations in the region, we noted that plantation costs in Indonesia and Malaysia are starting to converge. Costs per tonne of CPO produced in Indonesia have typically been lower compared with Malaysia, reflecting lower labour costs and different farming practices. This differential was not immediately obvious in our review of plantation costs, with some plantation costs in Indonesia higher compared with their Malaysian counterparts (Chart 28). This is partly because wages in some areas of Indonesia are now comparable to those offered in Malaysia. What we found, however, was that the cash cost of production in Indonesia is typically lower ex-mill compared with Malaysia. This is in line with the view that Malaysia has a more efficient downstream sector compared with Indonesia, but struggles to contain higher upstream costs that are caused partly by labour shortages. Further validation of costs on an industry- and country-wide basis is needed given the comparatively small sample size, accounting for differences in the treatment of plantation costs and the fragmented nature of the industry. At current prices, we found that plantation margins are healthy, ranging from around USD 451-642/t (Chart 29). We believe that current healthy profit margins in the palm sector are compounding structural deficiencies in the industry that will significantly limit downside risks. The prospect of slowing output in an industry that is vital to edible oil consumers in Asia, Africa and the Middle East who have few viable and affordable substitutes is a significantly bullish event in the industry.
Plantation margins are healthy given current CPO prices
Chart 28: Unit costs per tonne of CPO, USD At select companies operating either in Indonesia, Malaysia or both countries
Indonesia and Malaysia
Chart 29: Oil palm profit margins Profit margins are high on well-managed estates
1,400 1,200 1,000 Monthly average CPO price USD/t
Malaysia
800 600 400
Indonesia
200 0 0 100 200 300 400 500 600 Jan-03 Jan-05
Estimated CPO costs on a well-managed estate (USD/t)
Jan-07
Jan-09
Jan-11
Sources: USDA, Oil World, Reuters, Standard Chartered Research

30 April 2012

19
Fungibility and demand

Global CPO consumption stands at around 49.5mt, up from 5.3mt in 1982 Markets face the prospect of a much tighter soyoil market in 2012 Growing biodiesel mandates should provide a bullish signal to edible oil markets The consumption of palm oil as a percentage of the consumption of edible oils has been trending higher in an almost linear manner over the last 30 years. Demand for palm oil is closely associated with its fungibility with other edible oils. However, palm oil consumption has grown faster relative to other vegetable oils because of its price advantage. We expect the relationship between CPO and other edible oils to continue over the forecast period. To model demand, we also incorporate our view on sustainable CPO and biodiesel demand given that CPO is a feedstock for the latter. We expect CPO demand to outstrip supply by 2013. Global consumption of palm oil has grown in leaps and bounds over the last 30 years. In 1982, global consumption of palm oil stood at 5.3mt, with per capita consumption of just 1.2kg. Global per capita consumption of palm oil now stands at around 7.2kg, or around 49.5mt. Growth in palm oil consumption has been driven by rapid urbanisation, a young and growing population and rising per capita incomes. This is boosting out of home eating and the consumption of packaged food, for which CPO is a core ingredient. These trends are most evident in Asia, Africa and the Middle East. Biodiesel demand is also a key driver of CPO use, although this is mainly in Europe, but increasing in Latin America. We also expect demand for sustainable CPO to grow, as more consumers demand environmental accountability from food manufacturers. Nigeria is Africas largest importer and consumer of palm oil The top six CPO importers are India, China, the EU, Pakistan, Malaysia and Egypt, while the top six consumers are India, Indonesia, China, the EU, Malaysia and Pakistan. Nigeria lies just outside the top six consumers and is Sub-Saharan Africas largest importer and consumer of palm oil (Chart 30). Demographics in Indonesia, Egypt and Nigeria show a steady rise in the percentage of the population between the ages of 15 and 34 (Chart 31). Younger people, particularly in urban areas, tend to consume more packaged foods, which use significant quantities of palm oil.
Chart 30: Top 10 consumers of palm oil, 2011 Asia is the dominant user of palm oil, mt
USA Banglade Nigeria Pakistan Malaysia EU-27 China Indonesia India
Chart 31: % of population between the ages of 15 and 34 Selected countries, men (M) vs. women (W)
39 38 37 36 35 34 33 32 31 30 W, Egypt M, Egypt M, Nigeria W, Nigeria W, Indonesia M, Indonesia
1980
1985
1990
1995
2000
2005
2010
Sources: ERS,CONAB, Standard Chartered Research

