Buy into the changing landscape of palm oil

Although future production streams will increasingly be sourced westwards, Malaysia and Indonesia still account for over 80 per cent of global palm oil output in aggregate. So it's unsurprising that the threat of lower regional supplies sent futures prices to their highest point in 18 months recently - 2,912 ringgit ($889/£534) a tonne on the Bursa Malaysia Derivatives Exchange. Prices have eased since then, partially as a result of worries over Chinese demand (a familiar theme), but also because global stocks of substitutable oils (soya, corn, sunflower, etc) are in fairly healthy shape. It is, however, premature to assume that Chinese demand will fall away simply because the country's purchasing managers' index data hit a seven-month low in February. After all, China's January imports of palm oil were up by 18 per cent year on year, or 12 per cent above the monthly average through 2013.

Palm oil prices should also garner near-term support because Indonesian domestic demand has been rising strongly at the same time as Malaysian inventories are in decline - the latter economy is the largest exporter and marginal price lever. Indonesia's decision to raise the minimum content of biodiesel in fuel to at least 10 per cent could underpin prices later this year, too. The danger for producers is that if the warnings on El Niño were to pan out during the second half, there is no guarantee that any resultant price increases would fully mitigate the loss of yield.

Curiously, it was a prolonged period of heavy rains that held back production for New Britain Palm Oil (NBPO) in 2013. The company's gross profitability was down by just under a quarter, with the rain-ravaged harvest shortfall exacerbated by a 17 per cent reduction in average selling prices. Last year, New Britain was also forced to bear additional costs in defence of an unsuccessful hostile approach by one of its chief shareholders - Kulim (M) Bhd.

New Britain has prioritised bringing new plants towards fruition, while improving its infrastructure on the ground. As a result, it is probably now better-placed to ride out any adverse weather conditions. The Papua New Guinea-focused planter has made significant strides towards cutting its US dollar-based production expenses, while continued weakness of the local currency, the Kina, will also keep a lid on domestic plantation costs.

There's value on offer at New Britain. When you look at its performance relative to the sector, it is effectively trading 17 per cent below its implied share price based on an historic sector discount of cash profits to enterprise value.

And New Britain could come in for further unwanted attention from suitors, particularly as its production base is less controversial from an environmental perspective than many rivals. There's obviously a trend towards consolidation within the industry, but New Britain is not the only play in town. The share price of Asian Plantations (PALM) is up by 17 per cent on our long-dated buy call (203p, 11 Jan 2011), fuelled in part by continued takeover speculation - with Malaysian agricultural giant FELDA Global Ventures in the frame. Any buyer would have to pick up a tab for $129m (£78m) in accumulated borrowings, but the likes of FELDA could still push for a deal simply because securing fresh land in Indonesia and, especially, Malaysia for oil palm production has become increasingly difficult - Asian Plantations lays claim to four estates totalling over 51,000 acres.

IC VIEW: At this stage, it's impossible to say what effects - if any - El Niño will have on late-stage production this year. There is now more incentive to use substitute oils as palm oil's discount to other oils such as soya has narrowed towards its historic average. But it is conceivable that a hotter, drier spell of weather in central Asia could hamper production of alternative oils, thereby indirectly bumping up palm oil prices. There are obviously conflicting factors at play, but over the course of this year we think that the potential price drivers are likely to outweigh any negative influences - time will tell.

Go west to invest

Ethical palm oil has become a top priority for many of the world's biggest food producers, keen to avoid association with illegal deforestation and endangered orangutans. This, along with a lack of land availability in traditional growth zones such as Malaysia and Indonesia, is heaping pressure on those in the business of growing, processing and refining the stuff to look further afield to meet demand. The search has taken them to West Africa, one of the few places in the world where the crop flourishes and the industry is well established, but still has room to grow - the region is a net importer of 600,000 tonnes of palm oil a year. It is here, in Cote d'Ivoire, that fledgling palm oil company DekelOil (DKL) has set up shop and is hoping to produce its first batch of sustainably-sourced crude palm oil (CPO) this year.

DekelOil has just finished constructing one of West Africa's largest and most efficient palm processing mills, which came on stream last month. In 2014, the company expects to process at least 150,000 tonnes of fresh fruit bunches (FFB), producing 35,000 tonnes of crude palm oil - nearly half of the mill's total capacity. Apart from boasting sustainable oil, Dekel's unique selling point is that it is buying fruit directly from the thousands of smallholders in the country. Already, Dekel has signed contracts with more than 5,000 growers representing 27,000 hectares of existing plantations. It has 1,900 hectares of company-owned land, and is looking to add to that, so that a quarter of the harvest comes from own-plantations and the remainder from smallholders, ensuring the mill always has capacity for local farmers. This is an important point. A chronic shortage of milling capacity means many smallholders don't bother boosting yields or harvesting all their fruit. Dekel's offer to buy their crops now offers a huge incentive for them to do so. A new logistics system using a network of collection points makes transporting it much easier for them, too. A recent deal with a local refiner to deliver 24,000 tonnes of CPO a year is a positive development and the company is in discussions with other potential partners. Selling locally benefits both parties as it cuts insurance, transportation and marketing costs.

A company-owned nursery has a high-tech computerised irrigated system with capacity for 1m plants a year, which means the cost to maturity is lower than the industry standard. Cocoa fibre, a by-product of the West African cocoa industry, helps to bring on the saplings. Management is forecasting cash profit of $8m to $10m this year - helped by a 13-year corporation tax exemption. Because 70 per cent of the cost base is buying the fruit, and the cost of fruit is pegged to the market price of palm oil, the company can make pretty accurate earnings projections. For Dekel to break even, the market price for crude palm oil need only be $500 a tonne - well below current spot prices.

Bear in mind, however, that this investment is extremely high risk, certainly not for widows and orphans. Almost half the shares are owned by an Indian private equity backer, and the free-float is just 32 per cent. There's a wide spread of 1.5p to 2p, too. That said, the company is keen to diversify its shareholder base. An African investment fund recently bought a chunk of shares and Dekel is set to enlist a new, higher-profile broker in April - usually a good sign. There's also a chance it could be taken over one day, probably by a major palm oil company hunting for growth and sustainable production.