Profits gush from palm oil
19 October 2009 The Investors Chronicle
Written by:
Mark Robinson
Next time you load up your weekly shopping basket, the chances are that around 13 per cent of the items you put in there will have been produced using processed palm oil. Each one of us unwittingly consumes in the region of 11kg of the stuff each year. Often its presence is difficult to detect as the products it is found in are either unlabelled, or classify it as 'vegetable oil' in their listed ingredients.
Products that use palm oil range from cosmetics to chocolate bars to margarine and even baby formula. From Fairy Liquid to Pot Noodle, palm oil is integral to many of the UK's most prominent household brand names and United Biscuits, Nestlè, Mars, Cadbury and Premier Foods are all major customers. Unilever alone accounts for 6-8 per cent of total world production, which makes it the commodity's largest end-user.
According to the US Department of Agriculture (USDA), annual global production stands at 45.1m metric tonnes and the market is growing thanks to the low cost of palm oil compared with alternative sources of vegetable oil. Output of crude palm oil (CPO) has increased 400 per cent since 1990 and about 89 per cent of it comes from Malaysia and Indonesia. This rapid expansion means the palm oil industry now accounts for approximately one-third of total non-petroleum oil production and makes up 59 per cent of the total export market.
The growth in the market has prompted rousing share price performances from the five UK-listed growers. REA Holdings, MP Evans, Anglo-Eastern Plantations and Narborough Plantations have recorded an average 111 per cent increase in their share prices over the past five years, while the most recent entrant to the sub-sector, New Britain Palm Oil, has managed an 87 per cent rise since this time last year. Collectively, this little corner of the food producer sector is worth in the region of £1bn. The average dividend yield of 2.1 per cent is somewhat short of the sector average, while an earnings multiple of 16 times is in line with food producers as a whole.
Eastern promise
Demand for CPO has a broad geographical base, but much of the recent growth is linked to the rise in living standards within Asian economies, most notably India and China. Discretionary income is on the rise and dietary patterns are changing. "As incomes grow people eat more vegetable oil, use more soap and fry rather than boil their food," says industry veteran Richard Robinow who chairs both REA Holdings and MP Evans. "Per capita consumption of vegetable oil in India and China is less than half of that in Europe," he adds.
Given the relatively low levels of consumption of palm oil in Asian markets, there is still considerable growth potential. The same is true of eastern Europe, which is another key geographic target for the industry. Some industry analysts are predicting that total CPO production could rise to 70m metric tonnes by 2020.
Mr Robinow also points out that customers in developing countries tend to opt for palm oil not only because it is relatively inexpensive but also for its chemical composition. Unlike some vegetable extracts, it retains its freshness at room temperature for months, which is a considerable advantage in areas without refrigeration.
Priced in
Palm oil's growing popularity is largely a result of low production costs. The average medium-sized plantation produces a tonne of CPO for about $350 (£213), whereas an equivalent quantity of oil derived from soyabeans would cost in excess of $710 after factoring in fertiliser, seed and ancillary costs. Another competitive advantage relates to yield. Multiples vary, but oil palms routinely deliver in excess of eight times the yield per hectare compared with other vegetable oils.
However, the price of CPO cannot be seen in isolation from other vegetable oil crops, such as soyabeans, maize, sunflower and rapeseed. Unlike these alternative oil sources, oil palms are perennial plants so output cannot be changed on a year-by-year basis. And a bad harvest from other vegetable oil crops tends to be a key factor in pushing the price of CPO higher, while a good harvest will push it lower.
The relationship between CPO prices and that of other soft commodities means that, even though CPO does not tend to be traded heavily itself, its price still feels the effect of speculation. Trading in soyabeans on the Chicago Mercantile Exchange, for example, can go some way towards explaining last year's price spike. And in common with many other soft commodities, there has been considerable volatility in the price of CPO in recent years.
The CPO price reached an unprecedented high of $1,375 per tonne in March last year, only to collapse in the aftermath of the credit crunch to $420. The price did recover fairly rapidly, and has since been trading in the range $500-$800. The current price of $645 is still 18 per cent above the adjusted five-year average. Despite this volatility, palm oil has retained its competitive edge. The price discount to oil derived from soyabeans edged up from 18.4 per cent in August to 20.3 per cent in September, which is marginally higher than the five-year average of 19.9 per cent.
The price weakness in the first half of this year was linked to a number of general economic factors, including an unprecedented rate of industrial destocking and a sharp reduction in Indian demand. Recently, prices for vegetable oils came under renewed pressure following reports that European Union (EU) rapeseed output is expected to reach a record 19.5m metric tonnes this season. However, this may yet be offset by expected weak US soyabean and peanut production.
Hostile environment
In recent years environmental groups, such as Greenpeace and Friends of the Earth, have turned up the heat on south-east Asia's palm oil industry, citing deforestation and climate change as principal reasons for their opposition to industry expansion.
Already these campaigns have borne fruit. For example, the EU has introduced restrictions relating to the use of palm oil in meeting the renewable energy obligations of member states. A bigger threat is that intra-national bodies such as the EU could conceivably push for reforms within the industry through the use of trade restrictions, or even by threatening to withhold regional aid to countries that convert forest land to oil palm estates. But the industry also has strong supporters. Organisations such as the World Bank have pointed to the dramatic effects that palm oil is having in dragging isolated rural communities out of poverty.
Environmental campaigners will be hoping for increased industry regulation when definitive agreements are announced under the United Nations Framework Convention on Climate Change later this year in Copenhagen. However, industry insiders are confident that the voluntary measures undertaken by the palm oil industry, which are necessary to obtain certification under the auspices of the Roundtable on Sustainable Palm Oil (RSPO), should hold sway. The RSPO was established in 2001 in order to set clear ethical and ecological standards for the production of palm oil, although its impartiality is often brought into question by eco-campaigners.
Favourites:
Shares in both MP Evans and REA Holdings took a battering due to the short-term volatility in commodity markets, but this should not deter investors from looking at both companies as part of a long-term strategy. Gross profits look anaemic when set against the unprecedented highs of 2008, but that spike only served to distort valuations. A better guide to prospects can be found by looking at the companies' long-term development strategies, which are predicated on a $400 price for CPO - well below the five-year average.
Outsiders
Shares in New Britain Palm Oil, Papua New Guinea's largest oil palm plantation and milling operator, have been traded on the London Stock Exchange since December 2007. The company received a tremendous boost recently when it signed a five-year deal to supply palm oil to Italy's Ferrero SpA, whose brands include Kinder and Nutella. The breakthrough was partially due to the fact that New Britain was one of the first companies to be independently certified by the Roundtable on Sustainable Palm Oil in the production of sustainable and ethical palm oil.
IC View:
Regardless of the noise being made by environmental lobby groups, it looks as though a regulated palm oil industry is here to stay. The price spike in 2008, although speculative in nature, was a reminder that the supply of vegetable oils - like many other 'softs' - will struggle to keep pace with demand as consumers in developing economies grow more affluent. The chief UK players in the industry have been beneficiaries of strong regional political support and are well-placed to exploit an upsurge in demand over the coming decade.
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