Monday, September 24, 2012

CPO prices may remain depresssed for a long while


One of the basic principles of economic model is that the market functions well in determining price by matching supply and demand for any good or service so that the supply of and the demand for the good or service will be in equilibrium. This is illustrated by a simple chart (Chart 1), where the demand curve is red while the supply curve is green. The logic behind the demand curve is simply this: as the price increases, the demand drops. At the same time that the price increases, the supply increases. However, there is a limit to the increase or decline in demand or supply. No matter how high is the price of rice, we still need to consume rice as it is a staple diet. No matter how high is the shipping rate, we still have to charter a ship to transport our export. Conversely, no matter how high is the price of rice, the farmer cannot increase that supply significantly until next year when he would plant more paddy. The same goes for the shipping companies as the number of ships available is limited at that moment in time. They could order more ships to fill the demand but there will be a time lag.


Chart 1: Supply & demand curve in equilibrium

In 2007, the demand curve for CPO shifted to the right [see Chart 2] due to increased demand for CPO for use in biodiesel fuel and also from increased demand by consumers in China & India (a result of improved living standard). As supply curve remained stationary, CPO prices shot up and broke above the USD600 (or equivalent to RM2000) per tonne [see Chart 3].


Chart 2: Demand curve shifted to the right 


Chart 3: CPO Prices, in USD per tonne (Source: Mongabay)

The period of super-normal profit induced many plantation companies to open up new land for cultivation of palm oil. Due to time lag, where oil palm trees can only start to produce FFB after 3-4 years (while the more productive age is above 7 years old), the increase in oil palm estate land did not make a dent in the price of CPO for the past few years.

However, as the tree begins to reach the age of 7th year, the FFB output should increase significantly in the next few years. This increase will result in the supply curve shifting to the right. This shifting of the supply curve will result in a new price equilibrium with prices dropping back.



Chart 3: Supply curve shifted to the right

Some may argue that the demand by consumers in China & India are still strong. And, so is the demand for use in biodiesel. However, this additional demand has been factored into the demand curve and the increase (if any) will be marginal and this would not represent a shift in the demand curve. As such, I do not foresee CPO going back to the heyday of RM4000 per tonne. In fact, I believe there is greater likelihood of CPO dropping further to possibly RM2000 per tonne.

In fact, if you read analysts' reports, one of the argument made to buy a plantation stock is that more oil palm estate will be reaching maturity or reaching the more productive phase over the next few years. When this event happens- and there are many companies that are poised to enjoy increased output- wouldn't the increased supply of CPO result in lower prices. My experience in rubber glove sector in late 2010 (here) and the shipping sector in late 2007 (here) taught me something- when everybody increased their capacity to benefit from super-normal profit, that sector will eventually suffer a sharp drop in prices and abysmal profit. I believe that we will see this in plantation sector. The best way to profit from this peak price scenario is to sell off the productive assets. Maybulk sold off most its ship in 2007-2008. CBIP sold off its plantation assets or investment in early part of the year.

12 comments:

K C said...

I believe there are too many factors affecting palm oil future, just like future contracts of other commodities. For example adverse weather condition affecting other crops will shift the palm oil demand curve further right, and it may also affect the supply of palm oil and shift the supply curve left. These will cause the rise of price. Government and trade policies changes also affect the equilibrium price of the crop. In conclusion, there are just too many random factors interacting and research have shown that predicting the future price of palm oil or any other crop have been futile.

Mat Cendana said...

There was a time not too long ago when it was in the mid-RM1,000 or so. Then it went up and up past 2,000. Had felt that was `too high' already and was thinking about opening a futures account just to short sell CPO. Wasn't into technical analysis at that time and fortunately I didn't trade in it. Would have made big losses ignorantly betting against an upward trend.

The previous extraordinary times of high CPO prices are over. Or at least the previous cycle. There might be small upswings now and then and going above RM2,000 but I don't think it will get to 3,000. Plantations and settlers have had a great ride for the past few years but I feel it's time to adapt to the new cycle and realities. The same goes for industrial metals too - tin, iron, etc. Precious metals and crude oil are another matter though.

steve said...

Thanks Alex. This is interesting.

ewastemonster said...

I am a planter, if ffb drop below RM400, we still can make profit, but it drop further below RM300 and calculate with the wages today. It is very difficult to make profit. Maybe the bad day is coming soon.

jeremy tan said...

Hi Alex,

What is the outlook for rubber prices?

It seems to be on an uptrend since QE3 was announced.

It has been raining a lot too.

ikan bilis said...

If I'm going long, CPO price weaknesses (i.e. dismay quarterly profits) will be a nice chance to accumulate. Price over-shoot goes both way, up and down... just like oil, gas, coal and rice! New equilibrium price will always be higher than the previous status quo. With rising world population and middle income group in developing countries, consumer commodities prices can only go up; EU/US crisis or not.
Having said all that, it would probably be a bad time to buy right now... KLCI looks ready to dive.

Big Sea said...

Alex,

I like your graph and explanation very much.
Demand and Supply should always be the primary factors of pricing. Other factors should not last long.

~*Je@nne*~ said...

Always believed that Supply&Demand curve is the base catalyst to all futures products traded anywhere.

Nice share! Thx! :)

Alex Lu said...

Hi K C

You are right. Many random factors come into play. However, one has to determine what are the critical factors and what are transient factors. In the first category, I will put down things like the use of CPO as an input for the making biodiesel or the sudden surge in CPO usage in huge population countries like India & China (due to a jump in living standard). In the second category, I will put down things like El Nino, US drought affecting corn output, etc.

There is one important factor that I reserved for last and that's the effect of commodity cycle. This cycle is tied to global inflation. Because inflation is so miscalculated, we may think that it is not there. It IS here and it is with us and it explains why we have to pay so much for houses, healthcare, tertiary education, food, etc. That's the product of money printing & currency debasement. If ECB & Fed continue with their QE measures, the party for commodities & other risk assets may continue. That may help to prod up CPO prices much longer than the play between the forces of supply & demand.

Alex Lu said...

Hi Mat Cendana,

It is all a cycle. My BM teacher used to tell us back in late 1970s that his parent in kampong bought a refrigerator in 1950s due to the boom in rubber prices. His kampong did not have electricity supply then and the refrigerator was used as a cupboard. We had a good laugh then but we should know that it is all a cycle. What goes up must come back down! What goes down must come back up!

Despite the political angle, I thought the listing of FGV was very timely. The government raised some money which can be used to find other long-term investments.

Alex Lu said...

Hi ewastemonster

ffb drop below RM400? I wouldn't go that far.

Alex Lu said...

Hi jeremy tan

The price of rubber rose from USD0.50 per pound in 2003 to USD2.80 per pound in 2011. Today, it is at USD1.30 per pound. See ink below.

I think it should stabilize at the present level (between USD1.30-1.50 per pound) for a while. It may rebound a bit from here but I doubt it will go above USD2.00 per pound again.


http://www.mongabay.com/commodities/price-charts/price-of-rubber.html