30 April 2012
Sources: World Bank data, Standard Chartered Research

20
Overview of CPO demand in China

Chinas edible oil consumption is on par with the global average but lags OECD countries China is the second-largest importer and consumer of palm oil and accounts for around 13% of global palm oil consumption. Per capita demand in China rose to around 4.5kg in 2011 from under 20 grammes in 1982. While per capita consumption of edible oils in China has improved significantly over the last five years we currently estimate it at 25kg and on par with the global average it is still significantly below per capita consumption in OECD countries such as Canada (41kg), the US (50kg) and the EU-27 (61kg). Edible oil consumption is higher in urban areas compared with rural areas. Soyoil is the most used edible oil in China, accounting for around 22% of total edible oil consumption. Soyoil is a derivative of soybeans, which is used to make soy meal, and Chinas robust demand for soybeans for meals implies a relatively good supply of soyoil. The popularity of palm oil in China is due largely to its price competitiveness compared with other edible oils such as soybean and rapeseed. This makes CPO attractive for use in both the food and non-food sectors. Data from the MPOC shows that instant noodles account for around 20% of CPO use in China, food processing for 33%, cooking for 22%, soap for 16% and the oleo chemical industry for 6% (Chart 33). Reports from both the MPOC and the USDA point to the strong use of CPO in the production of instant noodles. Industry sources show a significant rise in instantnoodle production to over 8mt in 2011, up over 22% y/y. Instant noodles are popular with younger people including students, migrant workers and office workers as they are easily prepared and eaten. Instant-noodle consumption will remain robust, although consumers are moving from the low-end to the high-end market We believe that instant-noodle consumption in China will remain robust, although our in-house research takes the view that increasing disposable income and changing lifestyles are encouraging consumers to move from the mid- or low-end market to the high-end market. This trend is especially true in top-tier cities where many young professionals will switch to high-end noodles instead of dining out. The place that instant noodles occupies on the menu in China is intimately linked to the need for convenience and competitively priced food. In that regard, Chinas brisk pace of urbanisation, combined with the growing intensity of urban consumption, augurs well for the development of a large and buoyant fast-food/out-of-home food market that will support CPO demand in the longer term. Chart 32: Per capita use of CPO in India India has stepped up its use of CPO (kg)
7 6 5 4 3 2 1 0 Jan-80 Jan-84 Jan-88 Jan-92 Jan-96 Jan-00 Jan-04 Jan-08 Jan-12 Sources: USDA, Standard Chartered Research
30 April 2012
The popularity of CPO for use in Chinas food and non-food sectors is due largely to its price competitiveness relative to substitute edible oils
Chart 33: Allocation of CPO use in China, 2011 The bulk of CPO goes into food processing
35% 30% 25% 20% 15% 10% 5% 0% Food processing/ Cooking catering Instant noodles Soaps Oleochemicals

21
Profiling CPO demand in India

India is the top importer and consumer of palm oil Per capita consumption of palm oil is 6.4kg compared with 4.5kg in China (Chart 32) India is a price-sensitive edible oil market Imposes zero import duties on crude edible oil/ nominal import duties on refined oils CPO demand has been boosted by government schemes, including mid-day meals Refined soyoil is preferred by upper- and middle-income households Palm oil is mostly consumed in the out-of-home sector (mainly food outlets) Out-of-home consumption will drive CPO demand over the long term Palm oil is mainly consumed in lower-income households CPO is consumed mostly in the summer months CPO consumption drops during winter months as CPO becomes semi-solid CPO imports tend to increase in Q4 due to lower domestic output and festival demand South India is the largest consumer of CPO relative to other oils Sources: POC, Standard Chartered Research
Chart 34: CPO trade flow from Indonesia and Malaysia
EU US INDIA PAKISTAN AND SOUTH ASIA
CHINA
MENA
NEA / SEA
MALAYSIA
INDONESIA mt 1 5 10 Imported from Malaysia Indonesia
SUB-SAHARAN AFRICA
20
Sources: MPOB, GAPKI, Standard Chartered Research
30 April 2012
22
Demand for sustainable palm oil and why it matters

The trade-off between expanding plantations and the environmental pressures it creates is of concern to the industry Another perennial concern in the industry is the environmental impact of palm plantations, and the trade-off between expanding plantation area to meet growing demand and the environmental and social pressures that it creates. It is against this backdrop that the Roundtable on Sustainable Palm Oil (RSPO) was formed in 2004. According to industry reports, palm oil plantations account for around 8.2mn ha of land in Indonesia, with this area forecast to increase by around 2.4% annually over the next decade (or 200k ha p.a.). This will be fuelled by the countrys ambitious output target of 40mt by 2040. Membership in the RSPO is open across the entire supply chain, and in its inaugural qualitative review, the organisation cited a strong increase in membership and sales of certified palm oil. Among consumer goods manufacturers and retailers, membership has grown primarily in the EU, particularly multinational food processors. The reason we articulate trends in the RSPO is because consumers, a large swathe of whom are in middle- and high-income countries, are increasingly interested in products that are sustainably sourced. In that regard, demand for sustainable palm oil is growing and likely to continue to grow as consumers reach the middle-income bracket. Producers are also able to charge a premium for certified sustainable palm oil (CSPO) (Chart 35). The palm oil growers association for Indonesia (GAPKI) and Malaysian Palm Oil Council (MPOC) have both opted out of the RSPO. This decision is partly because of uncertainty regarding the operation of the scheme and partly because of comparatively slow sales of CSPO. This could affect consumer perception about the sourcing of CPO by these two markets. However, both Indonesia and Malaysia have indicated they will establish domestic certification schemes that should allay some of these concerns. Despite anticipated domestic certification schemes, 90% of CSPO annual production capacity is from Indonesia and Malaysia, and as of December 2011, data from the RSPO shows that Indonesia and Malaysia together had 72 oil palm growers adhering to the scheme (Chart 36). Sustainable palm oil is also key to accessing markets such as the US where demand for biofuels is growing. The US Environmental Protection Agency (EPA) in 2012 raised its annual renewable fuel mandates by 9.4% y/y to 15.2bn gallons. The EPA in January said CPO converted into biofuels in Indonesia and Malaysia fell short of cutting greenhouse gas emissions by the required 20% necessary to access the US market. This is particularly important for Indonesia, which subsidises biofuel output Chart 36: Top 10 RSPO member countries By number of members as of December 2011
Belgium Singapore 80% 60% 40% 20% 0% Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Switzerland USA Netherlands France Germany Indonesia Malaysia UK 0 20 40 60 80 100 120
We expect consumers to become increasingly interested in products that are sustainably sourced
Although Indonesia and Malaysia have both opted out of the RSPO, 90% of sustainable palm oil is from both countries
The US EPA has ruled that CPO converted into biofuels in Indonesia and Malaysia falls short of its benchmark
Chart 35: Certified sustainable palm oil uptake (% y/y) There has been a pick-up in market interest
100%
Sources: RSPO, Standard Chartered Research

