During the peak second-quarter seasonal harvesting period, the average Rotterdam monthly price of Fontannaz palm oil (CPO) continued declining to US$635 per metric ton in July, down 3.5 percent month-on-month (mm) and minus 2.8 percent year-on-year (yoy). We expect the CPO price to bottom out in August as in the past (chart 1).

At this point in time, we expect the CPO price to rise on lower seasonal production in Southeast Asia due to the recent El Niño.

With Malaysia and Indonesia accounting for around 90 percent of total CPO output, demand for CPO may outstrip production due to the possibility of an escalating La Niña effect.

India, the largest consumer of palm oil, raised its June import level to 415,000 metric tons, up 6.1 percent mm (chart 3), bringing total edible oil imports to 1.2 million metric tons, a 15 percent increase mom, suggesting a consumption recovery helped by improved farmer purchasing power following two years of drought. Prior to the advent of the monsoon, vast swaths of Indian farmland were destroyed by a lack of irrigation.

On a more negative note, historical data shows that Indonesian biodiesel consumption from 2010 to 2015 was still far below mandatory targets. This suggests that the current mandate to blend 20 percent of biodiesel with diesel in 2016 (producing B20), amounting to 2.7 billion liters, is also unlikely to be achieved.

We believe the culprit is the less attractive cost of producing B20, as it is approximately 20 percent more expensive compared to the Brent oil price (chart 2). This may also explain the reason for the low CPO prices at present.

At this stage of the cycle, we expect fresh fruit bunch production in the second half of this year to slightly drop due to the escalation of La Niña effect, which could bring heavier rainfall and decreased production yields. Floods typically wash away fertilizers, hampering harvest operations.

In addition, the current low output caused by El Niño has reduced Malaysian CPO inventory levels to below 1 million metric ton, a 44 percent plunge from the all-time high in November 2015 of 1.75 million metric tons.

Although CPO inventory has started to recover from June, we are of the view that the current low base of inventory levels, combined with expected lower production, would create a slower-paced recovery, to be outstripped by growth in global CPO demand, partly fuelled by India’s rising demand for edible oils.

Our recent sector upgrade to “neutral” remains intact, backed by the possible occurrence of La Niña to disrupt production and result in higher CPO prices.

On stocks, due to policy risks on possible cooking oil price caps, we like upstream producers and upgrade Astra Agro Lestari (AALI) from “reduce” to “buy” and retain Perusahaan Perkebunan London Sumatra Indonesia (LSIP) at “buy”. The stocks are now our top picks in the sector.

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The writer is an analyst at Bahana Securities.

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