By Ong Xien Fong
Graph of monthly CPO prices. Source: S&P Capital IQ
With rising Crude Palm Oil (CPO) prices, palm oil counters are receiving renewed interest again. Despite still being far from historic highs, some palm oil counters have dramatically increased in price recently. However, evaluating palm oil counters is not easy due to the many jargon used in reports. When I first reviewed investor presentation slides a while back, I remembered having to repeatedly Google the various jargon to try and understand the entire palm oil production process. This two part article series aims to help those interested in understanding the palm oil business so as to invest in palm oil counters. In this first part, jargon and processes would be covered to provide a foundation towards understanding the industry.
Source of CPO Prices
There are various sources of CPO prices available on the internet. This is because different exchanges may quote different prices. For this article, the author used CPO settlement prices from the Kuala Lumpur Stock Exchange (KLSE). Future CPO (FCPO) prices from the KLSE are also traded on the Chicago Mercantile Exchange (CME) Globlex. FCPO from KLSE was used due to the ready availability of prices and the close proximity to palm oil production in the region.
FCPO is a Malaysian Ringgit denominated CPO future traded on KLSE since 1980. Contracts are physically settled with a contract size of 25 metric ton of CPO. As both the Ringgit and Rupiah have depreciated against the USD over the years, it is best to caution against using CPO prices quoted in USD to filter out forex movements.
In this article, CPO prices were taken from S&P Capital IQ, a paid platform. CPO prices can also be monitored for free from the Malaysian Palm Oil Council (MPOC) page or from Business Insider.
A simplified flowchart of the processes in the palm oil industry.
The above is a simplified flowchart on the entire process of palm oil and its products. Some parts of this process will be further explained later.
Comparison of Profit Margin Across Segments
Palm oil companies often report revenue from two segments:
1. Plantation/ Mills
2. Refinery/ Palm Laurics and Others
In order to decrease dependency on palm oil prices, there has been an increasing trend towards increasing revenue from downstream operations (Refinery). This trend gives the impression that downstream operations may be more profitable even though that may not be the case.
According to a business analyst from Toptal, upstream business (Plantation/ Mills) is actually the most lucrative (accounting for 50-60% profit of the value chain) followed by downstream oleochemical processing (15-25% profit of the value chain). The author has found this to be consistent with two large palm oil companies listed on SGX as well.
Graph of EBITDA margin across segments. Source: Bloomberg
As seen in the graph above, both Golden Agri-Resources and First Resources have much higher margins for the upstream business (plantations and palm oil mills) than their downstream business. For Golden Agri-Resources, ‘Palm, Laurics, Oilseeds & Others’ in their reports refer to “processing and merchandising of palm and oilseed-based products” and “production and distribution of other consumer products” (their downstream business).
Given that the upstream plantation business is the most lucrative, we would now delve into deeper insights into the jargon and processes.
Understanding Significant Jargon and Processes
Screenshot of investor presentation slides from First Resources.
The above image is part of an investor presentation slide. Such jargon are not uncommon and are important in making an investment decision in palm oil companies. The following part of the article will explain all the above jargon. If the below is too technical, fret not! These jargon are summarised in the second last paragraph.
1. Milling
After planting and harvesting, milling is the next process that is undertaken for the creation of palm oil (see flowchart). Milling is often done in close proximity to the plantation as Fresh Fruit Bunches (FFB) must be processed within 24 hours to prevent degradation of the oil. Steam is used to sterilise the fruits, soften the flesh and deactivate enzymes which would degrade the oil. The loose fruits are then crushed to produce oil (later further processed to become CPO), nuts and Palm Kernel Meal (PKM). The nuts are then used to produce Palm Kernel Oil (CKO). PKM is protein and fibre rich and is often used as animal feed, fertiliser or fuel for the milling process.
2. Crude Palm Oil vs Palm Kernel Oil
Crude Palm Oil (CPO) is oil derived from the flesh of the fruit while Crude Kernel Oil (CKO) is derived from the oil of the nut. Unrefined CPO is liquid at room temperature and is red. The end product (refined) CPO is the cooking oil we commonly use. On the other hand, PKO is solid at room temperature due to its high content of saturated fats.