30 April 2012
Sources: RSPO, Standard Chartered Research

23
Limited domestic market absorption of biofuels has created opportunities in Europe
and therefore has been more competitive in the biofuel trade compared with Malaysia. Limited domestic market absorption has also created export opportunities, particularly to southern Europe, where technical problems associated with the use of palm methyl ester at low temperatures are less relevant than in northern European countries. The attraction of investing in sustainable palm oil is also being promoted elsewhere in Europe. The Dutch Board for Margarine, Oils and Fats has asked the government to lobby the EU to exempt sustainable palm oil used in food from an import tax in Europe. We believe that Indonesia and Malaysia will press ahead with their own certification schemes. The impact on demand of opting out of the RSPO will be limited given growing regional consumption. However, the need to expand to other markets outside of Asia and the changing profile of CPO consumers will add urgency to national and global certification schemes in the longer term.
There will be limited short-term fallout from opting out of the RSPO; this will change in the longer term due to the need to increase market share
Biofuel demand
Biofuel demand is forecast to grow strongly over the long term; we believe first-generation feedstock such as CPO will continue to be widely used in the near term Demand for liquid biofuels has grown sharply in recent years in response to high energy prices. In absolute terms, consumption has risen from 300,000 barrels per day (kbd), or 15.3 million tonnes of oil equivalent (mmtoe), in 2000 to 1.77 million barrels per day (mmbd). The US International Energy Agency (IEA) forecasts consumption will reach 280mmtoe in 2030 and 750mmtoe in 2050. The IEA expects biofuels share of the total supply of road transport fuels globally to rise to 9.5% by 2030 from 1.5% in 2009, driven in part by supportive government policies. The growth is expected to come predominantly from Europe, Latin America and Asia. Although international policy targets the use of second-generation feedstock to cover biofuel output, we believe that conventional biofuels that use first-generation feedstock such as soyoil and CPO will continue to play a crucial role in the supply of biodiesel in the near to medium term. Current biodiesel mandates are shown on Table 3. Biodiesel currently accounts for around 18% of the biofuel market, with the top three producing regions being Latam, Europe and Asia. Using IEA data, we calculate that biodiesel output used around 17.5mt of edible oil feedstock in 2010. Given buoyant growth in biodiesel mandates, we forecast that biodiesel output will use around 20.7mt of edible oil feedstock in 2012. This equates to around 13% of total edible oil consumption and will contribute to a tighter edible oils market. In arriving at this estimate, we assume global biofuel output will increase by an average of 9% in 2011 and 2012. This is flat from 2010, but well below the 10-year average growth rate of 38%.
We calculate that biodiesel output will use around 20.7mt of edible oil feedstock in 2012, which should provide a bullish signal to markets
Table 3: Biodiesel mandates

Country Argentina Brazil Canada China EU India Indonesia Malaysia Thailand US Feedstock Soyoil Castor oil/ soyoil Animal fat, vegetable oils Used and imported veg oil, jathropha Rapeoil, sunfloweroil, soyoil Non edible oil seeds in wasteland Palm oil, jathropha Palm oil Palm oil, used veg oil Soyoil, tallow, recycled fats and oils Current blending targets 7% biodiesel blend 5% biodiesel 2% biodiesel Aspirational 10% biofuels blend by 2020 10% biodiesel share of transportation by 2020 Min. 20% ethanol blended petrol and diesel by 2017 An on-off 2.5% biodiesel mandate 5% biodiesel started in June and to be phased in over time 3% biodiesel blend The EPA proposes to mandate the blending of 15.2 billion gallons of renewable fuel into the US fuel supply in 2012 Sources: Biofuels digest, Standard Chartered Research
30 April 2012 24
While we highlight outright demand for CPO as a feedstock for biodiesel, it is also worth underlining the intrinsic price relationship that exists between energy markets and edible oils (particularly CPO). As the cheapest edible oil, CPO needs to be priced at a premium to crude oil to keep it in the food space. So, in its simplest form, CPO relative to crude oil provides a floor at a price ratio of 1:1. This will be important in forming price expectations for CPO.
Our CPO balance sheet

