Plantation Sector Report From HWangDBS

Strategy and stock picks
With upgraded outlook in CPO prices, we believe recent correction in palm oil prices and likewise consolidation in plantation share prices have provided enough upside potential to warrant raising positions now. Our key message is to remain selective, as we expect volatility in an otherwise
upward trend in price and consumption next year.

Why now is a good buying opportunity
There are several reasons why raising positions now are
warranted:

1. Lower expected edible oil inventories (both palm and soybean oils) next year are a precursor to higher prices
2. Rising crude oil prices in a global economic recovery would lift most commodity prices. Rubber has the highest correlation
3. Low borrowing costs have prompted planters to raise funds recently. This might spur new planting and milling capacity expansion next year, and hence, accelerate value creation
4. Stronger regional currencies would reduce borrowing costs and FX losses for companies with USD borrowings
5. Lower freight costs as a direct result of oversupply in shipping capacity should enhance exporters’ profitability

CPO prices upgraded
We expect palm oil prices to rebound in 4Q09, when production is seasonally lower. We expect palm oil prices to continue to rise next year despite a jump in South American soybean harvest. Soybean oil stocks are expected to decline yo-y by September CY10F , as crushing of soybeans are expected remain flat on still declining US livestock population. Taking cue from lower soybean oil inventory This year’s drought had cut soybean inventory and raised prices – despite a slowdown in demand. Even with anticipated jumps in US and South American soybean harvests in the current season, weak meat consumption is expected to cap any increase in US soybean crushing, which would cause a further reduction in soybean oil stock. Both Oil World and
USDA’s recent forecasts point to a y-o-y decline in global soybean and palm oil stocks by September CY10F. Upside to CPO prices seen We expect palm oil prices to rebound in 4QCY09 to between RM2,400 and RM2,500/MT. Low carryover stock, earlier supply-side setbacks, and resilient edible oil demand, had prompted us to cut our ending inventory assumptions for both palm and soybean oil. This may not affect this year’s assumed average of RM2,300/MT (YTD price is RM2,253), but our longer term price expectations are raised by 8.5%- 11.5% as a result.
The following factors are preconditions that support our view:

1. Strong Chinese appetite. The drought earlier this year has increased dependency on US soybean crop, which will be harvested between September and November (some delay expected). According to USDA, as at 10 September, export commitments for US new crop had jumped by 92% y-o-y to 630m bu., mostly to China.
2. Soybean oil inventory is not rising. Both USDA and Oil World now expect global soybean oil inventory to decline y-o-y by end of September CY10F. Much of the anticipated jump in South American and US soybean harvests this season will used to replenish depleted stocks, instead of being crushed for soybean meal.Demand for soybean meal has dropped this year and is expected to remain weak next year, as US livestock population is still declining due to negative feeding margin since May 2007, easing beef demand, and a drop in US pork exports since the H1N1 virus outbreak in April.
3. Palm oil inventory will fall next year. Lower-than expected palm oil production in 3QCY09 (cut in fertilizer application in 2H08 could be partly to blame) means possible lower carryover stock by the end of this year. We expect next year’s production to grow by 1.9m MT or 4.3% y-o-y, assuming Indonesian production target of 22.2m MT is unaffected by El Nino. In this scenario, we expect global palm oil inventory to decline by 0.6m MT to 6.7m MT by end of next year. Both Oil World and USDA also expect global palm oil inventory to decline yo-y by 0.5m MT and 0.1m MT by September 2010F, respectively.
4. Economic recovery. CY10F and CY11F crude oil prices imputed in our CPO price projections have now been raised to US$57 and US$75/bbl, respectively, on the back of anticipated economic recovery and weakening USD. We also raised our long-term crude oil price assumption to US$90/bbl from US$80/bbl previously.
5. Biodiesel back in the picture. After dropping by 43% this year, biodiesel consumption is expected to rise by 13% next year (USDA Oil Crops Outlook). Under the Renewable Fuel Standard (RFS2) published in May 2009, the EPA would set the mandatory blend by 30 November each year based on gasoline and diesel volume projections from the Energy Information Administration's (EIA) Short-Term Energy Outlook. As gasoline demand recovers, so too will demand for biodiesel.

We note that the recent drop in soybean prices in USD terms is even more pronounced in Brazilian real due to the weak USD. It also implies that Brazilian farmers may not have incentive to plant more soybean crop, unless they get sufficient return. Hence, the prospect of a jump in Brazilian soybean planting could have downside risks if soybean prices continue to decline.