CPO is the predominant product; for every 10 parts of CPO produced, 1 part of CKO is produced. Hence, CPO prices are often used as a leading indicator on how palm oil companies will perform.
3. Nucleus vs Plasma
Plasma holders are small independent farmers who agree to sell their fruits to a larger company. In exchange, these farmers enjoy benefits such as advice on plantation techniques, micro-financing (important for replanting efforts) and higher yielding strains of palm trees. In contrast, Nucleus plantations are maintained and held by the company itself.
Apart from the symbiotic relationship between plasma holders and palm companies it is noteworthy that companies have a plasma obligation under Indonesian law. Under Permentan No. 26/2007, plantations license (Izin Usaha Perkebunan (IUP)) for over 250 hectares issued after 2007 must provide 20% of land to local communities to be plasma holders. Companies with IUPs before 2007, though not obligated, must show evidence of improving local community lives.
4. Age of Plantations
Palm oil companies often provide a breakdown of the age of their plantations. But how much does production change for each phase of the life of a palm tree?
Commercial harvesting starts out at 3 years and production starts to rapidly increase thereafter. The optimal is then achieved from 8-18 years followed by a gradual decline in production. The commercial timespan of palm trees is about 25 years. Plantation with older trees face a double whammy; lower production yields and higher cost of harvesting.
The million dollar question currently is the optimal age for replanting. Unfortunately, there is no easy answer to that as there are numerous factors. At the basic beyond the optimal yield, the primary consideration is the expected future prices of palm oil and how long the high prices will last. High prices that are expected to last long will result in shorter optimal replanting as profit from future palm trees will be more than if no replanting was done. If high prices are not expected to last long, replanting should be postponed to maximise profit. Furthermore, replanting is not cheap due to the cost of planting, financing issues and lost in income.
If the 4 jargon are still too hard to comprehend, in essence, milling is the first step of processing. CPO, the predominant product, is the cooking oil we use while CKO is oil solid at room temperature. Nucleus is plantation owned by the company while plasma is owned by smallholders who agree to sell to a certain company in exchange for financial or other forms of assistance. The optimal age of fruit production for palm trees is between 8-18 years.
To conclude, this article covered the significant processes of palm oil production. Common jargon in investment materials such as CPO and CKO were also covered. In the next part of this article, you will learn other important considerations for selecting palm oil counters. Look out for the next part to find out more!
Disclosure: Links from the website are not related to NTU-IIC nor the author. The author merely seeks to advise the readers on where to derive data and is not paid by the above links and would not be responsible for any loss, damages or pricing inaccuracies from the above links. Views shared on this article are for educational purposes only. Views do not indicate or insinuate any investment decisions readers should undertake and should never replace investment advice given by an investment professional. The author’s views do not represent the views of Nanyang Technological University.
References:
Alam, A S A Ferdous & Er, Ah Choy & Begum, Halima. (2015). Malaysian oil palm industry: Prospect and problem. Journal of Food, Agriculture and Environment. 1313. 143-148.
An Investor’s Guide to Palm Oil: https://www.toptal.com/finance/market-research-analysts/palm-oil-investing
Crude Palm Oil Mill Process: https://andythoncianus.wixsite.com/andythoncianus/single-post/2018/03/11/Crude-Palm-Oil-Mill-Process
FCPO Product Brochure: https://www.bursamalaysia.com/sites/5bb54be15f36ca0af339077a/assets/5d5e64575b711a6fbc2aa31f/FCPO_Product_Brochure_200219.pdf
Indonesia: “Plasma Obligation” For Oil Palm Plantation Business Established Prior To The Issuance Of Regulation Of The Indonesian Minister Of Agriculture No.26/2007: http://www.mondaq.com/x/467128/Inward+Foreign+Investment/Plasma+Obligation+For+Oil+Palm+Plantation+Business+Established+Prior+To+The+Issuance+Of+Regulation+Of+The+Indonesian+Minister+Of+Agriculture+No262007
Plasma Scheme: https://www.bumitama-agri.com/page/layout/24/23/plasma-scheme
Riverina: https://www.riverina.com.au/products/palm-kernel-meal/
The Optimal Age of Oil Palm Replanting: http://palmoilis.mpob.gov.my/publications/OPIEJ/opiejv2n1-2.pdf