We forecast palm oil consumption in two steps. First, we look at consumption of palm oil relative to the consumption of all edible oils. The consumption of palm oil as a percentage of the consumption of edible oils has been trending higher in an almost linear manner over the last 30 years (see Chart 37). We assume this ratio will continue (R2 = 97%). As GDP per capita increases, it is apparent that the use of CPO increases as a share of edible oils Second, we do a regression between global edible oil consumption and global GDP per capita using historical data between 1980 and 2011. Based on Standard Chartereds Global Research long-term forecasts for global GDP, we can forecast global edible oil consumption. Using this result along with our forecast CPO to edible oil consumption ratio, we can forecast global CPO consumption for the next few years. The results are shown in Table 4. As GDP per capita increases, it is apparent that the use of palm oil increases as a share of global edible oils. Research from the UN Food and Agricultural Organisation (FAO) supports our view that demand will largely come from developing countries, particularly in Asia, on account of per capita income and population growth. Against that backdrop, China will remain the leading consumer of vegetable oil in the longer term, followed by the EU, India and the US. An important differentiation, and one that we have previously highlighted, is that in China and India, consumption is largely for food, while in the EU and US the biodiesel industry represents a significant source of demand. Chart 38: CPO and edible oil consumption historical and forecasted, mt
180 Forecast ratio 0.35 0.30 0.25 0.20 0.15 0.10 1980 1985 1990 1995 2000 2005 2010 2015 CPO to Edible oil ratio 160 140 120 100 80 60 40 20 0 1980 1985 1990 1995 2000 World CPO Consumption 2005 2010 2015 Edible Oil Consumption (EOC) EOC forecast
Research from the FAO sides with our view that CPO demand will largely come from developing countries, particularly in Asia
Chart 37: CPO to edible oil consumption ratio trending higher in an almost linear manner
0.40
CPO Forecast
Table 4: Results of consumption and supply analysis

World CPO consumption, mt 2012E 2013F 2014F 49.6 54.7 59.5 CPO supply, mt 50.6 53.3 56.3 CPO supply balance, mt 1.0 -1.4 -3.2 Edible oil consumption, mt 150.8 159.7 170.6 CPO to edible oil ratio 0.329 0.342 0.349 GDP % y/y 4.40 4.51 4.54 GDP per capita, USD 6,244 6,421 6,637

30 April 2012 25
Compared with the FAOs estimates (Table 5), our model on demand (and on supply) is more aggressive. Although the FAO forecasts an increase in CPO consumption as a share of edible oil demand as we do, we are comfortable with our projections given higher actual demand and supply numbers in 2011, which overshot the FAO forecast. Strong demand for biodiesel will be an important driver of CPO demand in the medium to long term. Demand for non-food use of vegetable oil (in particular for biodiesel) should account for about one-third of global consumption growth, according to the FAO. By 2020, biodiesel production should account for 15% of total consumption, compared to 10% in 2008-10. This will be fuelled by higher mandatory use in both developed and developing countries. Table 5: FAO global edible oil consumption forecasts
World CPO consumption, mt 49.3 51.1 52.9 Edible oil consumption, mt 149.4 153.0 156.2 Of which food 123.6 126.0 128.1 Of which biofuels 18.8 19.8 20.7 CPO to edible oil ratio 0.329 0.334 0.339 Edible oil output, mt 146.3 150.2 153.4 Source: UN FAO
2011/12 2012/13 2013/14
30 April 2012
26
CPO price outlook

Looking at fundamental supply data since 1992, it is clear that the y/y supply of palm oil has a material effect on the price of palm oil (see Chart 39). The correlation between annual price changes and y/y supply changes is calculated to be -83%. Our forecasts for supply are estimated to be 50.6mt in 2012, 53.3mt in 2013 and 56.3mt in 2014. We forecast that the resulting supply balance in CPO in 2013 will be at its lowest in 20 years. However, our earlier model showed CPO consumption increasing 5.2%, 10.2% and 8.9% in 2012, 2013 and 2014, respectively. We have found that consumption as approximated by import figures is not a significant driver of CPO prices. In fact, annual changes in prices show a negative correlation (-48%) with changes in imports, which is highly unexpected. Trying to derive CPO prices in isolation from other edible oils will not lead to credible outcomes Trying to derive CPO prices in isolation from other edible oils will not lead to credible outcomes due to their fungible nature. Their fundamentals have a material impact on one another, with soyoil and CPO prices having a 69% correlation. With soyoil being the dominant and most liquid edible oil, this suggests it would be the price leader rather than the price follower in the edible oils market. We use Granger causality to determine the dependency of soyoil and CPO on lagged (historical) values and other variables. We use a 4-lag vector autoregressive (VAR) model on differenced CPO and soyoil prices (CPOt and soyoilt) and conduct F-tests to determine the explanatory power of each variable. The results are in Table 6. The results show that CPOt and soyoilt are both dependent on lagged changes in soyoil price (soyoilt-1, etc). However, lagged changes in CPO (CPOt-1, etc) only affect CPOt and not soyoilt. This asymmetry is partly a reflection of the size of the soyoil market compared to palm oil. We can build a CPO price model that incorporates soyoil prices without worrying about a feedback mechanism to equalise with soyoil (i.e., CPO pushes soyoil prices higher, then soyoil pushes CPO prices higher, and so on). The mechanism appears to be unidirectional. We factor soyoil prices into our model without having to worry about the feedback effects of CPO prices on soyoil prices. We use an autoregressive model using y/y soyoil price changes and y/y CPO global supply changes as variables. The results are reported in Table 7. The Durbin-Watson test for first-order serial correlation is 2.09, which is close to the theoretical absence of serial correlation. Chart 39: Change in annual average CPO price and supply Percentage changes
80% 60% 40% 20% 0% -20% -40% -60% 1988 1992 1996 Supply y/y (inverted, RHS) 2000 2004 2008 2012 2016 Forecast Avg % price chg -8% -4% 0% 4% 8% 12% 16%
Chart 40: CPO medium-term forecast price Historical and forecast, MYR/t
4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 1999 2001 2003 2005 2007 2009 2011 2013 2015 Bull case Bear case Base case CPO price

30 April 2012

27
All variables are deemed to be significant at the 1% level. The goodness of fit for our model is R2=88%. Standard error of the model is 203. Our forecasts for soyoil based on our previous studies are USc 65/lb for 2012, USc 66/lb for 2013, USc 54/lb for 2014 and USc 60/lb in 2015. Our model forecast prices are capped and floored by the historical relationship with other oils. We discuss this in the next section.
Table 6: Granger causality between soyoil and CPO using a 4-lag VAR model F-Statistic Soyoil granger causes Soyoil Soyoil granger causes CPO CPO granger causes Soyoil CPO granger causes CPO 2.9413 2.5599 2.0064 5.6314 Significance 0.02170 0.03999 0.09522 0.00026
Table 7: Model coefficient statistics Variable CPOt-1 CPOt-1. Soyoil(y/y)t CPOt-1. CPO Supply(y/y)t Coefficient 1.29 0.76 -3.51 Std error 0.04 0.11 0.42 T-stat 31.00 6.87 -8.36 Significance (two-tail) 0.000000000 0.000000199 0.000000013
30 April 2012
28
Ratios to show price boundaries

As discussed before in previous sections, ratios between CPO and other oils provide natural boundaries to future CPO prices. Based on our ratios from historical data, we can estimate these boundaries for various percentiles of historical ratios (summarised in Table 8). Factoring in CPO supply and soyoil forecasts, and the cap and floors, our CPO forecast model (R2=88%) arrives at prices of MYR 3,450/t for 2012, MYR 3,620/t for 2013, MYR 3,228/t for 2014 and MYR 3,456/t for 2015 (Chart 40). We remain bullish CPO, but we now expect prices to rally in Q4-2012 rather than stay flat We have long been aggressive in our forecasts on CPO, and our model vindicates our bullish view. Our forecast is also based on our expectation of a drop in CPO yields, a decline in inventories, an increase in import demand and firmer energy prices in Q4-2012 through 2015. We also expect the soybean complex market, which is seasonally stronger in Q4, to add a bullish tone to CPO prices. We continue to see upside momentum building in 2012, but we now expect most of the upside in Q4-2012 rather than in Q3-2012 as normal price seasonality in Q4 is reinforced by the weaker impact of La Nia weather. We expect the market to average MYR 3,500/t in Q2-2012 (MYR 3,400/t previously), MYR 3,350/t (MYR 3,600/t previously) in Q3-2012 and MYR 3,700/t (MYR 3,600/t previously) in Q4-2012, for an annual average of MYR 3,450/t (MYR 3,450/t previously). Our annual average forecast remains unchanged from our previous forecast, but now adequately reflects upside risks further along the curve. Our forecasts suggest a tighter spread between soyoil and CPO over the medium term. We believe this will be a reflection of the supply premium in CPO and its growing importance in the global diet. Our forecasts suggest CPO will remain adequately priced relative to crude oil prices and near the middle of the 2008/11 price ratio. We do not believe our forecasts are mispriced relative to soyoil (Chart 41) and crude energy prices (Chart 42). Table 8: Snapshot of relative ratios palm oil (CPO), crude oil (Brent) and soyoil (SBO)
SBO/CPO CPO/Brent CPO MYR/t SBO USc/lb Brent USD/bbl 2000-2011 Average 2000-2011 range 1.26 1.01 - 1.76 1.40 0.74 2.31 1,944 31.1 59 2011 1.15 1.32 3,272 55.5 111 Now 1.07 1.31 3,500 56.0 120 2012F 1.32 1.23 3,450 65.0 121 2013F 1.17 1.39 3,620 66.0 123 2014F 1.01 1.30 3,228 54.0 127 2015F 1.01 1.37 3,456 60.0 130
Chart 41: SBO/CPO spread within range, but suggesting a near-term ceiling for CPO
1.9 1.8 1.7 1.6 1.5 1.4 1.3 1.2 1.1 1.0 0.9 Jan-00 Jan-02
Chart 42: CPO/Brent crude ratio CPO appears adequately priced relative to energy prices
2.5 2.3 2.1 1.9 1.7 1.5 1.3 1.1 0.9 0.7 0.5
CPO /Brent ratio
SBO/CPO ratio 3-year average SBO/CPO ratio
3-year average CPO/Brent ratio
Jan-04
Jan-06
Jan-08
Jan-10
Jan-12
Jan-00 Aug-01 Mar-03 Oct-04 May-06 Nov-07 Jun-09 Jan-11 Sources: Reuters, Standard Chartered Research
29

30 April 2012
Estate owners should no longer delay planting decisions

Historically, farmers are pessimistic on the outlook for prices and tend to delay replanting due to uncertainties over prices and costs. Our long-term bullish view on CPO, relatively accommodative global interest rates and the deteriorating age profile of trees in Malaysia should help to persuade owners, particularly in Malaysia, that replanting decisions are best not delayed. Estate owners should use the deterministic approach to establish the optimum replanting age for their trees We recommend estate owners employ the deterministic approach highlighted in academic literature to establish the optimum replanting age for their trees. This is to maximise net revenue over time and is done by comparing marginal net revenue (MNR) from the current batch of plantings to the estimated amortised present value of net revenue (AVNR) from the subsequent batch of plantings. The optimum replanting age is determined when the MNR in year n of the current batch of plantings is equal to the AVNR in year n of the subsequent batch of plantings (see Chart 43). On the chart, these points are x and y. However, after point y, the MNR from the current batch is lower than the AVNR from the subsequent batch, meaning profits obtained would be higher on the subsequent batch. The relevant equation is sourced from the oil palm industry journal. This approach is best used by individual estate owners with knowledge of gross revenue, interest payments, annual costs, field establishment costs and the age of their estates. MNRn = Yn [(an1 i) + bn + cn] where Yn = Gross revenue an-1 i = Interest on unpaid balances for establishment and land cost bn = annual costs cn = field establishment costs n = age in years In order to make a valid comparison of revenue, it is necessary to compare anticipated revenue at the same point in time. This arises from the fact that a sum of money received or paid at the present time is worth much more in the future. Future net revenues (NR) are discounted to their present value to make possible their Chart 43: Determining the optimal replacement age of oil palms
4,000 3,000 2,000 1,000 0 -1,000 -2,000 -3,000 -4,000 -5,000 -6,000 1 3 5 7 9 11 13 15 17 19 Year 21 23 25 27 29 31 33 35 x y AVNR MNR
Source: Oil palm industry economic journal

30 April 2012 30
comparison with the present value. The present value (PV) of future NR forthcoming at the end on n years in the future can be expressed as follows:
Where i is the market rate of interest. To obtain the amortised PV, the PV of the NR is accumulated and then multiplied with an amortising factor (AF) of:
From the above equation, we deduce that the optimal replanting age of an estate will be shorter the higher the CPO prices as costs incurred at replanting are recovered over a shorter period.
Conclusion
The market is entering a period of severe demand rationing as falling CPO yields struggle to cope with burgeoning demand A storm is brewing in the edible oils industry, generated by a shortfall in CPO (and soyoil output) in 2012. CPO productivity in South East Asia has been trending lower over recent years, and we believe this trend will worsen in the coming seasons due to poor farming practices and the ageing profile of trees. Some market participants are aware of this, and most cannot afford to ignore it. The market is entering a period of severe demand rationing. Rationing CPO will be difficult as its versatility and its growing use in food, biofuels and industrial feedstock has enhanced its consumption over the last 30 years. We believe that demand for edible oils, including palm oil, is set to grow even more in the near to medium term as per capita consumption increases. While supply continues to grow to meet that need, we believe oil palm estates in South East Asia that supply the bulk of global demand need a facelift to reverse a severe slowdown in yields. This will lead to rising costs for estates, which will add to the price aspirations of producers in the palm oil sector in the near to long term. With productivity central to the sector, we believe the CPO market is gearing up for a step change in its cost structure, which will push prices higher in 2012, but even more so in 2013.
30 April 2012
31
Appendix SEA policy developments and impact on trade

A new CPO fiscal regime went into effect in Indonesia in October 2011 The aim of the new tax structure is to promote downstream activities The sector can no longer rely only on trade data from Malaysia to gauge industry-wide fundamentals Policy changes in the CPO industry have a huge bearing on the market Palm oil is the key agricultural export in both Indonesia and Malaysia and its importance in the economic fabric of both countries make the industry susceptible to frequent reform. However, because of the environmental, social and macroeconomic implications associated with the use of palm oil, policy changes within the CPO industry have far-reaching consequences. The key policy change in 2011 was Indonesias announcement of a change to its CPO export tax grid (see Table 9). In August 2011, Indonesia announced changes to the export tax structure in its palm oil sector that would come into effect in October 2011. The key changes in the law included setting a minimum tax rate for crude palm oil at 7.5% (previously 1.5%) and capping it at 22.5% (previously 25%). The export tax for palm olein was reduced to 13% from 25%. According to policy makers, changes in the export tax structure will foster the growth of the refining (downstream) sector in the CPO industry, limit price volatility and meet its long-term objective of securing adequate supply for domestic (mainly cooking) purposes. The new tax regime replaced the previous system in which trade ministry and industry officials met monthly to decide the tax rate for the coming month, using the average spot crude palm oil prices in Rotterdam from the preceding 30 days as a reference price. Now the reference price is derived from the weighted average of three markets Rotterdam, Bursa Malaysia and ICDX from the 30 preceding days and calculated on or around the 20th of each month. Changes to Indonesias CPO tax structure is part of a raft of measures to overtake Malaysia The need to promote the downstream sector is understandable, in our view. However, the new laws are part of a raft of measures being introduced by policy makers in Indonesia as the country positions itself to become the dominant regional and global player in the palm oil trade, particularly after it overtook Malaysia to become the top producer of palm oil in the 2007/08 season.
Indonesia introduced a new fiscal regime for its palm oil industry with the aim of promoting downstream activity
Table 9: Indonesia CPO export rates The CPO export tax rate is now capped at 22.5%
USD/t <700 701-750 751-800 801-850 851-900 901-950 951-1,000 1,001-1,050 1,051-1,100 1,101-1,150 1,151-1200 1,201-1,250 >1,251 Tax rate, old regime 0% 1.5% 3% 4.5% 6% 7.5% 10% 12.5% 15% 17.5% 20% 22.5% 25% Tax rate, new regime 0% 0% 7.5% 9% 10.5% 12% 13.5% 15% 16.5% 18% 19.5% 21% 22.5%
Chart 44: Maximum tariff under different CPO price scales, USD/t, Importers pay more if the CPO price is between USD751/t and USD1200/t
350 300 250 200 150 100 50 0 <700 801-850 951-1,000 1,101-1,150 >1,251 New regime Old regime
Sources: Gapki, Standard Chartered Research

30 April 2012
Sources: Gapki, Standard Chartered Research

32
We believe the entire South East Asian CPO industry and its stakeholders will go through a difficult period of adjustment. Indonesias key export markets of India and China, both with idle refining capacity, will have to accept the new terms of trade. In the short term, we expect an inventory build-up in South East Asia as importers assess how best to react to the reform, although we believe that this window will be limited by a tight edible oil/oilseeds market. Indias crude palm imports, which come mainly from Indonesia, have slumped Still, this development has not been well received in India, where CPO imports declined sharply in Q4-2011 and have yet to recover. The decline in demand is not a coincidence. Indonesias CPO export tax changes, which effectively increased the tariff for its CPO exports within a band of USD 751/t to USD 1,150/t (see Chart 44), triggered an immediate outcry in India, which is the top importer of crude palm oil, most of which it sources from Indonesia. India traditionally imports around 6mt of CPO a year (Chart 45), which it refines for use in its domestic market. With a refining capacity of around 15mt, there is concern that a lot of refining capacity would be idle. Many in Indias edible oil sector, including the influential Solvent Extractors Association (SEA), requested protectionist measures in favour of the local refining industry. We are concerned that attempts to increase the base price of refined CPO imports could backfire and instead stoke inflationary pressures (Chart 46). Options will be limited for Indian refiners in the short term. While domestic oilseed output has increased moderately, India will still rely significantly on imports to meet its edible oil requirements. The initial decision to slow CPO imports in anticipation of lower prices, was wrong, in our view (see Agricultural Insight, 8 November 2011, Crude palm oil Finding a floor), as we expected the market to trend higher. According to industry reports, Indias demand is now likely to rise to 7.5mt in 2011/12, up 15.4%, with a significant increase in its refined palm imports. Both refiners and consumers in India will feel the pinch of higher edible oil prices The twin tasks of appeasing refiners and containing inflationary pressures will be challenging in the absence of a robust soybean harvest or cheaper alternative sources of CPO. In the current environment, both refiners and consumers will feel the pinch of firmer CPO and RBD palm prices, in our view. We see opportunity for exporters in Africa to increase output and productivity in the longer term, boosting exports to India until they can also increase refining capacity.
Indias decision to slow its imports of CPO in the aftermath of the Indonesia tax change was wrong, in our view
Chart 45: Indias monthly CPO imports Yet to recover after dropping sharply in Q4-2011
700 600 500 400 300 200 100 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Sources: SEA, Standard Chartered Research
30 April 2012
Chart 46: Trend of edible oil inflation in India Edible oil has a weight of 3.04% in the WPI
India CPO imports, kt
20 15 10 5 0 -5 -10 -15 Jan-09 Jun-09 Nov-09 Apr-10 Sep-10 Feb-11 Jul-11 Dec-11

33
Indonesia is looking to upscale its CPO industry

In February 2012, Indonesia established a new refined, bleached and deodorised (RBD) palm olein futures contract. This contract will be settled physically with delivery points in Jakarta, Semarang and Surabaya, key port cities on the island of Java where most of the refineries are based. Higher industry margins in Indonesia are already attracting refiners from Malaysia who are now looking to explore or expand refinery capacity in Indonesia. Indonesia plans to raise its refining capacity from the current estimate of 6mt to 24mt by 2014 This follows the previous launch of a CPO contract on the ICDX to rival Bursa Malaysia's palm oil futures in May 2011. However, volumes have been very light compared to those in Malaysia. A CPO physical trade platform launched by the Jakarta Futures Exchange in June 2009 and the USD-denominated CME/Singapore Exchange that was launched in June 2007 have also seen limited success. Undeterred, Indonesia plans to increase its annual refining capacity from the current estimate of 6mt to 24mt in 2014. This will rival Malaysias refining capacity, which is currently at around 18mt. This will not only challenge Malaysia's dominance in exporting refined palm oil, but will also mean industry players can no longer rely only on data from Malaysia to adequately gauge demand and supply fundamentals in the industry. There has been some concern that Indonesia is not adequately addressing structural challenges ahead of key initiatives in the CPO sector This has led to growing concern in the industry that Indonesia has not yet addressed some of the structural challenges it faces ahead of key initiatives it is implementing. One of the chief concerns expressed by industry players is the absence of trade data from Indonesia. Understandably, the effort required to survey production stocks and output on the archipelago of 17,000 islands is significant considering the size of the industry. However, stakeholders have also pointed to the need to strengthen the regulatory environment as a way to improve data collection. Efforts to overcome these impediments will be constrained by the fragmented nature of inventories in Indonesia. According to industry estimates, storage capacity at major seaports stands at around 1.12mt. This is in addition to storage at palm oil mills and refineries, as well as stocks in transit to seaports by trucks and small and medium-size boats.
Chart 47: Indonesian palm oil export flow
Export to destination country

Belawan
Dumai Teluk Bayur Export to destination country
Pontianak
Balikpapan
Tarakan
Panjang
Source: USDA
30 April 2012 34
The prospective increase in vessel traffic in Indonesia will strain current export capacity
The market has also expressed concern that the development of infrastructure facilities, especially at ports, necessary to support larger CPO shipments, lags the overall growth of Indonesias palm oil production. For example, wharves at the major Sumatran ports of Dumai, Belawan, Panjang and Teluk Bayur cannot serve more than two vessels with relatively long loading times of around four hours per vessel. The prospective increase in vessel traffic on the back of a more competitive refined market will pressure current capacity with the risk of higher inventory in transit. One of the regions most disadvantaged is Kalimantan, which does not have a deepsea port that can serve vessels. Though Kalimantan produces nearly one-quarter of Indonesias output, CPO producers there have to rely either on ports in Sumatra or in Malaysia and Singapore. This also leaves inventory vulnerable to disruptions along this extended supply chain, at least until the Maloy deep seaport in East Kalimantan is completed.
Indonesia has strengthened trade ties with Pakistan, a fast-growing CPO importer
Indonesia is also strengthening bilateral trade flows with Pakistan, a fast-growing CPO export market, in a bid to regain market share lost to Malaysia. This is after a Preferential Trade Agreement (PTA) between Malaysia and Pakistan in 2007 accorded a zero tariff to Pakistans imports of Malaysian CPO. Indonesia has now followed suit with its own PTA, which lowers Pakistans duty on Indonesian CPO from 15% to zero. Malaysias reaction to increased competition from Indonesia has been relatively measured, the most visible of which was the announcement of a 3mt tax-free CPO quota in February 2012, which is significantly below last years 3.6mt. However, we understand this limit can be raised if necessary. Some players in the industry were disappointed, as they had hoped for a bigger quota to counter Indonesias rising influence. Policy makers in Malaysia are said to be considering a number of options, one of which is to provide special funding incentives to refiners to move further downstream. Industry sources also say the Malaysian government will soon announce plans to help the palm oil industry cope with the export tax changes in Indonesia. Some in the market are sceptical about the impact of any new incentives. Otherwise, we believe that Malaysia may have to adopt an export tax regime similar to that of Indonesia. We believe these regulatory, structural and infrastructural bottlenecks will take some time to resolve. This will overlap a critical period in Indonesia as it attempts to boost its downstream sector and tight and declining global edible oil stocks. We believe the resulting impact will be more bullish than bearish for markets in the near to medium term.
Policy makers in Malaysia are said to be considering a number of incentives to benefit refiners; however, some in the market remain sceptical
Table 10: Comparative table of Indonesias old and new tax regimes Maximum taxes for refined products are much lower
Comparative items Number of palm oil based products subject to tax Tax free palm oil price threshold Tax rate range (min to max) Crude products Pure refined products Mixed refined products Biodiesel (FAME) Old export tax regulations 15 products Less than or equal to USD 700/t 1.5-25% 1.5-23/25% 1.5-21/23% 2-10% New export tax regulations 29 products Less than or equal to USD 750/t 7.5-22.5% 3-15% 2-10% 2-7.5%
Source: Ministry of Finance of Republic of Indonesia (summarised)

30 April 2012 35
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Crude Palm Oil - A Price Storm Is Brewing 28 04 12 11 31

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Global Research | 30 April 2012

Crude palm oil A price storm is brewing

Koun-Ken Lee, +65 6596 8256

Crude palm oil A price storm is brewing

Sources: MPOB, Standard Chartered Research

Crude palm oil A price storm is brewing

Hedging and trade recommendations

Chart 3: BMD CPO futures, MYR/t We recommend shorting September futures

Fwd Qtr avg

Source: Standard Chartered Research

Crude palm oil A price storm is brewing

Fresh fruit bunches (FFB)

Milling Crude palm oil/ Palm kernel oil

RBD palm oil

Food (75%): Cooking oils and frying fats

RBD Olein (80%)

Double fractionation/ palm mid fractionation

Hydrogenation/ Oleo chemical interesterification processing

Sources: MVO, Standard Chartered Research

Crude palm oil A price storm is brewing

Three building blocks productivity, fungibility and demand

An unprecedented increase in CPO yields in South East Asia

Chart 6: High yields boosted inventories in Malaysia Month-end closing stocks, mt

Sources: MPOB, Standard Chartered Research

Sources: MPOB, Standard Chartered Research

Crude palm oil A price storm is brewing

Sources: Reuters, Standard Chartered Research

Sources: SEA, Reuters, Standard Chartered Research

Crude palm oil A price storm is brewing

Crude palm oil A price storm is brewing

Productivity A protracted decline in CPO yields is in sight

Other major edible oils

Crude palm oil A price storm is brewing

Crude palm oil A price storm is brewing

Palm oil seasonality

Chart 14: BMD CPO forward curve, MYR/t 9 April 2012

Avg yield (inverted, RHS)

Sources: Bloomberg, Standard Chartered Research

Crude palm oil A price storm is brewing

Weather and CPO, a marriage gone sour

Sources: FAO, Standard Chartered Research

Crude palm oil A price storm is brewing

2.5 t-stat 5% 2.0 1.5 Corr 1.0 0.5 0.0 -0.5

Crude palm oil A price storm is brewing

Crude palm oil A price storm is brewing

Our CPO supply forecasts

Table 2: CPO supply forecasts, mt (BASE CASE)

47.9 50.6 53.3 56.3 59.4

4.51 5.50 5.49 5.53 5.5

23.6 25.4 27.3 29.3 31.5

18.2 18.7 19.2 19.7 20.3

6.1 6.5 6.9 7.3 7.7

CPO supply forecasts, mt (HIGH CASE)

CPO supply forecasts, mt (LOW CASE)

Sources: USDA, Standard Chartered Research

Crude palm oil A price storm is brewing

Higher industry costs An indication of yield erosion

Malaysias headache is Indonesias, too

Sources: Oil palm industry journal, Standard Chartered Research

Crude palm oil A price storm is brewing

Growing pains in Indonesia and Malaysia

Sources: MPOB, Standard Chartered Research

Sources: USDA, IPOC, Standard Chartered Research